European Parliament report finds favour in central bank digital currencies

A new, focused report by the European Parliament’s Economic and Monetary Affairs Committee has found in favour of supporting central bank digital currencies which they define differently from cryptocurrrencies.

One can distinguish between digital or virtual currencies on the one hand and cryptocurrencies
on the other, the paper notes. While cryptocurrencies use cryptographic functions in the processes of e.g. authorising or verifying transactions, digital currencies include all currencies that are implemented on computer systems (including, for example, in the form of a simple database).

Cryptocurrencies can therefore be considered a special case of digital currencies. Characteristic features include the absence of a central counterparty, non-discriminatory public access, and security against fraudulent spending.

Currently, cryptocurrencies such as Bitcoin could not supplant traditional currencies to any
significant degree, the paper continues. The available technology faces severe limitations regarding scalability. In particular, it would be prohibitively expensive to conduct even a moderate share of the transactions now handled via traditional currencies through cryptocurrencies.

Rather than as a medium of exchange, crypto and related assets are so far primarily used as a
vehicle for financial speculation. Typically, cryptocurrencies are not based on sound underlying
values, so it is hard to value them rationally.

The associated large swings in value seem to attract speculators looking for outsized returns. Furthermore, it is hard to get a handle on the volatility of these assets in order to implement proper risk management (this fact supports high capital requirements as an appropriate regulatory response).

The fact that they seem to be uncorrelated with traditional investments is therefore difficult to exploit through a hedging strategy.

Central Bank Digital Currencies

With central bank digital currencies (CBDC), the broader public could be granted access to non-tangible central bank money. Recent developments in cryptocurrencies initiated a debate about
the scope for a “central bank digital currency” (Koning 2016, Broadbent 2016, Smets 2016).

Monetary Aggregates in the Euro Area and digital currenciesWith a rather trustworthy issuer, the central bank would likely act as a central counterpart to ensure
authenticity of transactions, so possible disadvantages of cryptocurrencies with respect to slow and
costly transactions would ease. The central bank could guarantee free convertibility of CBDC units to cash at a fixed rate of 1:1 and thereby ensure the same degree of price stability as the official currency from the start.

Digital currency units (Fedcoins) would be a third form of central bank liability beyond cash and
reserves. In the current banking system, money issued by the central bank can be held as cash or
reserves. The former (cash) is accessible to anyone, the latter (holding reserves) is only accessible to
banks.

If non-banks intend to hold non-tangible money, they must rely on deposits at commercial
banks. In essence, such fractional reserve deposits represent claims against commercial banks, instead of claims against the central bank. With the introduction of Fedcoins, households and businesses would be enabled to hold non-tangible central bank money, i.e. direct claims against the central bank.

This would mean that base money functions as a third form of central bank liability beyond cash and reserves. In practice, the central bank would guarantee convertibility between CBDC units, cash and reserves at a fixed rate of 1:1:1.

Fundamentally, a digital currency issued by the central bank could substitute bank deposits as the main form of money holding. With a CBDC, there would be freedom to choose between holding liquidity in the forms of cash, digital central bank money or as bank deposits. So far, in the Euro area more than 80% of monetary aggregate M1 are sight deposits (figure above). As soon as holding and transferring money on CBDC accounts is convenient, safe and frictionless, a growing number of people and businesses would probably prefer to hold liquidity in their CBDC accounts.

As a consequence, commercial banks would increasingly lose the ability to attract deposits. So far, sight deposits have been a major and reliable source of funding for commercial banks. In fact, an integral part of the business model of banks consists of collecting short-run deposits and granting long-run loans (maturity transformation). If a substantial share of depositors transferred their money to CBDC accounts, the fractional reserve banking system would be challenged at its core.

The full report can be found HERE

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