International ratings agency Moody's says central bank digital currencies could displace commercial banks from their current role in the payments system, disrupt their business models, and force changes to their funding model

International ratings agency Moody's says central bank digital currencies could displace commercial banks from their current role in the payments system, disrupt their business models, and force changes to their funding model

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.

Risk-free payment

"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."

Going negative

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." 

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18 Comments

Yes. I have made reference to this previously on interest dot co, but I think the idea has yet to really be understood by most people. The move to CBDCs does make retail banks redundant to a large extent, particularly when the currency can be divvied out and allocated by fintechs. I think what will be most interesting is that the traditional banking model is a honeypot for many in a class-based establishment. Sure, you have people who rise up the totem pole based on their abilities. But let's be honest. Anyone really worth their salt in terms of achievement is not working for a retail bank. The big fat payouts at the banks are relatively few and captured by those who know how to play the politics and say the right things.

I have been asked by people 'well doesn't this idea of central bank currencies and stablecoins make Bitcoin redundant?' My answer is possibly but no. The adoption of CBDCs probably makes BTC more valuable as people start to understand how and why it is different (particularly the decentralized scarcity properties). But people are still grappling conceptually with these things at the moment.

Thank you, that is a must read.

Absolute must read. Raoul Pal also did a video summarising the potential outcomes that I recommend listening to https://www.youtube.com/watch?v=qL2LfVRl3J0

Great piece today from Raoul Pal at Real Vision on the CBDC. https://youtu.be/qL2LfVRl3J0 He specifically talks about the impact on banks.

The Trends journal have been saying this for months. Central Banks are coordinating a takeover of the system with digital currency and no cash. The banks will go the way of the phone book and corporates will get direct funding from their respective central bank. No small businesses and a UBI paid by the central banks. Fascism in its purist form...

To be honest I won't shed a tear for the commercial banks. They're parasites. At the moment they appear to exist solely to skim money out of the population and blow asset bubbles. How many billions have be siphoned out of NZ over the years by the 'big four' for example?

Agree - my view on them has deteriorated rapidly the last few years to now think, after the latest moves of the central banks (whom appear to now hold all retail bank risk), that why do we even bother with retail banks at all?

why do we even bother with retail banks at all?

Well Anglo Saxon societies are class based (even though many well dispute that), particularly the UK. As I mentioned earlier, retail banks have served as a 'domain' for those in powerful social classes to some in extent. If you know anything about what happened with the downfall of Barings Bank, you can clearly see what it's about.

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.

This is a tiring diversion from reality

vault cash held by our collective banks amounts to $843 million compared to a total $629,345 million balance sheet.

And if we are heading into a deflationary environment, evidenced by negative interest rates, all dollars will buy more in the future than today.

I hear you, but do you expect this deflationary environment to persist into the medium term ? Genuine question.

I hardly expect any immediate relief until market participants address the global shortage of dollar credit creation in the world caused by G-SIB banks stabilising, if not, contracting their Eurodollar balance sheets. Central banks engaging the digital currency wave hardly addresses the concerns of these market makers.

Demand for dollars via FX swaps
Aggregate data on the use FX swaps and FX forwards can be obtained from the BIS derivatives statistics.2 The BIS OTC derivatives data (OTC data) show that the total amount outstanding at end-June 2019 neared $86 trillion (Graph 2, first panel), with FX swaps accounting for an estimated three quarters of this total. Link

• At $13 trillion, the gross dollar liabilities of banks headquartered outside the United States at end-2019 were nearly as high as before the Great Financial Crisis. Most of their dollar funding was booked outside the United States.

• We measure non-US banks’ short-term dollar funding needs by comparing short-term dollar liabilities (including off-balance sheet FX swaps) with holdings of liquid dollar assets.

• The scale of the central bank swap lines are of similar magnitude to banks’ short-term dollar funding needs. Swap line usage peaked in May at $449 billion and has subsided since. However, dollar funding needs of corporates may yet reveal a broader need for dollars outside the banking system.
Link

"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".

I am starting to see the potential appeal of BitCoin.
Probably I will have to self-educate in order to get a better understanding of how BitCoin actually works.
I would not have touched it with a bargepole, but I am slowly starting to see the value of a currency that does not depreciate at the whim of the central banks. Precious metals might also have to be re-thought as an investment class to be taken more seriously than before.

This is the best place to start. By reading the original Bitcoin white paper, published on Oct. 31, 2008 by Satoshi Nakamoto. https://bitcoin.org/bitcoin.pdf

Probably I will have to self-educate in order to get a better understanding of how BitCoin actually works

Better late than never.

This little site provides a good summary/overview of some of Bitcoins monetary aspects.
https://www.bitcoinblockhalf.com/
Welcome to the rabbit hole my friend :)

How will inflation affect the value of CBDCs ?