Academic discussion on the practice of the central bank's digital currency DC/EP

Disclaimer: This article is for academic purposes only and reflects the author's personal views and does not represent any official attitude or work.

About the author: Long Baiyi, Bachelor of Computer Science, Master and Ph.D. Independent researcher in blockchain technology and monetary and financial theory, studied under the famous economist Zhu Jiaming. One of the first Libra authors in China. 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 the chief technology officer of Zhongjin Jiazi Investment Fund; and served as the general data association of Wanxiang Holdings. Founder and Chief Strategy Officer; previously a senior executive in financial services at Accenture Consulting and IBM Global Consulting Services, representing Accenture as the chief architect of the New Generation Trading Systems program at the Shanghai Stock Exchange.

The following is the text:

On August 10, 2019, Mu Changchun, deputy director of the Central Bank's Settlement Division, introduced the central bank's legal digital currency practice DC/EP (in the absence of ambiguity in this article, DC/EP and CBDC will be used interchangeably to represent the central bank's digital currency). The situation is summarized as follows:

  1. The central bank CBDC adopts a two-tier operation structure, that is, the central bank first converts CBDC to commercial banks or other operating agencies, and then these institutions are redeemed to the public;
  2. At this stage, CBDC is positioned as an electronic substitute for physical cash, which belongs to M0 and is regarded as the liability of the central bank;
  3. CBDC does not bear interest;
  4. The central bank believes that the two-tier operating system will not change the existing money delivery system and the dual account structure, and will not compete with the deposit currency of commercial banks;
  5. The central bank believes that the program does not affect the existing monetary policy transmission mechanism;
  6. Does not preset the technical route developed by CBDC

This paper mainly discusses the central bank CBDC program from the perspective of financial stability. The author recently published two papers on the central bank's CBDC, namely "A Practical Chinese CBDC and Libra Project Design" and "Dr. Dr. Long Baixuan CBDC Q&A" . Much of this article is based on an excerpt from the two articles on the DC/EP scheme and adds some content.

In the article "CBDC Q&A" , three typical CBDC design patterns are defined. In Mode 2, "only bank and non-bank financial institutions can open CBDC accounts in the central bank, and households and enterprises cannot directly access CBDC. In addition, there is no institution. Provide assets for the family and corporate sectors that are fully supported by the central bank's currency (ie, the derived currency of 100% reserves). According to the characteristics of DC/EP, DC/EP belongs to the CBDC design of mode 2.

"CBDC Q&A" has stated that "commercial banks like CBDC of Mode 2 because they essentially retain the system and interest structure of the existing monetary system and do not harm the existing business model of commercial banks (creating deposit money through lending) ), and with blockchain technology blessing, the banking system (including central banks and commercial banks) can reduce costs and efficiency in infrastructure, and through the blockchain traceability, traceability, non-tampering, programmable and other characteristics, banks The system can greatly enhance the control and control of the monetary system, such as KYC, anti-money laundering, counter-terrorism financing, and targeted monetary policy (such as targeted RRR, targeted currency, etc.).

Director Mu said, “Summary down, the central bank is the upper level and the commercial bank is the second level. This dual delivery system is suitable for our national conditions. It can use existing resources to mobilize the enthusiasm of commercial banks and smoothly improve the acceptance of digital currency. ". The existing physical cash “is easy to be forged anonymously, and there are risks for money laundering, terrorist financing, etc.”. Today's electronic payment tools cannot meet the public's demand for anonymous payments. The DC/EP design, "keeping the properties and main features of cash, also meets the needs of portable and anonymous, is a better tool to replace cash ."

From the perspective of financial stability, the CBDC design plan should follow the following principles to avoid or mitigate the impact of the introduction and implementation of CBDC on the stability of existing financial systems.

  1. Do not introduce uncertainty into existing monetary policy instruments and transmission mechanisms;
  2. Considering that CBDC may serve a completely different core objective, introduce new monetary policy tools for CBDC as much as possible;
  3. Does not change or significantly weaken the business model of commercial banks (creating deposit currency through loans, providing credit and liquidity to society);
  4. Avoid commercial bank runs that may result from the introduction of CBDC (such as depositors switching from bank deposits to CBDC on a large scale)

The current DC/EP design does not position it as a new currency tool and introduces new monetary policy tools. Therefore, this article focuses on the other three principles.

CBDC is safer than bank deposits, which is the root cause of bank deposits to CBDC runs.

In the CBDC program design, the most important financial stability risk comes from the bank “crowding” caused by the conversion of bank deposits to CBDC. The CBDC is positioned as M0, which is a kind of debt 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 electronic forms of 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.

Bank deposits to CBDC are much faster and larger than 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 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.

The risk of bank deposits to CBDC runs still exists in DC/EP practice

In the DC/EP practice, the commercial bank will initiate the issuance/return of the CBDC to the central bank, while deducting/increasing the equivalent reserve. Therefore, it can be considered that the central bank allows commercial banks to freely convert CBDC with reserves . 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 the Real-Time Full Settlement System (RTGS). When a bank pays CBDC for deposits, all non-bank entities can take advantage of this by transferring the deposit to the bank. When the deposit is lost to the bank, other banks must use the RTGS system to settle interbank payments with reserves. 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.

In the traditional currency issuance system, central banks and commercial banks have been managing the run of deposits to physical cash. Given the frictional cost of physical cash, the speed and scale of traditional runs occur. Under normal circumstances, the traditional form of the run is a crisis caused by the deterioration of the bank's solvency, so the risk management of the traditional run is more management of the bank's liquidity. Therefore, banks can be considered to guarantee the free exchange of bank deposits to physical cash. In the DC/EP program of the central bank, the current public information does not see any changes in this aspect, so this article carefully speculates that commercial banks will continue to guarantee the exchange of bank deposits to CBDC . When the net inflow of CBDC and net outflows is small and the action is slow, the banking sector may be able to cope. However, the challenge is whether or not the obligation can be fulfilled during the stress period. Assuming that the entire non-banking sector needs more CBDCs, and that the entire banking sector's consumption reserve for CBDC is still unable to meet demand, banks need to sell/collateralize qualifying assets to the central bank to obtain reserves for CBDC. Given the potential scale of redemption, the banking sector may quickly consume qualifying assets. The central bank may have to expand the list of eligible collateral, or even completely waive the collateral requirements for large unsecured loans. Therefore, the credibility of this guarantee depends on the commitment of the central bank as the lender of last resort . Given the potential size of liquidity requirements, there may be unprecedented risks to the central bank's balance sheet.

If the central bank promises to accept bank deposits in exchange for CBDC in an emergency, this will open the door for bank deposits to CBDC. It is conceivable that this kind of run can be run almost instantaneously, at an unprecedented scale, because it is run from the entire banking system, not from one bank to another. This reflects the fact that the liquidity support that the banking sector may need to request from the central bank will be an order of magnitude larger than the traditional bank run.

The consequence of a bank deposit to CBDC run is to significantly reduce 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 requires 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. Considering the currency multiplier, in general, even if the bank consumes liquid assets, it cannot support the user's deposit to CBDC, and the bank has to reclaim the loan assets at a discount. Banks may quickly fall into an insolvency situation.

The use of interest rate instruments by central banks (such as paying zero interest rates for CBDC in DC/EP practice) is not enough to curb bank deposits to CBDC runs. In the case of market panic, interest rate instruments may be very limited.

Under the traditional currency issuance system, currency holders may hold physical cash for considerations such as hedging and transaction anonymization, and will hold bank deposits due to wholesale payment, electronic, portable and interest rates. In DC/EP practice, although CBDC is positioned as a physical cash substitute, it has many attributes in common with bank deposits – supporting wholesale payments, electronics and portability. Therefore, CBDC is also a substitute for bank deposits .

Treating interest rates as a risk premium, the difference between bank deposits and CBDC is only the difference in risk premium and anonymization support. Therefore, the holder will choose between the risk preference and the anonymization requirement. Traditionally, money-holders' risk-free preferences are inhibited by the frictional cost of physical cash and the lack of support for wholesale payments, which can be better met in DC/EP practice. We define the income other than the financial income of the currency as “convenience income”. Although the bank deposit is higher than the interest rate of CBDC, the former has lower convenience income than the latter. In the money supply and demand relationship, the currency holder will eventually consider the financial benefits and convenience income of the currency to balance the bank deposits and the number of CBDCs. Similarly, CBDC's convenience income is greater than physical cash.

In the case that CBDC's convenience income is higher than physical cash and bank deposits, holders will be significantly inclined to hold CBDC instead of physical cash. The central bank's relying solely on interest rate instruments does not effectively inhibit holders from converting bank deposits to CBDC.

In the case of economic downturn or market panic, holders will be more concerned about asset security than financial gains, and more bank deposits will be switched to CBDC. At this point the interest rate instrument will become more ineffective.

DC/EP practices will weaken the effectiveness or uncertainty of central bank monetary policy instruments

Currency holders' preference for CBDC/bank deposits will be significantly affected by interest rate levels. Central banks can adjust liquidity through interest rate instruments. The lower the interest rate level, the holder tends to think that the risk premium of the deposit is not enough to offset the convenience income of CBDC, so it tends to hold more CBDC. In extreme cases, depositors may convert all deposits into CBDCs near zero interest rates. According to the results of the Bank of England's research in 2016, CBDC based on 30% of US GDP can surpass the macroeconomic results of traditionally issued currency based on 70% GDP. The conversion of more reserves into CBDC will weaken banks' ability to create derivative currencies and reduce the supply of liquidity. Therefore, the overall effect of CBDC's increased liquidity and reduced liquidity of sentiment will be uncertain, which will bring uncertainty to the effectiveness of the central bank's interest rate instruments .

If the CBDC supply exceeds actual demand for various reasons, the central bank will not be able to recover CBDC liquidity at zero interest rates. Traditional physical cash also has similar problems but has no real impact because (1) physical cash is only 5% less than M2 supply, and (2) physical cash transfer efficiency is much lower than bank deposits. It is reasonable to assume that physical cash flow efficiency is lower than One tenth of the deposit. Therefore, physical cash contributes less than 1% to the overall social mobility, and the central bank only needs to control the liquidity supply of bank deposits.

But CBDC will be very different, because (1) CBDC is not only a substitute for physical cash, but also a substitute for bank deposits. It is reasonable to assume that CBDC will account for 20% of M2 supply. (2) CBDC has higher transfer efficiency than bank deposits. It is reasonable to assume that the former has twice the transfer efficiency. Therefore, CBDC contributes nearly one-third to the overall mobility of society.

In the case that CBDC's impact on social mobility is comparable to bank deposits, if the overall social liquidity supply is excessive, the central bank will lack effective monetary policy tools to recover CBDC liquidity. The central bank traditionally uses interest rates and open market instruments to regulate liquidity, but now nearly one-third of liquidity is not affected by interest rate instruments, which will significantly weaken the effectiveness of existing interest rate instruments . The direct consequence of excess liquidity is inflation.

One of the core principles of DC/EP practice is that the total reserves and CBDC remain the same, thus maintaining the effectiveness of existing (quantitative) monetary policy instruments. Through the partial reserve system, the central bank controls the size of the bank's overall credit creation by controlling the total amount of reserves. When bank deposits are converted to CBDC, the bank's ability to create credit will be weakened. Although the central bank can control the total amount of reserves (CBDC), the previous analysis has shown that banks tend to keep CBDC zero inventories. Therefore, the number of CBDCs in the market equilibrium state will be jointly determined by non-bank financial institutions, households and enterprises. The amount of gold can therefore be determined. This means that the central bank has lost the ability to directly control the total amount of reserves and the overall credit scale of the bank .

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 intertemporal allocation decisions. Therefore, CBDC in DC/EP practice has weakened the central bank's control over risk-free interest rates .

DC/EP practices will have an impact on the amount or price of bank credit

The exchange of reserves into CBDC will directly weaken the bank's ability to create credit. In addition, this exchange also affects banking regulatory indicators. For example, Basel III requires restrictions on the share of “unstable” bank financing (through the “net stable financing ratio”) and requires minimum liquidity holdings to cover potential outflows of certain types of funds (through “ Flow coverage ratio"). These restrictions, in turn, affect the bank's ability to lend. The switch from bank deposits to CBDC not only exposes banks to the relatively stable loss of retail deposits, but also removes relatively high liquidity bonds. Commercial banks may have to use wholesale financing to replace bank deposits. These conditions may affect the regulatory ratio, which affects the amount or price of credit. The Deputy Governor of the Bank of Mexico recently expressed similar concerns.

The impact of DC/EP practices on the total social liquidity supply will be uncertain

Further consideration of the commercial bank's survival money based on the reserve fund will make the situation more complicated. Because CBDC replaces physical cash and bank deposits at the same time, reserves that exceed the traditional cash demand amount will be converted into CBDC, and the ability of commercial banks to create deposit currency will be weakened. The liquidity contributed by physical cash and deposit currency will decrease, but will increase the liquidity contributed by CBDC. Considering the previous conclusion, CBDC's transfer efficiency is higher than physical cash and bank deposits, so the flow of physical cash and sentiment is reduced. Whether the sex is enough to be compensated by the corresponding increase in CBDC liquidity will be uncertain.

Correct understanding of the goals of CBDC

The CBDC is by definition a central bank digital currency that serves only the central bank's objectives – reducing costs, improving efficiency, improving business capabilities and strengthening power. Under this goal, any feasible technical solution is optional, which is what the central bank calls “technical neutrality”. In the BISDC research report of the Bank for International Settlements, it is also mentioned that traditional centralized technology, alliance and public chain technologies are all optional, but the current public chain technology is not enough to support the central bank's CBDC demand. Therefore, the proposal and implementation of CBDC is to strengthen and further concentrate power, and it is not necessarily related to decentralization and democratization. The collective fantasy and climax of CBDC is naive and funny.

Let's review the goals of CBDC:

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) based on Block-chain technology payment and clearing system to reduce costs and increase efficiency; (3) the central bank to obtain stronger monetary system control capabilities, such as KYC, anti-money laundering, counter-terrorism financing and targeting functions (such as targeted RRR and targeted currency delivery) . With the emergence of Libra, the sovereign currency, the internationalization of the renminbi has now been elevated to a higher priority.

to sum up

Although the central bank's DC/EP practice nominally locates physical cash substitutes, it also partially replaces bank deposits. In DC/EP practice, reserves and CBDC are convertible, bank deposits and CBDC are convertible, which opens the door for bank deposits to CBDC. Although the central bank can use interest rate instruments to suppress this conversion, the effect is limited. DC/EP has a greater impact on the effectiveness of existing monetary policy instruments: it will significantly weaken or bring uncertainty to the effectiveness of central bank interest rate instruments; the central bank will lose the ability to directly control the amount of reserves and the overall credit scale of banks. Weaken the ability of the central bank to control risk-free interest rates. DC/EP practices may affect the amount and price of bank credit, and the impact on the total social liquidity supply will be uncertain.

We need to understand CBDC's goals correctly, which only serve the needs of the central bank rather than satisfying the public's wishes. The author believes that DC/EP is only the CBDC test of the central bank under the premise of controlling risks, so any design does not represent the final form of CBDC.

This article was authored by the author Long Baiyi to authorize Babbitt Information.

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