OKEx Research Recommended Reading: IMF Digital Currency Working Paper (2)

Original title: "OKEx Research Recommended Reading: IMF Digital Currency Working Paper (Part 2)"

Original source: OKEx Research

Guide

The International Monetary Fund (IMF) completed the article "Digital Currency for Cross-Border Payments: Macro-Financial Impact" on September 22, 2020. It focuses on four application scenarios of digital currency for cross-border payment, as well as specific analysis of these scenarios. Due to the length of the original working paper, we split it into three and published it separately. This article is the second of the original working paper.

The first article briefly introduces what CBDC and GSC are, and explains the factors and application scenarios that affect CBDC and GSC. The second part continues in-depth, focusing on the four paths of monetary policy transmission, financial stability, capital flow and international reserves, and discusses the possible consequences of CBDC and GSC for macro-finance. As we mentioned in the previous section, the application scenarios are divided into four categories based on the functions and usage levels of CBDC and GSC. Then, in the four different scenarios, how do the degree of currency substitution and the business cycle model affect monetary policy? While reducing the transaction costs of speculative positions and improving the convenience of holding them, will it add additional pressure to the traditional financial stability risks associated with currency substitution? Specifically, how various risks such as intermediation risk, liquidity risk, and operational risk are transmitted, as well as their connection and spillover effects with the local financial system are also crucial. The international capital market has never been smooth sailing, so what is the way CBDC and GSC affect cross-border capital flows. In the four scenarios, what adjustments the central bank will make to international reserves in response to digitalization are the focus of our attention under the digital trend.

This article was translated by the assistant analysts Angela and Cici Chen of the Institute, and the chief analyst William was responsible for the review.

Macro-Financial Consequences

A. Monetary policy transmission

1. Foreign CBDCs and GSCs can affect the transmission of monetary policy by increasing currency substitution and reshaping the business cycle synchronization model.

Currency substitution reduces the monetary authority's control over domestic liquidity, limiting the portion of the authority's direct influence and reducing the stability of money demand (El-Erian, 1988). As a result, monetary policy transmission—the degree to which policy-induced changes in monetary instruments (such as nominal money stocks or short-term nominal interest rates) affect macroeconomic variables—may be weakened. A replacement for CBDCs or GSCs would be no different than a replacement for existing fiat currencies. However, these new forms of digital currency may enhance currency substitution due to their greater availability. In addition, they could boost economic activity and trade linkages organized around big tech companies, helping to reshape patterns of business cycle synchrony, which could reduce the ability of monetary policy to respond to shocks.

2. Small-scale adoption of CBDC or GSC for remittances (scenario 1) may not have a significant impact on monetary policy effectiveness unless it boosts monetary substitute.

If they promote the growth of remittances by reducing transaction costs or regulatory barriers, they may affect the effectiveness of monetary policy in recipient countries. This is because there is a close relationship between obtaining a foreign currency at home and substitutes for that currency. For example, during Cambodia’s transition to democracy, the use of US dollars rose rapidly in just a few years, as large foreign aid flows provided ample US dollar liquidity (Kubo, 2017). Initially, dollar use was focused on payment systems, but it subsequently migrated to a store of value as consumers started saving dollars (Odajima, 2017).

3. If countries widely use foreign currency (including granting CBDC legal tender status) or GSC (scenario 2), their ability to withstand shocks will depend on their business cycle Is it synchronized with the business cycle of the currency issuing country.

When currency substitution occurs, the effectiveness of the monetary policy of the user country is weakened; but if the economic cycles of the user country and the issuing country are consistent, the monetary policy of the currency issuing country It can partially meet the needs of countries using foreign currencies. This could be the case if they face similar shocks, or become economically integrated as in a currency union. However, currency substitution often occurs in countries that are geographically and economically distant from the issuing country, and in these cases currency substitution reduces the country's ability to use monetary policy to absorb shocks.

4. With the global adoption of a single GSC (Scenario 3), domestic financial conditions will face more impacts from global factors.

Developing a unified monetary policy for a large number of countries may not allow the business cycles of each country to be fully aligned. a well-known challenge. In this case, the state, if it adopted the GSC as legal tender, would find itself in the position of a private company, which could raise the issue of delegating central responsibility for the state's macroeconomic policy to a for-profit company.

5. While privately issued currencies have circulated in various forms in the past, the global adoption of GSCs is unprecedented.

Therefore, any potential misuse of the payment system and misuse of the currency for private purposes may have more impact than before. If the platform issuer profits from other currency-related activities, he needs to subsidize the currency and provide interest. Conversely, if the currency is in high demand, the issuer can charge a fee for its use. Issuers can adjust interest rates or charges to maximize their own profits, rather than aiming at stabilizing the price and output of GSC. The potential conflict of interest is especially great if the company is also a major supplier of credit, since the need for credit may depend on the supplier's own currency status.

6. If the GSC has a price stability rule relative to the basket of goods sold on the big tech platforms, then the optimal currency area based on the synchronization of the national business cycle Concepts can be challenged.

Platform-based economic activity may undergo transformation. Industries closely tied to these platforms could be a source of shock to other parts of the economy. Furthermore, if GSCs pay an adjustable rate of return, changes in this rate of return may not be consistent with what is needed to stabilize the rest of the economy. However, GSCs employing 'platform linkage' can offer benefits such as ease of payment pressure and business cycles as they leverage complementary activities and data linkages to develop ecosystems of digital networks, such as tailor-made products and services or based on payment data credit (Brunnermeier and others, 2019b).

7. The monetary policy impact of global adoption of multipolarity (scenario 4) depends on whether multipolarity is characterized by national currency blocs or currencies within each country compete.

If multipolarity is divided by groups of countries, each adopting a CBDC or GSC, then using the monetary policies of these countries reflects the adoption of a single currency Condition. However, in order to attract more countries to join their respective camps and obtain seigniorage, CBDC issuing countries may provide sufficient swap lines or monetary policies to internalize some externalities to user countries. If GSCs had an adjustable rate of return, competition might prompt them to consider the business cyclicality of the country in which their currency is used. As such, competition may make each GSC currency bloc more akin to a currency union than a "dollarized" economy. However, as in a currency union, monetary policy can only be adjusted for the bloc and may not be of much help to countries whose business cycles differ from those of most eurozone members.

8. Multipolarity may mean that each country uses multiple currencies internally, perhaps because of the functions of the currency and different currencies preferred by different functions are separate.

Swapping to multiple currencies has the same effect on the home currency as replacing the home currency from one currency, with two exceptions. First, diversity may bring diversity benefits. Second, multiple currencies can complicate pegs if the local currency is still in use. Many countries that have adopted a single foreign currency as an alternative currency have adjusted their monetary policies to limit bilateral exchange rate movements in order to stabilize domestic balance sheets affected by foreign currencies. However, with multiple currencies, exchange rate fluctuations between foreign currencies can complicate such stabilization efforts.

9. Cross-border use of CBDC may affect the monetary policy of the issuing country.

On the one hand, the central bank that issues currency can increase seigniorage revenue. On the other hand, fluctuations in external demand for CBDC could lead to large fluctuations in capital flows. Whether the capital flows associated with the use of a CBDC create challenges for the issuing central bank depends on the size and depth of the country's financial markets. Market liquidity in some reserve currency-issuing countries may undergo significant changes due to global capital flows. This may occur if the issuer's financial markets are shallow relative to the size of its economy, or because its economy is relatively small relative to the global economy. If sterilization fails to stem large swings in capital flows, CBDC issuers could experience market liquidity and asset price volatility that reflect global demand for their currency.

B. Financial stability

1. Reduced speculative positions for easier access to foreign exchange CBDCs and GSCs may create additional incentives to take risks and increase vulnerability.

The first question is whether improving the ease of holding and transacting new digital currencies will add additional pressure to traditional financial stability risks associated with currency substitution , such as the financing risk and solvency risk caused by currency mismatch. Another question is whether using them in normal conditions poses an intermediate risk and increases operational risk during stressful times. Box 2 discusses the implications of widespread adoption and use of CBDCs and GSCs on the structure of financial intermediation. In addition, cyber-attacks, failure of asset custodians or wallet service providers (such as crypto exchanges and/or authorized resellers) or liquidity risks for GSC market makers (FSB 2020) could trigger a crisis of confidence. Countries hosting GSC arrangements will need to consider whether the GSC arrangements themselves present significant liquidity, market and operational risks, as well as their linkages and spillovers to the local financial system.

2. Small-scale adoption of CBDC or GSC for remittances (scenario 1) could mean little impact on financial institutions’ balance sheet vulnerabilities.

In this scenario, users may hold balances in CBDC or GSC for transactional purposes only. In some cases, individuals could temporarily hold limited CBDC or GSC balances as a store of value, replacing bank deposits. The associated modest decline in bank deposits could lead to a modest increase in funding risk as banks cover the loss of deposit funding from other, more volatile sources. In addition, banks that rely heavily on cross-border payment fees may see this revenue stream diminished.

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3. Greater currency substitution (scenario 2) is likely to increase financing and solvency risk pressures compared to what is observed in economies with low levels of financing (Gulde and others, 2004; Levi Yevaty, 2006; De Nicolò and others, 2005).

A CBDC or GSC could increase the degree of substitution of foreign currencies already in use, as the friction to acquire and trade in such currencies could be reduced. For example, foreign banknotes may not be freely available and may be costly to ship from the country of issue, limiting their use as a means of payment. In a CBDC or GSC, there are no regulatory hurdles and availability is limited only by technology. Higher usage as a means of payment may also lead to higher usage as a store of value due to the complementary functions of money. As individuals replace CBDC or GSC with domestic bank deposits as a store of value and means of payment, banks will face higher funding and currency risks (Box 2). Banks may also face higher credit risk if they denominate loans in CBDC or GSC. This is especially important for borrowers whose primary source of income is in local currency, or whose collateral is denominated in local currency.

4. In times of stress, the use of foreign currency CBDC or GSC may lead to higher operational risks.

Mancini-Griffoli et al. (2018) analyze the potential impact of a CBDC on the financial stability of the issuing country. According to them, the impact may be limited, depending on the design characteristics of CBDC. However, for many emerging markets and developing countries, runs on the banking system are often associated with runs on currencies or countries (Laeven and Valencia, 2018). In this case, depositors would be incentivized to move their wealth into foreign assets. Access to foreign assets is an important factor for savers to consider when choosing whether to operate with a bank. Another important factor is whether the central bank issuing the currency has the backing of a lender of last resort. If opening and transferring to a digital wallet is faster and more accessible than opening and transferring to a digital wallet in a bank abroad, and given that emergency liquidity assistance from the issuing central bank may not be readily available, it may be Increase the motivation of depositors to operate.

5. The GSC ecosystem may also be an important source of risk.

All types of conventional risks, including liquidity, market, credit, operational and network risks, as well as with GSC wallet service providers, exchanges and other relevant markets Risks related to infrastructure may affect the value of the transaction. The realization of these risks could lead to a shift away from GSC to other safer currencies and assets, possibly causing a breakdown of the peg between GSC and the currency's face value. Such operations could result in potential losses for their holders, increasing volatile capital flows across borders and leading to broader financial stability implications.

6. In the case of global adoption of a single GSC (Scenario 3), domestic financial conditions will be influenced by global factors.

As the global financial system becomes more integrated, individual countries' domestic financial conditions are increasingly driven by the so-called global financial cycle (Agrippino and Rey , 2020). Widespread adoption of a single GSC could reinforce this trend. Global financial cycles may relate to perceived changes in ecosystem safety and security of GSC arrangements. This can also be caused by interest rate changes initiated by their GSC issuers. As a result, local regulatory authorities may find it difficult to control booms and busts. The euro area, for example, shows that some countries, such as Spain, face significant challenges in using regulatory and supervisory tools, stemming from upward pressure on property prices and credit, as a result of loose financial conditions in the euro area.

7. Global adoption of GSCs may pose systemic risks due to interlinkages. Pressure on any component of the GSC ecosystem can be transmitted quickly across borders.

This applies not only to "direct" channels related to the cross-border provision of the service itself (e.g. questions about the availability and conditions of the service and access to funding for support, and reserves), but also “indirect” channels, such as through reputational risk. The failure of a service provider (for example, a dealer of reserve assets, a wallet provider, a manager or a custodian/custodian/trustee) may cause users in other jurisdictions to question the security and reliability of GSC. Ultimately, a weakness in one jurisdiction can create risks for the entire ecosystem. This could lead to a potential failure of the global payment system, with global payments being disrupted.

8. With global adoption of multipolarity (Scenario 4), currency competition within a jurisdiction may destabilize local financial conditions more turbulent.

Low switching costs between CBDC and GSC could lead to their participation in currency blocs or instability in the digital currency space. However, competition can enhance the discipline of risk management. Privately issued currencies are attractive in the long run (Hayek, 1976), although Fernandez-Villaverde and Sanches (2019) argue that monetary competition can only provide stability constraints under certain conditions. Indeed, there is no consensus among economists on whether monetary competition has historically been associated with improved or worsened financial conditions (eg, White, 1995).

9. Currency competition can motivate GSC service providers to take higher risks in order to gain market share in the short term.

As GSCs benefit from strong network effects, issuers and service providers will face intense competitive pressure to gain market share. Therefore, an aggressive business model may expose the ecosystem to other risks. For example, a GSC service provider may seek to gain market dominance by losing money in the short run, compensated by higher profit margins (monopoly rents) in the long run. Taking too much risk to reap the rewards of "too big to fail" subsidies. Thus, the emergence of systemically important institutions and their potential anticompetitive effects may be sources of systemic risk.

C. Capital Flow

1. The use of CBDC and GSC may affect cross-border capital by reducing transaction costs and friction in international capital markets total traffic.

International capital markets are not all smooth sailing: transaction costs are high, markets are segmented due to information asymmetry or familiarity effects. From an investor perspective, the “pipelines” of market infrastructure could become more efficient due to the digitization of money and payments and the tokenization of related assets. As a result, transaction costs are reduced and foreign financial markets may become more accessible. If GSCs are bundled with big data from e-commerce and social networking platforms, they could also provide improved cross-border credit analysis and help reduce information asymmetry. From the borrower's perspective, reducing search and transaction costs can help improve cross-border credit. Transnational issuance by banks could reduce dependence on banks, improve access to international capital markets, and increase financial inclusion for SMEs in underdeveloped countries or around the world. At the same time, a more dispersed investor and borrower base could lead to more noise trading and herd behavior.

2. The small-scale adoption of CBDC or GSC for remittances (Scenario 1) may not significantly affect capital flows, but the use of more currency alternatives (Scenario 1) 2) May affect capital flow.

These new forms of digital currency could be offered directly to residents of a country via the Internet by non-resident service providers. As such, they can be used to efficiently execute cross-border transfers, bypassing traditional payment systems through which conversion restrictions and CFMs are often enforced. The relative ease of acquiring CBDCs and GSCs on the Internet makes them particularly attractive in systems where the costs and national regulatory burdens associated with traditional payment systems are high. If the adoption of these measures promotes capital flows or increases the volatility of capital flows, it may exacerbate the "policy trilemma" and complicate monetary policy and exchange rate management.

3. Global adoption of GSC (Scenario 3) could lead to greater integration of international capital markets.

Using a unified global currency board would largely eliminate exchange rate risk and revaluation risk. The use of GSCs, if tied to complex financial instruments, could make real-time hedging services and improved risk management more accessible to households and small businesses. However, the experience of the euro area banking and capital markets union shows that the full integration of financial systems and markets requires much more than a single currency.

4. Adoption of a single GSC globally may lead to more unstable financial conditions in the short term.

For a GSC tied to a social media platform, the incidence of herd behavior, panic and noise trading in financial assets may be higher, which may reflect two factors. First, there is noisier information disseminated on social media or other platforms. Second, investors operating in such an environment are more likely to adopt such behavior (small size, more noise trading, etc.). Indeed, from the social media/social platform and capital markets literature it is found that social media interactions reinforce various psychological biases in trading behaviour.

5. A global adoption scenario with multipolarization (Scenario 4) could create more opportunities for international risk sharing.

This may be the case if these CBDCs and GSCs are not correlated, either because the business cycle of the issuing country is out of sync, or because the unit of account of the GSC is not in sync with the Fiat currencies are different. Additionally, new types of safe assets with superior functionality may emerge, such as AAA-rated bonds denominated in GSC units of account but embedded in smart contracts with attractive risk hedging properties. They can provide opportunities for portfolio diversification and better hedges against idiosyncratic external risks facing countries. For example, small firms in commodity-exporting countries may have easier access to financial instruments to help them hedge against fluctuations in the prices of the goods they produce and export. However, the emergence of multiple CBDCs and GSCs may increase complexity while reducing various frictions. This can lead to fragmentation of established markets and official mechanisms for providing liquidity support, hampering the ability to hedge operations and thus exacerbating volatility.

D. International Reserves

1. Digitization can facilitate the cross-border use of currency, thereby Changing demand and supply for safe assets.

Although the U.S. dollar will likely remain the primary reserve currency for the foreseeable future, digitization can enable change to happen faster than previously envisioned. On the demand side, uneven rates of technological progress across countries or currency blocs, the emergence of alternative cross-border payment rails or the transfer of trade invoices and financial intermediaries denominated in CBDC or GSC could all reposition reserve currencies. On the supply side, new digital platforms have emerged and reached global scale in just a few years, providing alternative networks on which digital currencies can be used to stimulate post-launch adoption. Granting global access through a network of digital wallets could help credible CBDC issuers achieve a level of scale and market liquidity that was not previously feasible. The main difference is the potential higher scalability speed, and the possibility to reduce the transfer cost of the existing dominant currency network.

2. The adoption and use of CBDC and GSC may change the incentives for reserve holders and issuers.

The official sector uses reserves as a safe store of value with ready access to international liquidity. For reserve holders, the main drivers of the composition of a reserve currency are the size and creditworthiness of the issuer, the usefulness of the currency in trade and financial transactions (including foreign exchange intervention), and the inertia that enhances safety due to the coordination of beliefs. Anderson et al. (2020) compare these drivers in a new dataset of official reserve holdings and highlight the growing importance of financial linkages and inertia in explaining reserve currency shares. On the other hand, reserve issuers need to weigh the potential benefits and risks of using CBDC across borders. How these changes will depend on the impact of CBDCs and GSCs on the drivers of reserves in each case.

3. Adoption of CBDC or GSC for remittances (scenario 1) has limited impact on reserves as the scale of value for trade and financial transactions does not change.

In this case, CBDC or GSC can only be used as a channel to complete cross-border payments, and its value will not become an important relative price that affects economic decision-making. As a result, central banks rarely need to adjust the composition of their reserves.

4. More currency substitution triggered by CBDC or GSC (scenario 2) would lead central banks to increase foreign exchange reserves for precautionary purposes.

For reserve holders, increasing the likelihood of adoption of a foreign CBDC or GSC in trade and financial risk of exchange rate fluctuations, the reserves may be transferred to CBDC or GSC. Although the qualitative impact is similar to that of traditional currency substitution, a faster introduction of CBDC or GSC could reduce the inertia of reserve holdings observed so far. But confidence in reserve issuers, such as their ability to secure networks or provide emergency liquidity, remains critical. For issuers, the incentives to offer more safe assets may vary. If internationalization is a policy goal, issuers will at least partially adapt to changes in demand. Otherwise, higher demand could lead to a shortage of safe assets, which could lead to side effects such as lower risk premiums and higher leverage in the financial system (Caballero, Farhi, and Gourinchas, 2017).

5. Widespread adoption of GSCs with independent value scales (Scenario 3) could expose the gap between the profit motives of their private issuers and global monetary and financial stability Internal contradictions.

As GSCs and GSC-denominated safe assets become established in the global economy, central banks will want to hold safe GSC reserves. However, GSC issuers may have a conflict of interest in deciding the supply of reserves: the supply that satisfies demand may differ from the supply that maximizes the issuer's profits. Even under the current system, only a few central banks have currency swap arrangements, reducing the need for central banks to hold reserves. Private offerings could exacerbate the problem: it is unclear whether GSC providers will offer currency swaps to act as lenders of last resort, or how to prevent a chronic shortage of safe assets.

6. In Scenario 4, reserve assets may become more diversified as some CBDCs and GSCs become widely adopted and compete.

Farhi and Maggiori (2017) argue that while a lot of competition among reserve issuers is good in a multipolar system, too little competition can be harmful. For many reserve issuers, aggregate issuance is high but individual issuance is low, protecting the issuer's domestic financial stability. However, since there are few issuers, investors will quickly switch from one reserve asset to another, so coordination deteriorates, and with it, instability emerges. Carney (2019) argues that a “synthetic hegemonic currency” backed by a basket of CBDCs could reap similar benefits to a multipolar world by generating confidence in the underlying CBDC, thereby expanding the supply of safe assets.

7. In a multi-polar world, countries and The composition of reserves within countries may diversify, depending on the formation of currency blocs or competition among currencies within countries.

When a country adopts a single CBDC or GSC, the country's reserves will be primarily denominated in the value scale of its currency bloc. Conversely, the use of multiple currencies by residents can also diversify the reserve assets within the country.

This article is from a contribution and does not represent the opinion of Rhythm BlockBeats

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