Digital currencies have the potential to substantially re-shape the future of banking and financial intermediation. Whether the provision ...
Digital currencies have the potential to substantially re-shape the future of banking and financial intermediation. Whether the provision of a digital currency is by the public sector (central bank digital currency, CBDC) or a by a private initiative (narrowly referred to in this paper as a stablecoin), the eventual rollout of such new instruments is likely to provide a significant boost to the retail use of digital assets. At the same time, financial innovations may create new risks and vulnerabilities whose implications should always be thoroughly assessed.
This paper analyses the introduction of digital currencies in the network of financial accounts. We identify key channels through which the effects of these novel instruments propagate in the network, and we reveal significant direct and indirect consequences for most parts of the financial system. The international monetary and regulatory community has initiated work on several fronts to prepare for an orderly transition to digital currencies (see, e.g., G7, 2019; BIS, 2019; Basel Committee, 2019; FSB, 2019). While the importance of financial innovation per se is commonly recognised, these reports also highlight new threats to financial stability and call for a regulatory response. Among the potential risks of a disorderly transition is the possibility that,
depending on the ultimate role of existing financial intermediaries, the commercial banking system may experience the intractable loss of its fee-generating payment business, erosion of retail deposit funding and disintermediation of its core lending functions, with adverse consequences for the efficient allocation of credit to the economy. Additional risks not considered in this paper are associated with money laundering and digital dollarization. Careful planning and coordination among all the relevant parties seems essential to prevent damaging disruptions. A rapidly growing body of academic literature is devoted to the study of the design and implications of digital currencies. Theoretical models include Andolfatto (2018), Kim and Kwon (2018)
, Agur et al. (2019), Keister and Sanches (2019), Brunnermeier and Niepelt (2020) and Fernandez-Villaverde et al. (2020). These authors investigate, with sometimes conflicting results, the effects of different digital currency designs on bank lending and banks’ deposit market power, cost of funding and aggregate welfare. On the more conceptual side, Brunnermeier et al. (2019) discuss the effect of these instruments on models of monetary exchange and currency competition. Moreover, Adrian and Mancini-Griffoli (2019) propose a conceptual framework to categorise digital monies, and Bullmann et al. (2019) provide a taxonomy of the various models of private digital currencies. In a quasi-empirical approach using financial balance sheets, Kumhof and Noone (2018), in turn, study the introduction of CBDC and derive a set of “core principles” that could prevent runs from retail deposits to CBDC. Finally, Bindseil (2020) analyses the system-wide impact of both a CBDC and private digital currencies and argues that a two-tiered remuneration system may be sufficient to mitigate the risk of retail deposit runs to the CBDC. Our starting point is the introduction of a digital currency in financial accounts. An important challenge in using balance sheets is that, to date, no official consensus exists on the classification of digital currencies in national accounts statistics. We provide a critical review of the discussion and propose a statistical allocation for the digital financial assets that are considered in this paper. More specifically,
we consider a CBDC as a deposit scheme similar to the existing central bank deposit facilities, but with an extended list of counterparties, including non-financial agents. We classify stablecoins either as a new deposit instrument, termed “non-MFI deposits”, or a collective investment scheme where the digital instrument is a UCIT-type investment fund share. Armed with these definitions, we build on the work in Castrén and Kavonius (2013) and Castrén and Rancan (2014) and incorporate the new financial assets into the “Macro-Network”, a network of bilateral exposures among the institutional sectors of the economy. We model the introduction of a digital currency as a deposit shift out of commercial banks to the digital currency. Then, under the different designs,
we model a set of reactions from the sectors affected by the deposit shift, focusing on the banking sector and the implications that its adjustment may have on the other sectors. We find that in the process of balance sheet adjustments, the heterogeneous portfolios of bonds and loans held by the different sectors mean that the set of assets (securities DIGITAL CURRENCIES IN FINANCIAL NETWORKS Page 4 EBA STAFF PAPER SERIES or loans) that one sector may have to sell is not the same as the set of assets that another sector may be willing to buy.1 Price adjustments are then required to allow the markets to clear.2 Shock simulations give rise to the following main findings. First, we identify the key channels through which the impact of the introduction of digital currencies propagates to the main sectors of the economy. We show that even a relatively limited loss of deposits is sufficient to trigger major adjustments in banking-sector balance sheets, which, in turn, have implications for other sectors, including the “rest of the world” sector and, thereby, foreign residents and institutions. When the banking sector adjusts to a funding gap by redeeming loans, households experience the largest impact. When the banking sector reacts, instead, by selling securities, nonfinancial corporations are most affected. Our framework is flexible and capable of accounting for any securities portfolio structures and rules that govern the adjustment of the accounts of the various sectors. Second, by invoking network centrality measures, we observe changes in the relative importance of the individual nodes of the network (the institutional sectors).
The introduction of a CBDC or stablecoin will cause the sector issuing the digital currency to become a more central player in the network at the expense of the banking sector, but the process also has important consequences for third parties, such as the “rest of the world” sector. By affecting the shape of the macro network, the introduction of a digital currency may also affect the network’s stability properties. Our findings therefore also support the view that the regulation of digital currencies should take into account wider effects than just the immediate counterparty exposures. Finally, we show that because the key properties of financial networks are time-varying, it is not only the design of a digital currency but also the timing of its launch that matter in terms of the impact on the financial system. The remainder of this paper proceeds as follows.
First, Section 2 presents the data, after which Section 3 proposes an allocation of the different types of digital currencies into the financial accounts. Then, Section 4 introduces the methodology and the macro-network approach to modelling financial interlinkages, with a formal model relegated to the Annex. Next, Section 5 includes the simulation exercises to assess the dynamic impact of the introduction of a digital currency. Section 6 then generalises the results by looking at different shock sizes and assesses the time varying impact on network structures
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