11 October 2020
The IMF Annual Meetings kick off virtually this week with one key trending topic seemingly missing: What is the impact of central bank digital currencies (CBDC)? For the biggest gathering of central bankers, this seems odd. Most are actively exploring CBDC and it is hotly debated elsewhere. Also Covid-19 has served as a reminder that international monetary relations remain dysfunctional in many respects possibly undermining a sustained recovery of the world economy. Only the previous week, the ECB in a report on a digital euro proposes a fundamental change about access to central bank money that would enable international transactions to be settled in central bank money possibly greatly facilitating international exchange. It is aimed at making the euro a leading international currency. The IMF, guardian of international monetary relations, needs to take note.
The ECB report testifies to a long-standing limitation. Central bank money is very local. Only resident banks have typically access to central bank accounts. Bank notes are distributed normally to the local general public. It implies that electronic payments can only be cleared in central bank money among resident institutions. While international transactions can be conducted in claims denominated in dollars or euros, those normally always constitute claims on commercial banks. It increases dependence on domestic banks, propagates bank related risks and implies important differences in settlement conditions between domestic and international transactions.
The innovation in CBDC is the tokenisation of central bank money. While the ECB report has not specified the medium of a future digital euro, tokens seem best suited to meet actual and new payment demands. They would constitute a third money format next to bank notes and reserves and can significantly expand functionalities and utility of central bank money. The portability and programmability of tokens support new types of transactions, can preserve needed prudential controls, enable peer-to-peer transactions and operate 24/7. Tokens, similar to bank notes, can be issued to resident banks only but could be used for payments by non-resident banks. CBDC is about using central bank money irrespective of space and time.
Central bank money represents the safest money in any given currency area. It is therefore the preferred medium especially to settle large value payment transactions. If central bank money were to be made available to non-residents, it would reduce risk in international payments and transaction costs, enhance competition between resident and non-resident entities and advance international financial integration. The foreign exchange market would likely be one of the greatest beneficiaries.
The ECB report stipulates that the "digital euro should be potentially accessible outside the euro area." It would allow for example to settle a euro-denominated German government bond in central bank money when trading in Singapore. At present, the sale of a German government bond by a bank in Singapore would be settled in bank money or in a euro-denominated deposit issued by the payer bank in Singapore. While most Singapore banks are likely to meet their euro-denominated liabilities at all times they are not as likely to do so compared with the German government. Today a German government bond outside the Eurosystem can only be settled against a riskier claim.
The ECB advances that a digital euro would make the euro a more important international currency. International access to a digital euro will likely have an effect on preferences for using the euro in international payments. The euro has been trailing the dollar by a long stretch as an international currency to the increasing consternation of different E.U. entities and risk for the European financial system. The report highlights that a "strong international role of the euro reinforces European economic autonomy."
The ECB has offered nothing less than changing the geography of central bank money. It has importantly served as a reminder that existing practices for conducting international payments need to change if they were to improve materially. The tokenisation of central bank money now offers broader access with needed controls to reduce frictions between domestic and international markets, facilitate access to safe and liquid settlement mediums, ease balance of payments adjustments and thus improve international monetary relations. Those advantages may shift relative preferences of holding monies towards greater diversification in international payments. Herein may lie the biggest and most important contribution of CBDC.