Currency is already digital, and has been for years. But the basic model of banking is largely unchanged. This is because the system is based on the notion that digital currency issued by commercial banks is convertible into paper cash, which is a central bank liability. This paper explores what would happen if central banks started to issue digital currency directly, and idea that China and other countries are currently exploring Fintech expert Ajay S. Mookerjee believes that it would upend the traditional banking system. He argues that a switch to Central Bank Digital Currency (CBDC) would be safer for depositors (because CBDC is a direct liability of the issuing central bank, not of a commercial bank), would eliminate the need for commercial banks to directly take deposits from consumers and households, render much of the physical infrastructure of banking redundant, enable more effective monitoring and regulation of the financial system, and prove more inclusive. The potential cost savings in the US alone amount to $750 billion a year, as much as the country’s households spend on food.
Over 97% of the money in circulation today is from checking deposits – dollars deposited online and converted into a string of digital code by a commercial bank. The digitization of credit and debit card transactions and the development of banking apps has moved many traditionally cash-based transactions into digital space.
So far, the shift to digital has left the banking business relatively unscathed, at least in the West, where new players such as Paypal still rely on customers linking the service to their bank debit and credit cards. A few online-only banks have materialized, such as Chime and Nubank, but, again, these ride on existing rails. The Chinese financial sector has seen more disruption, as illustrated by the emergence of Alibaba’s Ant Financial and Tencent’s WeBank, which have leveraged looser data privacy protection and smart data analytics to dominate consumer payments and have also entered retail and small business banking. Broadly speaking, though, traditional banks have adjusted well to the digitization of money.
That could be about to change.
The impetus for more radical change is coming from China, whose central bank has been running an experiment with a form of cash called Central Bank Digital Currency (CBDC), which it envisions as the cash of the future, ultimately eliminating the need for paper money.
In a CBDC world, the digital code for each virtual currency unit will be held in a digital wallet and transferred seamlessly by the wallet-holder to other people’s digital wallets, very much as we see with today’s fintech and Big Tech digital wallets (think Venmo and ApplePay) and the wallets offered by the traditional banks (such as Zelle, a cooperative of six-banks including Chase, Bank of America, and Wells Fargo). In China, these services will be licensed to four state banks and three telecommunications companies, who will act as wallet distributors rather than cash depositories. Users will scan barcodes on their phones to make in-store payments or send money to other mobile wallets. The People’s Bank of China (PBOC) will periodically receive copies of customer transactions, stored on a mixed central and blockchain database.
The Chinese pilot began with the distribution of 100 million digital Yuan through lotteries in nine cities, including Shenzhen, Suzhou, Chengdu, Xiong’an, and the 2022 Winter Olympics Office Area in Beijing. By the end of September 2021, the digital currency pilot had recorded around 500 million transactions with 140 million users. E-Yuan will be fully rolled out during the Winter Olympics in February 2022, and if bilateral agreements with foreign monetary authorities are reached, tourists and business travelers in China will be able to obtain a Chinese e-wallet on their own phones.
Part of China’s motivation for introducing a CBDC is to reduce the country’s dependence on Alipay and WeChat, which currently account for 94% of online transactions, $16 trillion in value. It also helps reduce the threat from independent digital currencies such as Bitcoin, which could potentially threaten governments’ ability to manage their economies, not a prospect that a Chinese government would view with equanimity.
But China is not the only the only country interested in CBDCs: Sweden, Singapore, and South Korea are among 13 other countries testing pilots. The US is likely to follow suit; the Federal Reserve Bank of Boston, in collaboration with MIT, is currently designing a CBDC prototype. Possibly the US is worried about being left behind and the potential threat from China’s digital Yuan and its potential emergence as the global reserve currency supplanting the US dollar.
Ultimately, the technology underlying CBDCs will be Blockchain, the technology that enables Bitcoin. It consists of time-stamped record blocks with encrypted transaction activity, continuously audited by all verified network participants. Blockchain decentralizes the storage and trustworthy transmission of money. Although Blockchain remains slow and cannot yet support large-scale applications, the technology is expected to mature over the next three to five years and is likely to overcome its limitations. At a certain point, therefore, the existing digital infrastructure will be replaced, which will eliminate the dependence of new entrants on the resources and capabilities controlled by incumbent financial institutions.
How will CBDCs Change Banking?
In the traditional model of banking, some two centuries old, individuals or institutions receive money (from investments or pay) that they deposit with banks, which then use the money to make loans, setting aside (i.e., reserving) a proportion mandated by regulators (typically 10%) available for depositors to withdraw and convert into cash. Banks make a profit on difference between the (largely short-term) interest they pay to the depositors they market to and the (largely long-term) interest they receive on loans to business customers or investments in equivalent financial securities (such as corporate or government bonds).
While regulation ensures individual banks lend no more than their overall deposits less reserve, it has bloated the level of credit in the overall banking system. When a bank makes a loan, the borrower deposits the proceeds in their account, which is then treated as a fresh deposit and, minus the reserve, lent out again. This process is repeated several times over and means that the $16 trillion of deposits in the US results in banks allocating $50 trillion in funding for direct loans and backing for bond issues. This multiplier effect fuels economic growth, but the new money supply created is in the form of risky credit. Defaults are high – amounting in normal times to $200 billion per year but can be as much as three times bigger in times of crisis. And, as the 2008 meltdown demonstrated, the cost of these defaults is ultimately borne by households.
The banking business carries several risks: borrowers may default, short term interest rates may be higher than long-term ones, and depositors may seek to withdraw more cash than is available for withdrawal. The risks are cushioned through equity capital, the possibility of government support (usually through last-resort loans from a central bank), and retail deposit insurance schemes – all which come at a price.
What’s different about CBDC and regular digital cash issued by commercial banks is that each CBDC unit of cash will have a unique, unchanging digital identity. It will also be a direct liability of the central bank, just as paper dollars or yuan currently are. This is a key differentiation from today’s digital currency, which is a liability of the issuing bank, even though it is in theory convertible into paper cash on demand – a feature predicated on that cash being available to the bank in physical form. It is this differentiation that largely explains why the CBDC is likely to disrupt the basic model of the banking system, which has always been based on paper cash (or convertibility into it).
Let’s look at the key implications of a CBDC-based banking model:
Paper cash is essentially a bearer IOU issued by a central bank, for the bearer to spend (or put under the mattress) at any given time. Today’s digital currencies are predicated on the convertibility of the digital codes issued by commercial banks into paper cash, which is dependent in turn on the commercial bank having paper money on hand to use for the conversion. It’s that link to paper cash that gives the digital currency issued by commercial banks value and makes it safe to use.
But CBDCs are direct liabilities of the central bank, just as paper cash is, which makes CBDCs a safer form of digital money than commercial bank- issued digital money. The situation is equivalent to a scenario in which every citizen has, in essence, a checking account with the Central Bank. Their pay and investment payouts arrive in their central bank accounts, and they can keep cash in there, on which the central bank can, if it chooses, pay interest. Unlike a traditional deposit or checking account at a commercial bank, however, the depositor carries no risk, as a central bank is a sovereign credit, backed, at the end of the day, by the government’s ability to tax, not on a cushion of reserves and equity capital. There are no “runs” on the central bank, which eliminates the necessity of protecting depositors from bank runs through insurance plans. And at the level of the overall banking system, all liquidity (and credit) risk are spread across the entire population, not just each individual bank’s depositor base.
With the central bank effectively becoming the sole intermediary for financial transactions, banks would no longer compete for retail or business cash depositors, success in which currently underlies much of their market value. Instead, they will, essentially, all borrow wholesale from the central bank to finance their lending activities – the central bank thereby becomes the lender of first rather than last resort. With funding secured, inter-bank competition will be based entirely on the ability to recognize and price good loans and to bridge short-term and long-term interest rates efficiently, which will reduce the margins in that business to the benefit of good borrowers, engaging in value-creating projects. Competition for customer deposits will be replaced with competition for distributing their electronic wallets with the most innovative and user-friendly solutions.
CBDC will also facilitate the entry of new players from fintech, because the brand reputation of established banks as safe custodians of people’s money will no longer be a barrier to entry – nor will their networks of branches and paper cash outlets. The custodian of everyone’s cash and the clearer of all transaction will now be the central bank and there will no need for paper money for digital money to be convertible into, since a CBDC unit is itself a direct central bank liability, and exactly equivalent to paper money rather than merely convertible into it, making the paper cash redundant. People will no longer need outlets from cash, as well as fewer places to deposit cash or other valuables.
In a CBDC world, all transactions could in theory be monitored with the help of data analytics and AI in order to more quickly identify banks that are struggling or are engaging in questionable transactions. At present, financial regulators must rely on the reports provided by banks, which means that remedial action comes late and often at a greater cost. In addition, in a CBDC world in which digital bank codes are visible to the clearing institution, it becomes much easier for the authorities to identify the parties to a transaction, which greatly simplifies the detection of criminal activity and eliminates the black markets characteristic of countries that deal largely in physical money. The cost of fraud to U.S. financial services companies is estimated at 1.5% of revenues, or around $15 billion annually.
The switch also simplifies the execution of monetary policy–the central bank can immediately change supply by issuing or canceling codes in its own accounts. And by paying interest on CBDC holdings, however, the central bank can directly transmit monetary policy to households, instead of influencing commercial deposit rates through the rates it offers banks on their reserve accounts with the central bank. Today, with money held in commercial banks, the policymaker can only influence consumer and business behaviors indirectly.
Transacting with CBDC doesn’t require a bank account – important in developing countries, where typically a third of the population lack access to traditional finance and yet have access mobile internet. (In the U.S., approximately 5% of people are unbanked.) An unbanked Indian consumer with an Aadhar number and a smartphone could easily transact over a mobile app. This means that countries in the developed world will fairly easily be able to integrate people into the financial system who were traditionally outside of it.
What does it all add up to?
These changes stand to take out many of the costs and risks implicit in the traditional system, which was built at a time when customers needed secure branches to deposit bags of cash. That has resulted in a trillion-dollar, 85,000 branch, operations and payments infrastructure in the US that employs 1.2 million people – about a third of all truck drivers in the US. This infrastructure, which costs about $600 billion a year to run, is assumed be necessary for handling all deposits and payments (this number is the approximately 60% cost/income ratio of US banks applied to related revenues of around $1 trillion, half of which comes from commercial banking and the rest from processing payments).
But if customers no longer need to physically deposit cash, then the $600 billion annual spending on physical infrastructure is a complete waste of money – equivalent to paying one out of three truck drivers to drive around with an empty truck for a year. Beyond the unnecessary waste of the physical infrastructure, the system is slow and expensive: payments take an average of 1-3 days to settle, and card processing fees eat up half of retailing profit margins. Cross-border transfers are extortionary – it can cost a migrant worker as much as $50 to wire just a few hundred dollars home through a commercial bank.
With CBDC and central banks holding deposits, banks cannot overstretch customer deposits as they currently do, which will significantly de-risk the banking system. Also, with CBDC’s instantaneous transactions, money circulates faster, reducing the need for short-term credit, which would reduce overall debt levels by 25%, or by $13 trillion. An even bigger impact could result from the lowering of default rates due to the precision of CBDC transaction data in monitoring the use of credit. Combining the lower debt levels with the lower credit default rates that we see in countries that have historically relied on transaction data (two-thirds lower than in the US), I estimate that the overall US credit default could conceivably fall from $200 billion to only $50 billion
All told, switching to a CBDC-based banking system could save the US economy a total $750 billion a year – roughly what US households spend on food in the same period.
What’s the catch?
CBDC is not without its problems. One obvious risk is to privacy. A number of U.S. lawmakers argue that China will use digital yuans for domestic surveillance. “Central banks increase control over money issuance and gain insight into how people spend their money but deprive users of their privacy,” notes Congressman Tom Emmer (R-MN), adding, “CBDCs would only be beneficial if they are open, permissionless and private.”
Other concerns revolve around the role of a central bank as a wholesale lender of first resort. State-controlled credit could potentially be susceptible to political pressure for sector-focused lending. Would there be formal criteria for determining which banks would qualify for central bank funding? How easy would these be to manipulate in some way?
Perhaps the biggest concern is with security, particularly cyber security. You can argue that the existing system, with multiple banks responsible for their own security, is exposed to more frequent but possibly more localized breaches of security. According to this logic, if the central bank gets hacked, then the whole system could be fatally compromised, although the risk of a breach actually occurring is perhaps reduced – given that a central bank would have the cyber expertise of its government at its disposal. Essentially, the trade-off would be between recurring but manageable breaches and highly infrequent but catastrophic ones. A central bank would definitely be too big to fail.
That said, the technology of the blockchain is highly secure and transactions are highly compartmentalized, which means that the central bank could potentially operate a highly distributed and compartmentalized system, thereby spreading the risk and consequences of any possible cyber-security breach more widely. Indeed, the future use of blockchain for cybersecurity is expected to improve on the present situation.
In my view, the move to low or no-cash economies based on CBDCs, whose sovereign monetary bodies compete on software-like features and costs, is inevitable. Its advent will certainly disrupt the banking industry, opening up the industry’s large, powerful incumbents to nimble, asset-light, and tech-savvy fintech competitors, more precisely focused on creating value within ecosystems than on building monopolistic empires. The new banking model will reach more people with better, faster services, and deliver credit to businesses on better terms, while preserving liquidity and efficiency in the capital markets. Overall exposure to risk will likely be reduced and, while some degree of privacy may be lost, the benefits from protection against fraud and other crimes will more than compensate.