CBDCs: Where do we go from here
The prevailing assumption in classical economics that banks primarily act as intermediaries between savers and borrowers has been a cornerstone of economic theory for decades. Even today most economic models are based on this assumption. Lately, however, this perspective has finally begun being increasingly challenged. In its 2014 research paper “Money creation in the modern economy” the Bank of England admitted that commercial banks are not merely intermediaries; they are, in fact, the primary creators of money in the modern financial system. This occurs through the process of credit creation, where loans extended to borrowers effectively generate new deposits, constituting new money in the economy. A re-calibration of the role of banks and how we view money creation and allocation has long been overdue.
And first of all, we need to get rid of the idea that Central Banks print money, a thought that is still being propagated among the financial market participants and the media. Central Banks, including The Federal Reserve, wield far less control over money creation and economic growth than commonly assumed. Quantitative easing (QE), often mischaracterized as "money printing," is primarily an asset swap where central banks purchase securities to increase bank reserves. These reserves, however, do not directly fuel lending or stimulate economic growth, as long as the commercial banking sector is not expanding its balance sheet. QE has consistently failed to produce the inflation or robust recovery it was designed to achieve. Theoretically our current two-tier system (commercial banks create money through lending, while central banks supply reserves to regulate this process), offers certain advantages as it ensures a level of oversight and control while allowing market-driven allocation of capital. But theory and reality are two different things.
The fragility of our financial system became glaringly apparent during the 2008 financial crisis, which exposed severe vulnerabilities in the banking sector. The regulatory backlash that followed imposed stringent limitations on banks, particularly regarding their ability to expand balance sheets. This regulatory clampdown, while aimed at enhancing stability, inadvertently stifled banks' capacity to fulfill their role as money creators, impeding economic growth and innovation to this date.
And while it is widely agreed that a reassessment of the system's structure and regulatory frameworks to strike a balance between stability and dynamism is necessary for a thriving financial system, no one really knows how to change this opaque system.
The next best thing we seem to have is the introduction of central bank digital currencies (CBDCs). The rise of CBDCs, as documented extensively in the numerous BIS research papers, is hoped to represent a paradigm shift in monetary systems. The motivations for CBDC introduction differ between developed and emerging markets. In advanced economies, the declining use of cash, financial efficiency, and the response to private digital currencies drive CBDC development. Emerging Markets, on the other hand, view CBDCs as tools to enhance financial inclusion and reduce reliance on cash-dominated private economy sectors. Either way, the potential benefits of better oversight and control in the system eventually lead to a higher degree of interconnectedness and complexity.
Taking a step back, CBDCs can be categorized into two major categories - retail and wholesale (I intentionally omit the hybrid form). Retail CBDCs are intended for use by the general public and would replace traditional cash, providing a government-backed digital currency accessible to all. Wholesale CBDCs, conversely, are limited to financial institutions, enabling them to settle inter-bank transactions more efficiently. While wholesale CBDCs complement the current two-tier system, retail CBDCs could fundamentally alter it, potentially centralizing money creation under government control.
The idea of retail CBDC echoes the centralized monetary system of the Soviet Union, where the state controlled all financial resources and flows — a system that ultimately failed due to its inefficiency and lack of innovation. Retail CBDCs could risk similar pitfalls, transferring the responsibility for capital allocation to central authorities and stifling the free-market mechanisms that underpin modern economies. Wholesale CBDCs, while promising to preserve the private sector's role in capital allocation and leverage technological advancements to enhance efficiency, are aligned closely with the current broken system and are highly likely to suffer from the same shortcomings.
To address the challenges above, policymakers must ensure that CBDCs integrate seamlessly with existing systems, preserving the dynamism of the free market while mitigating risks. Safeguards must also be implemented to prevent the concentration of financial power and ensure that the benefits of CBDCs are equitably distributed.
An over-regulated financial sector needs to be transformed allowing for more innovation and a more lean regulational environment. In such an evolving landscape, crypto-native financial institutions, such as Montes Auri and other crypto banks, are poised to play a transformative role. These entities, by leveraging blockchain and decentralized technologies, can offer innovative financial products that will help to bridge the transition from traditional to a new digital, DLT based financial system. And while the future path of the crypto and CBDC markets is yet to be determined, crypto native financial providers will emerge as pivotal players, driving competition, fostering innovation, and reshaping the banking system as we know it now.