Coronavirus Central Bank Digital Currency

Macquarie Island, a UNESCO World Heritage Site, lies in the southwest Pacific Ocean, about halfway between New Zealand and Antarctica. In the 1870s sailors introduced rabbits as a source of food, and with no predators, the rabbits quickly multiplied but soon far exceeded the needs of the passing whalers. The rabbit population grew to such a level that they devoured everything green, leading to one of the most enduring examples of unintended consequences: the reduced vegetation led to dramatic erosion which in turn decimated the island’s bird population.

As coronavirus sweeps continents, killing thousands and extinguishing businesses, central banks have likewise been trying to introduce sustenance for their stalled economies. As on Macquarie Island, the consequences will be far reaching and also unintended.

Digital US Dollar

The draft of the US coronavirus relief plan, the CARES Act, authorized the creation of a digital dollar, a Central Bank Digital Currency (“CBDC”), that would give ‘any person’ an account at the central bank. Currently the public can hold currency only in the form of physical banknotes with electronic currency limited to banks. Even though the digital dollar provision was struck from the final act, it was a groundbreaking proposal as it would have permitted the public to hold and use a digital version of the US dollar. A subsequent bill recently introduced in US Senate makes a similar proposal, keeping the issue under active consideration.

Huge technical and policy hurdles need to be surmounted, but immediate, nearly free, secure transfers of state issued currency would provide a terrific benefit to consumers. And a digital currency could dramatically increase the central bank’s monetary policy tool set, catalyzing quick adoption with long term implications for both fiat currencies and Bitcoin.

Benefits

The ability to hold and send a digital US dollar opens up instant and free transactions as a transfer from one account at the central bank to another does not require an intermediary like PayPal or Visa. And payments could be in far smaller increments than are currently economical to transact. Widespread use of a CBDC would save consumers and businesses billions in credit card transaction fees and have a big impact especially in economies like Sweden that are nearly cashless. The credit card processing industry has well over $100 billion in revenue, much of which would no longer be necessary. As consumers moved away from cash, governments would save by the reduction or even elimination of physical banknotes.

Especially relevant in times of crisis, a CBDC also allows consumers to hold money without the risk of banks or other intermediaries defaulting. Valuables can be stolen, and banks can become insolvent, but central banks bear none of those risks.

Finally, a digital, infinitely divisible sovereign currency would eliminate the business model of all crypto stable coins and well over 90% of crypto coins in use today whose primary function is fast, cheap and highly divisible transfers. Why would anyone need XRP to transfer funds internationally if a digital US dollar was available for instantaneous, free transfers? Why would Ethereum need ETH to pay for transactions when fees could be paid in digital dollars in $0.00001 increments? The elimination of most crypto business models is a compelling side benefit that certainly interests governments.

Risks

While the benefits are real, risks fall into two categories: technical and economic. It is hard to think of a bigger target for hackers than a central bank with the ability to deposit unlimited digital currency into any account. The most trusted decentralized public ledgers today such as Bitcoin and Ethereum are both far too slow to handle the high volumes and have too little value to protect against a 51% attack when trillions are at stake. A private (centralized) network is the only likely architecture, but potentially with a public component such as Hedera’s Consensus Service https://www.hedera.com/consensus-service which adds public network security to a private network. If the network is well protected, however, vulnerability remains in the digital wallet that consumers need to send and receive currency. Who has liability if that wallet is hacked? We will need a minimum amount of government insurance such as what is currently provided by the FDIC for bank accounts.

The technical issues can be mitigated, but the wider economic issues are more complicated. If consumers preferred to hold their ‘cash’ at the central bank, banks would be deprived of deposits, eroding their capital base and reducing their ability to lend. Would banks need to increase interest rates to encourage deposits? If so, they would suffer margin compression unless they increased the rates charged on loans. And in times of crises, banks would be particularly vulnerable to deposits fleeing to the central bank. Banks perform a critical role in credit creation, and central banks would not want to impair this function. In the events deposits flowed to accounts at the central bank, it likely would offset that flow by injecting the banks with funds, effectively taking the bank’s credit risk instead of the public. And while sending and receiving from accounts at the central bank would be cost-less, the accounts would not offer credit, so the business model of credit card companies would remain, even if reduced.

Government Progress on CBDC

Central banks have been skeptical of digital currencies since their advent, but the threat of Libra, an extra-state currency with a global user base potentially in the billions, catalyzed an urgent re-evaluation. But even before Libra was announced, a long list of countries including Sweden, China, Turkey, Japan and Israel had announced they were looking into digital currencies. After Libra’s announcement on June 18th, 2019, the pace picked up, and by March 2020 both the IMF and the Bank of England published CBDC white papers, China had reportedly completed the basic functionality for a digital Yuan and US Federal Reserve Chairman Powell publicly confirmed the Fed’s evaluation of a CBDC. When China launches its CBDC, the US must follow or accept erosion of US dollar hegemony.

Public Policy

Policy questions are critical: who can have an account? Anyone that passes KYC? Only citizens? Businesses? All kinds of businesses? Could you use a digital dollar to buy a gun or pay for an abortion? And are we comfortable with the government having a record of every transfer made by every account? Will existing banks be responsible for the management of the accounts and bear the costs as proposed in the initial CARES Act? The government currently has the ability to freeze bank accounts, and freezing or emptying your account at the central bank would be even easier.

Digital US Dollar Urgency

What has been less discussed are the implications for immediate and granular monetary policy implementations that a CBDC provides, but it is this monetary policy potential which drive the current government interest given the coronavirus stimulus imperative. On February 13th 2008, President George Bush signed the economic stimulus act providing checks for all Americans, but most didn’t receive the funds until a full five months later in July, greatly diluting the benefit to consumers and the economy. With a CBDC, however, the transfer to each American’s account could happen in a day. If the deployment of the CARES Act funds stretches into months as seems likely, expect to see pressure for a digital dollar to speed up future disbursements. One of the delays in sending funds is accessing the 7% of Americans who are unbanked, and besides being faster, CBDC accounts don’t require a bank account, providing fast access to funds for this vulnerable population. As the economy remains stalled, and additional payments become necessary and more urgent, voters will have no patience for long delays. And the pressure could come from politicians as well. Imagine if during an address to the nation, the President could push a button and voters could see their digital wallet balance increase while he was still speaking.

Monetary Policy Flexibility

A digital dollar also offers a great deal more flexibility than the traditionally mailing of checks: rather than sending a single payment of $1,200, the government could send $300 a week for four weeks, or ten weeks. Or it could send $600, and then cut the amount in half each day for week. Or it could send $1,200 but have the funds expire if unused in a month. Or the funds could only be transferable to particular retailers or type of retailers..say grocery stores. The possibilities for immediate and finely tuned stimulus are nearly infinite. After addressing the current need, it is likely that medium term assistance is required and from there it is a very short step to a form of universal basic income (UBI) where the government provides regular payments. When the government realizes the potential power of a CBDC, how will it resist deployment?

CBDC Driven Inflation

When governments implement CBDCs, crypto currencies will surge as hundreds of millions of people become users of digital currencies. Not long after, however, it will be clear that most crypto currencies are useful only for speculation, and the digital dollar will supplant nearly all crypto currencies by being so much cheaper and easier to use. There are no conversion costs or transactions fees to convert a digital dollar into a dollar while the fee to convert your crypto asset is 1–5%.

Despite being widely used, CBDCs will be burdened by politicians out-doing each other by offering ever larger and more immediate monetary stimulus. As central banks around the world accustom consumers to the benefits of digital currency, politicians’ easy abuse of the limitless and immediate digital printing presses will debase fiat currencies at an unprecedented rate. Consumers, now comfortable with this new digital world, but faced with constant inflation and government monitoring, will turn to the only liquid, divisible, transportable asset capable of holding its value; the only trusted, non-debaseable currency; the only censorship resistant alternative, the digital currency that has been around since 2008. Bitcoin will become the global store of value, and central banks will have paved the way.

On Macquarie island, the original rabbit plan worked too well and ultimately required a multi-year extermination program to return the island to its pre-rabbit state. Likewise, CBDCs have the potential to work so well in effecting monetary policy, and be so tempting for abuse, that they disrupt the very environment they are designed to help.