Digital Money: Why, When, And What It Could Mean

Introduction

The transition to digital money is inevitable and imminent. According to the BIS, at least a fifth of the world’s population can expect an introduction to either global stablecoins (GSCs) or central bank digital currencies (CBDCs) ‘very soon’. With them will come greater financial inclusion, cross-border transaction efficiency, and an ecosystem of e-commerce/social media platforms. But there are also risks.

Two working papers by the IMF and BIS recently provided some informal insights into the macro-financial implications of digital currencies and stablecoins. Here, I distil their main findings:

• The implications of digital money depends crucially on the level of adoption, which is likely to be widespread.
• Conventional monetary policy is hindered even when digital currency is only used for cross-border transactions and for retail use on e-commerce and social media platforms.
• Currency substitution increases with greater adoption of digital money, leading to greater financial instability, capital flow volatility and a shortage of reserve holdings.
• Many of the macro-financial risks are attenuated in the long-run, but only under global adoption of both GSCs and CBDCs. Greater competition dilutes private firms influence over macroeconomic policy.

We first discuss the motives and likelihood of digital money adoption, and then turn to the macro financial implications.

Source: IMF page 9

Why Might Countries Adopt CBDCs, and To What Extent May They Be Used?

Like existing stablecoins, GSCs are a type of private digital money. The difference is they are issued by Big Techs, and so have the potential for widespread adoption through network effects. An example is Facebook’s ‘Libra’, a blockchain-based digital money fully backed by assets denominated in reserve currencies.

Libra’s announcement was a major tipping point for central banks, reinvigorating discussions around CBDCs – a digital form of central-bank-issued fiat money originally put forward by James Topin in 1987. A BIS survey of central banks in 21 DM and 45 EM economies reveals an evident move towards CBDC research. Around 80% are engaging in work related to CBDC, and 40% have already progressed from analytical studies to experiments or proofs of concept. Indeed, central bank governors and board members are giving more positive public speeches on the topic (Chart 2).

Source: BIS page 8

There are three reasons for this universal swing into CBDC. Firstly, global stablecoins could significantly alter monetary policy effectiveness. Secondly, late adoption of a CBDC could bring with it a period of greater currency switching during the non-adoption phase. Lastly, policymakers have exhausted many of the conventional tools through which they can impact the real economy.

The Benefits of CBDCs and GSCs

The implications of digital money on the financial landscape will depend, naturally, on its level of adoption.

Retail Solutions

CBDCs and GSCs intrinsically lower transaction costs, they are universally accessible, and they can provide access to complementary services or bundling. These benefits are predominantly retail-orientated, relating to cross-border payments, the desire to access credit and improving user-experience on digital platforms.

As such, retail solutions are perhaps the primary driving force behind adopting CBDCs and/or GSCs. They have the least impact on the financial system and significantly improve financial inclusion and efficiency. CBDCs designed only for retail and cross-border transactions would also be sufficient for central banks to send direct transfers to digital wallets, thereby increasing demand.

This niche adoption of digital money can, however, still have non-trivial implications for the financial system. Remittances to developing countries exceeded US$550bn in 2019, surpassing FDI and portfolio flows. The average cost of sending remittances is 10% of remittance value, or approximately US$55bn. Banks rely on remittances as a key source of income.

The Role of Money

Where CBDCs and GSCs become used for international transactions, they ultimately serve as a medium of exchange and unit of account. In this instance, users will likely hold balances of the CBDC or GSC only for transactional purposes. But some individuals could continue to hold limited balances of the CBDC or GSC as store of value, substituting for domestic bank deposits.

Adoption of digital money could progress beyond retail transactions in two directions, both related to the role of traditional money:

• Firstly, users swap domestic currency for a GSC or foreign CBDC for domestic transactions because the latter are a better medium of exchange. This switch occurs when there are domestic financial market liquidity issues or when a country has a small share in world output or trade.
• Secondly, users make the same swap to obtain a better store of value. This typically occurs against a backdrop of unsound domestic macroeconomic policies and distrust in policy institutions, which generates local currency volatility.

Digital money allows users to transfer money to or between digital wallets easily, so CBDCs and GSCs are likely to increase currency substitution. And currency substitution can have significant financial market implications. A sample of 154 (149) countries that report data on foreign currency deposits (loans) to total deposits (loans) shows that, while most countries around the world exhibit low levels of currency substitution, one third of countries currency substitution exceeds 30% of deposits/loans (Chart 3).

Source: IMF page 39

For digital money to progress towards a domestic medium of exchange and as a store of value, there needs to be global adoption of CBDCs or GSCs. Global adoption generates strong ‘network effects’ (when the private value of using a service or product increases with the number of other users). Given the existence of strong network effects among e-commerce and social media platforms, it is realistic to assume that GSCs can, in the absence of restrictive legislation, establish themselves as a key medium of exchange, unit of account and store of value. And, global adoption of GSCs would lead to greater adoption of CBDCs to limit private firms monetary policy influence. Next I present the implications of such a scenario.

The Macro-Financial Implications Of Digital Money

Each level of potential adoption will have different implications for the macro-finance landscape. Broadly, we can divide these into monetary policy, financial stability, capital flows, and international reserves.

Monetary Policy

The adoption of foreign digital currencies and stablecoins will hinder domestic central banks’ ability to conduct monetary policy. By how much depends on the level of currency substitution and the impact on the business cycle. Both factors are a positive function of adoption.

As already discussed, currency substitution is likely to increase in a digital world. And historically, when substitution occurs, the domestic usage of foreign currency tends to be highly persistent. In this case, monetary authorities have less control over financial stability. In other words, as adoption of digital currencies increases, the higher associated currency substitution will hinder domestic monetary policy.

Wider use of CBDCs will generate more global economic interdependence, generating business cycle concerns similar to those faced by countries in currency unions. That is, local regulatory authorities may find it more difficult to constrain boom and bust dynamics. Greater interconnectedness will bring other sources of risks, where weaknesses in one jurisdiction could raise risks for the entire ecosystem.

Greater adoption of GSCs is likely to have less predictable consequences. With just one global stablecoin, private companies will gain significant control over a country’s macroeconomic policy by charging rates of return and altering supply. Also, shocks to issuing firms are more likely to filter into other parts of the economy, generating greater macroeconomic instability. Competition among BigTech firms can, however, ensure the incentives of these firms align more closely to a country and lower adjustable rates of return to holding coins.

Financial Stability

CBDCs and GSCs could create additional incentives for risk taking and raise financial vulnerabilities. These include additional funding and solvency risks from greater currency substitution. For example, if users store money in a GSC, bank deposits will fall, and banks will compensate losses with other, more volatile sources. Banks will also face losses if they rely significantly on fees from cross-border payments.

Furthermore, use of foreign CBDC or GSC could lead to higher run risks in stressful times. For example, in many emerging markets and developing countries, a run on the banking system is often associated with a run on the currency or the country. In such cases, depositors tend to move wealth into foreign assets. Faster and more easily accessible digital wallets can therefore increase run risk.

Finally, low switching costs between CBDCs and GSCs could make the participation in a currency bloc or digital currency area unstable. It could also create incentives for GSC service providers to take on higher risks to gain market share in the short term. On the flipside, however, competition could foster discipline in risk management in order to maintain the attractiveness of privately issued money in the longer term.

Capital Flows

One key benefit of digital currencies is that they reduce transaction costs and frictions in international capital markets. For investors, this makes foreign financial markets more accessible and, if bundled with big data, can offer improved cross-border credit analytics and help lower information asymmetries.

From a borrower’s perspective, a reduction in search and transaction costs could help improve cross-border offerings by banks or reduce the reliance on banks, improve access to international capital markets, and lead to higher financial inclusion of less developed countries or of SMEs across the world.

More widespread adoption of digital currencies means more bypassing of traditional payment systems, through which exchange restrictions and CFMs are typically enforced. Not only does this make monetary policy more challenging, it is likely to generate significant capital flow volatility. Further, global adoption of a single GSC could lead to more volatile financial conditions in the short term. For example, if a GSC is bundled with social media platforms, there could be higher incidence of herding behaviour, panics and noise-trading of financial assets.

Despite the risks, global adoption would largely remove exchange risks and re-denomination risks. It could give households and small businesses easier access to real-time hedging services and improved risk management. It also creates more opportunities for international risk sharing if CBDCs and GSCs are not correlated. Also, new classes of safe assets could offer the opportunity of portfolio diversification and the construction of better hedges against idiosyncratic external risk facing countries.

International Reserves

Adoption and use of CBDCs and GSCs may alter the incentives for both reserve holders and issuers. Under local adoption, central banks would need to increase foreign reserves for precautionary motives. For issuers, the incentives to supply more safe assets may vary. If internationalisation is a policy objective, issuers would at least partially accommodate a rise in demand. Otherwise higher demand could lead to a shortage of safe assets, causing possible side effects such as depressed risk premiums and higher leverage in the financial system.

Under global adoption of a single GSC, central banks would want to hold safe GSC reserves. However, the GSC issuer may have a conflict of interest in deciding the supply of reserves: the supply that meets the demand may differ from the supply that would maximize the issuer’s profits. This could lead to a chronic shortage of safe assets.

As a few CBDCs and GSCs become widely adopted and compete, reserve holdings could become more diversified. Research suggests that a lot of competition between reserve issuers in a multipolar system is good. With many reserve issuers, total issuance is high but individual issuance is low, which protects the issuer’s domestic financial stability. However, with few issuers, coordination worsens, and instability ensues as investors can quickly substitute away from one reserve asset and towards another.

Bottom Line

Although wider adoption of digital money is feasible, BIS research concluded that distributed ledger technology (DLT) was still too immature for use in major central bank payment systems. It seems, therefore, unlikely that digital currencies will provide much more than a retail function in the short term. This will attenuate many of the adverse effects of CBDCs and GSCs discussed above.

In the long run, however, countries prone to macroeconomic instability will most likely be the first to see users adopt foreign digital currencies and global stablecoins. These are also the countries less likely to introduce their own CBDC projects (BIS, 2020). For these countries, the financial consequences stand to be most severe unless regulation is used to intervene.

Elsewhere, increased competition among CBDCs and GSCs, fewer cross-border transactional frictions and greater financial risk sharing could all be welfare enhancing. The downside will be a change in traditional monetary policy and greater macroeconomic volatility in the medium-term.

Click to view IMF Paper and BIS Paper.