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 The Money Manager Scenario

CBDC as Universal Reserves

In the extreme, a DL [distributed ledger] for everyone could open the possibility of creating a central bank digital currency. On some levels this is appealing. For example it would mean people have direct access to the ultimate risk-free asset. In its extreme form, it could fundamentally and perhaps abruptly reshape banking. However, were it to co-exist with the current banking model, it could exacerbate liquidity risk by lowering the frictions involved in running to central bank money. These questions and others are why these topics are being examined as part of the Bank’s research agenda, with the prospect of a central bank digital currency for the UK, in my view, still some way off. We will work to make payments easier, and though cash may no longer be the king it once was, its reign will endure for some time. This quote is from a speech by the Governor of the Bank of England, Mark Carney. While Carney raises some of the same issues that we have seen in the speech by Skingsley, the quote is also suited to illustrate a slightly different type of concerns regarding the implementation of CBDC. Carney refers to CBDC as 'the ultimate risk-free asset'. This conception gives
primacy to the function of money as a store of value. Having noted how 'direct access' to this kind of money is 'appealing' to the ordinary money user in the form of the 'people', he shifts the perspective to point out how the co-existence of CBDC and bank money would pose a risk to the current banking model. If money users are given the option to choose between holding electronic money in the central bank and in a commercial bank they may, in other words, choose the former since CBDC is a superior store of value. While other parts of Carney's speech also include other perspectives on CBDC, this particular passage represents the concerns of the money manager. For the money users, access to risk-free CBDC increase their scope of choice, convenience and security, but for money managers such as commercial banks, CBDC constitutes competition and a threat to their business model. It is from this latter perspective that universally accessible CBDC appears to be 'extreme' since it might 'abruptly reshape banking.'

In the scenario proposed by Skingsley, CBDC is complementary to both cash and bank deposit money. Carney is much less explicit about this but his juxtaposition between CBDC as being 'still some way off' and the prediction that the 'reign' of cash 'will endure for some time' seems to suggest that the two are conceived as alternatives. This is also how we may interpret the following quote from a speech by Deputy Governor for Monetary Policy at the Bank of England, Ben Broadbent:


As far as its economic effects are concerned, my guess is that much would depend on how exactly a central bank digital currency (CBDC) is designed – and in particular the extent to which it competes with the main form of money in the economy, commercial bank deposits. As individuals, we already have the ability to hold claims on the central bank, in the form of physical cash. If all a CBDC did was to substitute for cash – if it bore no interest and came without any of the extra services we get with bank accounts – people would probably still want to keep most of their money in commercial banks.


In addition to the positioning of CBDC as a 'substitute for cash', it is also worth remarking the prediction that money users would still keep their money in the bank if CBDC came without interest and 'extra services'. Given the current situation, where commercial bank deposit rates are close to if not outright zero and a substantial part of bank profits are derived from fees accrued from customers, it seems rather optimistic to base monetary policy on such a prediction. An alternative scenario is that when conventional banks lose their monopoly on the issuance of electronic money, the banking sector would be unbundled and banks would find themselves in even competition with peer-to-peer lending companies, unconventional payment service providers and other non-bank businesses in the provision of 'extra services' to money users.

As we have discussed previously, the money manager perspective is associated with the credit theory of money that explains how money is created when bank's issue new loans. In Broadbent's speech, we find a concern about CBDC that is derived from some version of this theory of money:


[T]aking deposits away from banks could impair their ability to make the loans in the first place. Banks would be more reliant on wholesale markets, a source of funding that didn’t prove particularly stable during the crisis, and could reduce their lending to the real economy as a result.



This is the really main point I want to get across. Some suggest that central banks will have to issue their own digital currency – i.e. to supply central bank money more widely, via some generalised distributed ledger – to meet a “competitive threat” from private-sector rivals. I suspect a more important issue for central banks considering such a move will be what it might mean for the funding of banks and the supply of credit.


The concern here is that the implementation of CBDC would impair the commercial bank's ability to create new money and lend it into 'the real economy'. While this concern is clearly valid, it is worth considering whether the problem is one of the supply of money, as suggested by Broadbent, or perhaps rather one of demand for money. Before delving further into this question, we shall conceptualize the concerns of the money manager in terms of the monetary policy trilemma.

Making Good Money Worse

From the money manager perspective, the prospect of CBDC being 'still some way off' thus provides some degree of comfort. It allows the banks to maintain their current business model and it allows the central bank to stick with option C in the policy trilemma. But if CBDC were to be implemented, the concerns of the money manager could be partially met by using it as an opportunity to phase out cash. This would effectively move the zero lower bound, which is currently preventing interest rates from moving far into negative territory. Such line of reasoning is illustrated by the following quote from Chief Economist at the Bank of England, Andrew Haldane:

One interesting solution, then, would be to maintain the principle of a government-backed currency, but have it issued in an electronic rather than paper form. This would preserve the social convention of a state-issued unit of account and medium of exchange, albeit with currency now held in digital rather than physical wallets. But it would allow negative interest rates to be levied on currency easily and speedily, so relaxing the ZLB [Zero Lower Bound] constraint.


In the previous section, we have already seen how the co-existence of CBDC and bank money forces the central bank to dedicate all of its monetary policy to the maintenance of parity by keeping an interest margin between CBDC and bank money corresponding to the difference in their perceived credit risk (optionA). The implementation of CBDC as a substitute for cash expands the scope of monetary policy since money users no longer have an interest free option to hold money. Cash is the weakest link in the central bank line of defense of parity. With cash removed, the central bank is now able to combat bank runs by increasing negative interest rates on CBDC. This removes the risk of 'bad' commercial bank deposit money driving out 'good' central bank reserve money since the central bank can always make CBDC 'worse' than bank money.


From the money manager perspective, this design model also opens up additional prospects. There are the immediate benefits of saving some operational costs from not having to handle cash, which has to be taken in and paid out to customers. Along similar lines, banks would also have to worry less about bank robberies if there was no cash to rob. But a much more significant prospect has to do with increasing revenue rather than just saving costs. In the current environment of low interest rates, it is difficult for commercial banks to make a profit on the interest spread between deposits and loans. If the central bank is willing to increase negative interest rates on CBDC, it opens up the space for banks to push this development and thus to make money not only by charging interests on loans but also charging negative interest rates on deposits. They can, in other words, innovate their business model by not only making money from borrowers but also from depositors.


Charging negative interest rates on either bank money or CBDC is essentially a form of money destruction. If the central bank imposes a 5 percent negative interest rate on CBDC it is decreasing the supply of CBDC by 5 percent per year. A scenario, where the central bank is forced to charge negative interest rates on CBDC in order to defend parity with bank money, it is thus essentially destroying CBDC held by money users to maintain the commercial banks' ability to create new bank money.

Money Supply or Money Demand

When Barrdear and Kumhof of the Bank of England define CBDC as 'a central bank ... granting universal ... access to its balance sheet' (see previous quote) they are only referring to the liability side of the central bank balance sheet. CBDC allows money users to hold the liabilities of the central bank, which puts them on par with banks. Today, however, banks are not only privileged by hav-ing access to the liability side of central bank balance sheets. They also enjoy a privileged access to the asset side of central bank balance sheet in so far as they have the exclusive right to initiate the buying or selling of financial securities in exchange for central bank reserve money. This typically happens through socalled repurchase agreements or repos. The most usual form of security to be traded between central banks and commercial banks is government bonds. When commercial banks are net-sellers of financial securities to the central bank, the supply of central bank reserve money is increased. This is what happens in ordinary open market operations and in more extreme measures in Quantitative Easing. An implementation of CBDC with universal access to the liability side of central bank balance sheets immediately raises the question if all money users should also have the opportunity to initiate an increase in the supply of CBDC by demanding to sell securities to the central bank. The question is, in other words, if universal access to the central bank balance sheet should be extended to the asset side.


There are three general options of how to design a CBDC model with regards to this question:

1) Only banks are granted the opportunity to exchange CBDC for financial securities with the central bank. This is the way it already works with central bank reserve money today.

2) All money users are granted the opportunity to buy and sell CBDC for financial securities at the central bank.

3) The central bank refrains from expanding or contracting the money supply through open market selling or purchasing of financial securities and no one is granted the opportunity to trade directly with the central bank.


The choice between these three different designs is no insignificant matter. It has profound implications for the management of the supply of money. The fundamental question in this regard is whether the size of the total amount of money in the economy shall be determined by demand or supply.


We normally refer to the amount of money in the economy as the 'money supply'. In the context of our current money system, this concept is misleading as money today is created in response to the demand for credit. Since banks can create new money by expanding their balance sheets, only under very special circumstances are they constrained by supply. When potential borrowers are rejected it is rarely due to a lack of money but rather because they are not regarded as credit worthy by the bank. It would thus be more appropriate to speak of the 'money demand' rather than the 'money supply'.


If CBDC is designed according to the perspective of the money manager, banks would maintain their exclusive privilege to trade securities for central bank money directly with the central bank. The central bank creates CBDC in response to demands from commercial banks requesting to buy CBDC. Commercial banks in turn respond to demands from money users wanting to hold CBDC instead of bank account money or cash. Commercial banks thus retain their role as the first creators of new money through their lending activity, which is determined by the demand for credit in the economy. Once the aggregate supply of money has been expanded by the commercial banks, its composition of CBDC and bank account money may be altered by the preferences of the money users. When commercial banks purchase CBDC from the central bank to meet demands from customers, it does not change the aggregate supply of money. When a bank pays out an amount of CBDC to a customer it simultaneously cancels out an equivalent amount of bank account money. If, however, the commercial bank purchases CBDC from the central bank and holds this money itself instead of paying it out to customers, it would amount to an increase in the supply of money. In essence, CBDC would be introduced into the economy in similar fashion as cash is supplied today.


At first sight it might seem as if such a model would put restrictions on the commercial banks' capacity to provide credit and lending into the economy. This was also the concern raised by Broadbent in the above. Since banks are obliged to meet money users' demand for conversion of bank money into CBDC, they have to make sure that
their stock of CBDC or at least their stock of liquid securities that are easily convertible into CBDC, is large enough to meet such a potential demand. If banks do not have enough CBDC they could be forced to reject potential borrowers.


This concern, however, rests on confusion between supply and demand. If central banks are committed to the maintenance of parity they are eo ipso also committed to the provision of enough CBDC to meet money users' demand for conversion of bank money into CBDC. If banks do not have enough CBDC on their balance sheet to meet demands for conversion, they simply just turn to the central bank and exchange some of their assets for CBDC. The creation of bank money and credit is not restricted by supply and thus 'taking deposits away from banks' does not, as suggested by Broadbent, 'impair their ability to make ... loans in the first place.'


This does not mean that the design model with CBDC and bank money is
without problems. But the risk is not, that banks are unable to make enough bank money, but rather that they are incited to make too many. If banks retain the opportunity to increase the total money supply through their issuance of new credit while the composition of the money supply in terms of bank account money, and CBDC is subsequently determined by the preferences of money users, the central bank may find itself faced with some difficult questions. In the aftermath of the financial crisis and under existing Quantitative Easing programs, central banks have increased the volume of open market operations and expanded their asset portfolio to comprise other kinds of securities than government bonds. This includes corporate bonds, mortgage bonds and even in some cases equity. Such increased engagement in financial markets has already posed a series of fundamental questions about the role and mandate of central banks: Which types of risks should a central bank take on? To what extent should it mobilize its balance sheet to interfere with the pricing of securities in the market? Should central banks shield private banks from losses and default by absorbing risky assets? In a model, where CBDC is implemented as complementary to bank account money, these questions are going to become even more pressing and pertinent.


If the central bank remains committed to supply whatever amount of CBDC
is demanded first by money users and then by commercial banks, the central bank may ultimately find itself unable to decide, how many securities it wants to buy and hold. This is conceivable in a kind of digital bank run scenario, where money users decide that CBDC are more attractive than bank account money and they turn to their bank for conversion. In order to meet such demand, the bank turns to the central bank to exchange securities for CBDC. The central bank would have to accept this proposition and take on the role of 'buyer of last resort' in order to maintain financial stability. But what happens when the commercial bank's stock of high-grade assets has been exhausted and money users' demand for CBDC is still not satisfied? The central bank may find itself taking over significant amounts of bad debts taken on by the banks. And how should the assets exchanged for CBDC be priced in the first place?


The central bank is an atypical agent in the financial market: It is ultimately
obliged to buy. It can create its own money. And it is not trading to make a profit. This means that its trading engagement will have profound effects on the pricing mechanisms of the market. This is already happening under current QE schemes, which have the effect of inflating asset prices as central banks are seemingly insatiable net buyers in the market. Furthermore, we have also seen central banks buying so-called 'troubled assets' from commercial banks as part of various bail-out schemes thus absorbing losses originally incurred by private corporations. An implementation of CBDC alongside bank account money will just exacerbate these effects.


A further scenario is that commercial banks take advantage of the central
bank's commitment to meet demands for CBDC by exchanging them for securities. We might see a repeat of the US mortgage crisis, where banks made a profit by extending excessive amounts of risky loans. These risks were then subsequently offloaded from the banks' balance sheet by being securitized and sold. Rather than selling such securities to unknowing investors, which happened in the build up to the crisis, the banks may now simply sell them to the central bank in exchange for CBDC.


Several central banks are currently engaged in QE schemes. These schemes are supply driven in the sense that the central banks decide the amount of new reserve money that they want to supply to the banking system by purchasing financial assets. In a money system with CBDC circulating alongside bank account money, central banks may find themselves in demand driven QE schemes, where the amount of new CBDC to be supplied is determined by demands from commercial banks and money users. The problem is not that banks have exclusive access to the asset side of the central bank balance sheet by being able to buy CBDC directly from the central bank. Expanding this access to all money users would merely exacerbate the problem. In the following, we shall be looking into a design model, where neither banks nor money users have access to this kind of direct exchange with the central bank. In this model, the money supply is thus truly driven by supply.