– September 1, 2019
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Should central banks issue their own version of digital cash? Historically, central banks have limited their interactions with the public to the provision of paper money. By introducing central bank digital currency, or CBDC, central banks would also be supplying us with electronic money. CBDC might be in the form of an account that people can keep at the central bank, or maybe some sort of blockchain token that the central bank issues to the public.

Over the last five years, CBDC has become a popular topic among monetary economists and central bankers. And while no central bank has actually implemented it, a number are seriously entertaining the possibility, including Sweden’s Riksbank and the People’s Bank of China.

A related concept has recently emerged: synthetic central bank digital currency, or sCBDC. In a new International Monetary Fund report, Tobias Adrian and Tommaso Mancini-Griffoli point out that it is possible to synthesize a version of CBDC by allowing fintech companies and other e-money providers to keep accounts at the central bank. Customers would in turn hold accounts at these fintechs. As long as fintechs always back each customer dollar (or yen or pound) with a dollar at the central bank, then it is as if customers are holding dollars at the central bank. Voila, we have effectively synthesized CBDC.

The main difference between CBDC and sCBDC is who is maintaining the end relationship with the customer, the central bank or the fintech. As Adrian and Mancini-Griffoli point out (and I agree), it makes a lot of sense to prefer the sCBDC. To begin with, a central bank may have better things to do than manage customer relations:

Synthetic CDBC outsources several steps to the private sector: technology choices, customer management, customer screening and monitoring including for “Know Your Customer” and AML/CFT (Anti-Money Laundering and Combating the Financing of Terrorism) purposes, regulatory compliance, and data management — all sources of substantial costs and risks.

The IMF’s Adrian and Mancini-Griffoli aren’t the only ones to arrive at the idea of sCBDC. There is a separate but related conversation in various circles about attempts by several U.S. banks to get accounts at the Fed so that they can offer “narrow banking” services. Rather than holding risky assets and loans, these narrow banks want to keep all their assets parked in interest-yielding accounts at the Fed, sluicing most of this interest back to their deposit-holding customers.

John Cochrane, an economist who often writes on the topic of narrow banking, recently made the connection between narrow banking and CBDC:

Central banks cannot operate retail digital currencies. Who do you call when you forgot your password? But narrow banks are the ideal institutions to provide the retail-facing end of digital currencies. The sooner the better.

Cochrane is thinking along the same lines as Adrian and Mancini-Griffoli’s sCBDC. And like them, his point is that narrow banks are better equipped to deal with the nitty-gritty of having a retail clientele.

Economists Michael Bordo and Andy Levin also arrive at the same end point in a recent Cato paper entitled “The Case of U.S. Digital Cash.” The Federal Reserve could produce digital cash itself, they write, but there is a conflict of interest in having the central bank compete with commercial banks for deposits:

It seems undesirable for the central bank to start competing directly with commercial banks in attracting deposits, especially in cases where the central bank also regulates and supervises those banks.

Bordo and Levin believe that digital cash should be supplied by private providers that offer special accounts to the public. These institutions would, in turn, hold depositors’ funds in “segregated reserve accounts” at the central bank. The advantage of this is that, instead of having one dominant issuer of CBDC (i.e., the central bank), a number of digital-currency providers would compete, presumably providing a superior product.

I can think of just one reason why a central bank might want to get into the business of issuing CBDC: to provide privacy. Anonymous payments are a controversial topic. Anonymity allows good people to guard their personal information. But it allows bad people to do the same. Nevertheless, I think there are decent arguments to be made for a widely available anonymous payments option.

Anti–money laundering regulations largely prevent the private sector from offering anonymous sCBDC. Even if they could supply it, bankers might be too worried about the risks involved in banking the anonymous to bother. Since central banks already issue the world’s most popular anonymous payments medium — paper money — they may have a natural role to play in directly providing a digital version of anonymous cash.

Banknotes are an old technology originally introduced in the 1600s, long before concerns about money laundering, income tax evasion, and drug smuggling emerged. Anonymity was incidental to the role that banknotes played as a payments medium. In some sense, the production of banknotes has been grandfathered into the system — it would be hard to imagine their being introduced from scratch today. But, if banknotes have been granted an exemption from money laundering rules, surely a new digital version of banknotes qualifies under this exemption. And, thus, central banks may be natural anonymity providers.

Unfortunately, most formal discussions about CBDC avoid the topic of anonymity, mention it fleetingly, or disavow it altogether. My sense is that central bankers are neither comfortable with nor intellectually capable of engaging in vital discussions about financial privacy and their role in providing society with anonymous payments. If so, an anonymous CBDC seems unlikely.

With this in mind, central banks should champion sCBDC. Let private providers compete in providing some sort of central bank–sanctioned version of digital currency to the masses. The central bank can limit itself to maintaining the back end and offering a degree of regulation. If sCBDC does not work, the central bank’s reputation won’t be tarnished. And, if sCBDC does take off, the central bank need not worry about its attention being diverted by all the day-to-day concerns of interacting with a retail clientele.

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J.P. Koning

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J.P. Koning is a financial writer and blogger with interests in monetary economics, economic history, finance, and fintech. He has worked as an equity researcher at a Canadian brokerage firm and a financial writer and publisher at a large Canadian bank. More recently, he has written several papers for R3, a distributed ledger company, on the topics of central bank cryptocurrency and cross border payments. He founded the popular blog Moneyness in 2012. He designs economics and financial wallcharts at Financial Graph & Art.

Koning earned his B.A. in Economics from McGill University.

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