A Unified Framework for Central Bank Digital Currency Design

Central banks have begun their own work program to assess the prospects of issuing a central bank digital currency (CBDC) for retail transactions. However, the issuance of CBDC has important implications for the implementation of monetary policy, the transmission of monetary policy, and financial stability, depending on the specific design features of CBDC, such as remuneration, holding limits, or the selection and pricing of assets held against CBDC. The ECB working paper A unified framework for CBDC design: remuneration, collateral haircuts and quantity constraints examines central bank digital currencies in a dynamic general equilibrium model (CBDC) macroeconomic impact. Central banks can set lending and deposit rates as well as collateral and volume requirements for CBDCs. This paper finds that fewer restrictions on central bank digital currencies reduce bank deposits. Positive interest rates or tighter collateral or quantity restrictions on central bank digital currencies would reduce welfare but might control financial disintermediation, especially if the elasticity of substitution between bank deposits and central bank digital currencies is small. The Institute of Financial Technology of Renmin University of China (WeChat ID: ruc_fintech) compiled the core part of the article.

The digital payments landscape has evolved rapidly over the past few years. Crypto assets and Big Tech's musings over issuing private currencies have raised concerns about the security and data protection associated with private currencies. In response to these developments, central banks have begun their own work program to assess the prospects of issuing a central bank digital currency (CBDC) for retail transactions. However, the issuance of CBDC has important implications for the implementation of monetary policy, the transmission of monetary policy and financial stability, depending on the specific design features of CBDC, such as the use of CBDC to pay workers, the limit of holding CBDC or the assets held against CBDC selection and pricing.

To study these questions, this paper constructs a general equilibrium model incorporating search and matching frictions that requires entrepreneurs to borrow internal money (bank deposits) and external money (CBDC) to pay for two different types of inputs used in production. The central bank chooses the interest rate at which it issues loans to entrepreneurs and the interest rate at which it pays workers on CBDC deposits. It could also limit the size of each loan and design a discount rate on future revenue from CBDC that is collateral for the loan. The model reflects the conditions under which CBDC exists in equilibrium by assuming a production function, and it allows us to analyze the impact of different CBDC design parameters on credit allocation and welfare within a unified framework.

The equilibrium allocation under the optimal solution is that CBDC is neither required by collateral nor limited by the cap on the total amount, and the lending spread is zero. Under the design of such CBDC policy parameters, the central bank can eliminate the welfare loss arising from matching friction in the investment goods market. Restrictions on the supply of CBDC have resulted in inefficient low investment and low production. This result arises because one of the inputs required for production is produced by workers who are paid in the form of CBDC, and substitution of this input is costly. As a result, the welfare gains brought about by CBDC depend on the degree of substitutability of production inputs paid for by internal or external money. As the mutual substitutability of these two forms of money increases, the welfare increase brought about by CBDC declines, and if the two currencies are perfect substitutes, the welfare increase will tend to zero.

Furthermore, we analyze how choices in CBDC design would affect bank lending, and interpret this as evidence that CBDCs have the potential to disintermediate the banking sector. If the degree of substitution between internal and external currencies is relatively high, a higher CBDC spread and stricter collateral requirements for CBDC will increase bank borrowing. If the degree of substitution is low, bank lending and CBDC demand fall together, albeit to a lesser extent, since the latter is now more difficult to replace by internal money. Putting a fixed cap on CBDC lending would undoubtedly increase the demand for bank loans. Overall, the central bank is thus able to control bank disintermediation by adjusting policy parameters with potentially incurring output and welfare losses.

We leave the impact of CBDC on monetary policy transmission or financial stability over the business cycle to future research. In our setup, prices are volatile and currencies are neutral. Furthermore, assets are safe and liquid. Therefore, our modeling framework can account for the impact of CBDC on steady state, that is, structural changes in the financial system.

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Author | Katrin Assenmacher, Aleksander Berentsen, Claus Brand, Nora Lamersdorf

Source | European Central Bank