CBDC and Monetary Sovereignty

The threat of private digital currency such as Libra

In June 2019, Facebook and its partners announced a plan to launch Libra, a private digital currency backed by financial assets. Their goal is to enable domestic and cross-border money transfer in a low-cost and secure way. The Libra Association, an independent not-for-profit membership organization, would oversee the currency (acting as a de facto central bank). Currently, there are 21 founding members, including one payments company (PayU) and a number of telecommunications (such as Vodafone) and marketplace companies (such as Uber, Lyft, Booking.com and Spotify).1 Importantly, Libra would be denominated in its own unit of account.

A digital currency like Libra could gain a substantial share of the global payments market and thus establish itself as a global standard for payments. First, Facebook’s e-wallet (Calibra) is intended to integrate with Facebook’s apps (including Messenger, Instagram and WhatsApp), which would give it incredible consumer reach. Second, Facebook has enough funds to speed up adoption by rewarding individuals who use Libra. Finally, consumers would likely be able to use Libra to buy goods and services directly from the marketplace companies that are members of the Libra Association. In fact, goods and services on these e-marketplaces could be quoted in Libra currency, thus reducing the need to exchange Libra for local currencies.

Wide domestic adoption of a digital currency denominated in a different unit of account threatens a country’s monetary sovereignty. For example, most central banks conduct monetary policy by setting a target for short-term interest rates in the interbank market for reserves. However, as noted by King (1999), this ability hinges on the central bank being the monopoly supplier of such reserves. If Libra were widely adopted, it could become the unit of account in the economy, replacing reserves as the settlement asset. This would make domestic monetary policy irrelevant.

In addition to greatly affecting a central banks’ ability to stabilize prices, a scenario where financial institutions substitute the central bank currency with a private digital currency like Libra could also reduce the capacity of the central bank to act as lender of last resort. The central bank would not be able to provide such currencies in unlimited quantities to financial institutions during liquidity crises, thus potentially deepening the likelihood and severity of such episodes.

Further, Libra would be issued by a private entity. Even though Libra’s exchange rate would not be fixed to one specific currency or an index of currencies, it would function as a “stablecoin”: it would be backed by a reserve of “low-volatility assets, including bank deposits and government securities.” However, it is unclear whether the long-run incentives of the Libra foundation would align with its non-profit nature and, therefore, with the stability of Libra.2 After all, one or more of the association members, in efforts to collect additional seigniorage, might pressure the Libra foundation to create money in excess of the money demand justified by the real growth in the economy (and thus create inflation).

CBDC and the effectiveness of monetary policy

Issuing a central bank digital currency (CBDC) could potentially counter the use of Libra. A CDBC could offer a new digital payment rail and an asset for real-time final settlement between individuals—a similar niche that physical cash has today.3 As noted by He (2018), modern monetary policy, based on the collective action of monetary policy committees and supported by central bank independence, is likely to offer the best hope for maintaining a stable unit of account. However, central banks also need to continue to make central bank money attractive as a payment instrument.

Libra is likely to be very convenient for online, peer-to-peer and cross-border transactions. This would give it advantages over current forms of central bank money (physical cash and reserves/settlement balances) and private money. Therefore, if consumers are willing to accept some currency risk along with the convenience of Libra, this digital currency could gain substantial market share—even if central banks set monetary policy optimally.4 Central banks could respond to this threat by allowing private companies to build applications for the CBDC. These might make central bank money more user-friendly in ways similar to Libra, thus facilitating the development of new, efficient (and low-cost) digital payments denominated in the local currency.

Central banks could increase the attractiveness of central bank money as a settlement vehicle between individuals by enabling interest payments on CBDC holdings. For this reason, if central banks decide to issue a CBDC, its design should allow it to be interest-bearing (even if the interest rate is set at zero to begin with). Having the flexibility to pay interest on CBDC holdings might prove useful in deterring people from adopting other private digital currencies in the future. We note, however, that these advantages should be weighed against the risk of disintermediating the banking sector (see, e.g., BIS 2018; Mancini Griffoli et al. 2018; Andolfatto 2018; Chiu et al. 2019; and Keister and Sanches 2019).

Fast action may be needed. Payment systems are characterized by strong network effects, where the value of the system increases with the number of users the network connects (which means there is an advantage if everyone uses the same system).5 Under certain circumstances, particularly in the case of the high costs of switching across payment systems, the feedback nature of networks can magnify a very small initial advantage of a payment system into an almost unbridgeable gap (see, e.g., Economides 1996). While it might not be possible for central banks to move sufficiently quickly to prevent a (potential) first-mover advantage by Libra, fast action would still help minimize this advantage.6 Furthermore, and given that switching costs exacerbate the network effects of payment systems, central banks might need to consider policies geared toward minimizing the cost for consumers and merchants to switch from Libra to a CBDC.

The threat to the Canadian financial system beyond Libra

Libra still needs to resolve many regulatory issues, including those related to cross-border payments and know-your-customer and anti-money-laundering requirements. But there are other digital currencies denominated in different units of account that could disrupt a central bank’s ability to stabilize prices and its lender-of-last-resort mandate:

• Walmart applied in January for a stablecoin patent intended to target low-income households that have problems with credit and carrying cash. By replacing traditional retail payment processors with blockchain, Walmart could significantly lower retail transaction costs. Importantly, the patent for Walmart’s stablecoin includes the possibility for users to earn interest on coins.
• In January 2020, senior officials from the People’s Bank of China confirmed that the bank has concluded the development and testing of China's sovereign digital currency. While this is not a private digital currency, it could threaten the monetary sovereignty of another country if it saw wide domestic adoption there (as it is denominated in a different unit of account).

Consequently, even if the probability of Libra being adopted in the short run is small, central banks need to be prepared—as the probability of Libra or a similar payment instrument being adopted in the medium term is significantly higher.

Other potential monetary policy benefits of a CBDC

Arguments have been made for other monetary policy benefits of a CBDC:

• Issuing a CBDC allows central banks to break the effective lower bound (Agarwal and Kimball 2015; Rogoff 2017).7 However, this can also be achieved by eliminating physical cash (or at least large-denomination bills).
• A CBDC can provide the information and tools to allow central banks to redistribute liquidity (Davoodalhosseini 2018). However, the questions remain as to whether this is the role of a central bank and whether this could risk other mandates, such as price stability, by threatening central bank independence.
• A CBDC rate can be a more transparent policy rate (Bordo and Levin 2017), and in this way could potentially strengthen the transmission of monetary policy. However, the size of these possible effects is unclear.

We thus find that there is a less compelling case for issuing a CBDC based on these benefits alone once we consider the potential impacts on the financial system.8

Conclusion

Wide adoption of a digital currency denominated in a different unit of account, such as Libra, presents a significant threat to monetary sovereignty and financial stability. Issuing a CBDC could potentially counter this threat. Making central bank money more user-friendly would increase its attractiveness as a means of payment in general and as an alternative to Libra in particular.

Endnotes

References

1. Agarwal, R. and M. Kimball. 2015. “Breaking Through the Zero Lower Bound.” International Monetary Fund Working Paper No. 15-224.
1. Andolfatto, D. 2018. "Assessing the Impact of Central Bank Digital Currency on Private Banks." Federal Reserve Bank of St. Louis Working Paper No. 2018-026B.
1. Bank for International Settlements (BIS). 2018. Central Bank Digital Currencies. Committee on Payments and Market Infrastructures and Markets Committee. Bank for International Settlements, March.
1. Bordo, M and A. Levin. 2017. “Central Bank Digital Currency and the Future of Monetary Policy.” Hoover Institution Economics Working Paper No. 17104.
1. Chiu, J., M. Davoodalhosseini, J. H. Jiang and Y. Zhu. 2019 "Central Bank Digital Currency and Banking.” Bank of Canada Staff Working Paper No. 2019-20.
1. Davoodalhosseini, M. 2018. “Central Bank Digital Currency and Monetary Policy.” Bank of Canada Staff Discussion Paper No. 2018-36.
1. Davoodalhosseini, M, F. Rivadeneyra and Y. Zhu. 2020. “CBDC and Monetary Policy.” Bank of Canada Staff Analytical Note No. 2020-4.
1. Economides, N. 1996. “The Economics of Networks.” International Journal of Industrial Organization 14 (6): 673–699.
1. Gowrisankaran, G. and J. Stavins. 2004. “Network Externalities and Technology Adoption: Lessons from Electronic Payments.” RAND Journal of Economics 35 (2): 260–276.
1. He, D. 2018. “Monetary Policy in the Digital Age.” Finance and Development, International Monetary Fund, June.
1. Katz, M. and C. Shapiro. 1986. “Technology Adoption in the Presence of Network Externalities.” Journal of Political Economy 94 (4): 822–841.
1. Keister, T. and D. Sanches. 2019. "Should Central Banks Issue Digital Currency?" Federal Reserve Bank of Philadelphia Working Paper No. 19-26.
1. King, M. 1999. “Challenges for Monetary Policy: New and Old.” Speech delivered at a symposium sponsored by the Federal Reserve Bank of Kansas City, Jackson Hole, August 27.
1. Mancini Griffoli, T., M. S. Martinez Peria, I. Agur, A. Ari, J. Kiff, A. Popescu and C. Rochon. 2018. "Casting Light on Central Bank Digital Currency." International Monetary Fund Staff Discussion Note No. 18-08.
1. Rogoff, K. S. 2017. The Curse of Cash: How Large-Denomination Bills Aid Crime and Tax Evasion and Constrain Monetary Policy. Princeton, NJ: Princeton University Press.
1. Zhu, Y. and S. Hendry. 2019. “A Framework for Analyzing Monetary Policy in an Economy with E-money.” Bank of Canada Staff Working Paper No. 2019-1.