By Dr. Chiragra Chakrabarty, Chief Executive Officer, KATIC Consulting
With digital currencies gathering steam even as doubts linger on the safety of using such forms of payment, central banks are stepping into the fray in an attempt to strike a balance between monetary stability and financial innovation
The needs of the financial system are ever evolving, and one aspect in particular that is constantly gaining momentum is the payments system. The heart of the payments system is cash, which is associated with money in the form of central bank-issued notes and coins in the contemporary monetary system.
A central bank has the sole right to issue paper notes representing legal tender (or fiat money) to the public and distribute them through commercial banks – this is the central bank’s monopoly. In addition to cash, a central bank issues money in another format to designated financial institutions (mainly, commercial banks) held as reserve balances or current account balances at the central bank, which are called “reserve deposits”. Thus, central bank money is comprised of cash and reserve deposits.
The definition of money does not stop here since it also encompasses private sector money, which has increasingly become important, both at the household and corporate sector level. The most important form that private sector money takes is bank deposits, which can be used to make payments through automated teller machine (ATM) cards, internet banking, and/or debit cards.
In addition, new types of private sector money based on distributed ledger technology (DLT) have emerged over the past decade. These are called digital tokens, crypto assets, crypto currencies, encrypted currencies, or virtual currencies. The first, and most famous, example is bitcoin. These digital coins have garnered considerable attention globally because of their potential to serve as a new payment tool and, thus, have firmly become part and parcel of private sector money.
What are digital currencies?
According to a report by the Bank for International Settlements (BIS) on digital currencies in November 2015, a digital currency is an asset represented in digital form and having some monetary characteristics. Bitcoin and its alternatives are based on cryptographic algorithms, so these kinds of virtual currencies are also called cryptocurrencies.
Private sector players are developing cryptocurrencies as well as payment system solutions and have proved flexible in tailoring their services to changes in consumer behaviour. Advances in private money in the digital sphere are especially significant. According to the European Central Bank (ECB), a virtual currency can be defined as a ‘type of unregulated, digital money, which is issued and is usually controlled by its developers and is used and accepted among the members of a specific virtual community.’
While it is true that cryptocurrencies are backed merely by trust in the issuing party, a genuine, privately issued digital currency could have greater monetary attributes if it served as a digital representation of an asset. This is why I believe that privately issued cryptocurrencies are not currencies in the true sense of the term.
What is the role of the central bank?
Central banks and governments across the globe have not regarded these digital tokens as “money” and have warned the public to use them with great caution because of the high volatility in their value and, thus, the high degree of risk involved. A key risk posed by privately issued cryptocurrencies is that the government or central bank does not back their redemption. The usability of these crypto assets diminishes as they become speculative vehicles with volatile purchasing power.
Now, turning to the central bank’s role, it is clear that the key task a central bank must perform is to provide an effective payments system, as it is a uniquely public good. A smoothly functioning payments system is critically important to the performance and credibility of an economy as well as for sustaining public confidence in the financial system at large. At the same time, the nature and form of the methods consumers use to transact have changed significantly, requiring central banks to remain alert to shifts in payments habits. The Official Monetary and Financial Institutions Forum (OMFIF)-IBM report on digital currencies noted that 69% of central banks surveyed pinpointed significant problems with cross- border payments systems.
Another important task of a central bank is to decide and implement the monetary policy. Central bank money (especially reserve deposits) and private sector money (bank deposits) are associated closely through the monetary policy exercises conducted by a central bank. However, if digital currencies are issued by various organisations in the form of private digital currency, then, according to King (1999), the central bank ceasing to be the monopoly supplier of such reserves would indeed deprive central banks of their ability to carry out monetary policy. At the same time, economists disagree about whether massive adjustments in central bank balance sheets would be necessary to move interest rates in a world where central bank liabilities ceased to perform any settlement functions.
Regardless of such disagreements, the ultimate concern is similar: “The only real question about such a future is how much the central banks’ monetary policies would matter” (Woodford 2000). To Benjamin Friedman, the real challenge is that “the interest rates that the central bank can set . . . become less closely— in the limit, not at all— connected to the interest rates and other asset prices that matter for ordinary economic transactions” (Friedman 2000).
Dollarisation in some developing economies provides an analogy. When a large part of the domestic financial system operates on the basis of a foreign currency, monetary policy for the local currency becomes disconnected from the local economy.
How should central banks respond to such challenges?
As former Managing Director of the International Monetary Fund (IMF) Christine Lagarde noted in a speech at the Bank of England, “The best response by central banks is to continue running effective monetary policy, while being open to fresh ideas and new demands, as economies evolve.”
Modern monetary policy, based on the collective wisdom and knowledge of monetary policy committee members—and supported by central bank independence, offers the best hope for maintaining stable units of account. Regulators should exercise suitable authority over the use of crypto assets to prevent money laundering and the financing of terrorism, strengthen consumer protection, and effectively tax crypto transactions.
Finally, central banks should continue to make their money attractive for use as a settlement vehicle. For example, they could make central bank money user- friendly in the digital world by issuing digital tokens of their own to supplement physical cash and bank reserves.
Are Central Bank Digital Currencies the way forward?
Central Bank Digital Currencies (CBDCs), denominated in an established fiat currency, could overcome these fundamental barriers. In essence, a CBDC represents the realisation of the idea of the issuance of digital tokens by central banks.
In terms of their usage, CBDCs can be applied in both wholesale and retail segments of the economy. A 2019 study by the BIS found that payments safety and efficiency were the two most important criteria that central banks considered among their motivations for issuing wholesale CBDCs.
There is significant potential for CBDCs to play a powerful role in upgrading incumbent centralised payments and settlement systems. It can be denominated in sovereign currency or government- backed assets and be issued by an institution that enables redemption of the digital currency into cash at any time.
How is Mauritius poised to benefit from the digital era?
Against this backdrop, it is heartening to note that the Bank of Mauritius (BOM) has already grasped the opportunities presented by emerging technologies. The BOM governor, in CoinDesk’s Consensus: Distributed virtual conference, noted that the banking regulator would soon make announcements in relation to the potential introduction of a retail focused CBDC.
This thrust was cemented when the Finance Minister announced in his 2020-21 Budget speech that several new products will be introduced to further enhance the competitiveness of the Mauritius Financial Services Sector, and among them, one is the Central Bank Digital Currency.
Another important aspect of this development, which I can already visualise, is that the Mauritian economy will eventually become free of physical cash and transform itself into a digital economy. The malpractices, which are being carried out in present- day economies using physical cash, will be reduced because the end-to-end usage of CBDCs can be audited in a seamless manner.
Indeed, in the new era of digital currencies and payment innovations arising therefrom, most efficient financial systems will warrant such a digital economy. In this brave new world, it is important that central banks lead from the front as economies evolve around them.
This article first appeared in the Mauritius Finance Magazine issued in August 2020.
