Designing central bank digital currencies

Various central banks are currently weighing up the introduction of central bank digital currency. This column proposes a framework that captures the key features and studies the implications of such a payment system. Central bank digital currency can be designed with attributes similar to cash or deposits.

Currency that closely competes with deposits would likely depress bank credit, while cashlike currency could lead to the disappearance of cash. The optimal central bank digital currency design hence trades off bank intermediation against the social value of maintaining diverse payment instruments. The currency could be interest-bearing, which may help alleviate this trade-off.

Payment systems and, more fundamentally, money are evolving rapidly. Developments in digital networks, information technology and the increasing share of internet-based retailing have created the demand and technological space for peer-to-peer digital transactions that have the potential to radically change payment and financial intermediation systems.

Central banks have been pondering whether and how to adapt. Many are exploring the idea of issuing a central bank digital currency (CBDC) - a new type of fiat money that expands digital access to central bank reserves to the public at large, instead of restricting it to commercial banks (BIS 2018, Mancini-Griffoli et al. 2018).1 A CBDC would combine the digital nature of deposits with the peer-topeer transaction use of cash. But would it also resemble deposits by coming in the form of an account at the central bank, or would it come closer to cash, materializing as a digital token? Would it pay interest rates like a bank deposit, or would its nominal return be fixed at naught, like cash?2

An analytical approach

In Agur et al. (2019), we build a theoretical framework geared at analysing the relationship between CBDC design, the demand for money types, financial intermediation, and network effects.3 The starting point is a model economy where banks collect deposits, extend credit to firms, and create social value in doing so: firms' projects are worth less if they cannot receive bank loans.

Households have heterogeneous preferences over anonymity and security in payments, represented by an interval with cash and deposits at opposite ends: cash provides anonymity in transactions, while bank secure.

A CBDC can take any point on this interval, depending on its design. For instance, a central bank could provide partial anonymity (e.g. towards third-parties but not the authorities), set transaction limits below which anonymity is retained, or make anonymity conditional, only to be lifted under court order. All of those possibilities are under consideration in central banks' CBDC studies (Mancini-Griffoli et al. 2018). As emphasized by Lagarde (2018), there is potential demand for partially anonymous means of payment that can, for example, protect consumers from the use of personal transactions data for credit assessments. This possibility is increasingly enabled by technological developments, as for instance discussed by Yao (2018) in the Chinese context.

Taking into account the design of the CBDC, households sort into different types of money according to three considerations: their (heterogeneous) preferences, network effects which make it inconvenient to use payment instruments with few users, and the interest rates offered

deposits

are more on deposits and possibly on CBDC.

Figure 1 depicts how money shares evolve in relation to CBDC design, where ? represents how cash-like the CBDC is made (0 is fully deposit-like and 1 is fully cash-like) and rcbdc is the interest rate offered on the CBDC.4 Panel A shows that cash holdings decline, and bank deposits rise as the CBDC becomes more cash-like. Panel B shows that a higher CBDC rate reduces the shares of both cash and deposits, while raising that of CBDC. Notably, when CBDC becomes sufficiently cash-like or rcbdc is sufficiently high, network externalities drive cash out of use. Deposits prove more resilient to competition from CBDC, as banks raise deposit rates in response.

Variety in payment instruments increases welfare because of heterogeneity in household preferences. CBDC then has social value due to its ability to blend features of cash and deposits. At the same time, introducing a CBDC has welfare costs to the extent that it crowds out demand for cash and deposits. Specifically, a cash-like CBDC design can reduce cash demand to the point where network effects cause the disappearance of cash.