What is money? Money is debt. Money is credit. A promise to pay. A way to store and transfer the value of effort across distance or time. Inscribed on all Rupee notes is “I promise to pay the bearer, the sum of..” . No one doubts the ability of the Reserve Bank of India to pay, so we keep our wealth in Rupees. Money, by itself, has no intrinsic value. Money represents something of value.

This something doesn’t have to be tangible. A creative solution to an expensive problem is worth a lot of money. Since money isn’t the actual value, but a representation, too much money representing the same ‘wealth’ causes inflation- prices go up. Too little money causes deflation- prices drop.

How is this money created? At the press of a button literally, in a bank. When you take a loan, the bank creates this money out of thin air and deposits it in your account. This deposit is a loan to the bank from you. The bank pays you interest on it as compensation.

Can’t the bank create an infinite amount of money then? No. Every Rupee that the bank loans out, requires some collateral to account for some of those loans going bad. When the bank loans out Rs100, it needs to have some percentage of that- say, Rs 10 in reserves. Once it hits this limit, it has to get more reserves through profits, or more deposits. The RBI indirectly influences how much money is created by adjusting how much reserves the banks need to have. At any point, however, the total complexity of the system is unknown. In practice, a 10% reserve requirement doesn’t mean the actual credit will be 10 times the deposits. It is far more, and worse- we don’t know how much!

From a million to a billion

The flow of money around the world is largely hidden from regulators, and its leverage is completely dark. Lets start with an investment bank in New York. It has branches in London, Singapore, and Tokyo. It has other banks as customers. A bank in London borrows $1b from this New York bank at 1%, and then lends it out at 2% to a European bank in Berlin. Using this $1b as collateral, the bank in Berlin may loan out $5b to a bank in Singapore. Which in turn may use that $5b as collateral to loan out $10b to a large shipping company. The original $1b has now turned into $16b, and in 3 different currencies. The total amount of leverage in the system is unknown, and opaque.

In times of crisis, like the 2008 Lehman Brothers collapse, all this interlinked credit led to a contagion of losses. Lehman’s default left its counter parties unable to pay their dues, which in turn cascaded throughout the system. At some point, this affected the regular banks which had deposits for everyone, not just investment banks. A failure of many large banks would have likely collapsed the global financial system.

Since then, central banks have tried to force banks to lower their total leverage and monitor risk more carefully, but assets have continued to grow.

Whats a CBDC? Isn’t money already digital?

Enter CBDCs. What do all of us want? A safe place to keep your money, and spend it easily- usually done through a bank. Some of it will get invested and spent, the rest of it will remain secure at the bank digitally. You dont need to hold physical cash. Storing your money securely, is a separate function from earning a return on it by taking risk. At a bank, you are always doing both. The money you give to your bank for safekeeping is actually a loan to the bank, which the bank is using as collateral to make loans!

What if you want to just keep it without the bank using it as collateral? An account at the central bank can work just as well. It will carry no risk of failure, as the central bank will not be in the business of making loans. If everyone has an account at the central bank, the cost of transactions can be zero, as its just an accounting entry in a database. UPI ( Unified Payments Interface) in India has shown that even without CBDCs, it is possible to have instant free and secure transactions at massive scale.

We could also have cash and CBDCs in parallel. The CBDC will be fungible with cash, and you can spend cash as always, while larger/distant transactions done digitally via CBDCs.

Cross border and cross currency transactions will require a negotiated settlement mechanism between the two central banks. In countries with a free currency like US or Japan, you can freely transfer money without the central bank getting involved. In closed currency regimes like India or China, all trades of local currency go through authorized banks, who in turn get their foreign currency from the central bank’s foreign exchange reserves.

Token vs account

Several major financial institutions have already published working papers on CBDCs- IMF, BIS and ECB. They cover two types of CBDCs. Token based and account based.

A token based digital currency (DC) will be almost like a banknote, but digital. It is uniquely identifiable, and can be used for transactions without being tied to a specific account. This is a bit similar to a crypto currency, but unlike a network that verifies the hash and uses consensus to validate transactions, in this case the verifier is just a single entity- the central bank. In this model, the transactions can be kept anonymous by verifying the transaction by verifying the token without any information about the counter parties. This also allows it to be stored ‘offline’ just like cash.

An account based DC is almost exactly like the current system, except that everyone’s account will be at the central bank. In this case, the individual units of money are not uniquely identifiable, only the accounts. This carries some extra risk of control- if the government disables your account, you are left with no way to make any transactions or accessing any of your money. The token based approach may still let you use the tokens you have in possession if the identity of the transacting counter parties is hidden.

Digital Yuan

China has begun trials of a Digital Renminbi. Unusually, the new digital currency will ‘expire’ after a set amount of time if not used. This approach can be extended further so that it can be spent only on certain items, since the government will now know the details of each transaction- it goes through them. This nature of CBDCs should make holders wary that their savings may ‘expire’ one day with a change in government policy, or leave them unable to spend it on what they need. For China, this is an avenue for greater state control over individuals. Especially when used along with tools like the social credit score. Your score may determine what you can spend your money on.

Summary

By centralizing all currency ownership and transactions, its a single point of failure. A bank’s systems going down due to a hack or technical trouble is not a cause for widespread problems. Other banks continue as before. By centralizing, we run the risk of bringing the whole economy to a halt in case of a centralized failure. On the other hand, bank bailouts and failures will not affect the average person. The only deposits the bank will have will be explicitly invested funds by professional investors.

By limiting banks to just loans backed by capital raised from shares or borrowed, the industry will shrink substantially. Borrowing costs may go up along with a drop in volume of credit available. Against other countries who dont have such limitations, this will lead to loss of competitiveness for its companies.

When accepting money as deposits, banks are required to do KYC and AML compliance checks. Beyond objective tests, banks use their experience, and discretion to do qualitative checks where they find it necessary. A bank has close relationships with its customers and thus knows the risk profile and background. With a central bank, this expertise will be missing, and may not even be possible to scale. This is also not a core function for a central bank, and may distract attention away from important tasks like managing inflation, and banking regulation.

Lack of privacy, and full control over your assets by the government is especially excessive in a world where CBDCs entirely replace cash. Every transaction you do will be logged with the central bank. This may be hacked some day, or the government may determine that some of it is illegal and prosecute you. Cash is almost impossible to track. If all transactions go digital via CBDC, everything from milk and bread to car purchases will be in government records.

CBDCs are an experiment- at a very early state, driven by an attempt to innovate after the rise of cryptocurrencies. In future, there may be a token based CBDC that uses crypto like consensus to validate transactions, but issuance is only done by the central bank. This combines best of both the worlds! It is too early to predict a winner, but we will likely see crypto currencies, central bank digital currencies, and regular currencies coexist side by side for a while, until we find a stable equilibrium.

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CBDCs: Central Bank digital currencies