Towards A Capital Efficient Digital Currency  

By | April 12, 2023

In this blog post, we analyse tokenized deposits in terms of financial motivation, regulation, technological implementation, and interaction with retail and wholesale central bank digital currencies (CBDCs), with particular attention to the European perspective. We conclude that the tokenization of deposits is a crucial enabler for the success of future CBDCs and needs to enter the debate about the evolution of monetary systems in the aftermath of SVB’s collapse. 

Digital Money in the Monetary System  

The plans of several monetary systems to issue digital currencies have been triggered by the popularity of digital, or crypto, “currencies” deployed on blockchain networks. When they launched a two-year investigation phase of a possible digital euro in 2021, EU institutions, like other monetary systems proposing CBDCs, provided indications that they favoured “a solution of continuity, where the digital euro would be issued as a digital version of cash and conceived to preserve, rather than disrupt, current monetary arrangements.” 

In most monetary systems, the status quo can be described as follows:  

  • The vast majority (typically around 90%) of the money available to the public is issued by commercial banks in the form of deposits in the books of banks.  
  • Similarly to commercial banks, central banks themselves issue book money, which can only be used by commercial banks to hold reserves.  
  • Central banks also issue the physical form of currency (banknotes), which represents a small percentage of available money. Commercial banks ensure convertibility of deposits to physical currency under a set of rules.  

In monetary jargon, book money issued by commercial banks via demand deposits (plus a minor cash component) is called M1.   

How M1 is created  

“Money can exist in a bank account in the form of a computer entry or stored in the form of a savings account. […] Commercial banks can also create so-called “inside” money, i.e. bank deposits—this happens every time they issue a new loan.”  

This quote summarizes the main features of deposit money, issued by private institutions and called “inside money,” as opposed to “outside money” issued by central banks. 

Account-based money was originally introduced by the private sector in the Renaissance through the first commercial banks. Later, central banks were created in order to bring more homogeneity and stability to national monetary systems, but they kept a decentralized system based on private financial institutions. Indeed, private financial institutions have a key role in providing credit to the economy. Lending directly to firms and households would pose critical challenges for central banks in terms of business model, client engagement, and scale of operations. Consider for instance the resources required to perform anti-money laundering (AML) checks on account holders, not to mention the management of client relationships, their data and privacy rights. Moreover, following the subsidiarity (or proximity) principle, capital allocation is more efficient when decentralized to the dynamics of the private sector, where commercial banks compete for the demand for loans in a market-based system.  

Deposit money is crucial in this equation. As neatly summarised by Brunnermeier and Landau 

Commercial banks are in the business of lending to firms and households. They are also in the business of creating deposit money. The lending activity is reflected on banks’ asset side of the balance sheet, while deposit taking on their liability side.  

Central bank digital money  

In this context, the introduction of a CBDC may have unintended effects. In the words of a senior ECB official: “The introduction of a CBDC can influence the transmission of monetary policy and financial stability through several channels that are mainly related to the substitution of commercial bank deposits with a public digital currency. In the Euro Area, as in all modern economies, banks grant loans and issue deposits, thereby performing maturity and liquidity transformation services that improve the allocation of households’ consumption across time and firms’ capital across productive activities. […] If households and firms were to substitute a large share of their deposits with the digital euro, or they were to use the digital euro as a safe haven in time of stress, banks would need to replace some of their stable funding and lose customer information that is essential to perform their activities. The Eurosystem’s ability to support the economy through the banking system may be weakened, with broad macroeconomic implications.” 

The mitigants currently under consideration go in the direction of setting “effective limits to the amount of digital euro individual users can hold and penalising remuneration on individual users’ digital euro holdings above a certain threshold,” and “integration of the digital euro infrastructure with bank deposits” with “strong involvement of the private sector.”  

The goal is to minimize possible hoarding of the future CBDC at the expense of deposit money. Supply restrictions are possible, and even relatively simple in the programmable world of current digital money. However, setting such parameters correctly is tricky, as the market dynamics of digital currencies reveal. No one can predict how the required penalization can change in times of uncertainty if not of crisis, or how in such times the presence of supply limits could affect the parity between scarce digital central bank money and deposit money.  

As for the involvement of the private sector, this has been reiterated in a recent report by the ECB: “Supervised intermediaries would, in their turn, have the contractual account management relationship with end users and be the direct contacts for individuals, merchants and businesses using the digital euro.” The plan seems to maintain a role for supervised intermediaries as similar as possible to the current one.  

However, digital money such as CBDCs will be issued by using current cryptographic techniques and automatic networked ledgers, and this has implications which may lead in a different direction compared to recent reforms on “open banking.” Open banking requires banks to put their data management and settlement facilities at the service of modern digital intermediaries. Digital money, instead, may distribute real-time settlement activities to the network ledger, transform account management and KYC through the usage of digital signatures and digital identity, and allow the usage of smart contracts for whitelisting and data management to support AML, compliance, and possibly participation to new forms of decentralized finance.  

Agustín Carstens, General Manager of the Bank for International Settlements, envisages “a digital infrastructure with the potential to combine the monetary system with other registries of real and financial claims. It would need to be a public-private partnership with a clear division of roles, and where the central bank is tasked with underpinning the trust in money. Such a ledger allows for the use of smart contracts and composability. […] With these new functionalities, any sequence of transactions in programmable money can be automated and seamlessly integrated. This reduces the need for manual interventions that delay transactions and reduces dependency on intermediaries, and also allows for simultaneous and near-instant payments and settlement.”  

Technological improvements would imply nontrivial changes in the role of supervised intermediaries, who need to play a proactive role, by taking this transformation as an opportunity to leverage the new open technological infrastructure and foster their role of core digital intermediaries that offer trusted custody, efficient capital allocation and, even more crucially, inside money issuance. Otherwise, the contrast between a “technologically superior” digital central bank money and traditional deposits may be too strong to be compensated only by supply control and involvement of commercial banks in relationship management.  

Due to all of the above, “deposit tokenization” may become a necessary enabler for CBDC and the first step in any central bank plan to foster digitization of the monetary system.  

Deposit circulation through the balance sheet  

This activity of “M1 money creation by balance sheet expansion” is limited by several regulatory devices, from prudential regulation to reserve requirements(Regulation EU 2021/378).  

How does money in the form of commercial bank liabilities circulate? We focus on the example of two banks that both belong to the same monetary system and have an account at the same central bank. This setup is typical of banks in the European Union and may appear simpler and more efficient than the typical “correspondent banking” business model. 

Let’s consider the case of Andrea, who has an account at Bank A with a balance of 5. Andrea orders a transfer of 3 units to Massimo, a customer of Bank M. Before the transfer, Massimo holds a balance of 1 in his account at Bank M. Deposits at Bank M total 40 units of account.  


After the transfer, financials appear “unbalanced” at Bank A, where total assets no longer equal total liabilities; in order to recover the missing piece of the puzzle, we need to include the Reserves of both banks.  

We learn that Bank A holds 8 units in deposit at the central bank (plus 1 in notes and coins); in turn, Bank M has a reserve base of 10, of which 7 are on deposit at the central bank. Andrea’s transfer to Massimo is settled when the same amount is transferred from Bank A’s account to Bank M’s deposit at the central bank.  

Digital M1  

In this section we attempt to outline the design of a token that could efficiently represent digital deposit money. We call it Digital M1 or DM1. It should have a few desirable properties:  

  1. The DM1 token represents the liability of a private monetary institution (the book of the token), and the token must always carry with it information to distinguish between liabilities of different banks. This happens with current deposits and does not compromise the “singleness of money.”
  2. The token is convertible 1:1 with central bank money at its booking institution by a client of the institution. The current rulebook regarding conversion may apply, including limitations, for example the daily and monthly limitations of ATM conversion, that are different if the ATM belongs to the book, to a different bank belonging to the same monetary system, or to a bank of a different currency circuit.
  3. DM1 is subject to fractional reserves. This will make it capital-efficient compared to stablecoins, which are typically fully backed by a portfolio of high quality assets (including bank deposits). We expect DM1  to become a pillar of the future M1network of institutional arrangements, including supervision and deposit guarantee schemes. This development may be part of a reasoned response to SVB’s recent fallout, which exposed the risks connected to inadequate liquidity coverage and unprotected deposits, but also the limitations of stablecoins such as USDC, that lost its peg when it emerged that around 8% of its reserves were locked in traditional deposits at the collapsed lender. 
  4. DM1 must satisfy core principles for deposit transactions: finality, AML compliance, and KYC checks in order to limit circulation to clients of a network of financial institutions.  

These properties could be implemented using automated ledgers, with tokens issued by smart contracts and wallets authorized by regulated institutions for whitelisted clients. A possible process of this kind is described by Chaum and Moser. Finality in a few seconds and lack of system downtime for up to several years are also achievable properties of blockchains, see for example the Algorand protocol 

One novel feature is that a user of DM1 would be a participant of both a traditional banking circuit and a modern blockchain network, which are based on different forms of identification:  

  • In the banking system, all services to clients, from execution to back-office are operated by the intermediary based on personal KYC identification.  
  • In blockchain networks, users authenticate themselves by signing digitally with their private keys.  

An authentication model based on private keys and digital signatures would preserve the benefits of digitization on distributed ledgers. Security and peace of mind for clients that do not want to manage private keys by themselves could be obtained by custody arrangements offered by banks (from key sharing and multisignature to total delegation to the bank).  

Other properties crucial to the workings of a monetary system, such as convertibility and credit rights, could keep on following the current practice of KYC legal identification and traditional identity verification. This could make DM1 a deposit token that settles in a decentralized fashion on-chain and converts into physical cash off-chain following current standards.  

The circulation of DM1  

In case of a credit transfer between users having accounts at the same bank, there is no variation in the total deposit liabilities of the booking institution. The only difference with respect to the current setup is that blockchain technology would allow transfers between them with no direct intervention on the part of the bank, except for monitoring transactions, which in any case would be automatically notarized on the distributed ledger.  

We now consider a transfer of DM1 between depositors that have been whitelisted by different institutions under an appropriate payment scheme. The originator of the transfer is a client of Bank A, while the beneficiary is a client of Bank M. The beneficiary could be allowed to keep in her wallet the DM1 tokens of Bank A even if she is not a client of Bank A. In this case, rules regarding convertibility into central bank money could be inspired by current arrangements for ATM conversion. For example, a European bank may only allow an ATM user who is the client of another European bank to convert into cash a smaller daily amount, or charge a larger fee for the service; outside the European Union other banks may not grant conversion as conveniently.  

When Bank A’s tokens comes back in the hands of a client of Bank A, or when the holder passes KYC checks with Bank A, full conversion rights could be restored. As it happens with stablecoins, this “refund” possibility is enough to maintain par value even if rarely requested in practice (also in SVB’s crisis, USDC regained full parity as soon as the integrity of the refund was confirmed). In the meanwhile, DM1 tokens could circulate on a peer-to-peer, automated basis among whitelisted wallets.  

More conservatively, regulators could require that a token transfer between clients of different banks is tantamount to a change of book, whereby the deposit liability of the transferor’s bank (the “outgoing book”) is converted into a deposit liability of the transferee’s bank (the “incoming book”). In order to balance the asset side, such “conversion” must be atomic (settlement that is both simultaneous and instant) to a transfer of an equivalent amount of outside money between the outgoing and the incoming booking institutions. With this approach, a bank would allow its clients to hold only inside money issued by itself, by changing the book of all outgoing DM1. Intermediate designs could also be considered to bolster the resilience of the current monetary architecture by achieving a fine balance between the empowerment of depositors, the opportunities for increased protection enabled by programmability and any applicable limitations on convertibility.  

The asset-side trigger that compensates for the liability adjustment can be implemented without the availability of on-chain central bank money, as demonstrated in a recent study by the Bank of Italy. Interbank agreements can be translated into the possibility for whitelisted clients of different banks to transact on the same platform: The atomic features demonstrated in the study would ensure that in our scenario the on-chain transfer is completed with the instant settlement in central-bank money of the interbank leg . 

DM1 and the CBDC  

So far, we have assumed that DM1 is a retail product. However, a first application for DM1 could be a wholesale solution to provide an on-chain settlement asset for tokenized financial instruments. Retail circulation could then be a natural evolution. It could be seen as first a test and then a complement for a future CBDC. 

In case a wholesale form of CBDC is issued first, a retail DM1 could become a natural complement to involve the retail public in the evolution of money towards digitization and automation. Additionally, digital wholesale central bank money could be used in a change of book scenario to make asset-side adjustments totally automated through smart contracts.  

When both CBDC and DM1 are available to retail users, DM1 could mitigate the risk of excessive substitution of traditional deposits with digital central bank money. If DM1 tokens were designed to be as convenient and safe as the reference CBDC and used the features of automation provided by the same superior technology, individual users would be more likely to consider the two as substitutes.  

Also, quantitative limits to CBDC would be easier to introduce under this scenario. Consider for example the UK’s recent proposal to issue a future CBDC version of the pound under quantitative limits as low as 10,000 or 20,000 pounds per citizen. If this cap represented the absolute limit to the quantity of state-of-the-art digital money that a person could hold, the experience could be quite unsettling. In times of systemic stress, the risk that for individuals such limited amounts could become more valuable than deposits, perhaps as a consequence of merchant preference, could not be ruled out. If instead a limited CBDC amount could be seen as the “central bank reserve quantity” that every citizen holds among an otherwise indistinguishable digital currency issued by regulated institutions in the form of deposit tokens, such risks would realistically be less likely to materialize. 

 

Massimo Morini is Chief Economist at Algorand Foundation and Academic Fellow at Bocconi University.  

Andrea Prampolini is head of financial, digital & markets tech – IMI Corporate & Investment Banking Division at Intesa Sanpaolo and adjunct professor at Politecnico di Milano Graduate School of Management.   

This post was adapted from their paper, “Inside Digital Currency,” available on SSRN 

 

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