By Frances Coppola
“Reserves” are money that commercial banks keep on deposit at central banks. Reserves are the largest part of what is known as the “monetary base” or “m0,” the money directly issued by central banks; the rest is notes and coins – what we think of as “currency.”2 Commercial banks use bank reserves to settle both domestic and global payments. In some countries, banks are required to keep sufficient reserves on hand to accommodate withdrawal of a certain proportion of their deposits: in the U.S., this “reserve ratio” is up to 10 percent.3 But since the advent of quantitative easing (QE), there have been far more reserves in the financial system than banks want. Banks (collectively) are obliged to hold all the reserves issued by the central bank, and they can’t always find a productive use for them.4 So central banks have been paying interest on reserves – or, in some cases, charging interest.
This causes a fundamental divide in the monetary base, since of course notes and coins do not bear interest. Even more importantly, it paves the way for central banks to issue digital currencies for global payments.
When we talk of “digital currencies,” we usually mean the growing range of private sector alternatives to national currencies that are springing up as part of the fintech revolution.
Cryptocurrencies such as Bitcoin and Ethereum are digital currencies that can be used for international payments. We don’t think of national currencies as digital currency.
And yet, as Ben Broadbent of the Bank of England points out, central banks do issue digital currencies – but to banks, not to everyone.5 Bank reserves are electronic, and they are used as a final means of settlement between banks. They are, in effect, the banks’ digital currency. And they are used for global payments. An international wire transfer in dollars between a bank in the U.S. and a bank in India is settled via Fedwire using electronic bank reserves held at the Federal Reserve.
Further, it’s not just central banks that issue digital currency – commercial banks do, too. Anyone with a deposit account is effectively using a digital currency issued by that bank, which the bank guarantees to be exchangeable at par for the central bank’s digital currency or its notes-and-coins equivalent. This ensures that a dollar in a bank account is worth the same as a dollar bill. The bank’s guarantee is backed by government deposit insurance up to a limit, which in the U.S. is currently $250,000.6 Above that, government doesn’t routinely guarantee convertibility to central bank money, whether digital or notes and coins – though as we saw in 2008, governments might temporarily guarantee convertibility far above that limit to prevent a systemic meltdown.
The majority of the money in circulation is digital currency issued by commercial banks,7 as is the vast majority of the money issued by central banks. Apart from transactions in notes, coins and paper checks, all global payments are now made using digital currency. The currency may be a combination of commercial bank and central bank digital money or it may be an alternative digital currency such as bitcoin.
But central banks are thinking of going further. They have discovered that by managing the interest rate they pay on reserves, they can control the general level of interest rates in the economy.8 The more widely such interest-bearing central bank money is used, the more effective monetary policy should be. So there could be a case for making central bank digital currency available to non-banks.
The Federal Reserve is already experimenting with this. As part of its strategy for gradually raising interest rates, it has introduced what it calls “overnight reverse repos” (ON RRP), which allow some non-bank financial corporations to deposit money overnight at the central bank in much the same way as a bank does. Money deposited at the central bank is implicitly exchanged one-for-one for newly-created reserves: the commercial bank money that these reserves replace is destroyed. So when the money is withdrawn the next day, it has effectively become central bank money.9
So far, the Federal Reserve has resisted extending ON RRP operations to non-financial corporations or households.10 But in theory, there is no reason why these should not be able to deposit money at the central bank too. A number of think-tanks11 and economists12 have seriously proposed that central banks should offer all businesses and households deposit accounts with payment facilities. This would effectively extend “reserves” – the digital money issued by central banks – to everyone. Digital money created by commercial banks would become a thing of the past. Central banks would have taken control of both money creation and payments.13
The U.S. dollar is the most widely used currency for international payments – the nearest thing there is to a universal currency. So, if the Federal Reserve decided to issue digital currency directly to businesses and households, giving them direct access to the central bank for domestic and international wire transfers, it would become the world’s premier issuer of digital currency for global payments. It would eliminate the need for international wire transfers to be sent via commercial banks.
Going further, if all central banks issued digital currency directly to households and businesses, it would also be possible for major central banks to intermediate global payments in multiple currencies, without the need for correspondent banks. Such a central bank network is already to some extent in existence, since FX conversion among the world’s reserve currencies can already be seamlessly handled using the currency swap lines established in 2008 to ensure that the world’s premier central banks could provide unlimited dollar liquidity to their country’s commercial banks in the financial crisis.14 These swap lines were made permanent in 2013.
One way a new central bank global payments network using digital currencies may emerge is for the banks to simply allow businesses and households to access existing central bank real-time gross settlement (RTGS) systems such as Fedwire. Alternatively, they could build new, fast, secure and transparent facilities using blockchain or another distributed ledger technology. The Bank of England,15 the Federal Reserve,16 the European Central Bank17 and the People’s Bank of China18 are all looking seriously at blockchain as a global payments mechanism.
A global payments network consisting entirely of central banks is that trade finance – and indeed domestic finance too, such as overdrafts – would expose central banks to credit risk. This is one of the major obstacles to ending commercial banks’ responsibility for money creation and international payments. Because taxpayers ultimately back central banks, taxpayers could end up with the losses from loan defaults.19
A new international payments network based on central bank digital currencies could work on an entirely pre-funded basis, as cryptocurrency networks currently do. This would ensure that payments could not fail, but it would potentially create a greater need for trade finance and short-term credit facilities. The lack of trusted intermediaries means that funds for B2B payments may have to be tied up in escrow accounts to ensure transactions complete.20 As banks stopped being payment service providers, therefore, they could acquire an enhanced role as providers of credit and guardians of responsible lending.
Digital currencies are already created by both central banks and commercial banks. But some think global payments could be faster, more efficient and more secure if they were entirely handled by central banks, rather than by a combination of central banks, commercial banks and payments service providers. Central banks are therefore looking seriously at adopting the new technologies that are revolutionizing the global payments arena.
With 17 years experience in the financial industry, Frances is a highly regarded writer and speaker on banking, finance and economics. She writes regularly for the Financial Times, Forbes and a range of financial industry publications. Her writing has featured in The Economist, the New York Times and the Wall Street Journal. She is a frequent commentator on TV, radio and online news media including the BBC and RT TV.
1. "Interest on Required Reserves and Excess Balances", U.S. Federal Reserve; https://www.federalreserve.gov/monetarypolicy/reqresbalances.htm
2. "What is the money supply? Is it important?", U.S. Federal Reserve; https://www.federalreserve.gov/faqs/money_12845.htm
3. "Reserve requirements", U.S. Federal Reserve; https://www.federalreserve.gov/monetarypolicy/reservereq.htm
4. "Banks don’t lend out reserves", Forbes; http://www.forbes.com/sites/francescoppola/2014/01/21/banks-dont-lend-out-reserves/%235c430d6c3594
5. "Central banks and digital currencies", Broadbent, Bank of England; http://www.bankofengland.co.uk/publications/Pages/speeches/2016/886.aspx
6. "Understanding Deposit Insurance", FDIC; https://www.fdic.gov/deposit/deposits/
7. Money creation in the modern economy, Bank of England; http://www.bankofengland.co.uk/publications/Documents/quarterlybulletin/2014/qb14q102.pdf
8. "Interest on Excess Reserves as a Monetary Policy Instrument", U.S. Federal Reserve; https://www.newyorkfed.org/newsevents/speeches/2014/pot141007.html
9. "Interest Rate Control During Normalization", Simon Potter, New York Federal Reserve Bank; https://www.newyorkfed.org/newsevents/speeches/2014/pot141007.html
10. "Overnight Reverse Repurchase Agreement Facility", U.S. Federal Reserve; https://www.federalreserve.gov/monetarypolicy/overnight-reverse-repurchase-agreements.htm
11. "How would you be affected if the Bank of England started issuing digital cash?", Positive Money; http://positivemoney.org/2016/02/how-would-you-be-affected-if-the-bank-of-england-starts-issuing-digital-cash/
12. "The macroeconomics of central bank issued digital currencies", Barrdear & Kumhof, Bank of England; http://www.bankofengland.co.uk/research/Documents/workingpapers/2016/swp605.pdf
13. "The Chicago Plan Revisited", Benes & Kumhof, The International Monetary Fund; http://www.imf.org/external/pubs/ft/wp/2012/wp12202.pdf
14. "Central Banks Make Swaps Permanent As Crisis Backstops", Bloomberg; http://www.bloomberg.com/news/articles/2013-10-31/ecb-makes-crisis-cash-lines-at-central-banks-permanent
15. "The Bank of England To Explore Distributed Ledger Technology For Settlement", Coindesk; http://www.coindesk.com/bank-england-distributed-ledger-settlement/
16. "Why central banks will issue digital currency", Adam Ludwin, Chain; https://blog.chain.com/why-central-banks-will-issue-digital-currency-5fd9c1d3d8a2%23.owkpcx65p
17. "European Central Bank Exploring Blockchain Tech Applications", Coindesk; http://www.coindesk.com/european-central-bank-exploring-blockchain-tech-applications/
18. "On digital currencies, central banks should lead", Bloomberg; https://www.bloomberg.com/view/articles/2016-09-01/on-digital-currencies-central-banks-should-lead
19. "QE and bank solvency", Bruegel; http://bruegel.org/2015/01/qe-and-central-bank-solvency/
20. "Replacing letters of credit with escrow transactions using multi-sig accounts", Koji Takahashi; http://cryptocurrencylaw.blogspot.co.uk/2015/10/replacing-letters-of-credit-with-escrow.html