Central bank digital currencies and the international monetary system

25 August 2019

Mark Carney, Governor of the Bank of England, at his Jackson Hole addressof 23 August 2019, outlined the idea of a synthetic hegemonic currency to be based on a basket of national currencies and issued by a network of central bank digital currencies (CBDC). Such synthetic currency is meant to offer a new international settlement medium and especially act as an alternative to the persistent dominance of the dollar addressing long-held grievances in the international monetary system. Financial technology could become the new determinant of monetary and in particular international monetary relations.

Central bank liquidity is mostly local. Central bank money has remained critical in particular to settle large value transactions. But it is available only to holders of an account at a central bank. An exception are bank notes that can be held anywhere. CBDC can now achieve the same making central bank liquidity available universally. It may shift the relative attractiveness of national currencies.

The international monetary system, the rules governing the use of foreign exchange to manage international liquidity and facilitate international transactions, is strained. High exchange rate volatility and persistent large external imbalances show that the system does not operate as intended. It relies heavily on one national currency, the dollar. But the dollar is the currency of the U.S. and serves only to meet U.S. policy objectives. Those may or may not be congruent with the needs of the rest of the world.

The dollar has remained the main vehicle and invoicing currency and is used most in foreign exchange transactions. Central banks hold US$11.5 trillion in foreign exchange reserves, two-third of which in dollars. More than 70 percent of Japan’s imports from Asia are invoiced in dollars.

Dollar liquidity, as measured by cross-border and local credit in dollars excluding residents has been increasing rapidly to advanced economies. However, it has been stagnant to emerging markets since 2015 and declining to emerging Asia since 2013. The divergence in dollar liquidity risks undermining economic and financial integration (Figure 1). The need for new liquidity resources is real.

Figure 1. Dollar liquidity

CBDC is tokenised central bank money. It constitutes a third format of money next to bank notes and reserves. CBDC has been used in various projects to prove it can serve as settlement medium in national and international transactions, notably in projects Jasper with the Bank of Canada and Ubin with the Monetary Authority of Singapore and extensions thereof. CBDC is meant to serve token-based financial market infrastructures. It will be issued similar to bank notes against reserves and constitutes an integral part of the monetary base.

The innovation with CBDC rests in its token format. It makes CBDC portable and assume additional functionality and utility. Blockchain or distributed ledger technology (DLT) is normally seen as the best technology to administer tokens and allows CBDC to be used in peer-to-peer, payment versus payments and delivery versus payments transactions, e.g. for the exchange of asset token against payment tokens. DLT-enabled CBDC can meet the functionality of a bank note in digital format.

CBDC can be used to channel central bank liquidity to eligible institutions and against high-quality collateral wherever it is needed. While liquidity is extended mostly through loans and held in the form of bank deposits and securities, central bank money is normally not used to settle international transactions. CBDC offers the possibility to hold central bank money off shore and use central bank money to conduct international payments. It would enable smaller currencies to offer international liquidity by recalibrating payments relations and allowing greater diversification in the international monetary system.

The idea of a new hegemonic currency to replace the dollar seems naturally ambitious. Agreement on a common currency would most likely be subject to near insurmountable conflicts of interest. The difficulty of using a common currency is also being illustrated by the euro. Diversification seems the better approach. CBDC could make central bank money available universally and play an active role in the supply of needed liquidity. While the dominance of the dollar is likely to persist amid vast network effects, financial technology may offer the new comparative advantage for currencies. It could change the architecture of international liquidity.