Cryptocurrencies’ Challenge to Central Banks

Lambert here: They’ll pry coins and notes from my cold, dead hands. However, improving the existing payment system seems reasonable to me, if divorced from the question of abolishing cash. (I think “electronic cash” would make sense as a trope if coins and notes spontaneously combusted, could be hacked, had trackability built in, etc. They don’t.)

By Antonio Fatás, Professor of Economics at INSEAD and Beatrice Weder di Mauro, Distinguished Fellow, Emerging Markets Institute, INSEAD Singapore and Economic Policy and International Macroeconomics Professor, Gutenberg University Mainz; CEPR Research Fellow. Originally published at VoxEU.

The sudden rise of cryptocurrencies may pose challenges to central banks and financial intermediaries alike. At least these are their fans’ hopes and targets: to create private currencies that compete successfully with the official fiat currencies and disrupt business models of banks. In our previous Vox column, “Making (some) sense of cryptocurrencies” (Fatas and Weder di Maruo 2018), we examined their merit as substitutes for money and concluded that they are unlikely to achieve their high-flying aims. But we did concede that they have exposed inefficiencies in payments systems, in particular in cross-border transactions, and may contribute to redefining the concept of money as a means of payment. In China, plastic and paper are vanishing so quickly that vendors refuse to accept them, while phone-based payments systems are becoming ubiquitous. It is notable that it was the very absence of well-integrated and universally accessible electronic payments systems that opened the space for internet companies (Tencent and Alibaba) to leapfrog ahead in the fintech race (Chorzempa 2018).

The central banking community is alert to the challenge and is contemplating reactions which range from prohibiting private issuance to embracing them. For instance, in Sweden, where cash has also been declining so rapidly that it raises the prospect that the only legal tender might disappear, the Riksbank is considering whether it should introduce an e-krona, an electronic version of the Krona that could even be anonymous like cash – or, more precisely, pseudonymouslike bitcoin (Sveriges Riksbank 2017).

Why Central Banks Care

The interest in electronic forms of money as a substitute for physical cash had recently received some impetus when central banks in advanced economies collectively found themselves at the zero lower bound and wondering by how much they could further reduce rates before triggering a flight into cash. In a cashless society, monetary policy rates would not face an effective lower bound, which might obviate the need for quantitative easing measures (e.g. Buiter 2009). In addition, the strong evidence that anonymous cash is valued by those who conduct illegal business or are trying to evade taxes has increased calls for abolishing cash (Rogoff 2016).

But central banks now face a new challenge from private currencies, which might threaten the monopoly of issuance.1 If cash vanishes, it would leave households and firms without access to risk-free central bank money. Private money, whether it is issued by a bank or mined in a crypto community, is not backed by central bank. The former carries counterparty risk (partially mitigated by deposit insurance) and the latter carries stability and exchange rate risks.

The introduction of parallel currencies can have an effect on the operations of central banks at many levels (Fernández-Villaverde and Sanches 2016). There is an analogy between this situation and the case of central banks dealing with partial dollarisation of their economies (Baliño et al. 1999). First, if transactions in the new currency are widespread, it might make it impossible for the central bank to find appropriate intermediate targets for its monetary policy. Second, as individuals, corporations, and possible financial institutions increase their holdings of the new currency, it can potential make the financial system less stable unless the central bank can find ways to stabilise liquidity in those currencies. Finally, it can induce additional uncertainty and volatility in the exchange rate (Calvo and Vegh 1992)

What Are the Central Bank Options?

Central banks could create central bank digital currency (CBDC) for all individuals. They could provide a digital means of payments, which would be claims on the central bank. The simplest solution would be to allow individuals and corporations (not only financial intermediaries) to directly hold accounts at the central bank, which might even be interest bearing (Bordo and Levin 2017, BIS 2018a). Alternatively, central banks could resort to issuing own cryptocurrencies, possibly using some decentralised and near anonymous technology to mimic and replace banknotes (Andolfato 2015).

The Case for Central Bank Digital Currencies

For individuals, the advantage of holding central bank digital currency should come from efficiency in payment systems and handling of risks in deposit accounts.

Direct access to central bank accounts would enable the general public to hold legal tender in electronic form. If central banks chose to open up access to central bank accounts ‘to all’, this would create a centralised ledger making payments settlements extremely fast as all accounts would be in the same system without the need of intermediaries. If deposits were mostly held at the central bank, deposit insurance would also be obsolete.

Retail cross-border payments might also benefit if conducted through central banks directly, if central banks coordinated on mechanisms to handle those international payments. Setting standards would be much easier if there was just one centralised system per country. One might even imagine that some central banks open accounts for non-residents to offer their currency as vehicle for international payments – thus creating negative international spillovers, to which we return below.

The Case against Central Bank Digital Currencies

Out of the two options we have discussed, a central bank cryptocurrency using technologies similar to bitcoin and other cryptocurrencies would suffer from some of the same problem as those currencies (the decentralised validation process is inefficient and slow, and anonymity more a disadvantage than an advantage). Central banks seem to be reaching this conclusion as they are experimenting with cryptocurrency-type technologies since many of their projects require more centralization (Berentsen and Schar 2018). In addition, while replicating the anonymity of cash in electronic format might sound appealing, central banks would not want to offer cryptocurrencies as vehicles for illegal activities. On several grounds, the case against central bank cryptocurrencies seems to be strong.

What about the other CBDC option – central banks accepting deposits ‘from all’?

A key issue is how such a CBDC would affect financial stability and financial intermediaries. The presence of a safe deposit at the central bank could make commercial bank deposits highly volatile and bank runs could happen at the click of a mouse (or a nod to a mobile phone). The result may be sharply higher volatility and periodic panic flights to safety. In addition, shifting deposits to central banks might mean a challenge to existing business models of banks since they might lose a stable and cheap source of funding, namely, deposits. How strong this competition is will depend on how those accounts are handled. Would such funds be limited? Would they pay an interest? Furthermore, banks would lose the income they make from facilitating payments and also from the related network of relationships they build with their customers. To the extent that such services, networks, or even customer information are complementary to other banking services such as lending and wealth management, the competition for funds from central banks may have even larger disruptive consequences.

From the narrow perspective of the central bank, a general purpose CBDC may entail risks to its balance sheet. With higher demand for central bank money, it might need to hold more risky assets (sovereign debt or private assets). This might expand the role of central banks in maturity and credit risk transformation to banks and markets and expose them to political pressure, possibly weakening their independence (BIS 2018a). And if deposits at the central bank were interest bearing, profits from seignorage could be affected. Finally, responsibility for compliance with KYC (know your customer) and AML (anti-money laundering) would fall on the central bank. These operations might be outsourced to private operators but the difference with the present system is that the deposit would be a liability of the central bank and mistakes would – at the very least – carry reputational risks for them.

Should non-residents be allowed to hold the CBDC, this might entail cross-border externalities since it would expand global liquidity and the provision of safe assets. In times of crisis, capital flight from vulnerable countries into safe haven central banks could be magnified with related pressures on exchange rates and asset prices. (BIS 2018a).

Given such uncertainties, central bank accounts ‘for all’ would seem remote. Not so. This summer, Switzerland will be holding a referendum on a radical proposal: the ‘sovereign money’ initiative proposes that 100% of sight deposits be transferred to the central bank and commercial banks be prevented from creating money. Bacchetta (2018) shows how this reform would dislocate the banking sector, threatening financial stability as well as the central banks’ ability to conduct monetary policy.

So overall, the risks and uncertainties surrounding the adoption of CBDCs in the form of decentralised cryptocurrencies but also in the form of centralised provision central banks accounts seem to outweigh the advantages. This raises the question of whether payments systems – the main weakness of the existing infrastructure – can be improved in other ways.

Improving Payments Systems without a CBDC

There is increasing pressure for faster and more efficient payment systems. Lack of innovation on payment systems comes from the complex and outdated infrastructure that banks use. But, as we argued above, completely revamping the bank deposits model comes at a cost. Can innovation be introduced without challenging the bank deposit model?

Recent changes in regulation are likely to do so because they mandate banks to give access to providers of payment technologies (‘apps’). The open banking initiative in the UK or the related PSD2 directive of the EU are actively promoting innovation by requiring banks to provide access via APIs to customers’ accounts. The recent successful launch of a united payments interface in India to facilitate real-time payments is another example where regulation and coordination can make a large difference. In all these examples, individuals can use their preferred smartphone app to conduct payments without having to embrace a world with separate money balances and possibly separate currencies.

They use traditional currencies, commercial banks (with deposit insurance) continue to hold the money balances, but transactions are intermediated by small or large players in the payment space. Together with the ongoing upgrade of the existing Real Time Gross Settlement Systems (RTGS) (Carney 2018) we end up with a system that satisfies the demands increasingly brought forward by new technologies but maintaining the backbone of bank deposits and traditional central banks.

Smooth and low-cost cross-border payments systems are crucial for the functioning within the euro area, since national closed-loop solutions could lead to fragmentation. Thus, the European system is being upgraded and the new TARGET instant payment settlement (TIPS) service was launched recently and should be fully operational by the end of 2018. (ECB 2017).

However, beyond the euro area, central banks and regulators may fall short in improving cross-border retail payments systems. On one hand there is the complication of dealing with settlements systems across different currencies, on the other there is the lack of a global regulator or central bank that can impose a standard or a particular technology. This is a world where new players might have more room to challenge the status quo.


The risks of introducing central bank digital currency are high while the efficiency gains do not seem large. Cryptocurrencies issued by central banks would suffer from all the disadvantages of cryptocurrencies without offering clear advantages. Digital money ‘for all’ on central banks’ balance sheets could have disruptive effects on the financial system without offering strong advantages over a well governed two-tier system. A more efficient system can be achieved via innovation in current payment infrastructure that is encouraged by regulation which opens up competition to new players and technologies while maintaining the backbone of bank deposits and traditional central banks.

>References available at original post.

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About Lambert Strether

Readers, I have had a correspondent characterize my views as realistic cynical. Let me briefly explain them. I believe in universal programs that provide concrete material benefits, especially to the working class. Medicare for All is the prime example, but tuition-free college and a Post Office Bank also fall under this heading. So do a Jobs Guarantee and a Debt Jubilee. Clearly, neither liberal Democrats nor conservative Republicans can deliver on such programs, because the two are different flavors of neoliberalism (“Because markets”). I don’t much care about the “ism” that delivers the benefits, although whichever one does have to put common humanity first, as opposed to markets. Could be a second FDR saving capitalism, democratic socialism leashing and collaring it, or communism razing it. I don’t much care, as long as the benefits are delivered. To me, the key issue — and this is why Medicare for All is always first with me — is the tens of thousands of excess “deaths from despair,” as described by the Case-Deaton study, and other recent studies. That enormous body count makes Medicare for All, at the very least, a moral and strategic imperative. And that level of suffering and organic damage makes the concerns of identity politics — even the worthy fight to help the refugees Bush, Obama, and Clinton’s wars created — bright shiny objects by comparison. Hence my frustration with the news flow — currently in my view the swirling intersection of two, separate Shock Doctrine campaigns, one by the Administration, and the other by out-of-power liberals and their allies in the State and in the press — a news flow that constantly forces me to focus on matters that I regard as of secondary importance to the excess deaths. What kind of political economy is it that halts or even reverses the increases in life expectancy that civilized societies have achieved? I am also very hopeful that the continuing destruction of both party establishments will open the space for voices supporting programs similar to those I have listed; let’s call such voices “the left.” Volatility creates opportunity, especially if the Democrat establishment, which puts markets first and opposes all such programs, isn’t allowed to get back into the saddle. Eyes on the prize! I love the tactical level, and secretly love even the horse race, since I’ve been blogging about it daily for fourteen years, but everything I write has this perspective at the back of it.


  1. Tom Stone

    I wonder how well these digital currencies would work right now in rural Puerto Rico, or in the first week or two after the next big quake hits the West coast of the USA?
    It also seems to me that security might be an issue, Hackers have done quite well stealing Bitcoin from presumably secure depositories…
    And of course there’s the little matter of trust, every digital currency I have looked at is at heart a scam, and the vast majority are transparent frauds.
    They will blow up soon and billions of dollars of “Investments” will disappear.
    Physical cash is inefficient, so was the recordation of Real Property before MERS came along, sometimes inefficiencies increase robustness.

    1. JayTe

      Tom, hackers have done well stealing bitcoin from centralised exchanges. Meaning that all the bitcoin are held in one central location. A nice honeypot to attack. Decentralised exchanges don’t have these problems because the bitcoin is held by the individual parties. There is no honeypot unless they happen to know an individual with a large holding. That fact has nothing to do with the security of cryptocurrencies and everything to do with the inherent risks of centralising your assets under the control of anybody but yourself.

      Every digital currency is a scam?!? And untrustworty?!? Sorry but you couldn’t be more wrong. The whole point is not to trust a third party but to trust the code (which unlike with financial institutions, you can actually verify). That is the whole point of disintermediation. That Mr. Fatás wants to keep central banks given the amount of money that they have printed bailing out their friends on Wall Street is almost criminal. What’s clear is that you have a poor understanding of cryptocurrencies in general. If you did, you would realise that more and more cryptos are being tied directly to assets (insurance, real estate, commodities, etc). They are making the markets more liquid. And they will be even better in the future when one can do atomic transactions seemlessly across any number of cryptocurrencies with high transaction rates and if so desired anonymously. In fact, it is estimate by LAT Research that the asset backed cryptocurrency market trading value will easily exceed $40 trillion by 2025. You and the Mr. Fatás are oblivious of what is coming.

      1. The Prescription Was Clear

        Well, of course not.

        Code cannot actually be verified, nor can it be guaranteed to produce working results (as in “completely” and “without bugs”); not even if one actually is a programmer (as most people don’t stand an iota of a chance), or even a software corporation (as IBM’s famous conclusion, that they cannot get the amount of bugs below a certain threshold, proves).

        This is a well known problem, BTW, it stands at the core of the utter failure known as FLOSS.

        You can trust institutions far more than code, on a multiple orders of magnitude more, in fact. – But you have to be able to exert some meaningfull control over them, hence the need for govt. regulation and preference to state- (as opposed to “private-“) capitalism.

  2. Louis Fyne

    Maybe the Fed should try opening the Fed Discount window to ordinary citizens with a valid SSN before negative interest rates.

    As essentially, most of the pain of a recession comes from a liquidity crisis for ordinary people—just like the too big to fail banks had no short term funds to meet long term liabilities.

  3. Guglielmo Tell

    A bigger question is: how much money do the tech moguls – Gates, Zuckerberg, etc. – have stashed away in cryptocurrencies? It’s like offshore accounts to them! What are they going to do with? Could they hit the “non-crypto” stocks?

  4. rd

    I assume that central banks holding the bank deposits would require traditional banks to effectively become just clearing houses for securitized debt obligations as they would be unable to fund loans based on deposits they hold. This could make for a more robust financial system as individual banks would effectively just be fee-generation machines without the possibility of a run on the bank. It would be up to the security purchasers to verify that the banks are not just selling them crap.

    If the central bank is on the ball, it would be much more difficult to have illegal money going in and out of the country as every cash transaction would be done directly under central bank scrutiny.

  5. OpenThePodBayDoorsHAL

    Think, people. The company Xapo safely stores billions in Bitcoin. How do they do it? They send representatives to the computer manufacturer; custody the machine to their lab; put a clean, code-inspected operating system on it, load the Bitcoins, make sure the machine never once connects to the internet, then they take it to a concrete bunker 60 feet underground.
    Remind me how this is going to be “the great new internet money”?

    1. The Prescription Was Clear

      It isn’t, obviously.

      In fact, if one can reasonably trust the physical security of bank notes (anti-fraud measures, I mean), central bank’s printed cash is as compatible, transportable, and feature complete system as one can desire.

      And since we have next to no inflation (the only possible need for electronic money could come from a desire to keep running a high inflation economy, where constant money printing would turn into a logistics nightmare), there seems to be no reason to fiddle with (personal) computers whan it comes to currency, no reason what so ever.

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