Central Bank Digital Currencies: A Framework for Assessing

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Staff Discussion Paper/Document d’analyse du personnel 2016-22
Central Bank Digital Currencies: A Framework for Assessing Why and How
by Ben S. C. Fung and Hanna Halaburda
Bank of Canada staff discussion papers are completed staff research studies on a wide variety of subjects relevant to central bank policy, produced independently from the Bank’s Governing Council. This research may support or challenge prevailing policy orthodoxy. Therefore, the views expressed in this paper are solely those of the authors and may differ from official Bank of Canada views. No responsibility for them should be attributed to the Bank.

Bank of Canada Staff Discussion Paper 2016-22 November 2016
Central Bank Digital Currencies: A Framework for Assessing Why and How
Ben S. C. Fung and Hanna Halaburda Currency Department Bank of Canada
Ottawa, Ontario, Canada K1A 0G9 [email protected]
[email protected]

ISSN 1914-0568

© 2016 Bank of Canada

We thank Walter Engert, Theodoros Garanzotis, Grahame Johnson, Anneke Kosse, Scott Hendry, Tim Lane, Lukasz Pomorski, Francisco Rivadeneyra, Gerald Stuber, Maarten van Oordt, Warren Weber, Carolyn Wilkins and seminar participants at the Bank of Canada for helpful comments and suggestions. All remaining errors are our own.

Digital currencies have attracted strong interest in recent years and have the potential to become widely adopted for use in making payments. Public authorities and central banks around the world are closely monitoring developments in digital currencies and studying their implications for the economy, the financial system and central banks. One key policy question for public authorities such as a central bank is whether or not to issue its own digital currency that can be used by the general public to make payments. There are several public policy arguments for a central-bank-issued digital currency. This paper proposes a framework for assessing why a central bank should consider issuing a digital currency and how to implement it to improve the efficiency of the retail payment system.
Bank topics: E-money; Financial Services; Payment clearing and settlement systems JEL codes: E41, E42
Les monnaies numériques suscitent un vif intérêt depuis quelques années et sont susceptibles d’être adoptées à grande échelle comme moyens de paiement. Les autorités publiques et les banques centrales de partout dans le monde surveillent de près l’évolution de ces monnaies et étudient leurs implications pour l’économie, le système financier et les banques centrales. L’une des questions de politique importantes qui se posent aux autorités publiques, notamment les banques centrales, est de savoir si elles devraient ou non émettre leur propre monnaie numérique, que le grand public pourrait utiliser pour effectuer des paiements. Plusieurs arguments de politique publique plaident en faveur d’une monnaie numérique émise par une banque centrale. Le présent article propose un cadre visant à déterminer pourquoi une banque centrale devrait envisager l’émission d’une monnaie numérique et comment celle-ci pourrait être mise en place pour améliorer l’efficacité du système de paiement de détail.
Sujets : Monnaie électronique; Services financiers; Systèmes de compensation et de règlement des paiements Codes JEL : E41, E42

1 Introduction
Rapid technological progress and new business models in recent years have resulted in many innovative products in retail payments. These innovations are increasing the potential for major changes in the retail payment environment, including the decreased use of cash.1 To effectively carry out their own main functions in a changing environment, central banks need to monitor new developments and study the implications closely.
One of the most significant developments in recent years is the renewed interest in e-money.2 E-money developments and their implications were studied extensively in the early 1990s.3 Since then, the adoption of e-money products has been slower than expected both globally and in Canada. However, since 2009, innovations related to Bitcoin and its underlying blockchain technology have attracted strong interest in cryptocurrencies. These new generations of e-money, which are also often called digital or virtual currencies, are raising important questions for central banks, the financial system and the economy.4 For example, private digital currencies, if widely adopted for making payments, could substantially reduce the demand for bank notes and even chequing account deposits in banks. Therefore, it is important for central banks to understand the impact of these developments on their seigniorage revenue and monetary policy operations, on the safety and efficiency of payments systems, and on the policy for financial stability. Moreover, central banks should examine their own role in light of these developments, including whether to regulate digital currency or to develop their own digital currency.
Central banks have a keen interest in monitoring developments in e-money, understanding their implications and establishing a view on the potential role of public institutions.5 A key policy question for central banks is whether or not to issue its own digital currency that can be used by the general public to make payments.6 In fact, there are two closely related questions:
(i) Why might a central bank choose to issue its own digital currency?
1 For a discussion of innovations in retail payments and their implications in a number of countries, see Committee on Payment and Settlement Systems (2012).
2 E-money is broadly defined as monetary value stored in an electronic device that can be used to make payments. For a more detailed discussion about recent developments and issues about e-money, see Fung, Molico and Stuber (2014). While there are some differences among the terms e-money, digital currency and virtual currency, for the sake of simplicity, we use them interchangeably in this paper.
3 For example, see Bank for International Settlements (1996), Freedman (2000) and Stuber (1996). 4 See, for example, Ali et al. (2014), Committee on Payments and Market Infrastructures (2015) and Wilkins
(2014). 5 For example, the Bank of Canada started its e-money research program in 2013 and has published a number of
research papers on its website. The main objectives of the research program are to (i) deepen the understanding of digital alternatives to cash and their likely evolution and pace of adoption; (ii) analyze the implications for the Bank of an increased reliance on these alternatives; and (iii) establish a view on the potential role of public institutions as e-money issuers, and the need for regulation of e-money schemes. For research published by Bank of Canada staff under this e-money research program, see http://www.bankofcanada.ca/e-money. 6 A central bank digital currency can be defined as monetary value stored electronically that is a liability of the central bank and can be used to make payments.

(ii) If a central bank were to issue its own digital currency, what should it look like?
To answer the first question, a central bank would need to explore the public policy arguments for issuing its own digital currency and assess the effects on the economy, the financial system and the banks. For the second, a central bank would need to determine the design and characteristics of its digital currency, and the steps required to promote broad adoption. These two questions need not be answered in sequential order. For example, a digital currency’s design could affect its demand and its likelihood of being substituted for bank notes and bank deposits. Digital currency is an area that will continue to evolve in ways that cannot be fully anticipated today. For example, while Bitcoin has attracted much attention in recent years, the focus now is on the underlying blockchain technology. As such, the purpose of this paper is not to answer the two questions posed above but to propose a general framework to guide further thinking to address these questions. The framework should be general enough to be effective with today’s technology and with further technological advances. This paper is a first step in the research agenda on studying central bank digital currency.
The rest of the paper is organized as follows. In the next section, we discuss three broad public policy arguments for a central bank to consider issuing a digital currency. Section 3 focuses on one particular policy argument—whether a central bank should issue a digital currency to improve the efficiency of retail payments. In Section 4, we discuss some of the main characteristics of such a central bank digital currency. The final section concludes. To simplify terminology, we refer to central bank digital currency as CBDC.
2 Why Should a Central Bank Consider Issuing a Digital Currency?
In this section, we consider three public policy arguments for why a central bank might consider issuing its own digital currency.
First, a central bank may explore whether issuing a CBDC would improve the efficiency of its currency function. For example, as the sole issuer of bank notes in Canada, the Bank of Canada supplies bank notes that Canadians can use with confidence. In carrying out this function, the Bank is responsible for the design, production, distribution and destruction of bank notes. As such, the Bank is constantly exploring ways to improve the efficiency of currency operation and reduce the cost of cash handling. The evolution from paper bank notes to polymer bank notes— both in Canada and elsewhere—has improved the efficiency of the currency function and enhanced bank note security and durability. Going forward, it is important for a central bank to examine if it would further improve efficiency and security by issuing future generations of bank notes in digital form, taking advantage of the latest technological advances.

Second, a CBDC could improve the efficiency and safety of both retail and large-value payment systems. On the retail side, the focus is on how a digital currency can improve the efficiency of making payments—for example, at the point of sale (POS), online and peer-to-peer (P2P). There could also be benefits of having a CBDC for wholesale and interbank payments; for example, it could facilitate faster settlement and extended settlement hours.7
Third, a CBDC could be an appropriate policy response to payment innovations such as privately issued e-money and digital currency that might impair the central bank’s ability to achieve its monetary policy goals and to implement policies promoting financial stability.8 For instance, widely adopted private cryptocurrencies could severely weaken the transmission of monetary policy and also restrict the ability of the central bank to act as the lender of last resort. Moreover, it has been suggested that replacing physical bank notes with a CBDC would remove the effective lower bound on policy interest rates, permitting the central bank to implement negative policy interest rates if that were warranted by economic circumstances.9
The objective of this paper is to develop a framework for studying whether a central bank should consider issuing CBDC to improve the safety and efficiency of the retail payment system. Typically, a central bank provides bank notes for the general public and deposits at the central bank (reserves or settlement balances) for certain financial institutions.10 If a central bank were to issue a digital currency that could be used by the general public to make payments, the digital currency would compete with bank notes and other electronic payment methods, which would have important implications for the safety and efficiency of retail payments.11 Moreover, businesses and financial institutions could use a CBDC to make payments among themselves. Eventually, a CBDC would also have implications for large-value payments. Thus it seems reasonable to begin the study on CBDC with a focus on the payment systems.
7 See, for example, Ali et al. (2014) and Barrdear and Kumhof (2016). 8 See, for example, Committee on Payments and Market Infrastructures (2015). 9 See, for example, Rogoff (2015). For a discussion of the zero lower bound in Canada, see Witmer and Yang
(2016). 10 For example, in Canada, there are 17 financial institutions that are direct participants in the interbank settlement
system known as the Large Value Transfer System (LVTS). Each direct participant has a settlement account at the Bank of Canada and thus has access to deposits at the central bank. For a discussion of the LVTS and the settlement balance, see Arjani and McVanel (2006). 11 If a central bank were to issue a CBDC, it might consider allowing the general public to have access to its deposits or issuing a new digital currency that is completely different from bank notes and deposits by banks. We discuss this consideration in Section 4.

Central banks often play three roles in promoting the safety and efficiency of payment systems: facilitator or catalyst, overseer, and operator or direct provider.12 The level and type of intervention vary across central banks, reflecting different histories, institutional structures and legislative authorities.
Currently, many central banks are closely monitoring developments in private digital currencies and their implications for payment systems. Also, a number of central banks—including the Bank of Canada—have been actively conducting research and engaging in dialogue with the private sector and academics about issues and benefits related to digital currencies as well as the challenges raised. Some central banks and public authorities are also exploring if there is a role for them in helping promote common standards among issuers as well as collaboration among stakeholders.
If private digital currencies become broadly adopted, one of the main concerns is related to the safety of these systems. If privately issued digital currencies are used mainly for making retail payments, they do not necessarily pose any systemic risk to the financial system. Nevertheless, the failure of a major private digital currency scheme could potentially result in significant financial losses to users, a loss of confidence in these schemes, a disruption of retail payments and even considerable adverse economic effects. In addition, there could be a reputational risk for the regulators—including the central bank—who are seen as being responsible for oversight of the payment systems to ensure their safety. In that case, central banks and other public authorities would need to assess whether the existing oversight framework is adequate to address these concerns, and to improve the framework as required. Looking forward, if the risks related to digital currencies were to increase in a scenario where these digital currencies have become widely adopted and therefore the risks to the system have become more significant, the best course of action for central banks and public authorities would be to consider subjecting digital currencies to oversight. In this case, it is not necessary for a central bank to consider issuing its own digital currency.
Therefore, as far as the retail payment system is concerned, one possible reason for public authorities such as a central bank to issue a digital currency would be to promote efficiency. The next section discusses a framework for analyzing such a scenario.
12 For a discussion of the role of the central bank regarding e-money, see Fung, Molico and Stuber (2014).

3 Should a Central Bank Issue a Digital Currency in the Interest of Retail Payment System Efficiency?
A new payment system would be more efficient than existing alternatives if the social benefits from its introduction outweighed the social costs. Besides technological and economic factors affecting the costs and benefits, improvements—such as increasing protection of private data and providing easy access to new payment methods—would also enhance the benefits of these systems for customers and therefore the efficiency of the payment system overall.
As discussed above, it is in the context of efficiency that we discuss whether a central bank should issue its own digital currency. We propose a general framework to study this complex question.
1. Would a digital currency improve efficiency? The first key question is whether a digital currency could improve the efficiency of payment systems in the first place. If not, there is really no need for a central bank to consider issuing a digital currency.
2. Would privately issued digital currencies provide such efficiency improvements without government intervention?
Even if a digital currency could improve efficiency, another key question that a central bank needs to answer is whether the provision of such a currency could be left to the market. In other words, it is necessary to assess whether the private sector is likely to arrive at an efficient outcome without government intervention.
Clearly, there are already a number of privately provided digital currencies today, such as Bitcoin and other cryptocurrencies. The real question is whether these digital currencies improve social efficiency to the full extent of what is technologically possible, and whether these digital currencies are broadly adopted by users. If both questions are answered with “yes,” then there is no need for a CBDC in the context of improving efficiency of the retail payment system. Nevertheless, there may still be a potential role for the central bank or government to establish rules and regulations and to monitor compliance. Rules and regulations would protect the safety of these systems. However, there would be no need for the central bank to issue digital currency directly.
The question of whether the market could provide a digital currency that is at least as efficient as that of the central bank is not entirely a new one. This type of question has long been discussed in the economics literature in the context of other technologies (e.g., cellular phones). Importantly, this literature reflects concerns about anti-competitive forces such as barriers to

entry and market power that can arise because of network effects. Previous research has shown that there are strong network effects in the payments space as well.13
3. Would issuing a digital currency be the role that central banks should play in improving efficiency?
Finally, if a digital currency could improve efficiency but the privately provided solutions did not provide the efficiency improvement, then the next question is whether there is anything that a central bank could do to help bring an efficient digital currency to the market, such as examining if there is a barrier to entry and clarifying regulatory requirements. It is also important to ask whether issuing its own digital currency would be more desirable than other potential roles that the central bank could play, for example, facilitating or regulation. Figure 1 provides a recap of this high-level framework.
As we analyze each of these questions in more detail below, it will quickly become clear that the discussion also depends on what type of digital currency a central bank is considering. There is currently a wide range of digital currencies with different properties and characteristics, and an even broader spectrum of potential digital currencies that could be designed. Thus, the analysis will need to be conducted in parallel to the question of what characteristics of a digital currency would be desirable to increase the efficiency of retail payment system.
Figure 2 and Figure 3 illustrate the detailed analytical framework for individual questions, and we discuss these questions in the next three subsections.
3.1 Would a digital currency improve retail payment system efficiency?
The first issue is whether and how a digital currency could improve efficiency of the retail payment system. There are costs and benefits to every innovation. Efficiency is improved when the benefits to society are greater than the costs. It is possible to identify the following potential benefits of a digital currency:
• enabling transactions that are foregone at present because existing payment instruments do not allow users to overcome frictions in the marketplace
• reducing the cost of transactions currently conducted using existing payment methods; i.e., the digital currency could become a more cost-effective way to conduct such transactions than other instruments that already exist in the marketplace
13 See Katz and Shapiro (1985) and subsequent research about entry into the market with strong network effects (e.g., Halaburda, Piskorski and Yildirim 2015). Literature on optimal pricing in two-sided markets (e.g., Rochet and Tirole 2003) tells us about strategies the credit card companies adopt, i.e., subsidizing consumers and charging high merchant fees. Halaburda, Jullien and Yehezkel (2014) give insight into dynamics of the market with network effects.

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Central Bank Digital Currencies: A Framework for Assessing