Central bank digital currencies
13 January 2021
Erasmus and Turing
11 January 2021
Brexit and Marxism
3 January 2021
What to do about the Covid financial system bailouts?
22 December 2020
The crypto-technical response to the Covid-19 bailouts
13 December 2020
The libertarian response to the Covid-19 financial turmoil
9 December 2020
The socialist response to the Covid-19 financial turmoil
4 December 2020
On the response of the financial authorities to Covid-19
2 December 2020
The Covid-19 bailouts and the future of the capitalist banking system
26 November 2020
Which programming language is best for economic research: Julia, Matlab, Python or R?
20 August 2020
ARM on AWS for R
15 June 2020
Low vol strategies
8 May 2020
Of Julia and R
8 May 2020
How to manipulate risk forecasts 101
30 April 2020
The five principles of correct riskometer use
27 April 2020
The problem with Backtesting
25 April 2020
The magic of riskometers
24 April 2020
Risk and scientific socialism
23 April 2020
Financial crises and epidemics
19 April 2020
Hayek and Corona
17 April 2020
Hayek et Corona
17 April 2020
Ignoring the Corona analysis
15 April 2020
The coronavirus crisis is no 2008
26 March 2020
Artificial intelligence as a central banker
6 March 2020
Systemic consequences of outsourcing to the cloud
2 December 2019
The dissonance of the short and long term
12 August 2019
Central banks and reputation risk
6 August 2019
The Brexit culture war
5 May 2019
All about BoB — The Bank of England Bot
29 April 2019
My tiny, tiny contribution to Apple's fall in profits
6 January 2019
The 2018 market in a 250 year context
1 January 2019
Short and long-term risk
3 December 2018
Perceived and actual risk
2 December 2018
Cryptocurrencies: Financial stability and fairness
9 November 2018
The October 2018 stock market in a historical context
1 November 2018
The hierarchy of financial policies
12 September 2018
Which numerical computing language is best: Julia, MATLAB, Python or R?
9 July 2018
26 June 2018
What are risk models good for?
3 June 2018
The McNamara fallacy in financial policymaking
1 June 2018
VIX, CISS and all the political uncertainty
20 May 2018
Here be dragons
30 March 2018
Low risk as a predictor of financial crises
26 March 2018
Cryptocurrencies don't make sense
13 February 2018
Yesterday's mini crash in a historical context
6 February 2018
Artificial intelligence and the stability of markets
15 November 2017
European bank-sovereign doom loop
30 September 2017
Do the new financial regulations favour the largest banks?
27 September 2017
The ECB Systemic Risk Indicator
24 September 2017
Finance is not engineering
22 September 2017
University of Iceland seminar
14 June 2017
Brexit and systemic risk
31 May 2017
Should macroprudential policy target real estate prices?
12 May 2017
Learning from history at LQG
13 April 2017
Is Julia ready for prime time?
12 March 2017
With capital controls gone, Iceland must prioritise investing abroad
12 March 2017
Competing Brexit visions
25 February 2017
Systemic consequences of Brexit
23 February 2017
Why macropru can end up being procyclical
15 December 2016
The fatal flaw in macropru: It ignores political risk
8 December 2016
Why it doesn't make sense to hold bonds
27 June 2016
On the financial market consequences of Brexit
24 June 2016
Cyber risk as systemic risk
10 June 2016
Big Banks' Risk Does Not Compute
24 May 2016
Interview on þjóðbraut on Hringbraut
21 May 2016
Farewell CoCos
26 April 2016
Will Brexit give us the 1950s or Hong Kong?
18 April 2016
Of Brexit and regulations
16 April 2016
IMF and Iceland
12 April 2016
Stability in Iceland
7 April 2016
Everybody right, everybody wrong: Plural rationalities in macroprudential regulation
18 March 2016
Of tail risk
12 March 2016
Models and regulations and the political leadership
26 February 2016
Why do we rely so much on models when we know they can't be trusted?
25 February 2016
Does a true model exist and does it matter?
25 February 2016
The point of central banks
25 January 2016
Volatility, financial crises and Minsky's hypothesis
2 October 2015
Impact of the recent market turmoil on risk measures
28 August 2015
Iceland, Greece and political hectoring
13 August 2015
A proposed research and policy agenda for systemic risk
7 August 2015
Are asset managers systemically important?
5 August 2015
Objective function of macro-prudential regulations
24 July 2015
Risky business: Finding the balance between financial stability and risk
24 July 2015
Regulators could be responsible for next financial crash
21 July 2015
How Iceland is falling behind. On Sprengisandur
12 July 2015
Greece on Sprengisandur
12 July 2015
Why Iceland can now remove capital controls
11 June 2015
Market moves that are supposed to happen every half-decade keep happening
14 May 2015
Capital controls
12 May 2015
What do ES and VaR say about the tails
25 April 2015
Why risk is hard to measure
25 April 2015
Post-Crisis banking regulation: Evolution of economic thinking as it happened on Vox
2 March 2015
The Danish FX event
24 February 2015
On the Swiss FX shock
24 February 2015
Europe's proposed capital markets union
23 February 2015
What the Swiss FX shock says about risk models
18 January 2015
Model risk: Risk measures when models may be wrong
8 June 2014
The new market-risk regulations
28 November 2013
Solvency II: Three principles to respect
21 October 2013
Political challenges of the macroprudential agenda
6 September 2013
Iceland's post-Crisis economy: A myth or a miracle?
21 May 2013
The capital controls in Cyprus and the Icelandic experience
28 March 2013
Towards a more procyclical financial system
6 March 2013
Europe's pre-Eurozone debt crisis: Faroe Islands in the 1990s
11 September 2012
Countercyclical regulation in Solvency II: Merits and flaws
23 June 2012
The Greek crisis: When political desire triumphs economic reality
2 March 2012
Iceland and the IMF: Why the capital controls are entirely wrong
14 November 2011
Iceland: Was the IMF programme successful?
27 October 2011
How not to resolve a banking crisis: Learning from Iceland's mistakes
26 October 2011
Capital, politics and bank weaknesses
27 June 2011
The appropriate use of risk models: Part II
17 June 2011
The appropriate use of risk models: Part I
16 June 2011
Lessons from the Icesave rejection
27 April 2011
A prudential regulatory issue at the heart of Solvency II
31 March 2011
Valuing insurers' liabilities during crises: What EU policymakers should not do
18 March 2011
Risk and crises: How the models failed and are failing
18 February 2011
The saga of Icesave: A new CEPR Policy Insight
26 January 2010
Iceland applies for EU membership, the outcome is uncertain
21 July 2009
Bonus incensed
25 May 2009
Not so fast! There's no reason to regulate everything
25 March 2009
Modelling financial turmoil through endogenous risk
11 March 2009
Financial regulation built on sand: The myth of the riskometer
1 March 2009
Government failures in Iceland: Entranced by banking
9 February 2009
How bad could the crisis get? Lessons from Iceland
12 November 2008
Regulation and financial models: Complexity kills
29 September 2008
Blame the models
8 May 2008

Central bank digital currencies

13 January 2021

Central-bank digital currencies will make the financial system more efficient. But will they make it safer? Maybe, but they could easily end up increasing systemic risk. Depends on the implementation.

I have been discussing what the bailouts of the financial system in response to Covid-19 mean for the future of the financial system. In my last piece, I suggested diversity was the solution.

But there is one topic I didn’t get into in detail, and that is central-bank digital currencies or CBDCs in short.

I’m not going to get into what CBDCs are in any detail, plenty of information out there, only Google or DuckDuckGo away. I list some references at the bottom.

As far as I can tell, the main reason central banks, at least in the democratic world, are contemplating CBDCs is to forestall the emergence of alternative payment systems, especially foreign ones that are outside the control of the central bank. They remember how PayPal came out of nowhere, and by the time it got on their radar, it was too late to do anything about it.

There is one more reason some advance for taking up CBDCs, and that is it allows the central banks to precisely control the money supply, and hence tune the economy in real time to achieve optimal efficiency, prevent crises and ensure stable economic growth. While popular with some sector of the commentariat, I suspect this reason is less important than the first.

Competition is a forceful agent of change, and no matter how reluctant the central banks are to take up CBDCs, I suspect they have no choice.

And that leaves the question of how they affect financial stability?

The obvious implementation is not going to happen

The most obvious way to do CBDCs is simply for the central bank to create money that exists as a token on a blockchain under its own control. Then, the main difference between CBDCs and cryptocurrencies is simply that the central bank controls the blockchain and not algorithms. Cryptocurrency advocates would argue that such a setup is not a blockchain at all, it’s just a database to keep track of digital currency records.

We all might even be able to have direct access to central bank money.

Superficially, such CBDCs sound like a rather nice idea. There would not have been a need for the visible bailouts of the financial system back in March because of Covid-19, and the 2008 crisis could even manage much better. The central banks would have tweaked the money supply and helped banks in need in a much more targeted way, with much less visibility.

The central problem is that if the central bank controls the blockchain, all transactions, savings and lending and all other uses of money take place on the central bank blockchain. The central bank has perfect visibility and control — all deposits are within the central bank and all lending made by it. Of course, the central bank can delegate this to the private sector, but then the banks are reduced to franchisees executing the central banks’ wishes.

There are sound economic and social reasons why that is a horrible idea.

The economic reason is that the central bank will fully control the money, which can be adjusted to suit the country’s economic needs. The central bank both directs total credit in the economy and who gets it. Yes, they can promise they will not take advantage, but at the end of the day the central bank is authorised by the government, and current reassurances do not bind future presidents or prime ministers.

Meanwhile, the central bank becomes the most powerful institution in society. It knows precisely how much money you have and what you do with the money. It decides whether you get a loan on not. Again, they can promise not to abuse this power, but it is not up to them. The politicians will decide.

No sane central bank in the democratic world would implement CBDCs in such a way. A nondemocratic country might well find such a vehicle for social control highly desirable.

The future is hybrid

The highbrow ideas of democracy and social control are not the main reasons why the central banks reject partially displacing existing money with tokens on a blockchain. The objections are more practical.

The central banks really don’t want to be customer facing. Having to set up call centres and be on the irate end of consumer complaints and set up a vast infrastructure, with all the attendant costs, reputation risk and the risk of hacking.

So what is the central bank to do? They just can’t ignore CBDCs, then the private sector will supply its own competitor. The central banks don’t want another PayPal creeping upon them.

There are alternatives being discussed, I will only briefly mention two main categories of alternatives, the references at the bottom discuss the whole flora. See this BIS document for a good overview.

One solution is a hybrid model where financial institutions face clients, and the money they use are tokens on the central bank blockchain. So, regular clients use tokenised digital money, but only access the central bank blockchain by proxy, via their financial institution. Such a setup is not compatible with existing infrastructure, so it will take longer to implement and be more costly, but then would be more efficient than the second alternative.

A less radical solution is an intermediated model, where client facing financial institutions continue to use existing account based setups. The role of the central bank blockchain is then just a more efficient payment system.

While unclear exactly where this will land, the eventuality is not.

It is less clear what CBDCs will do to financial stability.

CBDCs and the stability of the financial system

CBDCs give the architects of the financial system a once-in-a-lifetime chance to retool the financial system. Many things will change, and how the financial authorities go about their job tells us whether CBDCs are stabilising or destabilising.

In the last piece, I advocated diversity as the primary way of achieving financial stability — diversity in financial institutions and diversity in financial regulations.

The main force of financial instability is homogeneity. Of course, no one says it in that way. No. They talk about level playing fields and fairness and crisis prevention and clear rules. All of which push towards homogeneity and hence instability.

So, how could CBDCs be destabilising? We don’t need to look any further than the FSB’s holistic document that I have discussed so often in the series. The vision advocated there is to bring all parts of the financial system under same — uniform — regulatory umbrella, the reason being that the regulated banks did not have problems in March 2020, but the non-bank parts of the system did. So the answer is to make everybody a bank and regulated in the same way. More monitoring and control to ensure they achieve the objectives set by the financial authorities. The realisation of that vision is homogeneity and hence financial instability.

Because CBDCs give the financial authorities the opportunity to make so many changes to the structure of the financial system, if they take their leave from the FSB holistic document, they have the once-in-a-lifetime power to act achieve homogeneity.

CBDCs are then destabilising.

I suspect that is the most likely outcome, (a nameless senior central banking acquaintance told me the hybrid document is the roadmap for the future) but there is an alternative.

How can CBDCs be stabilising?

CBDCs provide two clear directions for diversity.

First, they reduce the cost and improve the efficiency of financial intermediation. If condoned by the financial authorities, new ways of financial intermediation have a rare chance to blossom.

And second, the CBDCs help the financial authorities to better monitor abuse an other activities (like ALM). In other words, CBDCs help them to achieve their micro prudential and market integrity objectives.

That means that financial authorities normally reluctant to allow new forms of financial intermediation — which means almost all of them — have less reason to object.

So, an enlightened central bank could decide to use CBDCs to increase diversity, benefiting everybody. Except the incumbents.

It will be interesting to see how the cookie crumbles.




Several friends and colleagues have commented on this series. Robert Macrae and Nikola Tchouparov gave me excellent comments that significantly improved the pieces. We don’t always, or even usually, agree, and all opinions are mine alone.

I received excellent comments on this piece from Raphael Auer, Giulio Cornelli and Jon Frost, all at the BIS. I thank them from the bottom of my heart. We don’t necessarily agree, and all content is my responsibility only.

© All rights reserved, Jon Danielsson, 2021