Getting serious about digital fiat currencies

The digital revolution has profound implications for central banks. They have to decide whether to issue digital fiat currencies (DFCs) in order to maximize economic gains, remain relevant in a digital world, and respond to the cryptocurrency challenge. These considerations were apparent in the ITU DFC Focus Group conference at Cornell’s New York Tech Campus in late July, where central bankers formed the majority of more than 100 participants, and where I moderated the economic implications panel.

Currently, cash is the only state-backed, easy-to-use and anonymous payments system. But it is expensive to produce and use, carries theft/loss risks and requires physical presence for transactions. In recent years, mobile providers have offered cheap and easily available digital payment services. Cryptocurrencies have also emerged, promising to offer a supposedly more trusted alternative to state money.

However, mobile operators essentially provide private money, which carries credit, technology and stability risks. Meanwhile, cryptocurrencies are neither private nor public liabilities. They are also volatile, speculative and associated with money laundering. They use excessive energy and computing power, are prone to cyber breaches, and bring financial stability risks.

As such, more and more central banks are seriously considering issuing DFCs. A DFC is a legal tender that is electronic and fully convertible one-for-one into sovereign-backed notes. It is universal, available 24/7, and usable across all payment networks. DFC provides instant and final settlement, is included in base money, and has cash-like properties.

The benefits of DFCs are substantial. First, a DFC would provide a credit risk-free payments system backed by the state. It would avoid concentration and technology risk associated with privately operated systems. It would help maintain control over money supply. It would ensure that central banks remain relevant in countries like Sweden, where cash use has dramatically declined, besides continuing to earn seigniorage income.

Second, there are large efficiency gains due to sharply reduced physical currency printing and distributing expenses, as well as other transaction costs. The total annual societal cost of cash is 1-2% of gross domestic product (GDP), or 3-5% of the value of a transaction. DFCs would drive down costs to a fraction of that. Moreover, episodes of cash shortages and ATMs running dry, as in India during the demonetization shock, would become a historical curiosity.

Other benefits derive from expanded reach and commerce. DFCs are not limited by the denomination structure of physical banknotes and, unlike cash, can be used for long-distance transactions, thereby helping small businesses and individuals. Financial inclusion will also be lifted in developing countries, as residents can access DFCs through mobile phones. Cross-border transaction costs could drop significantly if DFC and special drawing rights-linked payment solutions emerged.

While the benefits are clear, central banks are apprehensive about design and technology, implementation costs, and monetary policy and financial stability implications.

The appropriate design of DFCs will help overcome these apprehensions. They can be designed as a token-based system where storage and processing are decentralized in a payments instrument. Another option is for DFCs to be an accounts-based system where storage and transactions processing are centralized with the central bank. The token-based model most closely resembles cash and is most practical, where the DFC is distributed across payments systems, with a database recording individual transactions.

In a token-based system, monetary policy transmission and financial stability consequences should be limited. Implementation costs would be one-time infrastructure deployment with monitoring and supervision expenses. Anonymity for small transactions could be preserved for privacy with large ones monitored for anti-money laundering purposes and for other illicit activities.

In contrast, an accounts-based approach, where the central bank offers digital accounts to retail consumers, runs the risk of being a competitor to commercial banks and could contribute to financial instability during flights to safety. Interest-bearing DFC accounts could result in bank disintermediation, negatively impacting credit expansion, economic growth and profitability.

A key question is whether DFCs should use the distributed ledger technology (DLT) underpinning blockchains, which are replicated across network participants. While the DLT solution is potentially attractive, inherent weaknesses similar to those of cryptocurrencies, speed and transaction volume limitations, and question marks regarding the finality of a transaction, as discussed in the Bank of International Settlements annual report, may rule it out. Not surprisingly, DLT-based experiments by central banks have so far had mixed results.

Thus, there is a strong case for central banks to issue token-based DFCs alongside physical cash. It could be utilized for retail as well as wholesale transactions. It would lead to a more robust, efficient, safe, regulated and legal tender-based digital payment system. It would also be growth enhancing due to large cost savings and expanded business opportunities and financial inclusion. The Reserve Bank of India, which is studying whether to issue DFCs, would be well-advised to do so, taking these factors into consideration. This would help realize Prime Minister Narendra Modi’s vision of a digital India.

Bejoy Das Gupta is chief economist of eCurrency and adjunct professor at the Maxwell School of Citizenship and Public Affairs.

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