Cryptocurrencies and their potential impact on central banking have sparked a policy debate on addressing their potential risks to the banking and monetary systems. By highlighting the functional similarities between bitcoin and central bank money (CeBM) and investigating the challenges that the potential wider adoption of cryptocurrencies can pose to central banks, my working paper discusses issuing central bank digital currency (CBDC) as a policy response to provide an alternative digital currency, which could aim at complementing, substituting or otherwise exerting a competitive force on cryptocurrencies by leveraging on its price stability. The economic rationales and various design features of issuing CBDC have been thoroughly investigated; however, legal treatment of issuing CBDC remains largely wanting. This paper is an attempt to narrow this gap by studying the potential legal challenges that the European Central Bank (ECB) may face in issuing its own CBDC.
In addition to the potential legal impediments to issuing CBDC as legal tender, the introduction of such a virtual currency by the ECB would beget potential effects that might either undermine the ECB’s mandate as well as its basic and ancillary tasks, or otherwise come into conflict with the constitutional constraints set by the EU primary laws on the ECB in employing its monetary policy tools. Such constitutional Rubicons would be crossed if issuing CBDC would lead to banking disintermediation and thereby put central banks in the position of allocating scarce financial recourses - namely credit - depriving commercial banks of their funding base and undermining their stability, and removing the existing constraints on the monetary policy operations.
First, if the design of the CBDC would entail disintermediated public access to the central bank balance sheet, in the absence of any other remedies, introducing CBDC would result in destabilizing consequences for the banking sector. This is because with the introduction of CBDC, if a commercial bank cannot compensate its customers for the extra counterparty risk inherent in bank liabilities or commercial bank money (CoBM), there would be no reason for depositors to hold balances with a commercial bank. Instead, commercial bank depositors would move substantial parts of their balances from their transaction accounts held with commercial banks to the central banks’ balance sheets. Deprived of customer deposits, commercial banks are likely to become highly dependent on the wholesale markets with higher interest rates and less stable funding (with short-term maturities), intensifying the maturity mismatch and liquidity problems in the banking sector, resulting in the banking sector instability. This impact would be highly likely in distressed times during which the depositors switch deposits from their commercial bank accounts to their CBDC account, facilitating a run from bank deposits to the safety of the CBDC, namely a ‘destabilizing flight to quality’. Such a consequence would be inimical to the European System of Central Banks’ statutory mandate of contributing to ‘the smooth conduct of policies pursued by the competent authorities relating to the prudential supervision of credit institutions and the stability of the financial system’. (See Article 127(5) of the Treaty on the Functioning of the European Union (TFEU)).
Second, the shrinkage in the bank deposits due to the disintermediated access to central bank books would curtail banks’ ability to make loans - at least under the fractional reserve theory of banking. As granting credit by banks amounts to decentralized creation of money or credit in the financial system, depriving the banking system of this function and providing the central bank with such a possibility may eventually lead to centralization of credit allocation under the control of central banks. This would be detrimental to the efficient allocation of credit in the economy and would undermine ‘the principle of an open market economy with free competition’, in accordance to which the ECB should act. (See Article 127 of the TFEU and article 2 of the Protocol (no 4) on the Statute of the European System of Central Banks and of the European Central Bank)
Finally, if the introduction of CBDC is simultaneous with abolishing physical cash and banning other forms of private money (such as cryptocurrencies), it would effectively remove the Zero Lower Bound (ZLB) constraint in the conduct of monetary policy. On the upside, this would furnish central banks with powerful tools for the conduct of monetary policy. However, on the downside, it would entail a de facto power of slashing CBDC deposits held with central banks. Although negative interest rates have proven to be effective even in the presence of cash, the existence of cash and other alternatives would create an effective lower bound and limit the depth of the negative territory a central bank can march in.
In addition, physical cash provides users with ‘irrevocable access to the payments system’. As payment systems are part of the financial market infrastructures (FMIs), account-based CBDC would ease revoking legal and natural persons’ access to such FMIs, giving rise to potential financial inclusion concerns. Financial inclusion risks have been partly addressed in the traditional payment services by the Directive 2014/92/EU (Payment Accounts Directive (PAD)), however, the PAD in its current form, may not be applicable to payment systems based on CBDC. In the event of introducing CBDC, it seems that the PAD needs to be amended to include access to CBDC. Otherwise, issuing CBDC would grant further censorship powers and exclusionary capacity to the state vis-à-vis individuals. Moreover, since CBDC is likely to be programmable – meaning that various smart contracts and features could be hardwired in them – it is likely that such a currency would give rise to privacy concerns, as it may erode the privacy and anonymity of users and grant additional surveillance powers to the state. This may justify higher levels of central bank public accountability, appropriate safeguards, and standards of judicial scrutiny.
To summarize, depending on the design features of the CBDC (for instance, value-based vs account-based, wholesale vs retail-oriented, interest-bearing vs non-interest bearing, etc), in addition to the technical issues, and potential transitional risks, the ECB would face legal risks in issuing such a currency. Unless appropriate safeguards are in place to protect citizens from the potential abuse of the absence of the ZBL constraint, to minimize the potentially destabilizing impact of CBDC on banking and financial stability, to allow the efficient allocation of credit in a decentralized manner, and to address the potential concerns about financial inclusion and privacy, issuing CDBC by the ECB is unlikely to pass muster with the existing EU constitutional constraints.
Hossein Nabilou is a postdoctoral researcher in Banking and Financial Law at the University of Luxembourg; Faculty of Law, Economics and Finance.