From cryptocurrencies to CBDCs, what future for money?

February 01, 2024 Agriculture

The development of cryptocurrencies should be seen in the context of a war between different approaches to offering economic players the possibility of storing and growing their savings and liquidity, of settling transactions, and of serving as a unit of account in financial and commercial contracts. In fact, there is considerable demand for currencies with low transaction costs, particularly for international transactions or for micro-contributions and micro-payments. [For example, the e-yuan has a transaction cost of 0.1%, compared with the 2% that credit card companies may charge].

High transaction costs

Any asset has the potential to be used as a currency, but very few succeed in becoming a store of value, a medium of exchange and a unit of account. Bitcoin, in particular, is a long way from achieving this. Bitcoin's transaction costs are still high. What's more, it has not yet adopted the two-sided payment card model (which involves charging the merchant and not the buyer, or even subsidizing the latter through discounts or free miles for using the card); today bitcoin serves essentially, at least in developed countries, as a store of value/speculative tool and has few benefits for transactions, apart from illegal ones.

High volatility

The very high volatility of cryptocurrency values is another factor making their use as a unit of account for contracts unlikely. This is why some cryptocurrencies are designed as stablecoins; the most important of these stablecoins today is Tether. The idea is to match the cryptocurrency with a collateral that guarantees its value. This collateral can take several forms. It can consist of securities issued in a traditional currency (such as the dollar), for example Treasury bills, or tomorrow a central bank digital currency (CBDC). These reserves must then be in sufficient quantity to peg the cryptocurrency to the chosen currency. But, of course, this requires an attentive prudential supervisor. For, as with all financial institutions, there is a strong temptation to invest in riskier, higher-yield assets than in relatively safe but low-yield ones (which is why the monitoring of the liquidity requirements imposed on banks by Basel 3 regulations is always a tricky business). In fact, in 2021, Tether, whose dollar reserves were supposed to correspond 1 for 1 to the number of tokens, was ordered by the US Commodity Futures Trading Commission to pay $41 million for claiming to be 100% covered by fiat currency, when in fact only 27.6% was covered. In addition, the platform may wish to grant loans to affiliated companies, which it must be prevented from doing.

The need for a regulator

There are, of course, other possible forms of collateral: financial assets, stored commodities (durable goods), raw materials, or even... other crypto-currencies (which might be useful if the values of crypto-currencies were negatively correlated, but unfortunately they seem to be positively correlated). In any case, only a prudential regulator, such as the ones for banks, can guarantee the public that the institution doesn't get too comfortable with the rules it has laid down.

Moreover the nationality of this regulator is an important issue as crypto-currencies and the corresponding investors are totally global. One of the traditional roles of the banking regulator is to protect small depositors, SMEs and other regulated institutions against the risk of bankruptcy of the bank where their savings or liquid assets are deposited: see my book with Mathias Dewatripont The Prudential Regulation of Banks (MIT Press, 1994) for a discussion of the philosophy of prudential supervision. A national regulator may in fact be torn between the desire to enhance the attractiveness of its financial center (by attracting cryptocurrency-related businesses) and that of protecting those investors located on its territory, who are only a fraction of all investors, which therefore leads it to favor the former objective.

The central position of the states

Against this backdrop, competition for leadership in digital payments will take place among at least three groups of players: decentralized cryptocurrencies, sponsored private currencies (Libra/Diem or any other Big Tech currency) and central bank digital currencies (CBDCs). Central banks were late to enter this market, despite the competitive advantages they enjoy: the state decides what is legal tender, and can therefore force at least an optional use of its currency. This option becomes an obligation when it comes to the payment of taxes and other state levies. Finally, the state can force banks and fintech to join the state platform, as was the case for the renminbi in China and for Pix (a digital payments platform managed by the central bank) in Brazil. States will also be able to enter into agreements to make international transfers cheap, by ensuring that they are carried out automatically at the exchange rate prevailing on a highly liquid CBDC currency market. Finally, and mirroring the point already made in the previous article in this dossier about crypto-currencies, the positive benefit of CBDCs can quickly change sign in an autocratic state. The digital aspect of CBDCs will facilitate the surveillance and repression of citizens. Any additional power given to states requires the existence of the rule of law.

Who will access CBDCs?

The contours of this central bank digital currency have yet to be defined. In particular, who will be able to hold CBDCs, and in what proportions? Retail depositors? Those holding wholesale deposits (uninsured deposits)? What competition will there be for bank deposits? On this last point, there seems to be an emerging consensus that banks should not be drained of their stable funds. According to China's central bank, "the new digital currency is not intended to replace deposits in bank accounts and balances held by payment apps such as Alipay and WeChat". Similarly, a 2020 report from seven major central banks and the Bank for International Settlements defines the first of its three core principles in the following terms: "Coexistence with cash and other types of currency in a flexible and innovative payment system." Be that as it may, we must once again remember the economic fundamentals.

The digital revolution, by facilitating the introduction of new currencies, foreshadows intense competition between the private and public sectors and among countries to offer efficient services for savings, transactions and contract writing. While it's difficult to predict the outcome, we can bet that the few economic fundamentals discussed in this article will be at the center of developments.

Not all deposits can be guaranteed and/or demandable

First and foremost, not all deposits in financial institutions are supposed to be guaranteed (protected in the event of the institution's difficulties). The risk-free nature of retail deposits up to a certain limit (€100k in France per depositor and per institution) is currently guaranteed by the State. Ideally, this guarantee is provided by a sufficiently robust deposit guarantee fund; failing that, it comes from a bailout by the state, provided the latter is solvent. In normal times, however, deposits are covered by loans (narrow banking is suboptimal). It should also be noted that Basel's prudential supervision rules now rightly insist on a minimum amount of equity and bailinable liabilities for banks. Unfortunately, all too often, deposit guarantees apply to all depositors, whether or not the deposits are insured, as we saw again recently with the near-bankruptcy of Crédit Suisse.

Secondly, not all deposits in financial institutions are supposed to be demandable. If the transformation function of banks can be schematized by the characterization that banks on average accept demand deposits and lend on a long-term basis, it is normal for banks to have a portion of their liabilities in securities that are only payable at term (and compensate investors for this concession). This partly limits the banks’ liquidity risk.

What to do?

Broader access to CBDCs would considerably increase the size of safe demand deposits. Is this desirable? Let's not forget that, if a significant part of the banks' liabilities were transferred to the central bank, the government would be obliged to grant loans to compensate for the lost bank loans. However, the government generally lacks the necessary expertise to grant loans; it may also show favoritism for political ends in granting these loans; and lastly, it may be too lenient with insolvent borrowers (the "soft budget constraint" phenomenon). A more conservative approach would be to limit the amount per capita that can be held in CBDCs. CBDCs would de facto be the new insured deposits of individuals, and would pay the deposit insurance premium. The advantage of CBDCs would then be greater ease of use and low transaction costs for households.

Published in La Jaune & la Rouge, n° 792, February 2024,

Illustration Photo de André François McKenzie sur Unsplash