The Bank of Canada has issued a staff discussion paper considering the role of retail public money at a time when new technology and new participants, some non-financial firms, are entering the process of money creation 1.
While regulations can mitigate the obvious risks, the paper argues that regulations are too blunt, and reactive, an instrument to work alone, and there is a need for a Central Bank Digital Currency (CBDC) as well to maintain an efficient economy.
Today public and private money co-exist because cash means there is always an alternative to private money and regulations safeguard the financial system. Value can flow between public and private money because they exchange at par.
Underpinning this are financial regulations, deposit insurance, the monetary policy framework and the lender of last resort facility. At the moment retail public money complements policy initiatives, allowing updates to regulatory frameworks required by the developments in payment markets and the financial sector to work.
Transactions and contracts work because the state has monetary and regulatory sovereignty, allow it to regulate the creation of money (whether public or private).
Retail public money is issued on a not-for- profit basis. As a result, it is able to be both accessible and non-exclusionary and can, therefore, interlink different forms of private money using the official unit of account. It makes them convertible and uniform.
For public money to interlink successfully, it needs to be both universally accessible and relevant. This means merchants and consumers need to use it in sufficient amounts for it to be a credible alternative to private digital money. That doesn’t mean it has to have high usage.
If public and private money are not regarded as uniform, then they won’t automatically exchange at par and there is a risk that scale and reach of payment platforms, network effects, will lead to market failures.
The paper identifies three risks to the current system which lead to increased fragmentation of the monetary system:
Structural changes in the architecture of the monetary system are coming from the creation of new digital assets, the use of data in the digital economy and open banking. If the changes to the payment system led to fragmentation of the monetary system, when choosing payment instruments users will have to consider the risk of the option and the exchange rate with alternatives. If private money is no longer exchangeable at par, the private money ‘winners’ then get market power.
One response to digitalisation is to regulate banking fees, compel banks to offer free bank accounts, take actions to increase competition in the financial sector and to extend deposit insurance.
However, regulations alone would not compensate those risks fully and they are unlikely to be in place in a timely manner or to be efficient. Perhaps worst of all, they are likely to be reactive, failing to understand and anticipate future changes. If private issuers of money don’t have public money to compete against, they may be in a stronger position to shape any regulatory framework to suit their agenda.
The authors believe regulation and digital public money, a CBDC, is needed.
Today the Bank of Canada has a legal monopoly to issue banknotes, Canada has a regulatory frame for the creation of money by financial institutions and wholesale and retail payment systems operate or are regulated by the public sector. In systems such as this private firms intending to issue private money should have sufficient incentives to:
If, as a result of a fragmented system, different forms of money have different risks or benefits, they will be priced accordingly. Users will need to monitor both risks and exchange rates when different forms of money compete, leading to the monetary system losing uniformity and efficiency.
The financial system has seen change and innovation before, but the advent of daily interest accounts, cheques and card based payments used at the point of sale did not disrupt the system. Users had the option to pay using cash and settlement was made in central bank money. Uniformity was maintained and fragmentation avoided.
The increased diversity of money combined with links between customer data and financial transactions are creating new market forces. If cash is not widely used and loses its transactional role, consumers take the option of using it as an alternative to private money. If a CBDC exists, then it can fill the role of cash in a digital world, ensuring an alternative option is maintained. Offered with regulatory and policy responses appropriate to the payment market, a CBDC can ensure access to convertible and uniform money is maintained.
Arguments for a CBDC apply equally to new sectors of the economy which are, and will, be created by technology such as blockchain, programmable money, smart contracts, decentralised finance and the internet of things.
The paper argues that no part of the economy of any real size should be closed off to the use of retail public money.
The paper does not believe that indefinite support for cash is sufficient to preserve a role for public money in the long term because the digital economy is likely to eventually overpower the physical one where cash is economically relevant.
If there were no retail public money, retail depositors could only exit their bank by going to another bank, other financial assets (eg. stocks, corporate bonds or government bonds), commodities (eg. gold) or to a foreign currency. But in a general financial crisis, people would not move to another bank and bonds and gold are illiquid and cannot be used for purchases, and a foreign currency may not be accepted.
In a crisis, therefore, only a retail public money would be a safe and highly liquid means of payment, protecting monetary sovereignty.
1 - Staff Discussion Paper 2024-11. ‘The Role of Public Money in the Digital Age’. Francisco Rivadeneyra, Scott Hendry, Alejandro García.
