In collaboration with the University of Pennsylvania, University of Chicago, and the French Ecole Polytechnique, the US Federal Reserve Bank of Philadelphia released an insightful paper on the future of digital currencies, in the form of still theoretical Central Bank Digital Currencies (CBDCs). One may think we are getting ahead of ourselves with such an institution, but the progress forward can only be obtained with careful preparation.
The Federal Reserve on Central Bank Digital Currencies
To many people, and especially early cryptocurrency adopters, such a concept may seem like anathema – the very opposite of the original spirit of blockchain and its primary manifestation – cryptocurrencies. However, it doesn’t take long to make a compelling argument for the centralized filtering system for cryptocurrencies, one that would have a host of benefits outside normalizing digital currencies.
With this in mind, we should view the recent paper published by the US Federal Reserve Bank of Philadelphia. This paper explores the possibility that central banks could just as well issue digital currencies, thus we call them central bank digital currency (CBDC). Whether account-based (identity verification) or token-based (payment verification so the user can remain anonymous), such banks would have their own sets of advantages and disadvantages.
Central Bank Digital Currencies Explained
The paper at hand primarily discusses the implications of an account-based CBDC. On one hand, such a system would directly compete against commercial banks, as deposits constitute their bread and butter.
This would put CBDCs into an enviable position of mediation between investors and savers. Furthermore, CBDCs would become critical for the maturity transformation – shorter timeframes for banks borrowing money than lending it.
By having these roles, CBDCs could prove instrumental in alleviating financial crises, bailouts, and bank runs (remember Greece?). This is likely why central banks beyond the Fed — to include the European Central Bank — are actively assessing CBDCs.
We know from the example of the Fed where centralized power ends up, even if it was initially envisioned within a different set of terms. In the end, it’s all about the proper allocation of funds. Would CBDCs allow for optimal mechanisms to facilitate the flow of funds between investors and savers?
Similar studies, such as Brunnermeier and Niepelt (2019), Andolfatto (2018) and Chiu et al. (2019), have different methodologies, but this paper largely corresponds with the general notion that CBDCs would improve liquidity insurance and maturity transformation while reducing bank runs.
They also point to the grave danger of unseen costs and upheavals that a central bank monopoly could create. When individuals and businesses realize there is no reason to hold their deposits in a commercial bank, instead of a central bank, this would mark a revolution in the banking system.
We are already seeing this effect today; every commercial bank is effectively beholden to the Fed. If that is the case, why have costly intermediaries – commercial banks – at all? Why not just outright nationalize the Fed as a public utility? With digital money around the corner, these questions will be at the forefront now, more than ever before.
Paradoxically, digital money makes centralization exceedingly easy. Would CBDCs be more beneficial, as an instrument of convenience and financial stability? We want to know what you think in the comments section below.