Implicit vs Explicit CBDCs
Central Bank Digital Currencies have receded from the headlines after their post-Libra peak, but research continues in the background in many jurisdictions, particularly Europe. The headline discussion often has a political bent to it, but this was always going to happen. CBDCs are so transformative that the decision to issue one in any country must ultimately come from the political sphere.
But something important is missing from the debate. Many countries have been slowly moving towards de facto CBDCs for years, thanks to government interventions into their private banking systems. Understanding this process is an important design consideration going forward. My goal in describing it here is to inject nuance into the debate. I’m going to try to remain neutral on the broader question of whether CBDCs are desirable — something I explore in detail in my book.
The Hierarchy of Money
Money is understood to be hierarchical. What this means for everyday people is that even within the same currency, not all units are created equal. The biggest differentiator is risk. All else being equal, a physical dollar bill is less risky than a dollar deposited at a bank, because the bank can fail.
The specific risk is counterparty risk. All fiat money is a promise and it matters who is on the other side. Physical cash is technically a promise by the central bank. It’s no longer redeemable for precious metals, but it is backed by the assets of the central bank, which are mostly government bonds. This makes it a liability in the financial sense. Central banks can’t fail so their promises are the safest. That’s why central bank money, comprised mostly of physical cash and the reserves that commercial banks keep with the central bank, is the safest kind of money.
Commercial bank money on the other hand, which consists of the deposits people and businesses keep with private institutions, is riskier. Commercial banks can fail, so their promises are less reliable. We can play this game all the way down the monetary pyramid — dollars on a store gift card aren’t as safe as dollars in a checking account — but the most important economic distinction is the one between central bank money and private forms of money.
Central bank digital currencies are important because they are a new form of central bank money. They can combine the safety of physical cash with the convenience of digital payments. Depending on their design, they can significantly expand access to central bank money. Many commercial bank clients would shift into a CBDC if given the option, either immediately or at the start of the next crisis. It’s better money.
Thus, one of the primary arguments against a general purpose CBDC is the likely disruption of the private sector. A massive shift into a CBDC would deprive commercial banks of a cheaper source of funding, impeding their ability to lend. The central bank could try to rectify the situation by providing wholesale funding to commercial banks — which it would now be in a better position to do given its enlarged balance sheet. But now a public entity has much greater say on private credit creation, something many opponents of CBDCs do not want.
There are countless nuances to these machinations given the design of a CBDC, but most of what I’ve covered so far is already contained within the ongoing CBDC debate. Here’s the part that isn’t.
De facto CBDCs
The standard debate on CBDCs often assumes a clear distinction between public organizations like the Federal Reserve and private ones like commercial banks. But the reality of our banking system is more messy, and it gets messier with every passing crisis.
Banks are special entities that can only exist by government charter. They are highly regulated and subject to rules like capital requirements — some percentage of their assets must always be high quality assets like Treasuries or central bank money. In return they get to participate in government-run deposit insurance and are eligible for special central bank backstops.
That said, they are still private entities. They are for-profit, owned by shareholders, and managed by executives — not government officials. This means they can fail — and occasionally should. Why else would shareholders get to enjoy any upside, or management generous salaries? If there is no free lunch then rewards must come from taking risk, the risk of failing.
But banks don’t really fail anymore. Not catastrophically, anyway. Governments use increasingly heroic measures to save them — or at least their depositors — and the threshold above which a bailout is introduced keeps falling, as seen recently with Silicon Valley Bank. To be fair, SVBs debt and equity holders were wiped out, but their depositors were not, even the ones who had balances far above the FDIC limit. Those depositors were not expecting to be rescued. If they were, there wouldn’t have been a run in the first place. But they were saved, despite being creditors in a private relationship with a for-profit entity. Such relationships should have at least some risk.
Other regional banks were saved entirely thanks to extraordinary new measures like the Fed’s BTFP program. In the case of Credit Suisse, the Swiss government engineered an emergency acquisition by a competitor, changed its laws to allow the merger, and provided a multi-billion franc backstop.
In both situations, governments took measures that were not explicitly spelled out ahead of time. There was no prior mention of a Federal Reserve lending facility to help with duration issues or Swiss government backstop, yet both happened. As did countless other previously unexpected emergency programs enacted by governments all around the world during the pandemic.
These actions introduce a new kind of moral hazard into the monetary system, and blur the distinction between a public central bank and private commercial banks. If the depositors of commercial banks are generally going to be rescued by the government, aren’t the liabilities of those banks effectively as safe as the ones of the central bank?
This is not a value judgment on the merits of saving depositors, but rather a simple observation of how markets will eventually discount counterparty risk.
The increasingly blurred line between the two types of money is most apparent with Systemically Important Financial Institutions, better know as “too big to fail” banks. Indeed, one of the consequences of the regional banking crisis in the US was the flow of deposits from smaller banks to larger ones due to the general perception that the latter are always immune, and rightly so. It’s hard to imagine an institution like JPMorgan ever being allowed to fail, raising an important economic question: what’s the difference between a deposit with JPM and one at the Fed, at least from a safety and soundness perspective?
Bank rescues can become a self-fulfilling prophecy. The more the public expects them to happen, the more likely they become. Otherwise even a small failure could be catastrophic. But if deposits at commercial banks are generally perceived to be as safe as deposits with a central bank, then the hierarchy of money has been flattened, and we’ve already arrived at de facto or implicit CBDCs.
Conclusion
Central bank digital currencies are controversial for several reasons, including the possible disintermediation of commercial banking. This potential disruption is one reason some market participants argue against the more aggressive, general purpose designs. But such arguments lose credibility when governments backstop all private bank deposits.
There are many other reasons why people might be for or against CBDCs, including the implicit variety. For example, commercial banks that are fully backed by the central bank provide their depositors with a layer of privacy they might not have with a general purpose CBDC. We can even expand the definition of implicit CBDCs to include narrow banks, e-money providers or stablecoins that are fully backed by central bank money — they too would provide a layer of privacy. Notably, these so-called synthetic CBDCs are at least acknowledged in the debate.
But standard banks that are de facto private front-ends for the central bank are not. They should be, because they are taking an order of magnitude more risk than narrow banks or stablecoins in the hope of generating a higher return for their shareholders, while the public underwrites their potential downside.
To reiterate: this dynamic is not presented as an augment for CBDCs. Nor is it an argument against government interventions and bailouts. It is presented as a reason to realign the debate.
Societies that accept greater government intervention in the private banking system have already embraced implicit CBDCs. Financially, they might be better off switching to the explicit variety. They would have less moral hazard while enjoying other benefits such as greater economic inclusion and less friction in payments.
Conversely, societies that want a clear separation between public and private money should be opposed to bank bailouts and any designation of “too big to fail.” If you are against explicit CBDCs then you should question the implicit variety too.
