How will the issuance of central bank digital currency change the operating mechanism of commercial banks?

What will the world be like in the future? What will money be like in the future?

With the impact of the rapid development of virtual currencies such as Bitcoin on the legal currency system, central banks of major countries have gradually realized that only by issuing central bank digital currencies can the market position of legal currency be effectively guaranteed fundamentally.

Zhou Xiaochuan, the governor of the central bank, pointed out that China has a large population and a large size. For example, a small country can complete a new version of the RMB in a few months, but China needs about ten years. Therefore, digital currency and cash will be in a parallel and gradually replace each other for a long time. The transaction cost of cash will gradually increase in the later period. For example, in the past, banks counted a large number of coins, and they would not leave until they finished counting, and they did not charge fees. Later, they may need to charge fees. With the incentive mechanism, people will naturally use more digital currency, but the two will still coexist for a long time.

He believes that digital currency must be issued by the central bank as legal tender. The issuance, circulation and trading of digital currency should follow the idea of ​​integrating traditional currency with digital currency and implement the same management principles. This means that Q coins and the like are definitely not acceptable.

Central banks in many countries have begun to study the issuance of legal digital currencies. For example, researchers at the Bank of Canada have published several working papers in recent years to explore the impact of central bank digital currency issuance on social welfare and other aspects; the Bank of England published a working paper in August this year, "Macroeconomics of Central Bank Digital Currency Issuance", which theoretically explored the possible impact of central bank digital currency issuance on the macroeconomy; the People's Bank of China established a digital currency research project team a few years ago and recently disclosed related research. In addition, Ecuador is trying to issue a digital currency - Ecuador currency - by the central bank.

Models for issuing digital currency

Considering the current situation and the trend of deep integration of science and technology and finance in the future, the issuance of digital currency by the central bank is undoubtedly an inevitable event. As for which country's central bank will issue it first and when, there are many uncertainties. Another big uncertainty is whether the issuance mechanism of the central bank's digital currency is single or multiple.

When a central bank issues digital currency, it needs to establish a basic digital currency system first. In this system, the central bank is in charge of the digital currency issuance vault, commercial banks manage the bank vault, and the public and individuals hold digital wallets. This is essentially not much different from the existing monetary system, except that the managed currency has changed from paper money to digital cryptocurrency. In terms of the issuance mechanism, there are two models: one is the traditional "central bank-commercial bank" model, that is, the central bank issues digital currency from the central bank's issuance vault to the commercial bank's bank vault. When an individual withdraws money from a commercial bank, the digital currency is transferred from the commercial bank to the individual's digital wallet. The other model is the "central bank-public" model, that is, the central bank can directly issue digital currency from the currency issuance vault to the public and individual digital wallets. In essence, no matter which issuance model is used, the currency is ultimately held by the public and is a liability of the central bank to the public.

Ben Broadbent, deputy governor of the Bank of England, said in his speech on "Central Banks and Digital Currency" at the London School of Economics on March 2, 2016 that the balance sheet of the central bank can be open to every market participant (including individuals), but this may lead to the transfer of commercial bank deposits to the central bank, which will have many impacts. Although Ben Broadbent specifically stated that the content of the speech only represents his personal opinion and does not represent the official attitude of the Bank of England, at least we can observe that the senior management of the Bank of England has no clear preference on the issuance mechanism of digital currency.

The People's Bank of China began research on digital currency several years ago. The 17th issue of "China Finance" in 2016 published a series of articles on digital currency research by the People's Bank of China's digital currency research project team and its members. The articles clearly expressed their preference for the first issuance mechanism, which would allow legal digital currency to gradually replace paper currency under the existing monetary framework without subverting the existing currency issuance and circulation system.

Untested financial environment

If the "central bank-public" currency issuance mechanism is chosen, it means that the central bank can start the money helicopter when necessary and directly implement a negative interest rate monetary policy. This is undoubtedly a one-time thing for central banks such as the European Central Bank and the Bank of Japan that are currently implementing negative interest rates. However, this currency issuance mechanism completely subverts the existing currency issuance and circulation system, thus entering an unprecedented and untested financial environment. As Ben Broadbent worried, if deposits are moved from commercial banks to central banks, it will become safer to deposit funds in the central bank. The problem is that it will also damage the bank's initial credit capacity.

In the current banking system, banks mainly transform short-term deposits into medium- and long-term loans by assuming the function of maturity transformation, and in the process, they play the role of money creation to meet the financing needs of society. The performance of this function requires rolling demand deposits to flow within the banking system. If a large number of demand deposits are transferred to the central bank, then, as Ben Broadbent worries, banks will immediately lose their source of liquidity and rely more on the wholesale market. Funds in the wholesale market are quite unstable during economic crises, which will eventually lead to banks reducing their credit support for the real economy. This means that during an economic crisis, the funds that banks can absorb will become more scarce, and credit will further shrink, thereby accelerating the economic recession.

In addition, John Cochrane, a famous professor of finance at the University of Chicago, believes that with the issuance of digital currency, depositors will no longer need to rely on commercial banks to hold their current deposit accounts, and the government will be able to get rid of the risky deposit insurance business. Commercial banks that want to continue lending will increase their long-term capital in the debt and equity markets, ending the mismatch between current deposits and long-term loans that cause liquidity problems, and then the economic crisis and financial operations will end.

Rewriting the mechanism of commercial banks

Regardless of the digital currency issuance mechanism, it is certain that the era of commercial banks making money without doing anything will become history. Digital wallets will meet the payment functions of various scenarios like current paper money. Whether the digital currency owned by individuals is deposited in the bank's demand deposits to obtain corresponding interest and bear the losses caused by the possible bankruptcy of the bank, or kept in a safer digital wallet, such a simple behavioral choice will completely change the operating mechanism of commercial banks and determine their fate. Commercial banks will face unprecedented competition in demand deposits, and the substitutability between digital currency held by individuals and demand deposits will become more sensitive to interest rates and risks in the banking system. The equilibrium of market competition may go to two extremes. On one end, the bank's demand deposit interest rate is close to that of time deposits, and individuals will empty the digital currency in their digital wallets and deposit it in their bank accounts; on the other end, individuals will empty the bank's demand deposits and deposit this part of the digital currency that meets liquidity preferences in their digital wallets. Banks will no longer be financial intermediaries that perform maturity conversion functions. The situation in the current paper currency environment will no longer be an equilibrium result, that is, people may no longer keep part of the money in a bank current account and hold another part of the money in their hands at the same time, because changes in interest rates or other relevant factors will drive people to move completely from one end to the other in the distribution of their money holdings.

With the advent of the digital currency era, the number of physical outlets of commercial banks will also be greatly reduced, replaced by digital outlets or smart outlets. The development of artificial intelligence technology will further accelerate the strategic adjustment of the layout of commercial bank outlets. The resulting cost reduction will help offset the cost increase brought about by commercial banks in deposit competition. It is foreseeable that when physical outlets are no longer the main source of deposits for commercial banks and even become an operating burden, the current large banks may even be eliminated in the process of forming a new market structure. Small and medium-sized banks that conform to this development trend will have the opportunity to achieve a return to the market, and financial technology strength and more convenient and personalized financial services will be the dominant factors in the formation of this new market structure.

In short, the issuance of digital currency by the central bank is a great monetary reform in human history, which will eventually create a more financially stable world. In this process, the financial infrastructure will be reconstructed, the financial system will be redesigned, and the financial transaction environment will be reshaped, and the biggest risk lies in the risk of path transfer. In the process of mankind's transition from the monetary economic system of paper money to the monetary economic system of the digital age, due to entering an unprecedented and untested financial world, known and unknown risks are intertwined, and every small step forward may face huge challenges, such as the stability of the digital currency system, hacker attacks, coordination with central banks of other countries, and the alternation of new and old forces of financial institutions in this process, which are very likely to bring great instability to finance. This requires the central bank to strengthen relevant research and scientific predictions, and make systematic institutional arrangements in the process of path transfer to cope with the resulting market turmoil and financial risks.