Dragon White: The Central Bank Digital Currency Q&A Handbook – a book that takes you through CBDC and Libra

In the Q&A format, Dr. Long Baiyu prepared a series of topics related to CBDC (which will also be limited to Libra) to help readers understand Dr. Long's CBDC and Libra related articles. Dr. Long is currently an independent monetary finance researcher whose views reflect only personal positions and do not reflect any official attitude. Dr. Long will continue to update this topic question and answer, readers can speak to Dr. Long through the comment area or send an email to longbaitao@gmail.com.

About the author: Long Baiyi , Bachelor of Computer Science, Master and Ph.D. I like to study blockchain and cryptocurrency technology and monetary and financial theory. Continuous entrepreneurs. He founded Zhixiang Technology, which focuses on financial cloud computing, quantitative investment, and machine learning. He obtained 27.5 million RMB investment from Qifu Capital; he served as chief technology officer of Zhongjin Jiazi Investment Fund before starting business; Data co-founder and chief strategy officer; previously a senior executive in financial services at Accenture Consulting and IBM Global Consulting Services, providing long-term technical, business and strategic consulting services to clients in China's financial services industry, representing Accenture as Shanghai Securities Chief designer of the Exchange's new generation trading system project.

The following is the text:

1. What is the main purpose of the central bank's digital currency (CBDC, the same below)? Where does the main driving force for its advancement come from?

The fundamental purpose of CBDC is to promote the internationalization of the RMB , especially in the “One Belt, One Road” policy environment, to improve the convenience of RMB cross-border payment, and to enhance the RMB as a tool for international trade pricing and payment settlement, and to enhance the status of the RMB as a value storage and reserve currency. The fundamental purpose of CBDC is not to improve the efficiency of RMB issuance and circulation, and not to improve the efficiency of settlement of RMB payments . The most important form of renminbi circulation now is commercial bank deposits, which are already in the form of electronic money, and there is no problem in the efficiency of its issuance and circulation. The central bank has also developed a modern real-time full-clearing system, so the efficiency of settlement of renminbi payments is also very high.

The main driving force of CBDC promotion is internal and external factors, all from the fundamental goal of RMB internationalization. Prior to this, attempts to internationalize the RMB, such as increasing the weight of the RMB in the IMF and raising the status of the global reserve currency, were not very successful. In the current SDR basket currency, the weights of the US dollar, Euro, Japanese Yen, British Pound and Renminbi are 41.73%, 30.93%, 8.3%, 8.09% and 10.92% respectively, and the RMB accounts for about 2% of the global reserve currency. The status of the economy is not commensurate. The development of Libra as a super-sovereign currency poses a new challenge for the internationalization of the RMB.

From the perspective of domestic currency management, the development of CBDC has the following advantages: (1) The central bank can better manage the creation and supply of money, make the monetary policy transmission mechanism more effective, and enhance the central bank's ability to cope with the business cycle; (2) The cost reduction and efficiency of the payment and clearing system based on blockchain technology; (3) The central bank has gained stronger control over the monetary system, such as KYC, anti-money laundering and counter-terrorism financing. However, these benefits are only a secondary purpose compared with the goal of RMB internationalization.

2. Is CBDC M1? What is the relationship with other forms of currency or currency in the central bank?

The CBDC is positioned as M0 in the same way as other forms of central bank currency, including physical cash and reserves (also known as “reserves”, and is considered a liability of the central bank. M0 plus commercial bank demand deposit, ie M1. M1 plus commercial banks' time deposits and large deposit certificates, ie M2. Bank deposits are the liabilities of commercial banks. The main form of currency in circulation is physical cash and bank deposits. The speech of Wang Xin, the director of the Central Bank Research Bureau, has clearly stated that “CBDC is positioned at M0”. Physical cash can be used by the whole society, but only the commercial banks, some non-bank financial institutions, the Ministry of Finance and foreign central banks can access the reserve system. Commercial banks create deposit currencies primarily by issuing loans or purchasing assets, and destroying deposit currencies when loans are returned or sold. Different CBDC systems may have very different scopes of application in principle. Some regard CBDC as the electronic version of the central bank's physical cash, and some regard CBDC as a central bank reserve that expands the accessible range. Some regard CBDC as a substitute for commercial bank deposits. It is not clear the relationship between CBDC and other forms of central bank in China's official version. The CBDC proposed in Dr. Long's paper has several specific characteristics: (1) CBDC positioning is M0; (2) Any person and institution can be in the central bank. Opening a CBDC account; (3) CBDC is a token-based system; (4) CBDC can use an operating structure that is completely independent of the existing central bank; (5) CBDC is interest-bearing, and under reasonable assumptions, interest rates can be different Central bank reserves; (6) CBDC not only supports retail payments and interbank clearing, but also supports cross-border payments; (7) CBDC's issuance mechanism can be different from cash and reserves, such as supporting different collateral and allowing for a wider range of The main body participates in the issuance of CBDC. The author reminds the reader that the Chinese central bank is likely to give CBDC a different characteristic from the above depending on different considerations . The discussion in this article, unless specifically stated, is directed to the CBDC program proposed in Dr. Long's paper.

3. What is the biggest system risk of CBDC? Why is it happening?

The biggest system risk of CBDC comes from the large-scale switch of commercial bank deposits to the CBDC run.

As explained in Question 2, CBDC is positioned as M0, which is a kind of liability of the central bank. The bank deposit is positioned as M1/M2, which is a kind of liability of commercial banks. The central bank’s liabilities are risk-free, while commercial banks’ liabilities are risky. CBDC and bank deposits are all in the form of digital currency. In the past, ordinary depositors could only hold bank deposits except for physical cash. After the introduction of CBDC, ordinary depositors had the opportunity to hold CBDC for the first time. Considering the risk-free nature of CBDC, depositors have a strong incentive to switch bank deposits to CBDC. Even if the central bank uses interest rate instruments to curb this conversion, the effectiveness of interest rate instruments may be very limited in the event of market panic.

4. What is the difference between bank deposits to CBDC and traditional bank runs?

The traditional form of bank run is that commercial bank deposits are largely converted into cash and extracted from banks. The central bank has been managing this risk. However, the traditional run has some constraints: (1) There is a certain cost in the printing, distribution and storage of physical cash, that is, physical cash has a higher friction cost. Even if the run occurs, its scale and speed are limited; (2) banks generally set up some “obstacle” for extracting physical cash. For example, large-scale withdrawal requires advance notice, which helps the central bank to effectively predict physical cash demand. Considering that the total amount of currency in the form of physical cash is small (M2 is about 5%), this “obstacle” does not impair the face value consistency of physical cash with other forms of currency. (3) Traditional bank runs are generally directed at a single bank, not the entire banking system, so the system risk is limited.

The bank deposit to the CBDC run will bring great systemic risk. The CBDC is an electronic form of currency with zero "printing", distribution and storage costs, ie no friction costs. Therefore, the run at this time is instantaneous, instantaneous detonation, and the scale may be much larger. In addition, the current run is generally not for the behavior of a single bank, but for the entire banking system, depositors want to convert bank deposits into CBDC, so compared to the traditional scene, the run size is more than an order of magnitude.

  • 5. What are the consequences of the bank deposit to the CBDC run?

The consequence of a bank deposit to CBDC run is a significant reduction in the amount of liquidity that banks can use to support the creation of credit, thereby seriously affecting the amount or price of credit.

Use a simplified model to examine the business model of the bank. According to the requirements of the supervision, all the bank's deposit liabilities need to have corresponding asset support, and the asset requirements corresponding to different currency types of deposits are different. Physical cash deposits require 100% reserve (that is, commercial banks can only exchange one yuan of physical cash in the central bank's one-yuan reserve), considering that the physical cash storage costs and physical cash do not interest, commercial banks holding cash is essentially a loss. Therefore, all commercial banks tend to hold the minimum amount of cash, just to meet the needs of users. General deposits require partial reserves. Assuming a deposit reserve ratio of 10%, commercial banks can derive a deposit of ten yuan in the one-yuan reserve of the central bank. When commercial banks have insufficient reserves in the central bank, commercial banks can lend their reserves to the central bank by pledgeing their own liquid assets. Therefore, the size of a liquidity asset of a commercial bank constrains its ability to create a deposit currency. Considering that commercial banks create deposit currencies through loans, the size of liquid assets of commercial banks constrains the scale of their creation of credit. Similar to physical cash deposits, CBDC deposits require a 100% reserve. Therefore, switching from commercial bank deposits to CBDCs actually forces banks to transfer equivalent deposits from partial reserves to 100% reserves, which will quickly consume the liquid assets held by commercial banks, thus seriously affecting The amount and price of credit.

6. Can CBDC not pay interest like cash?

A reasonable CBDC design must pay interest. The assumption here is that cash as a form of currency in circulation, the trend is gradually decreasing, CBDC as an important form of central bank currency, will occupy an increasingly important position in the currency, so the currency for the quantity and price of CBDC Policy tools will become important.

Under this premise, the fundamental reason for paying adjustable interest rates for CBDC is to maintain price stability and maintain parity between CBDC and other currencies. The supply and demand of CBDC in the market needs a price to reach equilibrium. Suppose CBDC pays zero nominal interest rate like cash. If the central bank over-provisions CBDC because of the inaccurate forecast of real CBDC balance, then the method of eliminating over-supply can only be as follows: (1) CBDC depreciation thus destroys CBDC The parity relationship with other forms of currency, or (2) reducing the true value of the nominal CBDC balance makes it consistent with the real demand of CBDC, thus clearing the market through the general price level, but doing so directly violates the central bank's anti-inflation target. If the interest rate paid by CBDC is fixed, there is no third possible method. However, the adjustable interest rate can increase the demand of CBDC without the adjustment of the central bank's balance sheet, without destroying the parity relationship and without the price level adjustment.

Simply put, if CBDC is positioned as a new monetary instrument for the central bank, its price and quantity control will become an indispensable monetary policy tool for the central bank.

7. Can CBDC be regarded as an electronic version of central bank cash?

If CBDC supports cross-border payments, it is clear that CBDC cannot be considered an electronic version of the central bank's cash, as this will directly undermine the existing RMB foreign exchange management system.

If CBDC does not support cross-border payments, CBDC still has very different characteristics from cash. First, question 5 has explained why CBDC must pay adjustable interest. Second, from a payment instrument perspective, cash only supports retail payments, but in general CBDC can support direct payments (P2P form) between anyone or an organization because of its token-based design. Third, current design cash is almost untrackable, but CBDC is well-tracked, traceable, non-tamperable, and programmable due to its blockchain-based design, enabling central banks to enrich CBDC. Currency control function. These different characteristics make it impossible for CBDC to be seen as an electronic version of central bank cash.

8. Can the central bank support the exchange of CBDC and reserves?

If CBDC is designed to support cross-border payments, the central bank must ban the exchange of CBDC and reserves, as this directly undermines the existing RMB foreign exchange management system.

If CBDC is designed not to support cross-border payments, such redemption must also be prohibited. Because when depositors switch from bank deposits to CBDC in large numbers, prohibiting such exchanges will help maintain financial stability. If CBDC and reserves are freely convertible, in this case, a single bank willing to pay CBDC for deposits is enough to threaten financial stability. This stems from the bank's commitment to settle interbank payments in reserves through a real-time full clearing system. When a bank pays CBDC for deposits, all non-bank entities can take advantage of this by transferring the deposit to the bank. When losing deposits to the bank, other banks must use the reserve to settle interbank payments. When the central bank supports the immediate conversion of the reserve to CBDC, the bank can use its newly acquired reserves to obtain CBDC in order to pay to the depositors for this purpose. This will result in the destruction of deposits and trigger a system-wide, almost instantaneous bank run.

Second, if CBDC and reserves cannot be redeemed, they are different monetary instruments that can serve their core purposes. CBDC can be used not only as a retail payment medium, but also as an interbank settlement asset, and also supports cross-border payments. This gives the central bank a new policy tool, especially the number or interest rate of CBDC. On the other hand, the central bank can maintain control over the amount of reserves in the financial system and its interest rates. Maintaining control over reserves allows the central bank to continue to influence risk-free interest rates in the economy, which is a key factor in actual investment decisions and cross-cycle allocation decisions.

There are also academic papers that demonstrate that the interest rates of CBDC and reserves are different from the perspective of convenience income. The so-called convenience income refers to the premium of CBDC as a trading medium, and the interest rate of CBDC is equal to the risk-free rate minus its convenient income. The interest rate on the reserve is basically equivalent to the risk-free rate.

9. How to issue CBDC?

Waiting for the next update.

10. Does the commercial bank need to commit to the exchange of bank deposits to CBDC?

Waiting for the next update.

Recommended reading:

Dragon White: A practical Chinese central bank digital currency and Libra design

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Evaluating Libra from the history, current status and future of the monetary and financial system