Implications of central bank backed digital currencies (crypto currencies) on monetary policy, financial stability and balance sheets

Table of Content

Table of Figures

List of abbreviations

1. Introduction

2. The era of digital currencies
2.1. Cryptocurrencies, Digital Currencies, Virtual Currencies and Electronic Money
2.2. Central-Bank backed crypto-currency (CBDC)
2.3. Value versus account-based CBDC
2.4. Current state of research on CBDC amongst world’s central banks
2.5. Types of money in the current economic system of the Euro Area
2.6. Summary

3. Methodology
3.1. Derivation of the four scenarios
3.2. Guiding thread of the paper
3.3. Delimitations of the study
3.3.2. Constraints regarding the two technological implementation options of a CBDC
3.4. Expert interviews
3.5. Summary

4. Status quo: Monetary policy and the banking system in the Euro Area
4.1. Monetary policy of the European Central bank
4.1.1. Monetary Policy in the Euro Zone
4.1.2. Current Monetary Policy Tools
4.1.3. Zero lower bound (ZLB) and the post crisis dilemma of ECB
4.2. Financial Stability: Commercial banks & the fractional reserve banking system (FRB)
4.2.1. The split-circuit of the two-tier money and banking structure
4.3. Stylized balance sheets
4.4. Summary

5. Theoretical concepts and literature review
5.1. Dialectic of money
5.2. Agency- theory: Moral Hazard of banks
5.3. Currency vs. Banking School
5.3.1. New Currency School
5.3.2. Banking school
5.3.3. Comparison of key arguments from Currency- and Banking School
5.4. Sovereign money model
5.6. Summary

6. Implications of a CBDC on monetary policy, financial stability & balance sheets
6.1. Scenario 1 – CBDC as a complementary to cash and bank money
6.1.1. Monetary Policy
6.1.2. Financial Stability
6.1.3. Balance Sheets
6.2. Scenario 2 - CBDC as replacement for cash and complementary bank money
6.2.1. Monetary Policy
6.2.1.1 Monetary Policy Implications under a CBDC with a constant nominal value (non-interest bearing)
6.2.1.2 Monetary Policy Implications under an interest-bearing CBDC
6.2.2. Financial stability
6.2.3. Balance Sheets
6. Scenario 3 & 4 - CBDC as replacement for bank money and complementary/ replacement for cash
6.3.1. Monetary Policy
6.3.2. Financial stability
6.3.3. Balance Sheets
6.4. Summary of results

7. Discussion of scenarios in two schools: Currency vs. Banking School
7.1. Classification of Scenario
7.2. Classification of Scenario
7.3. Classification of Scenario 3 &
7.4. Summary

8. Discussion and suggestion for further research

9. Conclusion

References

Appendices

Abstract

Inspired by the recent publication of various Central Banks, that study the issuance of their own versions of digital currencies, this paper aims at identifying the implications of such a central bank issued digital currency on monetary policy, financial stability and non-bank private sector, central bank and commercial bank balance sheet. It does so by conducting a scenario analysis, where each scenario specifies a distinct form of how a central bank issued digital currency could be introduced and how the resulting implications on the spheres of interest might change as a consequence. The results of this scenario analysis propose that in either implementation mode a CBDC generally provides a positive effect on both financial stability and monetary policy. The degree of the advantageous effect is, however, not only dependent on the implementation scenario, but also on the behaviour of the central banks, the commercial banks and the general public. In terms of balance sheets, this paper identified major changes. The results and implications that have been derived are based on literature, an expert interview and previous research conducted by other central banks and notable scholars. Based on the implications stemming from the four investigated scenarios, this paper evaluates these implications from a perspective of the New Currency School and Banking School. All in all, since this paper sees a central bank backed digital currency as a potential catalyst for a substantial change of the current monetary system, it provides scenarios and theories that challenge the status quo.

Table of Figures

Figure1: Potential technology implementation option (Ahmat & Bashir 2017)

Figure 2: Current state of research on CBDC amongst world’s central banks (Bordo und Levin 2017; Ahmat & Bashir 2017; Central bank websites)

Figure 3: Relation of money types (Bjerg, 2017; Hörmann 2012)

Figure 4: 2x2 Matrix - derivation of the four scenarios

Figure 5: Methodological framwork - guided thread

Figure 6: Implementation of scenarios and its dependence on time

Figure 7: Money Multiplier

Figure 8: Split circuit of the banking system (Huber, 2017)

Figure 9: Balance Sheets of Central and commercial Banks and the Non-Bank Private Sector

Figure 10: Relation of money types with CBDC

Figure 11: Bank Balances for Scenario

Figure 12: Bank Balances – potential size change in Scenario

Figure 13: Relation of money types with CBDC and without Cash

Figure 14: Bank Balances for Scenario

Figure 15: Bank Balances – potential size change for Scneario

Figure 16: Relation of money types with CBDC and without bank money

Figure 17: Relation of money types with CBDC and without cash and bank money

Figure 18: Single money circuit

Figure 19: Bank Balances for Scenario

Figure 20: Bank Balances for Scenario

Figure 21: Bank Balances and single money circuit

List of abbreviations

Abbildung in dieser Leseprobe nicht enthalten

1. Introduction

In recent months, various central banks around the world (Bank of England, 2016; EY, 2017) have published papers about, conducted studies and experimented with their own versions of digital currencies. One reason could be the growing relevance of privately issued cryptocurrencies, such as Bitcoin, which have seen a drastic increase in media coverage as well as price and thus, have caught the attention not only of the financial sector, but also of the broad population. Other reasons could be the declining usage of cash and its inconvenience across many countries, such as Europe, the U.S., Canada or Australia. Digital currencies, therefore, propose a considerable alternative to physical cash, which is also appealing with regards to the rising preference for fast, cheap, secure and digital means of payment of today’s society (Reuters, 2017). Hence, in the light of these changes of preferences and the rising popularity of digital currencies, various central banks and scholars (Huber, 2017; Bjerg, 2017; Iversen, 2017) are exploring ways of introducing central bank backed digital currency (CBDC).

Not only, may those CBDCs serve as a tool to meet the needs of today’s society, but also as a tool to increase efficiency of monetary policy, to provide enhanced financial stability and potentially to restructure the whole financial ecosystem. Especially in the years following the financial crisis of 2007/08, central banks have increasingly engaged in unconventional operations to stimulate the European economy (ECB, 2017; Claeys, 2014; Gertler & Karadi, 2009), which in turn exposed them to more risk. Furthermore, especially the European Central Bank (ECB), has kept the key interest rates at zero percent over the last years (ECB, 2017) in order to facilitate further economic growth. As central banks in general and the ECB in specific, is running out of scope of action, the question arises how further financial and price stability could be maintained in the future. Due to its unique and yet fairly unexplored characteristics, a CBDC may circumvent the current limitations and drawbacks central banks are experiencing with regard to their monetary policy. In addition to the effects on the monetary policy and naturally also on the banking sector, a CBDC would also have meaningful implications for the society.

Furthermore, there are many possible ways of how such a CBDC could be implemented with regards to other already existing money types and with regards to its technological features. That is, due to its specific characteristics a CBDC could either work as a substitute or as a complementary to other existing types of money. The different ways in which a CBDC could be introduced, results in differing implications. Due to the very recent and unexplored nature of the topic at hand and in order to broaden perspectives, raise questions, challenge conventional thinking and especially, to look ahead in time, this paper will analyse a CBDC in its various possible implementation modes, using a scenario analysis.

Specifically, this paper aims to provide a scenario analysis of how a CBDC could potentially be implemented and which implications arise from each of those scenarios for monetary policy, financial stability and central bank, commercial bank as well as non-bank private sector balance sheets. When doing so, special attention was paid to the Eurozone and the monetary policy of the ECB. The research questions the paper will address for each of the implementation scenarios are:

What are the potential implications of CBDC?

The rest of this paper is organized as follows. The subsequent section will show the relevance of the topic discussed in this paper. Specifically, it will show what, why and how recent trends, circumstances and developments have made CBDC a topic of huge interest of both, scholars and financial institutions. After framing the topic within a context, the reader will be provided with a methodological part, that will firstly, justify why a scenario approach is used in this paper and secondly, describe how the different scenarios were derived. Additionally, this section of the paper will provide an overview of the approach and framework used to answer the research question with respect to the developed scenarios as well as the limitations this approach entails. After that, it is important to show the main characteristics of ECB’s monetary policy, financial stability, balance sheets and in general the current monetary system, in order to understand the implications a CBDC could have. Hereinafter, theoretical concepts and theories from different economic teaching schools will be presented in more detail. The analysis and assessment of the implementation scenarios and their implications will be legitimized by applying these concepts and theories. The main analytical part will illustrate the four conceptual scenarios and their effects on monetary policy, financial stability and balance sheets. After having answered the research question at hand using an explorative and qualitative scenario design, the paper will continue by assigning the respective implementation alternatives of a CBDC to the two financial teaching schools. As each teaching school is a set of ideas, theories and models developed by notable scholars over hundreds of years, they can be used as a basis to provide a discussion on the real-life applicability as well as advantages and disadvantages of each of the presented implementation scenarios. Hence, it goes without saying that suggestions for further research are existing and will be provided.

2. The era of digital currencies

As hinted upon in the beginning of the paper, the idea and technology behind cryptocurrencies pose a fundamental challenge to the current monetary system and the present notion of money itself. Events like the financial crisis of 2007/2008 made the general public ever more sceptical towards the status quo of the financial system (Pilcher, 2012). Marked by massive job cuts and economic downturns throughout the world and undoubtedly, to a major part caused and provoked by the world’s biggest commercial and investment banks and lack of regulations (Crotty, 2009), the financial crisis laid the foundation of what could be the abandonment of the current monetary system - the privileged position of commercial banks and especially money creation itself.

Bitcoin was the first potential answer to how such a change could look like (Nakamoto, 2009). Its underlying blockchain technology and predetermined growth rate provided an anonymous, safe and digital cash like alternative that doesn’t rely on trust in the behaviour of any issuer nor the trust in any intermediary. Simply put, Bitcoin proposes a system that depends on a decentralized, public ledger, that works as a blockchain. Transactions are not authenticated by intermediaries, such as banks, but by any member of the ledger who wants to compete in solving complex mathematical problems as a way to authenticate a bundle of transactions. The winners of this proof of work concept are rewarded with newly created bitcoins. The public ledger provides a transparent and write-once history that circumvents previous problems of digital or cryptocurrencies, such as double spending. Since nobody and everybody controls this ledger it is impossible to rewrite and falsify its history. Since it is decentralized, anonymous yet digital, it contradicts all the current notions, operating principles and characteristics of current money types, that are created and manipulable by one central institution or a privileged group of institutions. Many cryptocurrencies based on the same or similar technologies have followed, which not merely provide a simple, decentralized, digital alternative to cash, but also serve as a means to solve contractual problems (smart contracts). As of early 2018, all privately issued cryptocurrencies combined have an outstanding market value of 944 billion US$ (Coinmarketcap, 2018). Although not yet significant in size, when compared to the outstanding value of central bank issued currencies (e.g. only the US$ with a value of 1,6 trillion US$ in circulation (FED, 2018), the unprecedented pace at which the value of cryptocurrencies has grown in the last year alone (approx. 3650%) is an indicator of their rapidly increasing popularity as a means of exchange and store of value and thus also of their potential and considerable impact on the financial system and the wider economy.

In addition to the increasing popularity of privately issued cryptocurrencies, technological advancements, innovations and the need for convenience have paved the way for innovative payment solutions based on the already existing forms of money. Non-cash payment options, like credit cards, online transfers, direct-debit payments that have been proliferating in past years, recently have been complemented by innovative payment solutions that are gaining more and more ground, such as smartphone-enabled digital payment and mobile wallets (Mersch, 2017). In a traditional monetary system, central banks control and stimulate the economy through monetary policy. Although not yet used as a means of exchange but rather as a store of value, the increasing demand and popularity of cryptocurrencies might impair the ability of central banks to continue to do so in the future (Al-Laham et al., 2009). That is, with the growth of cryptocurrencies and the worldwide increasing (technological) readiness and willingness of people to embrace, understand and utilize these cryptocurrencies, the money reserve that the central banks use to effectively conduct monetary policy might be reduced (Fung et al., 2014).

The developments and potential implications for the central bank and the current financial system forced public authorities and central banks around the world to monitor the developments of crypto- and digital currencies and to study their implications. Specifically, as a way to provide a trustworthy opposite pole to these private currencies and to potentially retain their position in the economy, more and more central banks now consider issuing their own versions of digital currencies (Ahmat & Bashir, 2017). In order to more clearly understand the concept behind cryptocurrencies, electronic money and CBDC, the following section aims at briefly defining and especially distinguishing these different types of money and provide their main characteristics. The definition and characterization of cryptocurrencies will serve as a basis to justify its popularity and the central bank’s motivation to issue their own version of a digital currency that might, but not necessarily needs to be based on cryptography.

2.1. Cryptocurrencies, Digital Currencies, Virtual Currencies and Electronic Money

There is a lot of misunderstanding around the nature and characteristic of electronic money, virtual currencies, cryptocurrencies and other similar descriptions. Due to their non-physical and to some abstract nature, many casual readers might be tempted to use these terms interchangeably. For the sake of clarity, this paper will briefly define and categorize each of the above forms of money.

Electronic Money constitutes the by far biggest part of the money in Euro Zone. According to Fung, Molico & Stuber (2014), it can be defined as “…monetary value stored electronically on devices such as a chip or hard drive in personal computers or a server, represented by a claim on the issuer, which is issued on receipt of funds for the purpose of making payment transactions, and which is accepted by persons other than the issuer”. The most prominent form of electronic money is a deposit account held at a commercial bank. These deposit accounts constitute a liability to the commercial bank (the issuer) and a claim to the money user and have a legal like tender status. Upon demand, this electronic money may be converted to physical money (paper money and coins) by the claimholder, and thus it is a digital representation of a physical asset (Fiat Currency). It is processed by electronic payment systems that are tiered and thus centralized with the central bank at their centre (Barrdear & Kumhof, 2016).

Virtual Currencies (VC) on the other hand, are defined as a digital representation of value, not issued by a central bank, credit institution or e-money institution, which, in some circumstances, can be used as an alternative to money” (ECB, 2015). Hence, Virtual Currencies are digital representations of value that are not issued or controlled by a central bank or a public authority, are not (unlike Electronic Money) tied to a Fiat Currency and do not have legal tender status in any jurisdiction, except when agreed by specific members. In addition to the characteristics above, VCs can be either closed/ non-convertible or open/ convertible. The purpose of closed VCs is to be specific to a virtual domain or world (i.e. Online Games) and under the rules governing its use they cannot be converted for fiat currency and cannot be used to purchase real goods (FATF, 2014). Since closed VCs are issued by a central authority that prevents convertibility, they are centralized by definition (Lee & Chuen, 2015). Open VCs on the other hand can be converted back and forth for fiat currency and may be either centralized or decentralized.

Cryptocurrencies (CC), with the most prominent member Bitcoin, are math-based, decentralized convertible digital currencies. Their exchange, creation and transaction is secured through cryptographic techniques. They are innovative in the way by which they implement electronic records of money and exchange (peer to peer). Decentralized cryptocurrencies in specific, propose a distributed ledger system (DLT) and payment system that is updated in a decentralized manner, with its copies being dispersed among many agents, with no agent or entity being indispensable in order for a respective transaction to be processed (Barrdear & Kumhof, 2016). Those techniques used to secure information, communication and record keeping have existed for decades, it was however, the improvement of computer science, computing power and economics, that facilitated a safe, trustless and robust system operating as a payment and currency system at the same time. Although, not (yet) issued by any central bank, many countries have accepted CCs, such as Bitcoin as legal payment method (i.e. Japan) (Coindesk, 2017).

Such currencies can also be called digital currencies, if not based on cryptography. Since the research of the various central banks around the world is based on differing technological features of their new potential currencies, this paper will henceforth define any electronic version of central bank issued money as a central-bank backed digital currency (CBDC).

2.2. Central-Bank backed crypto-currency (CBDC)

Having clarified the differences between electronic money, virtual currencies and cryptocurrencies, this section now turns to the definition and potential properties of a CBDC. By CBDC, the Bank of England (Barrdear & Kumhof, 2016) refers to a central bank “granting universal, electronic, 24x7, national-currency-denominated and interest-bearing access to its balance sheet”. Up to this date, only commercial banks have access to central bank balance sheet. Therefore, in contrast to the status quo, a CBDC enables all money users in the economy to hold deposit accounts that are recorded on the central bank’s ledgers. These liabilities are issued by crediting the holder’s account and thus constitute an asset to holder and a liability to the central bank.

Barrdear & Kumhof (2016) do not elaborate on the important characteristic of anonymity of CBCD holders and their transactions in their paper, as they do only consider one implementation scenario, namely CBCD as an alternative to cash and bank money. Since, this paper however, will consider more alternatives, it is necessary to distinguish between CBCD that can be held and exchanged anonymously and CBDC that require the account holder to submit his/her identity, as well as a CBDC that is interest-bearing and interest free. The extent of anonymity has profound implications on the applicability of the respective implementation scenarios this paper will investigate. For example, a truly anonymous, peer-to-peer CBCD would be a substitute to cash, that is also anonymous by nature, but could under the current legislation of the European Union never replace bank money.

Whether anonymous or not, a CBCD adheres to Tobin’s (1987) proposal for “deposited currency accounts”. How a CBDC could differ in terms of its technological implementation options is illustrated in the subsequent section.

2.3. Value versus account-based CBDC

The two most distinguishing implementation options are illustrated in Figure 1.

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Figure 1 : Potential technology implementation option (Ahmat & Bashir 2017)

The first option can be called a value/token-based design with a decentralized technology. CBDC tokens in circulation could be transferred directly and electronically between individuals without involvement of the central bank. This peer-to-peer or person-to-person (P2P), decentralized nature of the value-/ token-based design would very much resemble the nature and characteristics of physical cash, such as providing the possibility of anonymous transactions. Whether a value based CBDC would inhibit the most important characteristic of cash, namely being non-interest bearing by nature, would depend on its implementation (Agarwal & Kimball 2015).

The other option is the account-based design with a centralized technology. CBDC would be registered and stored directly on the ledgers of the central bank and payments would be settled across these ledgers. This option would resemble the existing commercial bank money with the difference, however, that it would be a liability on the central bank ledgers instead of the banks ledgers. Both options could make use of the distributed ledger technology (Riksbank 2016; Barrdear, Kumhof 2016; Ahmat & Bashir 2017). According to the Riksbank (2016), a value-based account could be implemented more quickly, but at the same time would have more limited opportunities for development. While an account-based solution is considered to be more complex, it could in turn be also more adjustable to adhere to future changes in demand (Riksbank 2016). A combination of both options is also possible by having a value-based account for individuals, who are unable or even unwilling to have a CBDC account on the central bank ledgers or for small offline payments and an account-based account, which could match new technological needs or demands by individuals.

This paper, however, will consider only these two different accounts and only as two separate implementation options, since potential combinations of the two options may vary manifold and thus, would exceed the limited scope of the paper.

2.4. Current state of research on CBDC amongst world’s central banks

The idea of having a CBDC is spread over the world’s central banks (Riksbank 2016; Project Ubin, 2017; Arduino, 2016). The current state of research, however, is considerably diversified. While some central banks can be considered at its initial stage of research, others have already begun experimenting and simulating with a CBDC. Figure 2 illustrates the current state (01.2018) of research on CBDC amongst eleven different central banks, beginning with central banks uttering an interest on CBDC, continuing with central banks which already published researches and experimented with CBDC, up to one central bank which already implemented one.

Having an interest in a digital currency can be considered as the state’s first stage in implementing a CBDC. The Bank of Japan and the Bank of Estonia, for instance, can be located at this stage as they stated their interest in a CBDC in published papers (Meyer, 2017; Project Ubin 2017). Other central banks have already gone deeper into the topic and published diverse research articles: The most elaborate one has been published by the Bank of England, where a quantitative model has been developed, which aims to analyse possible consequences and implications of a CBDC (Barrdear & Kumhof, 2016). In addition, the U.S. Federal Reserve, the European Central Bank and the Sveriges Riksbank can be placed along this category. The latter has made a research plan for issuing a CBDC as a complementary to cash and bank money known as the e-krona project (Riksbank, 2017)

The next category contains central banks who already conducted practical experimentations with a CBDC. These experimentations are mostly simulations of a decentralized CBCD using a distributed ledger technology (DLT). The Bank of Canada, for instance, have found out some major gaps when it comes to distributed wholesale payment systems (Engert & Fung, 2017). The central bank of Singapore, China and Russia have also made simulations with their own requirements and results of a CBDC (Project Ubin, 2017; Valencic 2015; Arduino, 2016; Colibasanu, 2017; Shevchenko & Urivskiy, 2016; Hileman & Rauchs, 2017).

The only central bank, however, who already has implemented a CBDC, is the Central Bank of Ecuador, with its Dinero Electronico (Rispa, 2013). It distinguishes itself from most of the previous mentioned ideas of implementation in being a centralized CBDC (account-based option), without the DLT instead of decentralized one (value-based option) - the world’s first state-run electronic payment system. One of the major reasons for the implementation is the saving costs argument. In this way, the government is supposed to save a considerable amount of money in the future, for instance, Ecuador would save more than $3 million US Dollar each year, if it is not required to exchange old not usable notes for new ones anymore (Rosenfeld, 2015).

While there are many progresses on a potential CBDC from different central banks in the world, the case can still be considered at its beginning stage with a lot of space for improvement.

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Figure 2: Current state of research on CBDC amongst world’s central banks (Bordo und Levin 2017; Ahmat & Bashir 2017; Central bank websites)

2.5. Types of money in the current economic system of the Euro Area

In order to develop the scenarios, it is important to characterize and distinguish the existing types of money in terms of their form, accessibility, supply/ issuer as well as its creation and destruction. To do so, this paper will begin by characterizing and distinguishing the already existing forms of money according to these attributes. The current money system is based on three types of money (Beggs, 2017; Dyson & Hodgson, 2016): First, physical cash is the legitimate paper and hard money like the one US$ Dollar note, the ten Euro note or the British one-pound coin. It is accessible by all individuals and institutions, who want to use money in the economy. The users of cash can either be the government, banks, an individual or a central bank. The latter is responsible for the printing, minting and supply process. Normally, physical cash is supplied to the general public when it is exchanged for bank money. This is preceded by commercial banks, who in turn exchange cash for central bank reserve money (Bjerg, 2017).

Secondly, bank money on account is nowadays the electronically recorded demand deposit on the banking books of commercial banks. The access to bank money is provided through a bank account. The question of supply differs to physical money considerably: It finds its path to the economy in the process of loan extension: When a client borrows money from the bank, it accordingly exchanges the granted debt for bank money. From a simplified accounting perspective, the bank posts receivables on the one side, which is equal to the customers liability including eventual interests or other premiums. On the other side are the payables, which is the newly created bank money or in this case, a more appropriate name would be the banks book money (Hörmann, 2012). The mechanism by which book money is created can be regarded as a unique privilege given to banks. That is, they are able to grant a credit not on a basis of an already existing asset but moreover, by ‘just’ increasing their payables. Another way of creating book money is when commercial banks make payments to one of their deposit account holders. This occurs when the bank purchases goods, pays salaries or dividends to their employees, suppliers or shareholders (Bjerg, 2017). In contrast to that, money can be destroyed when the deposit account holders make repayments or interest payments to the bank.

Third, Central bank reserve money (CBRM) is the electronically recorded current account liability on the ledgers of central banks. Only the ones, who hold an account with the central bank have access to this type of money. Normally these are commercial banks, the treasury and other foreign central banks. Only in some cases employees or some certain non-bank financial institutions are allowed to hold these accounts. The supply and destruction of CBRM occurs in the process of selling, lending or purchasing government bonds or other particular financial securities to/from banks, which results in a decreasing or increasing money supply, respectively. Banks are also able to borrow money from the central banks, which usually requires the banks to hold a legitimized collateral usually in the form of financial securities (Dyson & Hodgson, 2017). Another way of creating reserve money is by crediting the accounts of foreign central banks in exchange for foreign currency reserve money (Rule, 2015).

Since the three distinct types of money have been distinguished, it can be now helpful to examine their differences and similarities by the help of a Venn diagram illustrated in Figure 3.

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Figure 3 : Relation of money types (Bjerg, 2017; Hörmann 2012)

First of all, it can be noted that cash and bank money are universally accessible, while central bank reserve money is not. Secondly, cash and central bank reserve money in turn, are both supplied by the central bank, while bank money is supplied by commercial banks. Thirdly, the common attribute of bank money and central bank reserve money is that both are electronic, while physical cash is literally only available physically.

It might seem counterintuitive to the casual reader that commercial banks create money that is treated like legal tender. The fractional reserve banking system is one of the reasons commercial banks have the ability to do so. This system, along with the purpose of commercial banks will be described in the later part of the paper, when the status quo of the monetary-, banking system and monetary policy of the euro system will be explained.

Having identified the different currently existing money types, the paper now turns to the depiction of how the research question at hand will be answered. Specifically, it will illustrate the research methodology, define the scenarios and explain how and why they have been developed and considered as well as it will highlight the delimitations of this paper.

2.6. Summary

The financial crisis of 2007/2008, its aftermath, limited effectiveness of current monetary policy, as well as the rapid rise of alternative, private cryptocurrencies have laid the foundation for the recent interest of central banks in studying and issuing their own versions of digital currencies. Especially, developments in terms of payment services and payment habits towards digital and decentralized means, have made studying the issuance of CBDC essential for many central banks, as a means to compensate for the decreasing usage of their currently only universally accessible money type, namely physical cash. Besides physical cash, the current monetary system further consists of universally accessible electronic bank money and electronic central bank reserves, which are only available to commercial banks and other selected institutions. In short, a CBDC would give universal, electronic access to the balance sheet of the central bank and could be either implemented in a centralized, account-based manner or as a decentralized, value-based & peer-to- peer solution.

3. Methodology

Kahn (1962) showed the importance of thinking ahead in time and of using the scenario methodology as a powerful tool to imagine and describe the future. According to Peter Schwartz (1991), scenarios are “stories about the way the world might turn out tomorrow, stories that can help us recognize and adapt to changing aspects of our present environment”. Thus, the scenario methodology can serve as a tool to depict and articulate all possible and plausible different future situations (conceptual futures) which can serve as an effective basis for today’s decision making. It is important to note however that a scenario is not a comprehensive image of the future, but rather an image that focuses on one specific segment of reality. Secondly, it is important to note that certain factors and events within a conceptual future can either be deemed relevant or can be ignored, but can also brought into play under certain assumptions in the course of the scenario analysis. Hence, neither do scenarios represent a future state as a whole, nor do they represent the future as such, but rather as a possible, plausible, future construct of the certain key factors (Kosow & Gassner, 2008).

A scenario analysis can make a meaningful contribution to science, since they are effective tools to “broaden perspectives, raise questions and challenge conventional thinking” (Greeuw et al. 2000) and to “look far and wide” (Barré, 2004). Yet, the implications and results derived from a scenario analysis should not be views as hard facts, hence their prognostic value should not be overestimated (Greeuw et al. 2000). This goal of this paper’s scenario analysis is to provide a deeper understanding of implications stemming from current trends and influences, such as digitalization and decentralization of money creation. The aim is also to reveal the limits of our knowledge, for example unpredictabilities of implications, gaps and uncertainties.

This paper uses an explorative and qualitative approach as a scenario technique, rather than a normative and quantitative approach. Based on Saunders et al. (2009), an exploratory study is proper if u want to discover what is going on, gain insights about a topic or a phenomenon – cryptocurrencies, digital currency and its potential impact on the economy.

3.1. Derivation of the four scenarios

As illustrated in the previous section, there are three types of money in the current financial system. Assuming that a CBDC would be equal to CBRM in terms of being backed by the central bank, the paper’s approach for deriving the scenarios will be based on the key question of how a CBDC could complement or replace the other two already existing forms of money - cash and bank money. A conclusive way to express and justify the scenarios worked out in this paper, is on the one hand in the degree of replacement and on the other hand, in the degree of complement of the two existing forms of money.

Thus, the two by two matrix in Figure 4 shows four different alternatives of how a CBDC could vary in its degree of complement and replacement. Similar approaches have been used by Bjerg (2016) and Krivoshey & Semerikova (2017). The four possible scenarios are as follows:

CBDC as a complement to both cash and bank money

CBDC as a replacement for cash and complement to bank money

CBCD as a complement to cash and a replacement for bank money

CBDC as a replacement for both cash and bank money

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Figure 4 : 2x2 Matrix - derivation of the four scenarios

3.2. Guiding thread of the paper

Figure 5 illustrates the methodological framework of the paper, which can serve as the ‘guided thread’. All the illustrated steps are serially numbered, which matches with the numeration of the corresponding paragraphs.

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Figure 5 : Methodological framework - guided thread

The left side of the Figure (1.) represents the current monetary, banking or economic system, where events (2.) like financial crisis or trends like the cryptocurrencies can challenge some pillars of the current system. This is the spot on the figure, which can change or affect the current system, from which different scenarios (3.) can result. Before doing that, however, the fundament of the framework is built by the ‘pool of theories’ (5.) followed by three chosen pillars - monetary policy (MP), financial stability (FS) and balance sheets (BS), through which the scenarios can receive a thorough examination (4.). Here, the main goal is to analyze the implications of the scenarios (6.). Besides that, the ‘pool of theories’ does not necessarily consist of coincided statements but moreover of partly contradictory theories or schools – illustrated by the ‘clash of schools’. This in turn, can challenge some implications, which are based on one of these contra dictionary theories.

In order to keep the biases as small as possible, the framework divided scholars and theories in two different schools – the New Currency School and the Banking School, where each school consists of similar or related scholars/ theories. While the current system can be assigned mostly to the Banking School, the CBDC by its different implementation scenarios can change this categorization considerably. Therefore, each scenario can be assigned more or less to one of the schools with overlapping or distinguishing statements (7.). At the end, all the received insights are supposed to lead to a proper discussion (8.) revealing not only the limitations of the paper but also opportunities and recommendations for further researches.

3.3. Delimitations of the study

The subsequent Figure 6 illustrates the fact that the variable of ‘time’ can change the implications, circumstances and even the scenarios considerably, which will be the anchor point of one of the paper’s delimitation.

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Figure 6: Implementation of scenarios and its dependence on time

The vertical axis represents the degree of change (proceeding from the current system) while the horizontal axis represents the value of time. Scenario 1 (S1) can therefore be implemented immediately or as a step by step approach - latter is represented by the transition line. Especially the balance sheets are a point in time view (snap-shot); during the time of transition they can look differently, because of still consisting of pre-reform positions. This paper, however, aims to show the long-term implications of each scenario and the most representative characteristics, rather than considering implications resulting ‘only’ from the transition of implementation. Furthermore, it is less complex to implement, for instance, S1 first and subsequently scenario 2 (S2). The reason is that the only difference - the availability of cash - can extinct naturally after a while, because it would not have been necessary or useful anymore. S2 therefore contains in addition to S1 one variable more – the abolishment of cash. Hence, it could be a matter of time when S1 changes to S2. The same implication can be made proceeding from S3 to S4.

The degree of change from S2 to S3, however, might be the most complex one, because it requires substantial changes to the monetary system. The time of transition therefore, is assumed to be much greater. Hence, the analyzed scenarios in this paper are not mutually exclusive but moreover can be implemented subsequently.

3.3.2. Constraints regarding the two technological implementation options of a CBDC

This paper will abstain from specifying the technological implementation, as it is primarily concerned with the macroeconomic implications of its adoption. By analyzing the potential implications of the scenarios, the paper will distinguish between the value-/ and account-based design if, and only if, these two options produce substantially different implications for the matter investigated in the respective section. Due to the scope of the paper, however, this subsequent distinction can be entered only by a limited factor. It is still necessary to mention, for instance, if it is assumed for the monetary policy part that the funds held in CBDC would or would not pay out interest.

3.4. Expert interviews

Due to the complex and current nature of the paper’s topic and methodological approach (scenario analysis) that lacks precedent, semi-structured expert interviews were found to be particularly suited to gain insights, untangle complexity and to help underpin the credibility of the developed hypothesis when answering the research question. As qualified experts, we have defined individuals, who are advisors or employees of central banks in areas of monetary policy and financial stability. Unfortunately, it was not possible to conduct more than one expert interview. The reasons for that were manifold. Firstly, since the topic of CBDC is fairly recent, not many central banks have published on this topic. Of those who have published and done research on this topic, only one individual was available in a timeframe that would allow to process the interview and include the insights into this paper. The expert interviewed is Reimo Juks, a financial stability advisor to the Swedish Riksbank. The insights gained from this interview will flow into this paper.

3.5. Summary

A scenario approach should be applied, if the research topic is currently at its initial stage and especially, if it is supposed to describe the future. The four implementation alternatives of a CBDC, considered in the scenarios vary in their extent to which they replace or co-exist with the currently, universally accessible types of money. The four scenarios considered are 1) CBDC as complementary to both cash and bank money, 2) CBDC as a replacement for cash and complimentary to bank money, 3) CBCD as complementary to cash and a replacement for bank money and 4) CBDC as a replacement for both cash and bank money. In each of these scenarios the implications for monetary policy, financial stability and balance sheets will be analyzed, in the context of the Eurozone.

Additionally, the four scenarios will be evaluated and classified through the lens of two teaching schools on monetary theory. The transition time between the current monetary system and the one proposed in each of the scenarios will not be considered, as only the long-term effects are of interest in this paper. Moreover, the analyzed scenarios are not mutually exclusive, but can be implemented one after the other. In order to further validate the developed hypotheses and implications, the insights of a semi-structured expert interview, with a representative of the Swedish Riksbank, will flow into this paper.

4. Status quo: Monetary policy and the banking system in the Euro Area

4.1. Monetary policy of the European Central bank

The ECB, based in Frankfurt am Main, Germany is an official European Union (EU) institution and the central bank for the Euro currency. It is the Single Supervisory Mechanism for banking supervision (ECB, 2017) and generally speaking, the administration of the monetary policy in the Eurozone. The Eurozone or the Euro rea is a monetary union of 19 out of 28 EU member states, that have adopted the euro as their common currency and sole legal tender (ECB, 2017). The remaining 9 EU members, that are not members of the Eurozone conduct monetary policy via their own respective central banks. The ECB states in Article 3 (Official Journal of the EU, 2008) that their main purpose is to maintain price stability and to safeguard the value of the euro. Based on Article 16 (Official Journal of the EU, 2008) it has the exclusive right for issuing or authorizing physical cash (Euro banknotes and coins).

4.1.1. Monetary Policy in the Euro Zone

As stated earlier the primary objective of the ECB is to maintain price stability. Price stability according to the ECB, is defined as year-on-year increase in the Harmonized Consumer Price Index (HICP) for the Euro area below, but close to 2%; the HICP consists of final costs paid by European consumers for the items in a basket of common goods (ECB, 2017). Over the course of existence of the Euro, the average HICP inflation rate has been 1,74% and thus, rather close to the targeted 2%, yet when looking at individual years strong volatility can be detected (Trading Economic, 2018).

The evaluation of price developments is done from two perspectives, namely the Economic Analysis and the Monetary Analysis. The Economic Analysis focuses on the short to medium-term determinants of price developments, taking account of the fact that price developments over this horizon are largely affected by the interplay of supply and demand of goods as well as the service and factor markets. The Monetary Analysis assesses the long-term factors affecting price development and specifically the long run relationship between money and prices. This long-term analysis serves as means of counter checking the monetary policy implications derived from the Economic Analysis (ECB, 2008). Based on the insights of this two-pillared assessment, the governing council signals its monetary policy stance by setting three key interest rates every six weeks. Firstly, the interest rate on main refinancing operations (MRO), that provides the majority of the liquidity to the banking system. Secondly, the rate on the deposit facility, which is the interest paid on liquidity of credit institutions that can be deposited at the Central Bank overnight. Lastly, the rate on the marginal lending facility that reflects the cost of overnight credits of the ECB to credit institutions (Nautz & Offermanns, 2006). These last two interest rates, indirectly steer the interbank lending market (Euribor), by setting a corridor at which overnight interbank lending can occur.

4.1.2. Current Monetary Policy Tools

In order to implement the monetary policy decisions of the ECB Governing Council and specifically in order steer the key interest rates to the specified levels, three policy tools can be used. The task of applying those tools and implementing the decisions of the Governing Council is a decentralized process, and thus not only involves the ECB but also the national central banks of the respective countries, that have adopted the Euro (ECB, 2017). The three current monetary tools are described in the following section.

1. Open market operations are the main tool for steering the interest rates and managing the liquidity situation in the market (ECB Homepage, 2017). There are five instruments available to the Eurosystem for the conduct of those operations. These are reverse transactions, outright transactions, issuance of ECB debt certificates, FX swaps & the collection of fixed term deposits. These five instruments are utilized within four types of market operations. Each type serves a distinct role in terms of aim, regularity and procedure (Alvarez et al., 2017).

a) Main refinancing operations (MRO), which are liquidity providing reverse transactions on a one week basis to the credit institutions and thus steer short term interest rates.
b) Long-term refinancing operations (LTRO), which are additional liquidity providing reverse transactions that have a maturity of normally three months. While MROs and LTROs are solely used to provide liquidity, fine tuning operations and structural operations, the third and fourth type of open market operations, can be used both for providing and absorbing liquidity.
c) Fine tuning operations, are conducted on an ad-hoc basis, whenever there is need to provide or absorb liquidity due to unexpected liquidity fluctuations.
d) Structural operations are carried out through reverse, outright transactions or the issuance of debt certificates are utilized when the ECB wants to adjust its structural position towards the financial sector.

2. Standing facilities, in the form of the deposit facility and the marginal lending facility (defined earlier) serve as a tool to provide and absorb overnight liquidity. As of March 2016, the deposit facility, the marginal lending facility and the rate on the main refinancing operations are set at - 0.4%, 0.25% and 0.00% respectively (ECB, 2017).

3. The ECB requires credit institutions to hold deposits on account with their national central bank. These deposits are called minimum required reserves (MRR). The MRR has to be maintained by the credit institutions on average over one holding period, which is one month. As of 2012 this reserve requirement is set at 1% (Bundesbank, 2017).

4.1.3. Zero lower bound (ZLB) and the post crisis dilemma of ECB

“Exceptional times have called for exceptional actions…” (Trichet, 2009).

The financial crisis has forced the ECB to adopt unprecedented, non-standard monetary policy tools. As non-standard the ECB considers policies that have not been conducted prior to the crisis such as, asset repurchases, LTROs as well as forward guidance (ECB, 2017). Prior to the financial crisis the ECB realized its monetary policy mainly by setting the overnight interest rates or by open market operations. The liquidity providing open market operations were executed via reverse transactions against eligible collateral provided by the banks. These reverse transactions ensured that the risk and exposure of ECB’s balance sheet was minimized. It also ensured that the ECB was neither involved in direct lending to the private sector or the governments nor in outright transactions (purchases) of private or government debt. The shift to non-standard, more risk bearing measures was a consequence of the sharp decrease of key interest rates in the post crisis years, to rates equaling zero. Short-term interest rates equal to zero cause a liquidity trap and limit the ability of central banks to further stimulate price stability and economic growth through the interest rate transmission channel. In order to circumvent the inability to operate at the ZLB and provide additional stimulus the ECB adopted non-standard measures.

4.2. Financial Stability: Commercial banks & the fractional reserve banking system (FRB)

The bank industry consists of lawful organizations with different banking divisions. The most common distinction hereby occurs between investment and commercial banks. While investment banks promote the acquisition and sale of stocks, bonds, other financial instruments as well as help companies in making IPOs, the primary objective of commercial banks is to manage deposit accounts for businesses and individuals and to grant loans (Hellenkamp, 2015). This paper will mainly focus on the commercial banks and the relation of depositing and crediting instead of taking other banking related services into consideration. While banks also offer other useful services like money transactions, certifying the credit-worthiness of businesses or the safe-keeping of precious stones, their most basic service is to provide two assurances to its depositors: The first one is to provide safety for the deposits of their customers and the second one is the ability of on-demand exchange of bank money for cash (Ravn, 2015).

Furthermore, it is important to distinguish between commercial banks and moneylenders. The latter advance money out of their private capital and usually do not accept deposits. The bank instead, is able to lend money on the basis of only a fraction of its deposit liabilities - the fractional reserve banking system (FRB). The FRB allows banks to act as a financial intermediary between savers and borrowers, so that they are able to provide long-term loans without losing the ability of providing immediate liquidity to (a fraction of) depositors on demand. Only when too many depositors are demanding money at the same time, the bank can face considerable problems. This refers to the term ‘bank run’, a scenario where the bank is not able to provide liquidity due to too many requests by depositors. To mitigate this risk, the government or the corresponding central bank can regulate the action of banks in certain ways by providing deposit insurances, for instance, or by imposing reserve requirements and capital adequacy ratios, as stipulated in the Basel Regulations. Since banks need to hold reserves in quantities that are less than the quantity of their deposit liabilities, the FRB restricts indirectly the money supply to grow beyond a certain percentage above the underlying required reserve money (Giduskova, 2008; Nuri 2002).

Since 2012, the ECB has further decreased the MRR to 1% (EZB, 2017). To demonstrate the impact of an increased or decreased MRR, the money multiplier serves as a heuristic to illustrate how much money a bank can create. Figure 7 illustrates five different examples of minimum reserve requirements with a fixed initial expansion of 100 Euro (initial deposit of 100 Euro)

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Figure 7: Money Multiplier

The formula is m = 1/R, where m stands for the maximum amount and R for the MRR. Hence, putting R = 20% the formula’s result is 5, which means that the bank is allowed to lend out in total 500 € for every 100 € deposited. The following simplified example should illustrate this approach: Having a 20% minimum reserve ratio, for example, the bank is allowed to lend out 80 € on a deposit basis of 100 € . While another individual will receive this granted 80 € as a deposit, the bank, which will receive the deposit can lend out another 64 € to another individual. The same is possible with the newly deposited 64 €, allowing a bank to grant another 51,20€ (20% of 64 €) to another individual. This can be theoretically played through until no money for lending is available anymore. The sum of the 100 € , 64 € , 51,20 € and so on, is represented on the vertical axis, while the horizontal axis represents the manifold individuals owning the deposits. In the case of 20% minimum reserve ratio, the saturation point of the graph is 500 €, which is the total money created on the basis on 100 € (illustrated by the light blue graph.). Comparing it with the other MRR’s, one can observe the following relation: the lower the MRR’s the higher the relative increase of the total created money. Hence, with the current minimum reserve ratio of 1% banks in the Euro Area are allowed to create theoretically one hundred times the initial deposited money (dark blue graph) (Krugman & Wells, 2009)

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