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Quasi-Money: The Hunch-Buck of the ECB

If ever a company’s president and most senior executive publicly expresses a hunch about something that company might well do, it’s notable. Even more so when the c-suite officer is Madame Lagarde of the European Central Bank (ECB), who coyly alluded to the adoption of a central bank digital currency (CBDC). Regarding a crypto coin for the euro zone, she said, “My hunch is that it will come.… If it’s cheaper, faster, more secure for the users then we should explore it. If it’s going to contribute to a better monetary sovereignty, a better autonomy for the euro area, I think we should explore it.” But is a CBDC faster, cheaper, more secure? Would it contribute to monetary sovereignty and euro-area autonomy? What are those things, anyway?

Most readers will have at least heard of cryptocurrencies—some will have read about Facebook’s Libra project (set to launch next year); some may even hodl some bitcoins. Recently, PayPal announced it would facilitate cryptocurrency transactions on its platform, helping send the prices (in dollar terms) soaring. But for those new to crypto, a clearer understanding of these developments requires first distinguishing between the cryptocurrency coins themselves, which tend to garner a lot of the headlines, and the underlying technologies.

Bitcoin, for example, is built on a technology called the blockchain, which the Harvard Business Review described as “an open, distributed ledger that can record transactions between two parties efficiently and in a verifiable and permanent way.” Simply put, blockchain technology can record transactions digitally, in real time, and can store the information publicly, transparently in the cloud, to be monitored and verified in perpetuity. A cryptocurrency is merely one application of this digital record-keeping technology.

Such a powerful tool has broad appeal—and not just for cyberpunk anarchists seeking to upend the very nature of money as we know it. Central bankers, too, recognize how they might deploy this same technology to make their national currencies—and their payments and settlements systems—faster and more secure.

As Mme. Lagard noted, the European Central Bank (ECB) has summarized its views in a policy report and is conducting a series of tests to evaluate the prospects of a euro zone cryptocurrency. Nor is the ECB isn’t alone: China started testing a digital yuan by handing out 10 million digital coins via a country-wide lottery; winners will spend the currency as the central bank evaluates the results. Sweden was the first to begin testing a CBDC earlier this year. And the Federal Reserve is building its knowledge-base on the subject and has even been internally testing distributed ledger technologies to support a digital dollar.

As structurally critical financial market institutions and the largest global reserve currency central banks move ahead with their designs, obvious questions follow: What value does a CBDC bring that consumers don’t already realize through online banking and payments systems? Use of ATMs, checks and cash has fallen for years as credit cards, debit cards and electronic payments have risen. Not to mention central banks already use digital ledgers (even if they’re not built on blockchains). So does any of this matter?

In some sense, the answer is no. Those who gave up on cash long ago wouldn’t see much difference in their day-to-day business. They’d likely continue tapping and swiping their way to consumer bliss. Transactions would clear much faster—almost instantaneously—so no more waiting on banks and credit card companies to communicate with each other. But such small ripples on the surface belie the tectonic shifts beneath. Currently, digital payments are not direct to the vendor, but go through a third party—like a bank or a dedicated payments and settlements company. A CBDC would disintermediate the third party from the process, using blockchain technology to match buyers’ funds directly with the product or service’s sellers. This might be bad news for consumer banks.

It’s not simply that a bank’s role in facilitating transactions might change. A CBDC could put banks out of the deposit-taking business entirely.  A government’s digital currency would offer a higher-quality (i.e., safer) alternative to a bank deposit. Of course, some (not all) deposits are insured by the FDIC, but that seldom prevents people from seeking shelter for their cash in times of stress. Should CBDCs effectively compete with banks for deposits, it would upend the core business model. Deposits, which are depositors’ assets and the bank’s liabilities, are considered a stable source of funding; the bank is financing its loan book and its trading book with deposits, and deposit accounts generally remain pretty steady. Aside from deposits, the bank taps wholesale money markets, which tend to be a volatile source of funding and quick to dry up when markets or the economy is under duress. The ultimate effect could be to create more systemic risks. Still, there are proposals for managing the risks CBDCs pose. But as the Economist recently noted, “The problem of disrupting the banks may be avoidable with clever engineering. But it would be wise to consider whether it even needs avoiding in the first place. For those willing to entertain futuristic ideas, CBDCs may offer an opportunity to rethink the financial system from the ground up.”

Such a rethinking might be past due. In addition to the risks of financial crises, the banking system is arguably leaving too many unbanked and underbanked. In the US, about 6.5% of the population is unbanked (That’s about 8 million people, or two Los Angeleses). With the right design, the Fed estimates that proportion could fall to 2.0%. The same goes in other countries—particularly emerging markets—where access to a mobile network for digital transactions is often much more accessible than a bank branch. Of course, cutting-edge innovations like digital currency might leave people behind, too, as early adopters will tend to be those who are most plugged in. But with ubiquitous mobile phones and next-generation wireless networks, paper money may go the way of the $2 bill.