International ratings agency Moody's Investors Service is warning that central bank digital currencies (CBDC's) could have "profound negative consequences" for commercial banks - displacing their current role in the payments system, disrupting their business models, and forcing changes to their funding model.
Moody's also says, however, that central banks face a "dilemma", in that if do not take up CBDCs their roles could be undermined, while if the adapt too fast they may disrupt the financial system by undermining the role of the commercial bank.
Much work is currently being done globally on the potential for CBDCs. The Bank for International Settlements (BIS), which is owned by 62 central banks, including our Reserve Bank (RBNZ), recently issued a report identifying the foundational principles necessary for any publicly available CBDCs to help central banks meet their public policy objectives.
RBNZ Assistant Governor Christian Hawkesby said this week the central bank had "no immediate plans to launch a CBDC in New Zealand", but was "following developments very carefully".
In a new report on CBDCs, Moody's indicates that any type of CBDC would likely cause some disruption for commercial banks, but this would depend on which type was chosen.
It notes that Facebook's Libra project has been a catalyst for the work now going on with the central banks on CBDCs and says the potential for the Libra digital currency and similar projects to displace official currencies has propelled many central banks to defend the role of public money.
Moody's says CBDCs could take several forms:
- A “direct” CBDC model envisages individuals or companies having a direct but electronic claim on the central bank itself. But it could make the central bank responsible for managing retail payments with all the administrative background work this involves (including “know your customer” and anti money laundering procedures).
- An “indirect” model would relieve the central bank of the administrative burden of payments by granting an intermediary role to the private sector, much as Libra would do.
- A third “hybrid” model seeks to combine aspects of both direct and indirect models.
"The direct model of CBDC would clearly have profound consequences for today's commercial banks," Moody's says.
"If the size of CBDC balances were unlimited, retail and business customers would likely welcome the ease of risk-free payment offered by a CBDC and favour them ahead of cash reserves at a commercial bank. This would result in a significant loss of resources for the commercial banks, given that banks' primary source of funding is deposits."
Even if there were limits on the size of balances (as is the case with the current China pilot), the reduction in deposits "could still be material".
"And in times of stress, a deposit 'run' as customers exchange commercial bank money for CBDCs would be easier than today, making deposits inherently less stable."
Moody's says banks could compensate for this by a combination of (i) offering interest rates above that of the central bank; (ii) attracting funds by offering superior technology or other services; or (iii) turning to capital markets to replace the lost funding. These could increase funding costs, raise liquidity requirements, increase operating costs, or leave them more confidence-sensitive. In principle, these costs could be passed on to customers but the transition would nevertheless require "a difficult adjustment".
'Distinct from the central bank'
"Commercial banks would therefore have to move towards offering services distinct from the central bank, e.g. longer term savings and asset management.
"Meanwhile central banks would find themselves with far larger balance sheets and may need to redeploy this funding back into financial markets, e.g. by funding certain bank assets such as covered bonds."
Moody's says given the magnitude of these challenges it is unlikely that the direct CBDC model will be favoured by central banks, "not least because in many cases the same bodies have statutory responsibility for financial stability which could conceivably be threatened by a hasty adoption of this model".
"This also likely explains why most announced projects anticipate a hybrid or two-tier model. The hybrid two-tier model would clearly be less disruptive to the existing financial architecture."
Existing banks would be natural candidates for the financial intermediary role, running payment systems on behalf of the central bank, Moody's says.
"This would enable them to preserve a role in the payment system and continue to compete on service with successful banks able to charge a premium.
There could be consequences...
"However, where CBDC users are holding a claim on the central bank, there could still be consequences for banks' deposit bases as in the direct model.
The 'indirect model' would, according to Moody's, appear to offer the least threat to commercial banks.
"...But that is because it offers the least practical change for end-users and therefore appears less likely to attract support."
Moody's says that in terms of the central banks, they occupy a unique position in that they have a government-granted monopoly on the creation of a universally accepted means of risk-free payment. This privilege is unlikely to be displaced suddenly, which should give them time to consider different options.
But they do face a dilemma.
"The advent of 'stablecoins' such as Libra and the rapid advance of new payment providers on a national or global scale has propelled them to consider CBDCs more urgently as a defensive strategy.
"If they do not adapt, then customer behaviour may change anyway and undermine their role.
"However, if they adapt too fast, they may create a different kind of disruption to the financial system by undermining the role of the commercial bank. In either case, the ability of sovereign governments and their central banks to steer the economic policy mix would be affected."
The Moody's report also has a word on negative interest rates. This is timely in the New Zealand context because it is widely anticipated that the RBNZ will take rates negative here early next year by dropping the Official Cash Rate (currently on 0.25%) below zero.
Moody's points out that in a negative rates regime it actually pays to hold on to physical cash. So, CBDCs could be useful...
"...The zero nominal rate of return on cash offers a positive return relative to money kept in commercial bank balances that is subject to negative rates (setting aside the “zero bound” interest rate constraint on banks' retail depositors).
"Physical cash therefore becomes, in theory, more attractive as a relative storage of value than electronic money at commercial banks. But it is not a useful medium for the transmission of monetary policy because its nominal return is fixed.
"A CBDC could in principle end this anomaly by bearing a programmable interest rate aligned with (or potentially different to) the official policy rate.
"It could therefore bear a negative rate and effectively decay over time just as banks' deposits at the ECB do today.
"However, as long as physical cash continued to exist, any interest rate, positive or negative, would breach the notion that a CBDC must be economically equivalent to paper banknotes, and it would create a parallel form of cash rather than a truly interchangeable one.
"Digital currencies could also facilitate monetary easing as money could be created instantaneously and credited to individuals."