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Hurried, rapid steps into the age of digital currencies

Cash as a means of payment is declining around the world in favour of electronic money. The COVID-19 pandemic has intensified this trend. Central banks are speeding up their development of a new fourth type of money – e-currencies – in response to new public behaviours and demands for fast, simple, efficient means of payment. SEB’s economist discuss the subject in this theme article.

Behind the scenes, cryptocurrencies like bitcoin are moving ahead. E-currencies have advantages and may give monetary policymakers new tools and boost economic growth. Yet they are “unknown beasts” that, if improperly designed, may jeopardise economic growth and the stability of national and global financial and monetary systems.

Unlike physical banknotes and coins, electronic cash can offer fast, cost-effective payments both within and between countries. New behaviours and technological advances are driving developments in the payments market. In Sweden, which holds a leading position in the payments revolution, cash accounts for only 1 per cent of the concept of money; 99 per cent is electronic kronor. Households and businesses around the world simply prefer digital money to physical cash. The 2020-2021 pandemic has undoubtedly helped to increase public interest in contactless payments.

The world is on the threshold of profound changes in payments systems. Individuals, businesses and other actors want ever-faster payments. Central and commercial banks are trying to fulfil their wishes, while non-financial institutions are expanding their role in the payments market.

Today's three types of money are about to become four. According to the Bank for International Settlements, more than 85 per cent of the world's central banks have ongoing e-currency projects. On a very limited scale, the People’s Bank of China has gone from projects to practical experiments with its e-yuan. Last summer the European Central Bank began work on creating an e-euro within about 5 years, the same time frame as Sweden’s Riksbank is working with. In August, the US Federal Reserve presented a discussion paper on the pros and cons of introducing e-dollars. These steps into the digital currency age are thus both hurried and determined.

What is an e-currency, actually?

A new electronic currency, or e-currency, is intended as a digital complement to cash. E-currencies give households and businesses access to a new type of government electronic money, issued by central banks. They can be regarded as "digital banknotes and coins". Today only banks and other financial institutions have access to central bank digital money. An e-currency thus expands the number of actors with direct access to electronic central bank money. A household or business that has an e-currency receivable from a central bank also runs no liquidity, credit or market risks. In other words, e-currency is as risk-free as physical cash.

An e-currency is a double-edged sword. It has the potential to revolutionise and streamline payment systems and monetary policy. For example, it will be theoretically possible to have different interest rates for different sectors of society and geographies – making monetary policy more targeted and accurate and less dependent on transmission via the banking system. Meanwhile, e-currencies risk weakening and destabilising financial systems at national and global level. The design of e-currency infrastructure will also determine how much information central banks and governments will receive about transactions by individuals and businesses.

The conditions and objectives for launching e-currencies seem to be consistent between countries and central banks. For example, they must not complicate the implementation of monetary policy or jeopardise the stability of the financial system. E-currencies are also intended to coexist and complement cash and private bank money and contribute to greater innovation, efficiency and security in the entire payments system. They are also intended to protect people’s privacy and offset threats posed by the emergence of competing cryptocurrencies that may undermine monetary policy independence.

New monetary policy flexibility?

In theory, an e-currency has the potential to facilitate the implementation of new unconventional monetary policy, such as negative central bank key interest rates and the expansion of central bank balance sheets (QE policies), in three ways:

  1. policy manoeuvring room can be increased by allowing key rates to be negative, although the potential is limited by any continued access to physical cash;
  2. Quantitative easing (QE) policy can be targeted more directly – for example to market players and sectors that have specific liquidity needs – at different interest rates;
  3. Central banks and government are better able to pursue so-called “helicopter money” policies.

An interest-bearing and generally accepted e-currency is a potentially versatile central bank tool that will speed up and intensify the impact of monetary policy on the real economy. E-currencies remove the so-called zero bound on key interest rates if cash is not available as an alternative or if cash holdings are limited (for example by eliminating banknotes with higher denominations). In this environment, in practice the negative interest rate on an e-currency becomes a kind of government tax on savings. But if e-currencies are to exist in parallel with physical means of payment, for example mainly for emergency preparedness reasons, in practice it will be impossible for a central bank to have a negative key rate.

E-currencies that are linked to clearly negative key rates also run the risk of increased competition from other countries' physical and electronic currencies that carry zero or positive rates. In addition, interest in crypto assets may increase, making it more difficult to implement monetary policy. All in all, this suggests that e-currencies hardly offer greater opportunities for negative key rates.

If an e-currency, like cash, is interest-free and without volume restrictions (in other words, e-currency holdings are unlimited), it will be even harder than today to conduct monetary policy with negative key rates; the lower bound is clearly 0 per cent. It is also an increasingly widespread view that fiscal policy is a more efficient and powerful economic tool than monetary policy that employs negative key rates. In situations such as the global financial crisis of 2007-2008 and the 2020-2021 pandemic, there is reason to believe that the task of central banks is to ensure liquidity in the financial system and the maintenance of credit flows.

New risks to financial stability?

If the e-currency holdings of the general public are equated with traditional bank deposits, this also strengthens the co-variation between central bank key interest rates and the banking system's deposit rates, regardless of whether an e-currency is interest-free or interest-bearing. This puts the spotlight on the role of banks and other payment intermediaries in the national and global financial system.

E-currencies can pose a serious risk to the stability of the financial system – bank deposits risk being replaced instead by e-currency holdings. Looking ahead, this may both reduce and raise the cost of lending by the banking system. Higher financing costs and greater uncertainty about future financing may destabilise the entire system and have negative macroeconomic effects. The risk of instability will increase, especially since the financial system may suffer from stress.

E-currencies that are perceived as more attractive than deposit accounts at banks may eventually result in lower bank deposits. Today these funds are mainly used to finance long-term lending to households and businesses. Banks accept short-term deposits and make long-term loans. This transformation of maturities has a significant socio-economic value. If an e-currency becomes a substitute for the banks’ interest-bearing deposits, the funding costs of banks may vary to a greater extent than today. This, in turn, may affect lending to the private sector – both in terms of lending volumes and interest costs.

If the interest rate offered is at the same level, e-currencies may appear more attractive due to a government guarantee. This may force banks to offer higher interest rates on deposits, thereby increasing costs to the banks' borrowers. To reduce these risks, central banks can limit how much e-currency an individual or a business may hold, for example. Another alternative is for central banks to use other tools to ensure lending to banking systems. This significantly changes credit relations in the market. E-currencies also affect the asset side of central bank balance sheets. If e-currencies are highly popular, central banks will also need to invest such funds in such assets as government securities or other domestic credit instruments – in addition to their current holdings that are a result of QE policies. These purchases of fixed income securities will mean that the role of central banks as suppliers of credit in the economy will increase and that the role of commercial banks will weaken. This may lead to efficiency losses in both the pricing and allocation of loans.

The age of digital money is here...but...

Technology, a pandemic and cryptocurrencies – in a low interest rate environment – have accelerated the development of electronic money, while cash payments are continuing to decline. Digital money has the potential to transform the payments market, especially in emerging economies, by offering the general public secure and cost-effective tools for making payments.

Despite declining demand for cash by the general public, a completely cashless economy seems unreasonable. Some groups in society may need access to physical banknotes for various reasons. E-currencies also increase cyber risks and vulnerabilities in the infrastructure of the digital payments system. Many unclear points need to be addressed before we take our next steps into the age of digital currencies.

Nordic Outlook September 2021


Three types of money may become four

  • Central banks create “central bank money” by printing more physical cash and by lending electronic money to banks. Banks create private bank money based on the supply of electronic central bank money and their own balance sheets. Private bank money is exclusively electronic. The introduction of an e-currency thus means the introduction of a fourth type of money.
  • The "exchange rate" between cash and private bank money is 1 to 1; they are regarded as perfectly interchangeable even though they carry different credit risks. The “exchange rate” for e-currency in relation to both cash and private bank money would also be 1 to 1. Exchanges between the four different types of money would thus continue to take place without a change in value. The receivable that the public has in banks in the form of electronic money, or by possessing physical cash, can thus be replaced at any time by an e-currency receivable, which is then used for payments.


Crypto assets and “stablecoins”

  • Crypto assets like bitcoin, often misleadingly called e-currencies, can hardly be regarded today as functioning means of payment. They are far from risk-free or backed by a government or central bank. As bitcoin has confirmed, they have varied sharply in value over time.
  • Bitcoin can be a tool (but a volatile asset class) for investors who are looking for portfolio diversification and want to be able to carry out transactions anonymously (for better or worse). Bitcoin probably has little chance of becoming an established means of payment in countries with stable inflation and exchange rates and confidence in national institutions.
  • “Stablecoins” are a subgroup of cryptocurrencies that are designed to track the value of another asset class, for example a national currency like the US dollar. The issuer then holds a certain amount, for example in a dollar reserve, and creates a proportional quantity of "stablecoins". This money may be an attractive means of payment if its value is linked to a government-backed means of payment (such as the dollar) 1 to 1 and if it is backed by a pool of safe, liquid assets.
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