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 The Money User Scenario

CBDC as Electronic Cash

Should the Riksbank issue electronic means of payment in the same way as we now issue cash? This is a natural question for a central bank, as technological advances create new opportunities, as the printing press once upon a time made it possible to print banknotes. Banknotes were a complement to the minted coins, and are so today too. Similarly, an electronic means of payment, say an e-krona, could be a complement to physical cash. This is the question I intend to discuss today. The question is particularly relevant for us in Sweden, as cash is being used to a declining extent and is sometimes difficult to get hold of.

This is how Cecilia Skingsley of the Swedish Riksbank presents the question of CBDC. The quote provides an illustration of the conception of CBDC as an electronic form of cash. The stated reason for the Riksbank's interest in CBDC is a rapidly declining use of cash as a means of payment in the Swedish economy. This means that 'cash is no longer as easily accessible as before' and 'the general public finds it more difficult to get hold of money issued by the Riksbank'. We see here, how Skingsley represents the perspective and concerns of the 'general public' as money users.


The key concern is that if the development of the payment system is entirely determined by 'market participants', some groups of money users, including 'many consumers ... small companies and local clubs,' may lose 'access to basic payment services, including cash. In situations where the market is not able to supply basic payment services, it is the task of the state to ensure that everyone has access to such services'. It is, in other words, the responsibility of the central bank to secure the financial inclusion of all money users.



Another set of concerns regarding the declining availability of cash include issues of anonymity, security and resilience:

One cannot get away from the fact that cash has properties that electronic payment services lack. Will this mean that we lose a means of payment that cannot be directly replaced with something else? Cash can be handed over regardless of access to electricity or the internet. Cash payments are anony-mous. A payment can be made in cash without involving the banks. Even if cash is not used on a daily basis, it comprises a backup option in certain crisis situations. 


Again, we see how these concerns emerge from the money user perspective.
This perspective also plays out in Skingsley's account of the invention of money in terms of the classical story of barter:


The barter system is, in my view, the most important innovation of all time. The reason I think this is that trade is a necessary condition for welfare. There is hardly anyone who grows all their own food. Nor do we mine iron ore and grow rubber trees to be able to build our own car. Trade allows us to specialize in making goods and services that other people want and which therefore have a value. The carpenter does woodwork, the dentist fixes teeth, the author writes books and so on. In the beginning, we traded with one another simply by swapping goods and services. However, the barter system is not practical, as it means you have to find someone who has what you want and who also wants what you have. /.../ Money plays an important role in reducing transaction costs and this is why money is the second most important innovation in the history of the world. 


The design model proposed by the Riksbank as represented by Skingsley is one in which CBDC is complementary to both cash and bank money. While the option of replacing bank money does not even seem to be on the table, she explicitly states that: 'If the Riksbank chooses to issue e-krona, it would not be to replace cash, but so that the e-krona can act as a complement to cash'. In so far as the Riksbank's primary concern seems to be to represent the interests of the general public as money users, this design model makes perfect sense as it provides the money users with the widest scope of choice in terms of money and payment options.

The point of this review of the speech from the Riksbank is not to suggest that it represents the money user perspective exclusively. In its entirety, the speech includes a range of other viewpoints and reflections that should be associated with the two other perspectives. The same goes for the other speeches and text that we shall be quoting in our exposition of the other scenarios.

Sacrificing Sovereignty to Save Parity

By allowing money users the opportunity to hold money in the form of bank deposit money, cash or CBDC, as well as the option to freely convert between these kinds of money, the money user scenario opens up the dynamics of the monetary policy trilemma.


From the history of economics, we know the phrase 'bad money drives out good' also referred to as Gresham's law. Gresham's law was originally formulated in the context of precious metals money and it refers to a situation, where different forms of money circulate at the same nominal value, while there is a discrepancy between their respective commodity values. This may occur in a system based on a simultaneous circulation of gold and silver coins denominated at a certain fixed price ratio. If the market price of gold begins to increase relative to silver, the spread between market price and nominal value will also become smaller for gold coins than for silver coins. In such a situation, the 'bad' silver money will be preferred as medium of exchange and debt settlement thus 'driving out' of circulation the 'good' gold money, which is hoarded and used as a store of value.


The essence of central banks' responsibility for financial stability is the maintenance of parity between the different forms of money in circulation. Parity management amounts to keeping the mechanisms of Gresham's law in check. Skingsley touches upon this issue as she notes how 'the special thing about central bank money is that it has no nominal credit risk, as it stands for a claim on the central bank, which cannot go bankrupt.' In contrast, 'the commercial bank money does entail a risk - even if the risk is slight. If the bank fails, you may not be able to redeem your entire claim on the bank from its bankruptcy estate'. The introduction of CBDC poses a challenge to parity. If money users have access to risk free central bank money, why would they hold risky commercial bank money? The risk to financial stability is, in other words, that 'good' CBDC drives out 'bad' commercial bank deposit money. Such a break of parity is what we refer to as a 'run on the bank'.


Assuming that the central bank wants to maintain the policy objective of parity, it has to give up monetary sovereignty by putting its monetary policy solely in the service of defending parity. This is option (A) in the policy trilemma. We shall explore the implications of this option.


There are four main channels through which the central bank in collaboration with the treasury maintains parity. All of these channels are already in play today, but they may be pushed to further extremes in a system with CBDC. The first is by allowing citizens to carry out their financial transactions with the government in commercial bank money. If the treasury accepts bank money in payments of taxes at its nominal value, this provides a form of 'tax standard' on this kind of money. If money users start to worry about the credit risk of commercial bank money, the treasury provides a guarantee that the money users can always redeem this 'bad money' at the nominal value. In a system with CBDC, the treasury would thus still give the citizens the option of paying taxes in commercial bank money and the government may even choose to pay out salaries to public employees in bank money to support parity.


The second channel is the lender (or buyer) of last resort facility. The purpose of this facility today is to prevent liquidity crises by providing commercial banks with the opportunity to borrow or buy central bank reserves or cash in exchange for government bonds or other low risk securities. This gives the banks liquidity and flexibility in their asset management, which allows them to respond to shifting demands from money users for different kinds of money. In a system with CBDC, the banks would retain this opportunity. If money users were to suddenly demand conversion of their bank deposit money into CBDC in excess of the bank's stock of CBDC, the banks would be able to turn around to the central bank and convert their assets into CBDC, which would then subsequently be used to redeem the deposit liabilities of the banks. In extreme cases, the use of this channel in the defense of parity may face the central bank with some difficult questions as to the kind of assets it would be willing to accept in exchange or as collateral for the provision of CBDC to the banks. This issue shall be further explored in the next section.


The third channel is the depositor insurance, which guarantees commercial
bank money up to a certain amount (in Europe € 100.000) in the case of bank defaults. While such insurance is today initially underwritten by the collective of commercial banks, history seems to have established the expectation that in the case of a major systemic crisis, the central bank will ultimately step in to guarantee the guarantee. In a system with CBDC, the central bank will provide a similar guarantee by de facto promising to take over the deposit liabilities of insolvent banks and redeem them in CBDC. Such a promise would function to allevi-ate credit risk concerns among money users holding bank money and thereby serve to maintain parity.

The Question of Interest

The fourth channel, which would in practice function as the first line of defense against the challenge to parity, is the monetary policy tool of interests on CBDC. While the first three channels aim to defend parity against the logic of Gresham's Law by making commercial bank money as 'good' as CBDC, this fourth channel provides a similar defense by making CBDC as 'bad' as commercial bank money. Skingsley lays out the problem like this:

If the Riksbank launches an e-krona with a positive interest rate, it can in some situations be very attractive for both the general public and companies to convert their account balances in the banks to e-krona with the Riksbank. 

The difference between electronic CBDC and physical cash is not merely one
of convenience and functionality. While cash is by definition interest free, CBDC can be interest bearing. This provides the central bank with a tool to defend parity. In order to compensate money users for taking the credit risk of holding bank money instead of risk free CBDC, the central bank must set the interest rate on CBDC below the interest rate on bank money. This is not unlike the way that the central bank today adjusts the interest rate on central bank reserves. But still the central bank finds itself having to choose between the defense of parity and the use of monetary policy for other purposes.


If the central bank is committed to maintaining an interest rate on CBDC, which is lower than the interest rate on deposits, and perhaps even committed to widening the spread, if the general trust in the solvency of the banks is deteriorating, then the commercial banks' decisions on their deposit rates effectively set the upper bound of the CBDC interest rate and thus also a limit the scope of central bank monetary policy. What would happen, if the central bank wanted to raise interest rates in order to combat inflation, while the commercial banks insisted on lowering deposit rates to increase their profit margins? Would the central bank be willing to jeopardize parity to defeat the commercial banks in such a monetary policy chicken game? And what if a central bank committed to currency exchange rate management see the central bank of its benchmark currency raise interest rates, while its domestic banks insists on lowering their deposit rates. In such a situation, the central bank would find itself squeezed between the two policy trilemmas as it would have to choose between maintaining a currency peg or maintaining parity.


An even more pertinent problem in the current economic climate of historically low interest rates and a perceived risk of deflation is constituted by the lower bound on interest rates. The fact that money users may choose not only between bank money and CBDC but also cash institutes a de facto zero lower bound on interest rates. Even if it is technically possible to allow interest rates on CBDC to move below zero, such a move would soon compel money users to convert into interest free cash.


In a situation with declining bank money deposit rates, the central bank could find itself stuck and unable to adjust CBDC interest rates either up or down. Some central banks seem to already find themselves in this situation, where the commitment to parity has stifled their opportunity for sovereign monetary policy. The implementation of CBDC together with both cash and bank money would not relieve but probably rather intensify this deadlock. Just like one of the solutions to the conventional policy trilemma is to leave the monetary policy initiative to competing money makers in the form of a foreign central bank, the commitment to parity in the domestic monetary policy trilemma leaves the monetary policy initiative to competing money makers in the form of commercial banks. This is a theme that we shall be further expanding on in the following section.


The conclusion to the current section is that even if the Swedish Riksbank or
another central bank decides to afford money users a maximum availability of payment and money options by designing a system where CBDC co-exists with both cash and bank money, it may find itself having to pay the price of not being able to use monetary policy for anything else than defending the parity between the three kinds of money.