Will there be a crypto storm for central banks? Increasing focus on digital currencies

This week, a New York Fed symposium explained the headache central bankers face when faced with emerging digital technologies ranging from new ways of processing payments to new asset classes like cryptocurrencies and stablecoins.

The underlying technology has benefits, including better transaction speed, lower costs and easier access to banking services, and even with the recent crashes and volatility, it is believed to continue to progress. In other words, if left unchecked, systems developed by private companies could capture a greater share of funding and make “central bank money” less relevant, by reducing the central bank’s control over interest rates. .

Create a substitute in the form of a central bank digital currency, and new instabilities could arise, including the potential for a digital dollar or euro to replace conventional bank deposits and compete with money market and foreign exchange funds, other major financial instruments. In a crisis, the process could mimic a street to the banks, leaving the system out of liquidity, forcing the Fed, for example, to extend more credit to commercial banks or bolster its own holdings of government bonds and similar securities to maintain the stability of the economy. system.

Banks that lose deposits have to fight to get new ones and “depending on the intensity … the general level of short-term interest rates … could rise,” a Fed document concluded this week. The US central bank has introduced a digital currency at the retail level that is open to households. “A retail CBDC could increase stress on the financial sector, forcing the Federal Reserve to provide more liquidity to banks through existing instruments….”

The Fed is debating the development of a digital currency, as most central banks around the world are doing. No decision has been made yet, and officials say congressional approval is needed to proceed.

The tension point may seem distant, as the market value of cryptocurrencies and stablecoins remains a small part of the financial system. But payment processors, such as PayPal and Apple Pay, are growing rapidly, and earlier this year they were processing transactions at the scale of major credit card companies. Among cryptocurrencies and stablecoins, it was noted at the New York conference, some schemes include exotic lending schemes – credit creation – which, if stretched, could carry greater risks.

“What happens if the central bank runs out of relevant money, both at the retail and wholesale levels? In that case, the central bank could lose control of its monetary policy,” said Eswar Prasad, a Cornell University professor and author of the recent book “The Future of Money” on this topic, on the sidelines of the conference.

“In some countries it is now starting to become a problem. China, increasingly India or Sweden – the use of central bank money for retail payments has all but declined,” as the private payment providers intervened.

THE STAKES HAVE BEEN INCREASED

The implications of central bank digital currencies for monetary policy are only part of a broader view by institutions like the Fed at how emerging technologies will change the financial system. As these technologies gain prominence, the implications for financial stability and risks to individual investors have become a higher priority for research and regulation.

In the United States, President Joe Biden, citing the five-year growth of crypto assets from $14 billion to $3 trillion in November, issued an executive order in March describing the Treasury and other agencies to look at how the industry is best regulated .

Given the stakes, central banks around the world are quickly moving off the sidelines.

A Bank for International Settlements survey released last month of 81 central banks in countries responsible for nearly all of the world’s economic output found that more than 90% explored the idea of ​​a central bank digital currency.

More than a quarter of them are actively developing a digital currency or running pilot programs, a share that nearly doubled between 2020 and 2021. The explosion of electronic payments and investments in cryptocurrencies during the pandemic is accelerating work, respondents said. while about 60% of banks say their use of cash is decreasing.

Adoption doesn’t necessarily have to be disruptive.

In a presentation published at the New York Fed conference, Andrew Hauser, executive director for markets at the Bank of England, said that “although the technology may be new to any future CBDC … using the central bank’s balance sheet providing state-guaranteed transaction money… is one of the oldest functions of central banks.”

But the evolution can go fast.

“Innovation in money and payments has the potential to change the existing monetary system…on which current monetary policy frameworks are built,” said Lorie Logan, executive vice president of the New York Fed and recently named head of the Dallas Fed. “How things will evolve from here is uncertain, and the impact of these innovations could be game-changing, or more evolutionary.”

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