European Central Bank assessing ‘cash-like’ digital money

Yves Mersch, a member of the Executive Board of the European Central Bank (ECB), recently gave a speech discussing the details of a Central Bank-controlled digital currency referred to as Digital Base Money (DBM). Mersch says the ECB is currently considering the adoption of DBM, in one of two forms, centrally-controlled accounts somewhat like debit cards or Paypal, and an anonymous, cash-like DBM, which would be more like a cryptocurrency.

Making a clear distinction between “account-based” and “value-based," Mersch described the former as a transfer from one bank to another, debiting funds from the payer’s account and crediting the payee’s account. Meanwhile, value-based DBM is a possible replacement for cash, people would need electronic wallets to hold and use it.

The difference between the two types of DBM matters, Mersch explained, for two main reasons. The deployment would be significantly different. and “may require very different types of technology with specific safety features and costs.” Also, user anonymity can only occur with the value-based DBM, which “may influence the demand for DBM.”

“We now have technologies that could make it easier to issue DBM. This includes, in particular, Distributed Ledger Technology.”
— – Yves Mersch, European Central Bank Executive Board Member

Mersch outlined a few ways DBM could be provided, starting with a “straightforward approach” of allowing users to convert commercial bank deposits and cash into DBM at a 1 to 1 ratio. He claims that this approach would not result in a bank run, unless there is a systemic banking crisis and the entire financial system collapses. In such a dire case people would most likely, in his opinion, convert all their commercial bank deposits into default-free DBM.

The process could instigate a gradual substitution of commercial bank deposits. Mersch suggested that this case would see some commercial banks benefiting, while others suffer. Banks with excess DBM reserves could sell them, increasing their profitability as deposits bear a higher interest rate than excess reserves. However, profits at banks without excess reserves could fall as they replace those reserves with Central Bank credit, which usually has higher interest rates than the rates on customer deposits.

To prevent both bank runs and gradual deposit outflows the ECB could take a restrictive approach, and keep a tight control of the amount of DBM inflation. However, Mersch warned that if the demand for DBM exceeds the amount of DBM that the central bank wants to provide, DBM could be worth more than cash and commercial bank deposits. "DBM would truly be a currency on its own," Mersch said, which is not in line with fundamental ECB principles.

Having two currencies at two different prices goes against a Central Bank’s charter, and Mersch does not recommend this option. The ECB board member concluded that the most attractive option is to simply allow people to convert bank deposits directly into DBM at a rate of 1 to 1, providing they mainly substitute cash rather than bank deposits for DBM.

“As long as DBM mainly replaces cash, negative side effects of DBM might be unlikely. In this context, consideration could be given to making DBM as cash-like as possible, at least initially, until more experience is gained.”
— – Mersch

Mersch also addressed speculation around Central Banks and the abolition of cash. Although he is only speaking for the European Central Bank, DBM would merely be an additional option for non-banks to hold funds. He stressed that if the digital currency is ever introduced it would exist alongside cash, “for the foreseeable future.”

China’s Central Bank has also been investigating the use of a digital currency, and this research led them to several of the same conclusion. “Digital currency will co-exist with cash for quite a long time before it finally replaces cash,” said Zhou Xiaochuan, the People’s Bank of China (PBoC) Governor at a January 2016 summit on digital currencies. “The cost for cash transaction will gradually increase in the later stage […] With the transaction costs of paper money rising, people will be motivated to opt more for digital money.”

Xiaochuan explained that the PBoC is also looking at two types of digital currency, one account-based, and the other not. The latter would use a Blockchain and would be decentralized. "These two technologies can co-exist by being applied to different layers," the governor stated, while saying that digital currency should be designed to protect people’s privacy, making blockchain technology “a good choice.”

“Digital currency can be converted freely but its convertibility will also be controlled. We think, therefore, as a legal tender, digital currency must be issued by the central bank. The issuance, circulation and transaction of digital currency will follow the same management principles of traditional currency.” – Zhou Xiaochuan, People’s Bank of China Governor

The Bank of England has also investigated the technology, and published a staff working paper on the macroeconomics of Central Bank-issued digital currencies. The paper defines them as “an electronic form of money, or medium of exchange that features a distributed ledger and a decentralised payment system.”

The BoE explored Bitcoin for several paragraphs and came to the conclusion that the Proof of Work system is highly inefficient. The authors estimated that Bitcoin will consume the same amount of electricity as Denmark by 2020. “On that basis alone,” the paper concluded, “we believe that in order for a digital currency system to be socially beneficial over the long run, an alternative method of addressing the cheap talk problem in transaction verifications needs to be developed and adopted.”

The paper also addresses a BoE digital currency, which would necessitate a blockchain for the practical matter of ensuring the resiliency in a system that, “would clearly be of critical importance to the financial stability of the economy.”

“From the perspective of households and firms, CBDC [central bank digital currency] would be economically equivalent to the establishment of an online-only, reserve-backed, narrow bank alongside the existing commercial banking system and, as such, would represent an expansion of competition in the market for deposit accounts.”
— – Bank of England

While the 92-page report asked more questions than it answered, the Bank of England’s Chief Cashier, Victoria Cleland, gave a speech in September. The sentiment was similar to that of Mersch’s speech, Cleland revealed her bank’s work on central bank-issued digital currencies.

The British Central Bank’s research so far had only considered the account-based approach, where people can, “hold balances in central bank money and to pay each other in real time with full and final settlement, in an electronic format,” Cleland said. However, in her opinion, having a Central Bank introduce any sort of Central Bank digital currency, “could fundamentally change the structure of the financial system.”

“If a CBDC provided competition for commercial bank deposits,” Cleland posites, “one outcome could be a reduction in deposit funding available to commercial banks, undermining their ability to provide credit to consumers.”