EUROPEAN PARLIAMENT REPORT FINDS IN FAVOUR OF CENTRAL BANK DIGITAL CURRENCIES

A new 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 cryptocurrencies.

While cryptocurrencies use cryptographic functions to authorise or verify transactions, digital currencies are those that are implemented on computer systems, including in the form of a simple database.

Cryptocurrencies can therefore be considered a sub-set 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 proportion of the transactions now handled via traditional currencies through cryptocurrencies.

Crypto- and related assets are primarily used as a vehicle for financial speculation, rather than as a medium of exchange. 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 assess the volatility of these assets to implement proper risk management. This supports high capital requirements as an appropriate regulatory response.

As they seem to be uncorrelated with traditional investments, they are difficult to exploit through a hedging strategy.

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 CBDC.

With a trustworthy issuer, the central bank would likely act as a central counterpart to ensure authenticity of transactions, so the 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 CB liability beyond cash and reserves. In practice, the CB 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 Eurozone more than 80 percent of monetary aggregate M1 are sight deposits. 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. If a substantial share of depositors transferred their money to CBDC accounts, fractional reserve banking would be challenged to its core.

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