BitMEX: In-depth analysis of the different impacts of two types of central bank digital currency policies on credit and the economy

Prohibiting physical cash would increase credit expansion, while allowing the public to deposit directly with the central bank would lead to credit contraction.

Original Title: "BitMEX Research | Central Bank Digital Currency Report"
Author: BitMEX Research
Translator: Zi Ming
Editor: Roy Wang
Source: Crypto Valley

In the article, we analyze the concept of Central Bank Digital Currency (CBDC) and divide it into two distinct categories:

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• Prohibit physical cash;
• Allow retail customers to deposit directly with the central bank.

Our conclusion is that while these two policies complement each other in some respects, they have significantly different economic effects. The former would increase credit expansion, while the latter would lead to credit contraction. Due to the deflationary nature of allowing the public to hold electronic deposits with the central bank, we believe financial regulatory authorities are unlikely to allow these CBDC schemes to succeed in any meaningful way.

Over the past year or so, discussions about Central Bank Digital Currencies (CBDCs) have been increasing. CBDC can be simply explained as the prohibition of physical cash, thus making currency 100% electronic. This goal can be achieved without making any significant changes to existing electronic currency infrastructures as physical cash is already very rare in some jurisdictions. Another popular interpretation of CBDC is allowing the public to directly deposit electronic funds into the central bank. This can function both as a complement to the prohibition of physical cash policy and as an independent alternative in cases where cash still exists. In this article, we will explore the economic explanations of CBDC, and in the next issue, we will delve into some technical explanations that are often associated with financial institutions using blockchain technology or Distributed Ledger Technology (DLT). Economic and technical explanations are often erroneously bundled together, but we believe they should be considered completely separately. CBDC can be achieved almost without blockchain technology, and at the same time, any benefits of applying blockchain technology can be achieved independently of CBDC.

Economic Overview

Understanding the mechanism of the global financial system is crucial before evaluating the effectiveness of this proposal. We discussed this topic as early as October 2017. The primary driver of modern economies is the credit cycle, whether commercial banks are expanding or contracting their balance sheets. Banks expand their balance sheets by offering new loans, creating new assets (loans) and new liabilities (corresponding deposits) from their perspective.

From a liquidity perspective, the largest deposit-absorbing institutions in an economy have almost unlimited capacity to create new loans because the funds withdrawn will automatically be redeposited as deposits back into banks. However, there is one exception to the above scenario where depositors can withdraw funds from the banking system in physical cash. Banks need to tap into reserve funds for their own financing to make up for this shortfall. Therefore, if the public withdraws funds in physical cash from the banking system, the banks' ability to create new loan business will be constrained. Of course, there are other non-liquidity-based constraints on credit expansion, such as capital adequacy regulations. Please note that withdrawing funds from banks via international wire transfers does not limit the lending capacity of large banks. Buying foreign currency is a two-way transaction: one party sells the domestic currency, and the other party, the buyer, deposits the funds (perhaps indirectly) in the same large bank.

Therefore, physical cash has a unique position to some extent, as it is the only way to test the liquidity demand of large banks in the entire system. Of course, this is a rather weak test, as no one would want to withdraw millions of dollars in physical cash for various reasons (such as security), so the position of large banks is very strong, and their lending business is the main driver of the modern economic cycle.

In summary, we analyzed the two types of CBDC strategies, namely banning physical cash and allowing retail customers to deposit funds directly with the central bank. Banning physical cash eliminates the remaining liquidity constraint on banks, allowing them to expand their loan scale almost at will and create new funds. On the other hand, allowing the public to make electronic deposits with the central bank provides a powerful way for people to exit the commercial banking system, but this is likely to severely restrict the banks' ability to create loans. The potential economic impact of CBDC:

We believe that the possibility of banning physical cash is higher in these two policies. At least banning cash seems to reasonably coincide with other political and economic trends, namely:

• The number of experimental and expansionary monetary policies is increasing;
• National regulatory intensity is increasing;
• The use of the Internet and electronic systems is increasing;
• The level of protection measures for the banking system is increasing;
• National power levels are rising.

One of the most important arguments in favor of banning cash is that it suppresses criminals from using cash for illegal activities. The data related to this issue seems compelling. According to U.S. government data, in 1976, about 25% of cash in the U.S. was circulating in $100 denominations, and today, that proportion has reached 80%, which is why high-denomination bills are more popular among criminals.

"In some areas like the Midwest, there's almost no need for $100 bills. But what we've found in states like Florida, California, and Texas, border states, is a very interesting pattern of criminality, in fact, that these states are basically heavily involved in drug trafficking...that drugs are sold locally in $10, $20 bills, and then the drug dealers take these bills to the border states, where they basically change them into larger denominations for easier shipping." — James Henry

Kenneth Rogoff, former Chief Economist of the International Monetary Fund (IMF) and a prominent advocate of phased cash bans, first proposed banning higher denomination bills. The criminal use of cash is also a major reason he opposes cash.

"Cash plays a big role in crime. In fact, there are many potential transaction media in our lives. You can use uncut diamonds, you can use gold coins...but you have a hard time measuring their value, so that's why they're hard to be a real transaction medium in our current economy." — Ken Rogoff

Furthermore, he supports the ban on cash from a monetary policy perspective: "Interest rates have been stuck at zero for a long time, and there are indeed many economists and central bank researchers who believe that in times of economic depression, if we reduce interest rates to zero, or even to -2% or -4%, the situation could turn around, even if the economy is leaping forward, increasing levels of inflation, increasing employment rates, and so on. But why don't they really do this? The reason they don't do this is because of the existence of cash. Central bank governors naturally worry that if they set negative interest rates and people hoard money instead of depositing it in banks, or everyone withdraws money from banks, these expected phenomena will undermine the positive effects of this strategy on the economy because the actual interest rates won't really decrease; secondly, it will cause various confusion caused by the circulation of cash in the economy."

However, even Mr. Rogoff recognizes that cash has some powerful advantages that electronic systems cannot match, namely the high robustness of its system, or as he puts it, the ability to operate in a storm. "Of course, I'm not saying I absolutely support a cash ban policy right now, just because we are far from a perfect solution to storms, privacy, and some problems in small transactions; we certainly won't swipe a credit card for a piece of candy, but we will choose to pay with some small denomination bills." Banning cash in the short term is not feasible, but we also easily see how this view is gradually beginning to attract political attention, especially as electronic payment systems become more popular, and the proportion of cash used for crime continues to increase.

For electronic cash systems like BTC, this policy is certainly positive. In fact, the U.S. dollar is essentially an electronic currency system today, but it also has a side chain with bidirectional anchoring, anonymity, no credit risk, censorship resistance, and wide adoption, namely physical cash. In this regard, the dollar is more attractive to people than BTC. However, removing the physical "side chain" would make BTC more attractive.

Currently, only large financial institutions can hold electronic deposits with the central bank, typically including banks, credit unions, broker-dealers, and payment service providers. The idea behind this policy is to extend this privileged status to the general public. While the public can already make deposits with the central bank, it can only be done in cash form, which would enable the public to make electronic deposits with the central bank.

As we explained above, unlike the cash banning policy, which is contractionary in nature, this policy symbolizes a reversal of the political and economic trends that most economies have been moving forward with. As stated in a report by the Bank of England in March 2020: "If a large amount of deposits were to move from commercial banks to CBDC, it could affect the balance sheets of commercial banks and the Bank of England, the amount of credit that banks can provide to the wider economy, how banks implement and support monetary policy, and financial stability. However, the design of CBDC can help mitigate these risks."

The report continues: "If households and businesses believe that the risk of CBDC is lower than that of bank deposits in times of stress or financial uncertainty (although retail depositors are protected by the FSCS), a rush to safety could cause widespread systemic instability. In this sense, a rapid transition from deposits to CBDC is also equivalent to a run on the banking system. In principle, this can be achieved by converting from deposits to cash, but bank runs are also limited by the practical transaction frictions and costs involved in withdrawing and storing large amounts of cash."

For this reason, at least in most jurisdictions, we believe that this policy is unlikely to be effective.

Ecuador

The above ideas may seem somewhat extreme. However, Ecuador has previously conducted a similar experiment, as CNBC announced in 2015: "Ecuador will become the first country to launch its own digital currency." In the late 1990s, Ecuador suffered from severe hyperinflation, resulting in the complete dollarization of its economy. The local currency, the sucre, was withdrawn from circulation in September 2000. Therefore, despite the government launching a digital currency in 2015, the primary currency in the economy, the U.S. dollar, can still be obtained through U.S. government-issued paper currency. The digital currency system issued by the Ecuadorian government is denominated in U.S. dollars.

As a result, the electronic currency system faced credit risk from the Ecuadorian government and lacked a physical cash alternative with the same credit risk. While this does not fully align with the categories discussed in this report, it has some similarities. Due to lack of user demand, the system was eventually shut down in 2018. Scholar Lawrence White pointed out when analyzing the 2014 plan: "There is no reason to believe that central governments can operate mobile payment systems more effectively than private companies like Vodafone."

Ultimately, this project in Ecuador cost the government about $8 million and did not achieve much except providing lessons for other central banks.

Sweden

Another interesting case study is Sweden. In 2009, a criminal gang made a bold raid on a cash depot using a helicopter and stole millions of Swedish krona. Some economists believe that this event shocked Sweden and to some extent turned public opinion against cash to prevent such violent crimes. Sweden is one of the countries with the lowest cash usage in the world, in terms of transaction ratios and reserve ratios. According to the Swedish central bank, the proportion of circulating cash to GDP is less than 2%, compared to about 7% in the U.S. and 9% in the EU. The Swedish central bank has withdrawn the highest denomination bills from currency circulation, and cash usage is rapidly decreasing.

"In 2018, only 13% of transactions nationwide were paid in cash. In 2010, that figure was 39%. As more and more consumers turn to electronic payments, retailers accepting cash will eventually become unprofitable. If this trend continues, cash will no longer be widely accepted by Swedish households and retailers." — Swedish Central Bank

Since 2017, the Swedish central bank has been researching the proposed E-krona project, a CBDC project designed as a supplement to physical cash withdrawn from currency circulation. As of February 2020, the bank has partnered with Accenture to provide a pilot E-krona system. The pilot document mentioned the use of "blockchain technology": "The solution will be based on Distributed Ledger Technology (DLT), commonly referred to as blockchain technology." We believe that the use of the term "blockchain" indicates that the project has a long way to go before implementation. We expect the project to continue, but eventually the Swedish central bank will remove references to DLT and blockchain, as the Bank of England seems to have done in its latest report, as stated by the Bank of England:

"We do not believe that Distributed Ledger Technology (DLT) must be used to build a CBDC, and there is no intrinsic reason to believe that more traditional centralized technologies cannot be used to build a CBDC." — Bank of England

However, given Sweden's political and economic situation and government agencies' firmer stance on this policy, Sweden may be the next country to introduce a CBDC.

Over the past year or so, BTC, blockchain technology, and stablecoins like Tether seem to have increased interest in CBDC to some extent. The International Bank of Settlements, the Bank of England, the Riksbank of Sweden, and the European Central Bank have recently published research reports on this topic.

In small and wealthy countries like Sweden, CBDC may achieve limited success. However, we believe that the motivation to protect commercial banks from runs will ultimately outweigh all other considerations. Therefore, we think it is unlikely that CBDC will develop in any meaningful way in important jurisdictions. At least as long as the current economic paradigm of financial collapse and subsequent highly expansionary monetary policy persists, this situation will continue.

This article is authorized by ChainNews for reprint. Source: ChainNews (ID: chainnewscom)

Further Reading

• Did Bitcoin Miss the Hedge Attribute? A Review of the Counter-Trend Rise of Gold in 2008

• [Full Text of Coinbase Blog] Bitcoin's Disconnection from "Unrelated Assets" May Only Be Temporary

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