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Could central bank digital currencies kill monetary policy?

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I didn’t realise until the other day that the Bank of England has a blog Bank Underground.  Finally, a boring old British bank with a blog.  Not a consumer bank of course – none of those blog – but a good old central bank.

The Bank makes clear it’s not the opinions of the institution itself …

Bank Underground is a blog for Bank of England staff to share views that challenge – or support – prevailing policy orthodoxies. The views expressed here are those of the authors, and are not necessarily those of the Bank of England or its policy committees.

… but hey, it’s pretty cool (how many central banks can you say that about).  I guess it also reflects the hipstering of the Bank by the George Clooney of finance, Mark Carney.

Mark Clooney

Anyways, the site has lots of interesting entries, such as these recent catchy numbers:

The sort of stuff that gets lots of clicks going … maybe not, although this one did catch my eye:

Matchmaker, matchmaker make me a mortgage: What policymakers can learn from dating websites by Angelina Carvalho, Chiranjit Chakraborty and Georgia Latsi.

Actually, it didn’t really, this was the one that caught my eye:

Central bank digital currency: the end of monetary policy as we know it? by Marilyne Tolle.

It’s a brilliant analysis of the true implications of creating central bank digital currencies, and lays out both a positive and negative critique of the likely impacts.  How can it do that?  Well, enjoy …

Central bank digital currency: the end of monetary policy as we know it? by Marilyne Tolle.


Central banks (CBs) have long issued paper currency. The development of Bitcoin and other private digital currencies has provided them with the technological means to issue their own digital currency. But should they?

Addressing this question is part of the Bank’s Research Agenda. In this post I sketch out how a CB digital currency – call it CBcoin – might affect the monetary and banking systems – setting aside other important and complex systemic implications that range from prudential regulation and financial stability to technology, operational and financial conduct.

I argue that taken to its most extreme conclusion, CBcoin issuance could have far-reaching consequences for commercial and central banking – divorcing payments from private bank deposits and even putting an end to banks’ ability to create money. By redefining the architecture of payment systems, CBcoin could thus challenge fractional reserve banking and reshape the conduct of monetary policy.

The next big question for central banks?

Digital currency is no longer the preserve of cypherpunks and crypto-anarchists. Economists and central bankers alike have been pondering whether CBs should issue their own digital currency. Koning (2014) and Andolfatto (2015) have discussed the idea of ‘Fedcoin’, Ben Broadbent recently spoke on the possible technological underpinnings and consequences of a CB digital currency, and the People’s Bank of China has announced it is looking into the idea.

Show me the money

Cash is simply coins and notes – embodiments of ‘money.’ Because banknotes and coins circulate in the economy, they are also referred to as ‘currency’. Yet currency is only a very small part of money (see McLeay et al (2014)). Money mostly consists of electronic deposits: broad money consists of (currency and) households’ and firms’ deposits with commercial banks, while base or CB money consists of (currency and) commercial banks’ deposits with the CB (‘CB reserves’).

On the face of it, customer bank deposits and CB reserves are very similar. They are both current account balances. But there is a crucial difference. CB reserves are risk-free. Bank deposits are not, because banks engage in lending that incurs at least some risk. As Mervyn King (2010) remarked, the ‘pretence that risk-free deposits can be supported by risky assets is alchemy’. Commercial banks’ fallibility is the reason behind the existence of public deposit insurance and lending-of-last-resort by the CB – an attempt to enforce one-for-one convertibility between bank deposits and CB money.

What might happen if the CB were to issue digital currency?

Now assume a CB issued CBcoin, a digital currency with one-for-one convertibility with paper currency and CB reserves. The issuance of CBcoin would simply create a third CB liability, risk-free and irredeemable.

The first step would be to decide whether, and at what interest rate, CBcoin might be remunerated. CB reserves are the means by which most CBs today implement monetary policy, by setting the interest rate paid on the reserves (or via the rate on repo transactions).

If CBcoin were remunerated at the same rate as CB reserves, it would be interchangeable with reserves. And if the CB chose to replace cash with CBcoin, it could then charge a negative interest rate on deposits to bypass the dreaded zero lower bound, as considered by Kimball (2013) and Haldane (2015). In this scenario, the overall quantity of CB money would stay the same, only the composition of the CB liabilities would change.

But even if the CB didn’t use the price or quantity of CBcoin as an additional monetary policy instrument, CBcoin issuance could have much wider ramifications, as a by-product of its impact on the payment system.

An overhaul of transactions settlement?

CB reserves currently play a central role in payment systems. If two parties need to settle a transaction but hold deposits at different banks, the payment requires a transfer of funds between the two banks. Banks net out such transfers and settle the residual amount using CB reserves as the medium of exchange.  This makes CB money the ultimate settlement asset (see Rule (2015)). While some intermediated electronic payments such as the UK’s Faster Payments Service are fast, traditional systems can be slow, taking up to three business days to settle a transaction (see Kroeger and Sarkar (2016) and Yermack (2015)).

If households and firms were given access to CBcoin accounts at the CB, banks’ dominant role as providers of payment services would be called into question. As a risk-free, interest-bearing asset, CBcoin would be preferable to bank deposits (and even paper currency, presuming anonymity concerns were addressed), encouraging households and firms to convert their bank deposits into CBcoin deposits. The appeal of CBcoin vis-à-vis deposits would likely depend on the relative interest rate payable.

In effect, retail payments (and securities transactions) would no longer have to be mediated by banks, as the funds would be transferred directly from one party’s CBcoin account to another’s. A disintermediated payment system could gradually replace the current centralised system and its associated credit and liquidity risks (see BIS (2003)). The main benefit to CBcoin account holders would be access to cheap and fast peer-to-peer transactions.

An end to traditional banking?

Commercial banks currently have the power to create money. When a bank makes a loan, it simultaneously creates a deposit, adding to broad money. So, by extending credit, banks not only create their own funding (deposits), they also control the level of broad money in the economy (see McLeay et al (2014)). Banks hold a fraction of the loans they extend as CB reserves, so as to back a fraction of their deposit liabilities with CB reserves – a setup known as fractional reserve banking. This fractional backing of deposits means that if all households suddenly wished to convert their deposits into hard currency, banks would not have enough reserves to repay them, so would either need to sell off their loan books in exchange for currency or utilise the CB’s lender-of-last-resort facilities.

If households and firms converted their bank deposits into CBcoin, commercial banks’ deposit-funded model would come under pressure. Broadly speaking, there are two possible delimiting scenarios. In the first, banks would compete with CBcoin by offering higher interest rates on their customer deposits. How much higher would of course be an empirical matter. By raising banks’ funding costs – other things equal – this could dent bank profitability and lead to tighter credit conditions. But banks would continue to issue loans and create broad money.  In a recent paper, Barrdear and Kumhof use a DSGE model that accommodates fractional reserve banking to study the macroeconomic consequences of CB digital currency issuance.

Another scenario would see a large-scale shift of customer deposits into CBcoin, forcing banks to sell off their loan books. Bank deposits could still exist but as saving instruments, no longer used to make payments. Banks could still originate loans, provided they lent money actually invested by customers, say, in non-insured investment accounts that couldn’t be used as a medium of exchange. Banks would operate like mutual funds, losing their power to create money and becoming pure intermediaries of loanable funds, as described in economic textbooks.

Under this scenario, the contraction of broad money (bank deposits), and the attendant emergence of ‘private-sector base money’ made of CBcoin would mark the demise of fractional reserve banking (see Sams (2015)). The conversion of bank deposits into CBcoin deposits at the CB would amount to 100% reserve backing for deposits. This could usher in a system similar to the Chicago Plan, a set of monetary reforms proposed by Irving Fisher during the Great Depression and recently revisited by Benes and Kumhof (2012). The Plan’s call for the separation of the credit and money-creating functions of private banks would be addressed – with 100% reserve backing, banks could no longer create their own funding – deposits – by lending.  Similar “narrow banking” proposals have emerged since the financial crisis, such as that of Kay (2009), Kotlikoff’s Limited-Purpose Banking (2012) or the Vollgeld initiative (2015), recently rejected by the Swiss government.

A new framework for monetary policy?

The conflation of broad and base money, and the separation of credit and money, would allow the CB to control the money supply directly and independently of credit creation, calling for a reassessment of monetary policy along two dimensions. First, the prospect of direct control of the money supply might alter the relative merits of using interest rates or the money supply as the main policy instrument. If so, this newfound CB power could reopen the debate between advocates of rules versus discretion in the conduct of monetary policy. For instance, the signers of the Chicago Plan, in particular Milton Friedman, envisioned a constant money growth rule rather than the discretion over interest rates that has prevailed since CB independence in the 1990s.

Watch this space!

Mapping out the implications of CB digital currency issuance is a very complex endeavor. It is helpful as a first pass to sketch out partial scenarios, as I have done in this post for banking and monetary policy, but the devil lies in the detail. Research is ongoing so watch this space!

Marilyne Tolle works in the Bank’s MPC Unit.

Chris Skinner Author Avatar

Chris M Skinner

Chris Skinner is best known as an independent commentator on the financial markets through his blog,, as author of the bestselling book Digital Bank, and Chair of the European networking forum the Financial Services Club. He has been voted one of the most influential people in banking by The Financial Brand (as well as one of the best blogs), a FinTech Titan (Next Bank), one of the Fintech Leaders you need to follow (City AM, Deluxe and Jax Finance), as well as one of the Top 40 most influential people in financial technology by the Wall Street Journal's Financial News. To learn more click here...

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