At the dawn of a new age

ISBN 978-615-5318-48-1

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The ‘digital competitors’ (global technology corporations also known as BigTechs) entering the market of financial services may produce the ‘digital rivals’ to national currencies through the digital means of payment they offer, which can fundamentally transform the monetary system as we know it today. Central banks also need to respond to this challenge.

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Our decade may see a radical acceleration of financial innovation. The rush for resources is already focusing on technological innovations. The digital wave changes the way our world operates, including not only sustainability and the green transformation but also a profound change in how people think about money.

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Without huge revolutions, we would not be who we are today. Inventions, social innovations and intellectual breakthroughs are all crucial in human history. There is little doubt that money is among the most significant social innovations. It has always been present in people’s lives, ever since humans started living in communities. When exchanging resources, the parties had to find a common way to measuring value. This can take the form of shells, rocks, tobacco, metals, paper or even today’s digital currencies.

MNB | AT THE DAWN OF A NEW AGE – MONEY IN THE 21ST CENTURY

AT THE DAWN OF A NEW AGE – MONEY IN THE 21ST CENTURY

2021

In the decade of financial revolution, central banks all around the world are looking at possible ways of introducing digital currencies, while the global role of central banks has changed completely. Some of them, for example the People’s Bank of China or the Swedish Riksbank, have made good progress in their projects related to the opportunities of introducing a central bank digital currency. These developments may help the financial inclusion of those who currently do not use banking services, making the access to money very cheap, super fast and safe for companies and individuals alike, and money could move across borders quicker than ever before. This could present a major challenge to cash.

At the dawn of a new age Money in the 21st century

At the dawn of a new age Money in the 21st century A study volume of the Magyar Nemzeti Bank on central bank digital currency

At the dawn of a new age - Money in the 21st century A study volume of the Magyar Nemzeti Bank on central bank digital currency © Magyar Nemzeti Bank, 2021 Edited by: Ádám Banai and Benjámin Nagy The editors would like to express their gratitude to Governor György Matolcsy, Deputy governors Csaba Kandrács, Mihály Patai and Barnabás Virág for their professional comments during editing.

Published by: Magyar Nemzeti Bank Szabadság tér 9. 1054 Budapest, Hungary www.mnb.hu

Prepress and printing: Prospektus Kft. ISBN 978-615-5318-48-1 2021

Contents Foreword 7 Introduction 9 Balázs István Horváth, Gábor Horváth: Global cash alternatives and their impact on the implementation of monetary policy

Zoltán Szalai: Monetary theory and international spillover aspects of digital currencies

Eszter Boros, Marcell Horváth: Digital renminbi – Taking the US–China geopolitical rivalry to a new level?

Péter Fáykiss, Anikó Szombati: The conceptual framework of central bank digital currencies 95 Dániel Felcser, Zsolt Kuti, Gergő Török: Digital turnaround in monetary policy? – The monetary policy aspects of central bank digital currencies

135

Anna Boldizsár, Kálmán Árpád Marincsák, Balázs Sisak, Daniella Tóth: Will the central bank digital currency be the new cash? – The place of central bank digital currencies in the monetary system

168

Zénó Fülöp, János Szakács, Péter Szomorjai, Balázs Varga, Márton Zsigó: Financial stability aspects of the introduction of a central bank digital currency

197

László Kajdi–Lóránt Varga: Effects of central bank digital currency on payments

247

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István Ádor, Péter Eigen, Zoltán Huszár, Zsolt Láda-Hartyáni, Szilvia Szécsiné Kardos, Róbert Taczmann: Key implementation issues of central bank digital currency in the light of infrastructure and operation 283 András Szabolcs Csonka, Bálint Danóczy, Péter Sajtos: Strengthening the financial inclusion of the retail segment through the use of central bank digital currency – Retail account servicing and opportunities beyond

318

Laura Komlóssy, Blanka Kovács, Soma Sándor: Options to extend SME financing through central bank digital currency

357

Acknowledgements 381

Foreword ‘Money is like a sixth sense without which you cannot make a complete use of the other five.’ William Somerset Maugham Without huge revolutions, we would not be who we are today. Inventions, social innovations and intellectual breakthroughs are all crucial in human history. There is little doubt that money is among the most significant social innovations. It has always been present in people’s lives, ever since humans started living in communities. When exchanging resources, the parties had to find a common way for measuring value. This can take the form of shells, rocks, tobacco, metals, paper or even today’s digital currencies. Our decade may see a radical acceleration of financial innovation. The rush for resources is already focusing on technological innovations. The digital wave is changing the way our world operates, including not only sustainability and green transformation but also a profound change in how people think about money. The ‘digital competitors’ (global technology corporations also known as BigTechs) entering the market of financial services may produce the ‘digital rivals’ to national currencies through the digital means of payment they offer, which can fundamentally transform the monetary system as we know it today. Central banks also need to respond to this challenge. In the decade of financial revolution, central banks the world over are looking at possible ways of introducing digital currencies, while the global role of central banks has changed completely. Some of them, for example the People’s Bank of China or the Swedish Riksbank, have made good progress in their projects

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Foreword

related to the opportunities of introducing a central bank digital currency. These developments may help the financial inclusion of those who currently do not use banking services, making the access to money very cheap, super fast and safe for companies and individuals alike, and money could move across borders quicker than ever before. This could present a major challenge to cash. In terms of developing and implementing central bank digital currency, artificial intelligence and several other technological innovations, China is leading the way, and therefore the 2020s may be about Asia. It is time for Europe to find its own solutions in renewing the financial system. Only those will be able to overcome the three major challenges of our century, namely geopolitics, technology and money, who manage to tackle all of them. Those who miss out on the financial revolution will also lose out in the other two. György Matolcsy

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Introduction On digitalisation and central bank digital currencies in general One of the most significant megatrends shaping our world today is digitalisation, which may get a massive push from the consequences of the coronavirus pandemic all over the world. Home office, digital education and online shopping, to name but a few examples, have become part of our everyday lives. Digital solutions are increasingly common in finance, just like in many other areas of life. This trend has already been observed in recent years, and it was accelerated by the special year of 2020. The challenges of the 21st century affect traditional financial institutions as well as national currencies. The traditional monetary system now has an alternative in the form of the ‘digital competitors’ entering the market of financial services. Building on their huge user base, comprehensive and detailed information on their customers and their capitalisation and technological power, the global technology corporations – the BigTech firms – can compete against traditional financial institutions. They may also produce the ‘digital rivals’ to national currencies through the digital means of payment they offer, which may fundamentally transform the monetary system as we know it today with high penetration and widespread use. One might wonder whether the new services appearing in the payment system entail risks to the efficiency of monetary policy, financial stability, the enforceability of consumers’ interests and the preservation of society’s confidence in national payment systems. What could be the appropriate response from central banks in the face of the challenges posed by the digitalisation of money?

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Introduction

The heads of leading central banks increasingly point to central bank digital currencies as a potential solution to these challenges. Some of them, for example the Swedish Riksbank or the People’s Bank of China, have made good progress in their projects related to this. These developments may serve several innovative purposes: they may foster the financial inclusion of those without access to banking services, promote the reduction of cash and provide a widely available, risk‑free means of payment even if cash is driven out. The concept of central bank digital currencies is based on creating a form of money that emerges as a fusion of its functions it has fulfilled for centuries and the opportunities offered by digitalisation in the modern age. Using the money issued by the central bank, just like cash, which is therefore completely risk-free but also digital, is thus simple, convenient and fast (Figure 1). Furthermore, the other parameters can be configured with considerable freedom to align them to the aim of the potential introduction as regards accessibility, the anonymity of this form of money, the role of traditional financial institutions and the technological operation of the payment system.

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Introduction

Figure 1: System of different types of money Digital

Central bank issued

Internet money Bank deposit

Central bank reserves and settlement account

Central bank deposit account

CBDC (only for a limited group of partners)

CBDC (universally accessible)

Virtual money

Cash

Widely accessible

Community money

Peer-to-peer

Note: The central bank deposit account indicates the case when non-bank participants may also place a deposit with the central bank. Internet money is a money that can be purchased in various online games but can be spent only within the game. Source: Bech, M. – Garratt, R. (2017).

The period after 2010 will go down in economic history, and the most important lesson from its achievements is that the key to major economic policy turnarounds is the familiarity with, and efficient implementation of new instruments and creative innovations.1 The same goes for money: the results of the monetary policy turnaround launched after 2013 can only be sustained, and possibly even enhanced further, if the financial

or more details on the fiscal and financial stabilisation after 2010 and the F reform of central bank policy, see the 2nd edition of György Matolcsy’s Economic Balance and Growth.

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Introduction

innovations entailed by digitalisation are embraced with the necessary caution. Based on our earlier study,2 the annual social cost of payment instruments amounts to close to 1.5 per cent of GDP. Of this, society as a whole could save around HUF 100 billion, if payment habits shifted towards a more modern approach using much less cash and no paper-based solutions at all. Therefore, both the opportunities and the risks of the new digital solutions that will shape the monetary system in the decades ahead need to be identified and explored. Due to the special significance of the topic, the MNB summarises the theoretical considerations, the most important practical issues and the international experience gained so far related to central bank digital currencies in a comprehensive book of studies. It presents the motives behind the potential creation of this new instrument and the opportunities offered by this new form of money, which may fundamentally transform the monetary system. Contents The first study presents what happens when the settlement asset of a country used in its national and international payments becomes non-domestically issued. Based on the potential ways for the expansion of the settlement systems built on Big Tech’s existing platforms and digital ecosystems and countries’ traditional dollarisation experiences, a new concept, digital dollarisation, is described. The second study presents three main analytical frameworks, listing the arguments for introducing central bank digital currency

urján, A. – Divéki, É. – Keszy-Harmath, Z. – Kóczán, G. – Takács, K. (2011): T Nothing is free: A survey of the social cost of the main payment instruments in Hungary

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Introduction

in different approaches. The challenges faced by central banks on account of private players increasingly offering various payment alternatives to traditional central bank currency are discussed, together with the possible alternative central bank digital currency solutions, while considering which should be chosen under what scenarios. The world has been enthralled by the potential of central bank digital currencies, and by 2020 China had come closest to implementing the concept. Since testing of the digital renminbi began, more and more details have become known about China’s financial innovation. The third study assesses the future of the world currency. A centralised e‑RMB suitable for direct payments is the most serious challenge to the USD and the United States’ power in recent decades. The actual catalysts behind the increasingly serious discussion about the introduction of central bank digital currency included technological progress, the rise in electronic payments as well as the appearance of private solutions addressing the anomalies in payment systems. The way how different countries introduce it, however, will vary considerably. The fourth study presents and categorises the public policy, economic and technological considerations that need to be taken into account when deciding on the introduction of central bank digital currency. The introduction of CBDC means that the central bank provides non-financial actors access to the assets or liabilities side of its balance sheet, or even to both sides. The fifth study discusses how central banks would gain a new monetary policy instrument for bridging money markets and directly influencing the behaviour of non-financial actors, if they implement the CBDC as an interest‑bearing asset. As a result of technological progress, digital solutions now offer a convenient and secure alternative to cash use, which may facilitate the successful introduction of central bank digital

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Introduction

currency. The sixth study describes the motives of cash demand that can be reduced by the appearance of central bank digital currency, and whether based on that it can be a substitute or complement to banknotes. The introduction of central bank digital currency can also have a positive impact on financial stability, by maintaining the competitiveness of the financial system and making a quasi-riskfree digital payment instrument available to participants in the real economy. At the same time, the new system can significantly transform banking business models. The seventh study presents the resulting new banking and systemic risks. The eighth study examines the aims and future development scenarios that may warrant the introduction of central bank digital currency from the perspective of payments; it provides an overview of the aims that may be relevant to Hungarian households and companies in their current payments situation; and it shows the effect the potential operating models may have on the payments market. Traditional infrastructures and future IT solutions are examined against the key criteria of reliability, transaction speed and costeffectiveness. When choosing the business model, the needs of potential users must be considered, and the cooperation between the central bank and participants in payments must also be planned. The ninth study looks at the considerations behind choosing the operating model and the technological solutions supporting it as well as the options for establishing the infrastructure and personnel conditions necessary for performing the central bank’s new tasks. The tenth study describes in detail the possible social objectives of the introduction of retail CBDC at the international level, as well as the main international examples where consideration has been given to the introduction of such a framework along the lines of specific public policy objectives. It then presents the design aspects

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Introduction

of a retail CBDC framework geared towards financial inclusion, drawing on the findings and design structure presented in the chapter outlining the conceptual framework. The eleventh study presents the likely design and operational aspects of a possible form of central bank digital currency that is focused on SMEs. A low-cost, secure alternative lending channel in the form of central bank digital currency can help the SME sector, which is important for economic growth, to realise its development potential across financial cycles.

References Bech, M. – Garratt, R. (2017): Central bank cryptocurrencies, BIS Quarterly Review, September 2017 Matolcsy, Gy. (2020): Egyensúly és növekedés (Economic Balance and Growth) – 2nd edition. Book series of the Magyar Nemzeti Bank, Budapest, 2020. Available at: https:// www.mnb.hu/kiadvanyok/mnb-szakkonyvsorozat/egyensuly-es-novekedes-2-kiadas Turján, A. – Divéki, É. – Keszy-Harmath, Z. – Kóczán, G. – Takács, K. (2011): Semmi sincs ingyen: A főbb magyar fizetési módok társadalmi költségének felmérése. (Nothing is free: A survey of the social cost of the main payment instruments in Hungary). Occasional Papers No 93, https://www.mnb.hu/letoltes/mt93.pdf

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I. Global cash alternatives and their impact on the implementation of monetary policy Balázs István Horváth – Gábor Horváth The study presents what happens when the settlement asset of a country used in its national and international payments becomes non-domestically issued. The history of central banks’ emergence will be described briefly, which gives a big picture about the aspects that are crucial in establishing an economy’s monetary sovereignty and stability. A couple of instances are listed for the gradual marginalisation of a country’s conventional currency as it was replaced by a dominant foreign currency (dollarisation).3 Then the discussion will turn to the large technological corporations, referred to as Big Tech, that have a profound influence over society’s social and economic relations, and the potential forms of the global money alternatives offered by them as well as such money alternatives’ significance in the transformation of the current financial system. Based on the potential ways for the expansion of the settlement systems built on Big Tech’s existing platforms and digital ecosystems and countries’ traditional dollarisation experiences, a new concept, digital dollarisation, is described. An important consequence may be that the monetary sovereignty of certain nation states is undermined, as the role of the dominant currency is increasingly taken over by one or more global digital alternatives (e.g. Libra). The main hypothesis of the paper is that a potential response to the appearance of the global money alternatives is to create a central bank digital currency and ensure that it is used widely by people, in terms of the number and volume of transactions.

he primary sense in which the concept is used here does not cover the T conscious joining of a currency area.

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I. Global cash alternatives and their impact on the implementation of monetary policy

1. The significance of money as a settlement asset in history Over the course of history, the emergence of central banks is related to the issuance of top-quality financial liabilities used for widespread clearing. A typical misconception in connection with the beginnings of central banking is that its history started with the Swedish or the English central bank. Bindseil (2020) shows that institutions already fulfilled public central banking functions in 16th-century Venice, Amsterdam and Hamburg, albeit not in terms of conventional interest rate policy. According to a definition by Potter (1650), one of the main functions of central banks is that they issue the highest possible quality of financial liabilities that are used widely by economic actors in the given empire for settlement.4 This was often underpinned by law, as discussed by Knapp (1905) in his State Theory of Money. Knapp’s initial statement is that money was created by the state, so its essence and real theory do not belong to the economy, but to law (Bánfi, 2015). This conforms to the view that money did not arise from barter, it rather coincided with the consolidation of the central power necessary for organising the first governments, empires and civilisations (see Hart, 2005; Graeber, 2011). As the so-called inside money appeared, the significance of the ultimate settlement asset, outside money, also increased. When the parties to a transaction start using each other’s debt as money, that is referred to as inside money. This can also be regarded as a natural part of the development of money (Kiyotaki−Moore, 2002), arising from the liquidity need entailing the surge in the number of real economy transactions, and increasingly enabled by the double-entry bookkeeping method that started to become popular towards the end of the Middle Ages. However, the stability of inside money relies heavily on

Cited by Bindseil (2020), in his book on the rehabilitation of central banking.

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I. Global cash alternatives and their impact on the implementation of monetary policy

outside money, as attested by today’s financial system (Huber, 2017). Bank deposits, which are currently used as money and which increasingly dominate the monetary aggregates, in other words, banks’ liabilities, can be considered inside money (Table 1). Nevertheless, interbank settlements are conducted in central bank money: earlier in the form of giro deposits and cash, nowadays mostly in the form of central bank deposit money, i.e. liquidity. The stabilising effect exerted by this on financial and monetary developments5 was recognised early, in 1401 in Barcelona, 1407 in Genoa, 1580 in Naples and 16th‑century Venice, for example when Banco di Rialto was established with similar central bank mandates as today (Roberds−Velde, 2014). Table 1: Different features of inside and outside money Inside money

Outside money

Linked to private actor

Legitimised by the sovereign, the state or the central bank

Financial liability, debt

Precious-metal content or legally binding force

Its collateral is only partly held in reserves

High-quality ultimate settlement asset

Created through lending

Arising in a sovereign manner

Source: Authors’ work based on ECB (2015).

I n itself, inside money, or private liabilities, can be considered stable depending on the quality of the assets side of the issuing institutions. However, when lending overheats, bank balance sheets expand procyclically, and the growth rate of credit and (inside) money exceeds that of the real economy (boom periods). These are typically followed by potentially dramatic downturns, with a credit crunch where the banking system struggles with liquidity and solvency problems amidst the numerous bankruptcies (bust periods). Yet an ultimate settlement asset supported by public confidence is vital for the functioning of the financial system and ensuring smooth payment transactions. Following countless bank runs in 19th‑century US and UK during the period of free banking, first the Peel Banking Act of 1844 was introduced with the cooperation of Ricardo, then half a century later, the Federal Reserve was established in the US, albeit by private institutions, and this improved the stability of money for a while.

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I. Global cash alternatives and their impact on the implementation of monetary policy

Over the past 500 years, central banks have become the issuers of the highest-quality ultimate settlement asset, and they typically have some public mandate attributable to the sovereign. In the past centuries, central banks have usually improved the efficiency and safety of certain financial areas, mainly by reducing the instability and unpredictability caused by private inside credit money. First, they helped clearing through account-keeping, using so-called giro deposits, and later they issued anonymous banknotes available to anyone to help economic actors. Without efficient and reliable clearing systems, the emergence of any other market or institution would probably have been more difficult. They also helped the state or the ruler of the region in reaching their goals, either directly, by creating money,6 or indirectly through their interest rate and exchange rate policy. Central banks’ mandate, and its public nature, is stipulated by law, along with their privileges. In two-tier banking systems, the central bank is the monetary pillar of sovereignty.

or example, the Ways and Means overdraft facility of the Bank of England F reserved for wartime, which was last used in April 2020, to support the liquidity of HM Treasury (OMFIF 2020). Although only temporarily, the Treasury gained access to the central bank’s overdraft facility to prevent the sudden liquidity shortage from leading to market disturbances (Bank of England, 2020). During the 2008 crisis, the available loan amount was close to GBP 20 billion, while the currently availably overdraft drawings are below GBP 0.4 billion.

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I. Global cash alternatives and their impact on the implementation of monetary policy

Monetary independence and social stability During wartime, countries caused enormous damage to each other by counterfeiting each other’s banknotes. The American Continental Congress, which sought independence from the British Empire, decided to print banknotes called Continentals in 1775, which were circulated along with British coins after ratification by each state. After the adoption of the Declaration of Independence, Congress made acceptance of the Continental compulsory, and Washington could incarcerate those who did not comply. At that time, the paper money circulated with a mere 5-per cent discount relative to the precious metal coins. However, the Brits started counterfeiting, printing and devaluing the Continental almost immediately to undermine the monetary leg of the independence process, and after 5 or 6 years, Continentals were worth onethousandth of their face value (Zarlenga, 2003). But by that time the Continental Army had already fought its decisive battle at Yorktown, with French help, and the newly independent United States returned to a monetary system based on bullion to restore the weakened economic confidence. The French assignat and the Chinese fabi fell foul of international political intentions with less favourable consequences. The printing of assignats started in the year of the French Revolution, and, in accordance with the National Assembly’s plans, they were backed by the land confiscated from the Church. Assignats managed to retain 80 per cent of their purchasing power in the first two years, however, in the absence of tax revenues, as the revolution spiralled out of control, its representatives entered into armed conflict with more and more European countries, and they started printing assignats. However, their output did not even come close to the 400 assignat forgers in London, who eventually flooded the continent with twice as many counterfeit assignats

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I. Global cash alternatives and their impact on the implementation of monetary policy

than the official amount in circulation. With the autocracy of Napoleon, the Banque de France was established, which stabilised the franc with a gold standard. The Chinese fabi banknote was introduced in 1935 in the newly formed Republic of China. Nevertheless, in the wake of the full-scale occupation following Japan’s aggression in Manchuria, confidence in the fabi evaporated, and its excessive printing to finance the wartime budget led to hyperinflation and ultimately the banishment to Taiwan and the emergence of the People’s Republic of China (Ku, 2014). Even the central banks established before the 1800s pursued some form of monetary policy. Their primary mandate was to create high-quality outside money as an ultimate settlement asset to be used by society and safeguard its stability, and this was typically part of their founding charter. Secondly, when necessary, they ensured the currency’s convertibility to bullion, determining the exact exchange rate and keeping it stable. Thirdly, thanks to the size of their balance sheets, they adopted flexibly enough to economic conditions, managing seasonality and balance of payments fluctuations. Fourthly, it can be determined whether the monetary impetus provided to the economy or the financial system was of discretionary expansive or restrictive nature, mainly to fulfil the first two functions. Nonetheless, these institutions did not follow a conventional interest rate policy in today’s sense, as most of them had to operate with an interest rate specified in their charter (Bindseil, 2020). Central banks had to tackle universal challenges even in the past centuries. Perhaps one of the most important challenges from within the given unit of sovereignty is related to the concept of central bank independence and non-democratic, technocratic operation. The idea of central bank independence also originates from the Middle Ages, and it expresses the ambivalence about the

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I. Global cash alternatives and their impact on the implementation of monetary policy

state as the ‘sponsor/owner’. Although the founding documents stipulate that central banks are institutions serving the public interest, public policy and philosophical discussions continue to revolve around the extent of state influence over central banks.7 Transparency and accountability are not always ensured with central banks, and sometimes they do not represent the basic values of democratic forms of government. Yet the most daunting challenge has been when the currency issued by them has gradually lost its penetration and significance to a foreign currency.

2. Driving out the national currency – The process and historical examples of dollarisation Traditionally, the greatest threat to monetary sovereignty is the process of dollarisation. In modern monetary systems, stronger international currencies that enjoy more confidence and are widely used may drive out national currencies, which is referred to in the literature as dollarisation, based on the experiences with the dominant US dollar. During dollarisation, the role of the national currency is taken over by the currency of an economically more advanced country. As the local currency’s importance declines, the central bank’s room for manoeuvre also shrinks, and it may lose control over monetary aggregates and interest rates. Thereby, the country loses its monetary sovereignty, becoming unable to influence the economic actors’ decisions through its interest rate and exchange rate policy, and, perhaps most importantly, it loses its ability to create money. 7

J ohn Law or Alexander Hamilton were in favour of the public interest, while Ricardo usually argued against excessive state influence in the 19th century, but he was against money creation by private banks. For more on this, see the debate Currency School versus Banking School, for example between Laina and Goodhart.

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I. Global cash alternatives and their impact on the implementation of monetary policy

Although dollarisation had occurred earlier, it became widespread in the late 20th century. With respect to the main driving forces behind it, dollarisation can be deposit-driven or occur on a carry-trade basis (Geng, Scutaru and Wiegand, 2018). During deposit-driven dollarisation, households hold most of their deposits in a foreign currency due to a loss of confidence in the local currency. This form of currency substitution was widespread in countries with substantial inflation or economic instability (Vígh-Mikle, Zsámboki, 1999). In such a situation, the local currency cannot fulfil its asset function, therefore it is not suitable as a store of value, which prompts households to keep their savings in a foreign currency, and transactions are gradually revalued to that currency. In extremes cases, the local currency may lose its unit of account function, when its value is so volatile that the foreign currency becomes the preferred means of payment, with most of the transactions conducted with that currency. Dollarisation can also happen formally, if a country introduces the currency of another country, possibly after an informal dollarisation process. During carry-trade dollarisation, the household and corporate sectors are indebted in foreign currency, principally due to the lower interest rate on the foreign currency as compared to the domestic currency, and this creates an open foreign currency position and thus a financial stability risk (Geng, Scutaru and Wiegand, 2018). An important difference is that while deposit-driven dollarisation requires a major loss of confidence in the national currency, widespread foreign currency lending can occur in less dramatic economic situations, in the absence of the appropriate prudential measures. In both forms of dollarisation, the national monetary policy transmission mechanism is weakened as the role of the local currency diminishes. For a long time, mainstream economics mainly emphasised the benefits of deposit-driven dollarisation for developing countries. In a hyperinflation environment, when the exchange rate of the currency continuously depreciates, large-scale or even — 23 —

I. Global cash alternatives and their impact on the implementation of monetary policy

complete dollarisation reduces the importance of the depreciating domestic currency and thus may help mitigate inflation, which has a stabilising effect. In the long run, the greatest economic benefit can be the drop in transaction costs (Alesina-Barro, 2001) if the country’s trading partners also use the currency in question for clearing. Another advantage may be the drop in funding costs (Cohen, 2000), through the spillover effect of the lower borrowing rates in the more advanced country and the mitigation of risk premium. In exchange for the advantages of dollarisation, nation states must relinquish their monetary policy sovereignty. The lack of an independent monetary policy, i.e. the loss of the interest rate and exchange rate policy, considerably reduces a country’s ability to respond to economic shocks. The diminished role of the central bank increases the vulnerability of the financial sector (Mecagni et al., 2015), which may also have real economy consequences. A significant result of dollarisation is that it is very difficult to reverse the process, and for a long time economists regarded dedollarisation, or the restoration of monetary independence, to be almost impossible (Jameson, 2003). After considering the consequences and the possible effects, several countries decided to dollarise, but in many cases dollarisation can progress a great deal without, or in spite of, the state’s intention. There are also precedents for de-dollarisation. The main components of the successful strategies usually involve macroeconomic stabilisation and the promotion of amassing savings in the national currency while restoring confidence in it, along with prudential measures, which can reduce FX lending (Mecagni et al., 2015). Successful de-dollarisation occurred for example in Poland and Israel,8 by using the above methods.

I srael experienced dollarisation in the early 1980s, on account of high inflation and the loss of confidence in the local currency.

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I. Global cash alternatives and their impact on the implementation of monetary policy

In the CEE region, Poland faced dollarisation challenges twice in recent decades. In the 1980s, the market-oriented reforms of the planned economy entailed high inflation, which led to substantial dollarisation as financial constraints were eased (Sahay and Vegh, 1995). Poland was among the early reformers, and at the end of the 1980s both inflation and dollarisation exceeded the levels seen in other transition economies. Due to the high uncertainty, Polish households kept merely 20 per cent of their bank deposits in złoty, and most deposits were denominated in USD (Mecagni et al., 2015). However, Poland managed to restore confidence in the national currency by rapid macroeconomic consolidation and exchange rate stabilisation, so the volume of dollar deposits was pushed down considerably in a couple of years. The de-dollarisation strategy also included the issuance of złoty-denominated bonds with favourable interest terms, which improved the attraction of the currency as a savings instrument. Later, continued financial liberalisation and the significant interest rate differential relative to advanced countries’ currencies led to a rise in FX lending in Poland, just like in Hungary, which is an example of carry-trade dollarisation. Widespread FX lending across an entire national economy poses risks to all the parties concerned (Kolozsi, Banai and Vonnák, 2015). In Poland, there are still tens of thousands of pending court cases between debtors and the banks on franc-denominated loans. In several countries, the state decided to engage in formal dollarisation after the process started to take hold among the population. For example in Ecuador, households started to keep their savings in USD at the end of the 1990s, in the face of strengthening inflation developments and the continuous depreciation of the Ecuadorian sucre (White, 2014). Ecuador’s president announced in 2000 that the USD would become the only legal tender to curb hyperinflation (Anderson, 2016). The decision was a sort of last resort, and IMF experts argued that the Ecuadorian economy was not ready for it, nevertheless

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I. Global cash alternatives and their impact on the implementation of monetary policy

dollarisation did have a significant stabilising effect in the short run (Fischer, 2000). However, despite dollarisation’s inflation-reducing effect in the short run, the lack of monetary policy independence has caused difficulties for Ecuador several times in the two decades since then. Still, most economists believe that the impact of dollarisation has been positive so far, and it is seen as the saviour of the Ecuadorian economy (WSJ, 2018), but the long-term effects are far from straightforward. In a country with huge oil exports, the independent movements in the dollar exchange rate have made it repeatedly difficult to for the economy to adjust (WSJ, 2015). While Ecuador’s dependence on external shocks is almost certain to persist, the reasons that necessitated dollarisation may not characterise the economy forever. Figure 1: Examples for dollarization in Europe In Liechtenstein, the Swiss franc has been the official currency since 1920, before that the Austro-Hungarian crown was used by the principality

The San Marino lira, pegged to the Italian currency, was replaced in 2002 by the euro, which the state can use under a monetary agreement with the EU

Andorra and the Principality of Monaco may use the euro under a monetary agreement with the EU

Neither Montenegro nor Kosovo is a member of the Eurozone, after their independence they unilaterally introduced the euro as a currency still valid today

Following the declaration of independence, Albania had no independent currency until the introduction of the Albanian Lek in 1926.

Introduced in the 19th century, the Cypriot pound has been stably convertible to one pound sterling for many decades

Source: Authors’ own editing based on the collection of Schuler (2005).

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I. Global cash alternatives and their impact on the implementation of monetary policy

3. Big Tech ecosystems – Digital challengers to national currencies National currencies are facing a new challenge in the 21st century, which can be best described as digital dollarisation. The increasingly globalised population of the developed world that has already experienced the IT revolution perceives national contours less and less, which is largely owing to corporations that are on a par with countries in terms of the number of their users and economic clout, and that are collectively referred to as Big Tech.9 These companies have a huge user base, technological solutions and their own ecosystem, which allows them to develop their own settlement asset. Potential consequences include the continued fragmentation of international payments, and if a global private currency gains monopoly, it may drive out existing national currencies, too (this is the so-called digital dollarisation). The rise of tech firms impacts almost all walks of modern life, reshaping the structure of the economy and a multitude of value chains. In the past two decades, as online payments emerged, the way how individuals and companies pay for products and services has changed considerably. Recently, with the widespread use of smartphones and mobile internet, an increasing number of electronic payment alternatives have become available not only in e‑commerce but also in traditional payment situations (ECB, 2019). New payment technologies have often been developed by incumbents in the financial sector, but in many cases innovative firms with an IT background used them to carve out a piece for themselves from the financial segment (ECB, 2019). As the new payment methods are mainly popular among younger, more tech‑savvy generations, electronic payments are expected to expand further. While electronic payments are on the rise, cash is on the decline all over the world. The revolution in electronic

Typical examples include Facebook, Amazon, Apple and Google.

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I. Global cash alternatives and their impact on the implementation of monetary policy

payments transformed transactions the most in China, where people, who had used cash for almost every transaction before, reduced the share of cash payments to below 50 per cent in ten years. Figure 2: The share of cash usage within all transactions 100

Per cent

100

India

Brazil

China

USA

Sweden

2010 2020 (estimation)

Source: Authors’ work based on McKinsey (2020).

As electronic payments and digital currencies become popular, digital dollarisation may pose a challenge to monetary policy sovereignty. Digital dollarisation refers to the process where a country’s currency is supplanted partly or completely by the currency of a digital platform (Brunnermeier et al., 2019). This phenomenon is in many respects similar to traditional dollarisation, but there are many differences in terms of their preconditions and consequences. Besides the forms of electronic payments that emerged earlier and use the traditional currencies of nation states as units of account, the appearance of bitcoin in 2009 ushered in an era of money not issued by central banks that can be used electronically, in direct peer‑to‑peer transactions (BIS, 2017). With the rise in cryptocurrencies, the believers in all things tech have increasingly started to maintain, albeit probably

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I. Global cash alternatives and their impact on the implementation of monetary policy

wrongly, that bitcoin or other cryptocurrencies may be able to take over the role of traditional currencies and replace cash (Berentsen and Schär, 2018). Based on the experiences so far with the cryptocurrencies currently in circulation, these forms of money pose only a minor threat to national currencies. Although thousands of cryptocurrencies are traded nowadays, bitcoin accounts for more than two-thirds of their market value (Assenmacher, 2020). Bitcoin spread after the 2008 crisis, partly as a result of shaken trust in traditional financial actors, as it was able to create a payment solution without a central actor, independent of the traditional banking system (MNB, 2018). Nevertheless, despite its enormous market capitalisation, bitcoin has not become a true challenger to national currencies. On the one hand, the number of bitcoin transactions is low considering that bitcoin was originally devised as a means of payment, and on the other hand the number of transactions peaked in December 2017 (Assenmacher, 2020), and no significant rising trend has been detected since then. The main reason for the low efficiency of bitcoin as a means of payment is the substantial volatility of its price. The price of the best-known cryptocurrency has fluctuated between USD 1000 and almost USD 60,000 since 2017, and it was hardly able to function as a currency with such volatility, and it became a speculative tech investment vehicle. However, cryptocurrencies with certain special features may be able to jeopardise monetary sovereignty. Years after bitcoin was born, a new subtype of cryptocurrencies, the so-called stablecoins were developed to create stable cryptocurrencies that can be better used as money. Stablecoins are digital currencies independent from national currencies that use some kind of stabilisation mechanism to minimise the fluctuations in their value relative to traditional currencies (ECB, 2020). The most basic type is the tokenised fund, in which the value of the coins is derived from

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I. Global cash alternatives and their impact on the implementation of monetary policy

an underlying fund. For example Tether, the stablecoin with the largest market capitalisation, works on this principle. It is a cryptocurrency pegged to the USD exchange rate, and its price has fluctuated between USD 0.99 and 1.01 in the recent period. The fact that despite stablecoins’ smaller market capitalisation, their trading volume comes close to other cryptocurrencies, which proves that the former are better suited for replacing cash (ECB, 2020). At the same time, based on current trading data, they are mostly traded against other cryptocurrencies, which suggests that currently their main functions is to safely store the income from trading volatile cryptocurrencies without leaving the cryptouniverse (ECB, 2020). This use can be regarded as the partial adoption of the means of hoarding function, even if the volumes are currently low. Although stablecoins are definitely more suited to fulfil the functions of money than other cryptocurrencies, decisionmakers only started to focus on them when Libra, the cryptocurrency developed by Facebook, was announced in 2019. A digital currency that may be able to compete with national currencies could be modelled on Libra’s features from many respects. The envisaged cryptocurrency’s price will be pegged to a basket of national currencies (Libra Association, 2020). The Libra White Paper, originally published in 2019, drew a barrage of criticism from regulators, and intensified efforts to develop central bank digital currencies (Auer, Cornelli and Frost, 2020). In response to the strong reaction from regulators, the second version of the Libra White Paper was published, and one of the main changes is that the project is now referred to as a ‘payment system’, which enables the use of stablecoins representing national currencies along with the Libracoin (Libra Association, 2020). The digital representation of the national currencies was no doubt added to the Libra project to alleviate fears about monetary sovereignty. This is because the inclusion of stablecoins

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I. Global cash alternatives and their impact on the implementation of monetary policy

tied to the value of national currencies in the project may mitigate the risk of Libra becoming a primary unit of account. However, due to the characteristics of the planned Libracoin, countries have every reason to regard it as a monetary policy challenge. With Facebook’s help, Libra can appear in a digital ecosystem with a huge user base, and reach wide swathes of society quickly. Although based on the second White Paper the current state of the project is definitely less of a threat to sovereignty than the original plans, it shows the potential peril caused to national currencies by a tech giant’s currency. Among tech firms, the companies that have established their own ecosystem deserve special attention. In 2020, six out of the seven corporations with the largest market capitalisation have their own digital ecosystem, which is their main source of revenue (McKinsey, 2020). The platforms of these tech giants expand in two directions. Horizontally, their user base grows as it includes more and more people, and vertically, they seek to increasingly meet consumers’ needs by offering more services, thereby deepening users’ integration in the network. For example Facebook can already use its internal ecosystem to act as a platform for conducting sales transactions and offering products, one only needs to think of Facebook Marketplace and other advertising platforms available on the social network. With the current huge user base and peer‑to‑peer nature of the social platform, it can be reasonably assumed that a massive number of transactions will be conducted in the ecosystem once the Libra project is implemented. Although officially Libra’s main mission is to provide financial services to those who currently have no access to them (Disparte, 2020, Central Banking), it can be inferred from the above that such a digital currency can rival national currencies. And from certain respects, Libra may only be the beginning, as companies with similar huge ecosystems can also develop their own currencies.

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I. Global cash alternatives and their impact on the implementation of monetary policy

Another tech giant, Amazon, also poses a great challenge to incumbent financial corporations. The company, which mainly focuses on e-commerce, has developed a wide range of financial services in the past decade: it engages in lending and insurance in cooperation with various financial and technology partners. Moreover, users have the option to hold a digital wallet and make cash payments that can be used in the Amazon ecosystem. Together with the existing huge user base, the platform’s developing financial services take it only one step away from designing its own digital currency. With respect to the functions of money, when a currency similar to the above is backed by a basket of currencies, it may be able to fulfil the store of value function. Furthermore, building on the widely used digital platform, it can easily perform the unit of account function as well. If transactions reach a critical mass, there will be no more question about suitability for the standard of value function or the independence and (unchecked) rise of the given digital currency. There is another feature that may make digital platforms able to fulfil financial functions, namely the amount of processable data available to them. An ecosystem based on interactions where users perform various activities may be the perfect setting for exploring consumer preferences when coupled with a payment function (Brunnermeier et al., 2019). By introducing its own currency, an ecosystem may even increase the number of transactions conducted on the platform, which generates further information for the company, and this allows it to meet users’ needs even more. When the growing amount of data goes hand in hand with the customer experience enhanced with its help, this can have a mutually reinforcing effect. The so-called digital dollarisation, i.e. the widespread adoption in a country of a digital ecosystem’s currency independent from a sovereign, can start with the internationalisation of the given

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I. Global cash alternatives and their impact on the implementation of monetary policy

means of payment. Over the course of history, currencies have been adopted internationally either by becoming international savings instruments, or by being able to fulfil an international means of payment function (Brunnermeier et al., 2019). The currency of a digital ecosystem can first spread due to its role in transactions, however, when coupled with the appropriate exchange rate stability, it may also be able to act as an international store of value. While traditional dollarisation, or mainly its deposit-driven version, usually threatened those countries the most where the local currency was unable to appropriately fulfil the means of hoarding function, the new aspect in digital dollarisation is that it can appear even in countries whose currency has a sound savings instrument function.10 In advanced countries with a stable currency, digital currencies can spread through the expansion of the transactions on the platforms (Brunnermeier et al., 2019). Digital dollarisation impacts monetary policy via various channels. If a popular digital currency becomes dominant as a savings instrument, it considerably transforms the banking system’s balance sheet through the reduction of retail deposits. First, a decline in retail deposits could lift banks’ funding costs and thus also lending rates (Assenmacher, 2020), and second, the monetary authority would be unable to fully control the interest paid on deposits. A cross-border digital currency can entail financial stability risks. Confidence in the digital currency may be undermined, which could lead to waves of redemption similar 10

hile the examples of traditional dollarisation usually included some W difference in the level of development between the currency donor and the currency host, the Big Tech alternatives born in the technological revolution may even lead to digital dollarisation in advanced economies. One of the drivers of this process may be the advantage arising from financial diversification, or the IT developments based on the existing institutional system (e.g. Internet of Things). However, the example of the Kenyan M-Pesa mobile payment system suggests that a less developed country can start using a global digital currency by leapfrogging with the help of cheap smartphones.

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I. Global cash alternatives and their impact on the implementation of monetary policy

to traditional bank runs (Assenmacher, 2020). The national central bank may increasingly lose control over monetary aggregates and have diminished influence over the interest rates experienced by economic actors, especially if a digital currency backed by a foreign currency or multiple foreign currencies becomes widely used. The above changes may impact several channels of monetary policy transmission, just like in the case of traditional dollarisation. A nation state can be deprived of three of its most important monetary capacities in this manner: its money creation and seigniorage income, independent exchange rate policy and independent interest rate policy. If all newly created marginal currency liquidity is dollarised into a tech currency by domestic economic actors, it may dramatically devalue the currency and exert an inflationary impact. In this context, quantitative easing (QE) measures, which can perhaps now be considered conventional, are unable to push down yields when they are denominated in the domestic currency. The effect of the interest rate channel on bank loans also diminishes, since most of banks’ marginal cost of financing will be in tech currencies rather than the domestic currency. The situation may escalate to a point where national central banks stop creating liquidity in the domestic currency, because it does more damage than the benefits or retained control provided by it. Taking into account the above risks, the criticism levelled at central banks for a long time applies even more to global tech giants’ money alternatives. The internal politically motivated objections to traditional central banks and the challenges faced them by are even more relevant when it comes to new global currencies. The former issue of central bank independence may arise in reverse in connection with global corporations: they may have excessive influence over certain digitally dollarised countries, as they have an impact on those countries’ interest rate environment and monetary aggregates. Moreover, transparency

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I. Global cash alternatives and their impact on the implementation of monetary policy

and accountability, as related to democratic principles, are hardly applicable in connection with a currency issued by a company (group) floating above states, in an IT cloud. Ensuring nation states’ monetary sovereignty and independence becomes very difficult or even completely impossible. This phenomenon can be combated with nation states’ constitution11 or by developing a potential alternative.

4. Central bank digital currency – A potential response to the challenge In modern monetary systems, the only live monetary link between the state and economic actors is through the banking system. Cash makes up an increasingly small share of the monetary aggregates in the economy, which nowadays are dominated by deposit money created by banks through lending. In accordance with its mandate stipulated by law, the central bank determines the interbank interest rate environment in a way that ensures that it sooner or later spills over to the central bank interest rates experienced by real economy actors via various channels. However, if commercial banks lag behind in the digitalization competition, they may even become circumventable (MNB, 2019). Consequently, if there is a change in hierarchy due to the gradual marginalisation of cash and the widespread use of Big Tech money substitutes appearing as alternatives to deposit money (hereinafter: tech currencies) (Figure 3and Figure 4), that

ation states already stipulate the country’s official unit of account in their N constitutions. This can be potentially complemented with an explicit ban, making, for example, the widespread use of Libra unconstitutional. The middle way can also be included in the constitution, where the unit of account and standard of value function of the national currency is clarified, just like its synthetic replication in global tech currencies: this allows the same amount of tech currency to be used as there is forint liquidity in the system, and the amount of the two can only grow together.

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I. Global cash alternatives and their impact on the implementation of monetary policy

may threaten the monetary independence of the central bank and the state as a whole. Therefore strengthening the monetary link between households, companies and the state may help avoid the external threat and assist the banking system in keeping its function of financial resources allocation. Figure 3: The process of disintermediation in today’s monetary systems Client A

Bank (lending, money creation, payments, wealth mgmt etc.)

Client B

BigTech Platform (Payments, e-commerce, social networks, etc.)

Client A

Ba nk

S vis upe or ry?

Client B

Cental Bank?

Source: Authors’ work based on Brunnermeier et al. (2019).

Disintermediation is merely the first step towards losing monetary sovereignty. As Figure 3 shows, the current bank-based financial system, where most financial services are ultimately conducted through banks, may gradually lose its bank-centred features. As Big Tech platforms start offering a wide range of increasingly popular services, the previously independent entities, such as commercial banks that grant loans as well as asset managers and central banks performing supervision, first merely fall lower in the hierarchy. Figure 4 shows how this process is demonstrated on balance sheets. When a critical mass flows into tech currencies, the structure of earlier monetary aggregates will reflect that, relegating the banking system into a sort of tech custodian function, while the central bank’s balance sheet gradually shrinks. Eventually, the red entities in Figure 2 may lose even their subordinate role and become completely marginalised

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I. Global cash alternatives and their impact on the implementation of monetary policy

or even go out of business on account of their vertically integrated functions. As monetary sovereignty faced new challenges with the spread of digital currencies, the possibility of introducing a central bank digital currency has become a priority for central banks. Central bank digital currencies are official legal tender issued by the central bank in electronic form, universally accessible and suitable for conducting peer‑to‑peer transactions just like cash (BIS, 2017). The central bank can use a universally accessible central bank digital currency and its interest rate to influence the economy directly (Assenmacher, 2020). Figure 5 shows how today’s universally accessible money (cash and deposit money) can flow into a central bank digital currency, which may even become a safe‑haven asset against a global stablecoin with a potential hegemony. Figure 4: Tech currency emerging within today’s two‑tier banking and monetary systems Banking system

Central Bank Assets

Liabilities

Assets

FX Reserves

Cash

Cash*

CB Loans

Liquidity

Liquidity Loans, securities Techcurrency

Liabilities CB loans and other long-term funding Retail and wholesale deposit money Custodian tech-funding

Note: Cash is held mostly by real economy actors and to a smaller extent on the assets side of the banking system, that is why it was shown to be smaller on the banking system’s balance sheet than on the central bank’s liabilities side. Cash and deposit money together comprise the M1 monetary aggregate, the most important one available to the real economy right now. Source: Authors’ work.

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I. Global cash alternatives and their impact on the implementation of monetary policy

The introduction of central bank digital currencies may transform today’s two-tier banking systems, too. Although twotier banking systems and the efficient system of decentralised allocation of credit (market-based lending) are not directly at risk, central bank digital currencies may lead to a profound transformation in modern monetary systems. Nevertheless, the introduction of a central bank digital currency would entail more direct monetary policy implementation and several other favourable effects by reducing the existing frictions in the economy, for example by mitigating counterparty risk or transaction costs (Barrdear and Kumhof, 2016) and ensuring less procyclical bank operation. However, a separate study should be devoted to the magnitude of the transformation in the banking system and its financial stability implications, and these will be discussed later in the book. By setting the interest rate on the central bank digital currency, central banks can implement direct monetary policy transmission. If the central bank digital currency is ‘priced’ attractively enough in the prevailing interest rate environment, that may be favourable to households and also determine the floor of the interest rate corridor on the money market for institutional investors. Moreover, the interest rates experienced by real economy actors are outlined much more clearly, and bank interest rates need to quickly adjust accordingly, first on the deposit side, then on the lending side. Furthermore, the conventional monetary policy that loses its efficiency due to the interest rate set by modern advanced central banks around 012 may get a new instrument: if necessary, a slightly negative interest can be introduced for its

his is the so-called ZLB or zero lower bound, a sort of liquidity trap. Since T cash does not bear interest, it represents an implied interest rate floor at 0, and central bank’s more aggressive attempts at pushing rates below 0 may lead to cash hoarding. Some economists see the solution in central bank digital currencies, while others would introduce ‘helicopter money’, i.e. directly print money.

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I. Global cash alternatives and their impact on the implementation of monetary policy

new asset, thereby stimulating economic interactions (BIS, 2018). This is further discussed in another study of this book. Figure 5: Tech currency appears beside the introduction of CBDC Central Bank

Banking system

Assets

Liabilities

Assets

FX Reserves

Cash

Cash*

CB Loans

Liquidity

CBDC

Loans, securities Techcurrency

Liabilities CB Loans and other long-term funding Retail and wholesale deposit money

Nonetheless, the main motivation for central banks to introduce a central bank digital currency may be the preservation of nation states’ monetary sovereignty. If the legal tender is universally accessible in electronic form, that allows the national currency to remain the main unit of account even in a fully cashless society, even if new digital assets become widely used (Brunnermeier et al., 2019). This would leave the theoretical possibility of the ultimate capacity to reflect monetary sovereignty, namely the privilege to create money, in the hands of the state. As nation states determine the national currency in their constitution (in Hungary it is the forint), its electronic conversion could be governed by an agreement between the sovereign monetary authority and the global money issuing

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I. Global cash alternatives and their impact on the implementation of monetary policy

Big Tech firm. If the potential cooperation with future tech currencies is taken into account while designing a central bank digital currency, the constitution can be amended to lay down convertibility conditions for using a tech currency in the given country. To facilitate this, the platform would also accept the country’s digital currency used by the citizens of the country or within the country’s geographical borders. This would greatly reduce the chances of a digital dollarisation forced by the public, and the platforms may also find it positive that they are used more extensively due to convertibility (Brunnermeier et al., 2019). Preventing the growing fragmentation of international and national settlement assets probably carries both economic and geopolitical significance. The competition between large tech currencies (Facebook, Apple, Amazon, Google) on a market basis, in a Hayekian sense, does not necessarily promote the development of interoperability. This could lead to further fragmentation and a competitive disadvantage in the global economy, which calls into question the efficiency-improving effect of these platforms. And it may also lead to geopolitical conflicts, one only needs to think of today’s trade and currency war between China and the United States. Nation states’ central banks can become facilitators in this process by developing a central bank digital currency, thereby preserving their own independence and the economic advantages arising from technological progress foreseen today.

References Alesina A.–Barro R. J. (2001): Dollarization. American Economic Review, American Economic Association, Vol. 91(2), pp. 381−385, May. Anderson A. (2016): Dollarization: A Case Study of Ecuador. Journal of Economics and Development Studies June 2016, Vol. 4, No. 2, pp. 56−60. Assenmacher K. (2020): Monetary policy implications of digital currencies. SUERF Policy Note Issue No 165, May 2020, SUERF −The European Money and Finance Forum

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I. Global cash alternatives and their impact on the implementation of monetary policy Auer R.–Cornelli G.–Frost J. (2020): Covid-19, cash, and the future of payments. BIS Bulletins 3, Bank for International Settlements. Bánfi, Tamás (2015): Pénzügypolitika és pénzelmélet (Monetary policy and monetary theory). Cenzus, Budapest, 2015 Bank of International Settlements (2018): Central bank digital currencies, Committee on Payments and Market Infrastructures, https://www.bis.org/cpmi/publ/d174.pdf Bech M.−Garratt R. (2017): Central bank cryptocurrencies. BIS Quarterly Review September 2017 pp. 55−67. Berentsen A.–Schär F. (2018): The Case for Central Bank Electronic Money and the Non-case for Central Bank Cryptocurrencies. Federal Reserve Bank of St. Louis Review 100 (2), pp. 97−106. Bindseil, Ulrich (2020): Central banking before 1800 – A Rehabilitation, Oxford University Press, 2019 Brunnermeier M., K.–James H.–Landau J.-P. (2019): The Digitalization of Money. NBER Working Paper No. 26300, National Bureau of Economic Research Central Banking (2020): Libra’s Disparte on bigtech’s move into digital currency. Central Banking, 28.04.2020, Interview with D. Disparte, https://www.centralbanking. com/fintech/cbdc/7533891/libras-disparte-on-big-techs-move-into-digital-currency Cohen B. J. (2000): Dollarization: Pros and Cons. Paper prepared for the workshop. “Dollars, Democracy and Trade: External Influences on Economic Integration in the Americas”, Los Angeles, CA May 18, 2000 European Central Bank (2019): Implications of digitalisation in retail payments for the Eurosystem’s catalystrole European Central Bank (2020): Stablecoins: Implications for monetary policy, financial stability, market infrastructure and payments, and banking supervision in the euro area. ECB Occasional Paper Series No 247 / September 2020 European Central Bank (2015): What is money?, https://www.ecb.europa.eu/ explainers/tell-me-more/html/what_is_money.en.html Fischer S. (2000): Ecuador and the IMF – Address by Stanley Fischer. Edited version of the speech given at the Hoover Institution conference. Ehttps://www.imf.org/en/ News/Articles/2015/09/28/04/53/sp051900 Geng N.−Scutaru T.−Wiegand J. (2018): Carry Trade vs. Deposit-Driven Euroization. IMF Working Paper No. 18/58, International Monetary Fund Graeber, David (2011): Debt: the first 5000 years, Melville House Publishing, 2011 Hart, Keith (2005): Money – one anthropologist’s view, in J. G. Carrier (ed) A Handbook of Economic Anthropology (Cheltenham: Edward Elgar Publishing, 2005), pp. 160–175., https://thememorybank.co.uk/papers/money-one-anthropologistsview/ Huber, Joseph (2017): Split-circuit reserve banking – functioning, dysfunctions and future perspective, real-world economic review, 80.,http://www.paecon.net/ PAEReview/issue80/Huber80.pdf

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I. Global cash alternatives and their impact on the implementation of monetary policy Jameson K., P. (2003): Is It Possible to De-Dollarize?: The Case of Ecuador. International Journal of Political Economy, Vol. 33(1), pp. 42−60. Knapp, Georg (1905): The state theory of money, Simon Publications Inc., 2003 Kolozsi P., P.–Banai Á.–Vonnák B. (2015): A lakossági deviza-jelzáloghitelek kivezetése: időzítés és keretrendszer (Phasing out household foreign currency loans: schedule and framework). Financial and Economic Review, Vol. 14 Issue 3, September 2015, pp. 60–87 Ku, Stanley (2014): Helicopter Money – History and suggestions about the Power to Print Money, Just& Open Publishing, Hong Kong, 2014 Magyar Nemzeti Bank (2019): A Jövő Fenntartható Közgazdaságtana (Long-term Sustainable Econo-mix). Book series of the Magyar Nemzeti Bank on economics and monetary policy, Budapest, 2019. Available: https://www.mnb.hu/en/publications/ mnb-book-series/long-term-sustainable-econo-mix Magyar Nemzeti Bank (2018): Bankok a történelemben: innovációk és válságok (Banks in History: Innovations and Crises). Book series of the Magyar Nemzeti Bank on economics and monetary policy, Budapest, 2018. Available: https://www.mnb.hu/ en/publications/mnb-book-series/banks-in-history-innovations-and-crises McKinsey & Company (2020): Accelerating winds of change in global payments. Available at: https://www.mckinsey.com/industries/financial-services/our-insights/ accelerating-winds-of-change-in-global-payments McKinsey & Company (2020): Ecosystem 2.0: Climbing to the next level.,https://www. mckinsey.com/business-functions/mckinsey-digital/our-insights/ecosystem-2-point0-climbing-to-the-next-level# Mecagni M−Corrales J.−Dridi J.−Garcia-Verdu R.−Imam P.–Matz J.–Macario C.– Maino R.–Mu Y.–Moheeput A.–Narita F.–Pani M.−Torres M. R.–Weber S.–Yehoue E. (2015): Effective De‑Dollarization Strategies. In: Dollarization in Sub-Saharan Africa Experience and Lessons, International Monetary Fund, pp. 42-58. Potter, William (1650): The Key of Wealth, Kessinger Publishing, 2010 Ratna, S.–Végh, C. (1995): Dollarization in Transition Economies: Evidence and Policy Implications (September 1995). IMF Working Paper No. 95/96, International Monetary Fund Roberds, William-Velde, Francois R.: Early Public Banks (February 11, 2014). FRB of Chicago Working Paper No. 2014-03, https://ssrn.com/abstract=2399046 Schuler, Kurt (2005): Some Theory and History of Dollarization, Cato Journal, Vol. 25, No. 1 The Libra Association (2020): Libra White Paper v2.0,https://libra.org/en-US/whitepaper/ The Wall Street Journal (2015): Cheap Oil and Strong Dollar: Ecuador’s Twin Troubles. The Wall Street Journal, 2015. 11. 23.,https://www.wsj.com/articles/cheap-oil-andstrong-dollar-ecuadors-twin-troubles-1448320496

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I. Global cash alternatives and their impact on the implementation of monetary policy The Wall Street Journal (2018): The Dollar Rescued Ecuador. Can It Save Venezuela? The Wall Street Journal, 2018. 03. 27.,https://www.wsj.com/articles/the-dollar-rescuedecuador-can-it-save-venezuela-1522152001 Vígh-Mikle, Sz.−Zsámboki, B. (1999): A bankrendszer mérlegének denominációs összetétele 1991-1998 között (Denomination Structure of the Balance Sheet of the Hungarian Banking Sector, 1991-1998). MNB Working Papers, 1999/9, Magyar Nemzeti Bank White L., H. (2014): Dollarization and Free Choice in Currency. GMU Working Paper in Economics No. 14-44, George Mason University Zarlenga, Stephen A. (2002): The Lost Science of Money: The Mythology of Money − The Story of Power. American Monetary Institute.

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II. Monetary theory and international spillover aspects of digital currencies Zoltán Szalai The possibility, potential ways and necessity of introducing a central bank digital currency are influenced by the framework in which money itself is interpreted. The same goes for the role and features attributed to it, and the framework in which the operation and principal mechanisms of the financial system are analysed. The study presents three main analytical frameworks, listing the arguments for introducing a central bank digital currency in the different approaches. The challenges faced by central banks on account of private players increasingly offering various payment alternatives to traditional central bank money are discussed, together with the possible alternative central bank digital currency solutions, while considering which should be chosen under what scenarios.

1. Traditional, textbook approach or transaction approach In the traditional, textbook approach, money is primarily a technical instrument that facilitates the exchanging of goods and services but is otherwise neutral from the perspective of real economy developments. The two other aspects, the standard of value and store of value functions, arise from and support the transaction function. This theoretical framework assumes that money has evolved as a result of horizontal exchanges, through spontaneous selection over the centuries, and that it operates

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II. Monetary theory and international spillover aspects of digital currencies

based on convention.13 As the number of commodities and commodity owners taking part in the exchange of goods increases, it becomes increasingly difficult for the sellers of the commodities to find the partners that need their specific commodity but have a surplus of the exact commodity that the sellers need. The bottleneck in this double coincidence of wants is eliminated by finding a commodity that everyone is willing to exchange their surplus for, and this intermediary medium facilitates sales and purchases, in other words exchanges. The proponents of this socalled transaction approach maintain that money’s purchasing power, or price stability, can be maintained if money is available in the exact amount necessary for trading and the demand for holding money. Earlier, this was ensured by bullion, and even though initially such a medium of exchange had its own intrinsic value, in its monetary function it did not circulate based on that, but rather based on its increasingly divergent face value or representative value: intrinsic value fell short more and more of the face value that it had initially equalled, due to wear and tear and often intentional debasement. The money necessary for trading is ensured by the fact that money turns into bullion if its available in too large quantities, while on the other hand earlier savings return to circulation if there is too little money to conduct the necessary trade in goods and services. As the representative value and intrinsic value increasingly diverged, it turned out that the bullion money in circulation can be replaced by claims on itself, i.e. currencies. This led to the emergence of currencies that were traded in lieu of bullion money, and whose purchasing power was ensured by bullion’s convertibility to money. In the case of modern currencies, issuing central banks do not guarantee such convertibility any more. They merely promise that prices will remain stable on account of the central bank’s price stability policies, and that money will retain its purchasing power. According to the traditional 13

ECB (2015)

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textbook explanation, this stability is achieved by approximating the mechanism described briefly above, and ensuring that the exact amount of money necessary for that is in circulation, in other words, central banks need to imitate well the operation of earlier bullion money and money substitutes convertible to bullion money. In this approach, any instability in prices and money’s purchasing power is caused by external shocks (e.g. natural disasters, wars), or in the absence of those, misguided central bank (or government) policies. This may be due to a flawed economic policy approach or intentional economic policy manipulation (time inconsistency). Instability can also occur in the financial system if financial intermediaries suddenly face mass withdrawals of money (deposits, savings). Since financial intermediaries, in particular banks, are unable to recall the loans at the pace of deposit withdrawals, they are potentially vulnerable.14 Such situations may arise at any time, because in practice banks are always illiquid on assets (lending), and rational depositors are aware of this. Depositors are only held back from making a run on banks because they expect others to be similarly restrained.15 Since a run on banks is expensive (it requires time and energy, for example existing deposit agreements need to be terminated, which entails a loss of interest, and the deposit needs to be converted into cash or transferred to another bank etc.), people only pay this price if there is a reason for it (for example a potential bank run). To reduce this risk, one bank, the central bank, stands out from the rest, and it stops the panic as a lender of last resort by providing liquidity in such cases. Nevertheless, the government may make mistakes even in such a scenario, for example if private actors count on a bailout and are thus careless in lending (moral hazard).

Diamond and Dybvig (1983)

White (1999)

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The creators of the digital currencies or cryptocurrencies initiated by the private sector view the operation of the traditional financial system and financial intermediaries in almost exactly the same way. In contrast to the government (central bank) that ‘arbitrarily determines’ the money supply, they build their business model on the promise that they create money based on rules, which will therefore be more stable on account of its natural scarcity. The digital assets offered by the private sector create decentralised, unmediated, peer-to-peer links between those seeking and offering money. This is cheap transaction money, the purchasing power of which is ensured by the rule-based supply free from government intervention, and which is therefore also a savings instrument with a store of value function. The distributed ledger technology used for these assets enables safe and controlled transactions without a central governing body or player.16 In this approach, the risks identified by central banks and governments are similar to those observed in the case of various investment funds and securities intermediaries in the traditional (non-digital) financial sector.17 With these financial intermediaries, the main risk is that they may lose customer assets due to negligence or intentional theft. It is similar to the risk linked to deposits at banks, credit institutions or savings banks, invested by these financial intermediaries in illiquid instruments, making withdrawals difficult in a bank run. An important difference compared to banks that extend illiquid loans but are required to pay back the nominal value of deposits is that investment funds do not undertake the nominal obligation against customers that banks do, they simply guarantee that the money is invested in the assets specified by the customer. The related asset price risk is borne by customers, therefore investment funds’ assets and

See Chapter 9.

Lo (1986), Szalai, Z. (1998)

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liabilities side move in tandem with market rates. They can sell the securities at market prices, and that is all they owe to customers. As pointed out by several renowned experts,18 regulation is needed in the case of private digital assets that conforms to the regulation of the current traditional players if the related activities are also similar. This is intended to prevent the emergence of areas not covered by regulation and undue competitive advantage for any player. The potential effects and government responses can also be derived from this: – Consumer protection – managing risks arising from the negligent management or theft of customers assets, insufficient customer knowledge (lack of familiarity with the products), data protection; – Fight against money laundering and terrorist financing; – Depending on the assets’ popularity, it may also have macroeconomic consequences, for example if many people lose their savings, or, like in the case of the volatile bitcoin, assets are underpriced or overpriced, and this influences private actors’ consumption and investment behaviour; – It is important to monitor, regulate and, if necessary, limit the exposure of the traditional financial sector to this ‘alternative’ sector (this is analogous to the regulation of the relationship between banks and other financial intermediaries on the one hand, and banks and the shadow banking system on the other hand); – They compete with the traditional financial sector on the liabilities (deposit) side by offering alternative depositing opportunities, which may lead to financial instability;

Cœuré (2019)

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– Depending on the assets’ popularity, the effect of monetary policy (transmission) may be weakened.

2. Modern central bank or endogenous money theory approach The great financial crisis and the subsequent quantitative easing policies highlighted the unsatisfactory or, better yet, misleading nature of the traditional textbook, transaction-based approach more than ever before. Probably because of this, certain major central banks uncharacteristically considered it necessary to point out the mistake in the textbook approach.19 The most important shortcoming of the earlier textbook approach is that it depicts the financial system as a passive, neutral sector (or veil), i.e. as a financial intermediary that merely passively mediates savings to borrowers, facilitating the trade in commodities. This method disregards banks’ distinguishing feature that they lend out not only the deposits held by them, but also in excess of that. According to the new approach, the real limit to lending is the credit demand of borrowers with the appropriate creditworthiness and banks’ compliance with the capital requirements. Money is created during lending, when banks obtain a claim against the borrower, and at the same time record a deposit of equal amount on the liabilities side of their balance sheet. This approach leaves no room for the ‘oversupply of money’ explanation, which is a crucial element in the traditional theory regarding the instability of prices and money’s purchasing power. Money cannot be in oversupply relative to its demand, 19

ederal Reserve Bank: Carpenter and Demiralp (2010), Bank of England: F Nealy et al. (2014), Deutsche Bundesbank (2017), EKB: Ulrich Bindseil (2014), Magyar Nemzeti Bank: Ábel et al. (2016). They practically acknowledged the endogenous money theory represented and developed earlier by postKeynesian economists working based on Káldor et al. For more on this topic, see also Bánfi (2016).

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because by definition it is created endogenously, as a by-product of lending, in response to the demand for loans or money. In fact, additional banknotes and coins usually enter circulation through the conversion into cash of the bank deposits that arise together with the bank loans. By contrast, excess money can be created in the sense that aggregate demand, supported by lending, may exceed the economy’s potential output (macro-level overlending) or borrowers’ repayment ability (micro-level overlending, excessive credit risk). In other words, in the modern central bank approach, the assets side of banks’ balance sheet is considered risky from a monetary and financial stability perspective. Money is not seen as neutral, it is attributed a major macroeconomic effect: banks lending activities profoundly influence aggregate demand and its distribution by sectors, thereby enabling economic growth itself, which requires increased money supply. Risks arise if credit growth is too fast compared to the growth rate of potential output. Nonetheless, an appropriate amount of lending is necessary, otherwise output could only increase in the context of deflation, which is unviable due to the mass bankruptcies. Another possibility is that the private sector creates ‘money’ spontaneously,20 for example by B2B lending or ‘circular indebtedness’, which also leads to financial vulnerability. Government policy aims to provide the necessary amount of credit (money) and prevent overlending. This is heavily influenced by the government’s regulatory policy (regulated versus liberalised financial systems). In the modern central bank or endogenous money theory approach, the liabilities side of banks’ balance sheet, the main focus of the traditional approach, is considered less critical from a macroeconomic perspective. This is because liquidity strains and mass deposit withdrawals are regarded manageable with 20

Gurley and Shaw (1960)

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the best practices and institutionalised solutions developed in the past. These are exactly those that were mentioned in connection with the transaction approach. Since commercial banks operate the system of integrated payments, and liquidity problems at any of them may hamper the operation of the entire system, commercial banks initially supported any bank threatened by deposit withdrawals by providing liquidity to it to prevent such a scenario from materialising. They could do this all the more so because depositors usually placed the withdrawn deposits at another bank rather than hoarding cash. Later, to prevent conflicts of interest among banks, one bank rose above the others to act as a non-profit central bank and abandon its commercial activities, turning into a bank for banks overseeing financial stability and payments. As a result, modern financial systems are rarely faced with a bank run identified in the traditional approach, i.e. a bank failure due to mass deposit withdrawals, which characterised the 19th‑century US with its fragmented banking system, before the nationwide integrated payment system and the Fed were established. The modern central bank theory is broader than the transaction approach, as it contains the latter, complemented by the former’s focus on the modern banking system’s distinguishing features. Thanks to this, it takes into account a much broader range of risks and correlations in banking activities than simply the liabilities side of banks’ balance sheet. The potential risks identified by central banks and prudential authorities in connection with private digital assets and the measures for managing them can be derived from this: – The consumer protection and microeconomic risks mentioned at the transaction approach and the need for their regulation applies in this approach as well. – Just as modern commercial banks’ lending exceeding their deposits arose as an extension of their financial intermediary

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activities (deposit taking, asset management), the players initially declaring to create digital money for transaction functions only may start lending over time. Allowing lending may have a similar profound effect on macroeconomic (price) stability and financial stability as in the case of bricks-andmortar banks (see the 2008 Great Recession). In such a case, an operating licence and prudential requirements similar to those applying to banks should be stipulated for these players. – They may compete with the traditional banking system in lending too, threatening with a loss of market share and financial instability, if they can provide cheaper services using a credit assessment system based on artificial intelligence and exploiting the huge databases available to them for free. – These actors’ massive participation in lending may narrow the scope of central banks’ macroeconomic and financial stability policies, thereby limiting their effectiveness.

3. ‘Sovereign money’ approaches focusing on the role of the state A common characteristic of the theories of money focusing on the role of the state (sovereign) is that they trace back the emergence of money to intentional efforts of the political community, and they treat money as a vital part of sovereignty. The state defines money itself, regulates its supply and guarantees its acceptance in the transactions with the state, in tax payments and penalty payments, and the obligation to accept the money also covers private transactions. In this approach, spontaneous market transactions cannot generate a commonly accepted currency as in the transaction approach, here it is rather the other way around: the money defined by the sovereign enables the widespread division of labour on the market, which can arise through the use of money. This approach cites a historical precedent, namely that when — 52 —

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medieval banks managed different kinds of money, they recorded debts and receivables in various currencies, but the conversion rate between the currencies and also the settlement currency were often determined by a sovereign, the state or a prince, applying mainly, but not only, to the transactions with the sovereign.21 Other advocates of this approach underline the role of the state’s taxation capacity in the definition and acceptance of money. Formally and in terms of accounting (cf. also constitutionally, e.g. USD, see Desan (2014)), money is recorded as state debt, and it is accepted in payments on the debt against the state. Even in ancient Rome, the state determined what could be used as money. In ancient Babylon, the state defined money, whose value was guaranteed by state acceptance. A common streak in these types of money is that their purchasing power is derived from state or institutional acceptance and the enforcement of this acceptance by the state, therefore they do not have to have intrinsic (material) value or be convertible. The state provides certain services22 in exchange for money (protection, i.e. night-watchman state, complemented in modern times with welfare state services, such as education, healthcare). Money is far from neutral: beyond its economic impact, it also has a political and community character. It draws a line between private and community areas (e.g. welfare services). The approach focusing on the ‘state as a service provider’ emphasises consensus, while the approach focusing on taxation emphasises coercion between the sovereign and private actors. Accordingly, the democratic or autocratic nature of the state determines whether money operates democratically or autocratically. The supporters of private digital currencies highlight such currencies’ democratic nature free from oppression and state intervention. This optimism does not seem to be corroborated by the experiences from recent years. Since

Kregel (2016)

Aglietta (2016).

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the networked nature of the financial system is conducive to monopolisation, nowadays an increase can be seen in the market share of large, concentrated corporations that already enjoy a monopoly in other areas, instead of the rise in alternative, fragmented and competing service providers (fintech firms).23 In contrast to states, these large service providers (Big Tech) do not operate democratically, not even in principle, but rather as private limited companies. The sovereign theories of money focusing on state or constitutional origins and roles are the natural continuation of the approach developed by post-Keynesians. It has already been shown how the central bank arises from among commercial banks to ensure financial and monetary stability. The approaches that emphasise the role of the state take this one step further and point out that the stability behind the central bank is provided by none other than the state, with its own funds (taxation capacity) and state legislation. Central banks are often also legally state property, and for this very reason they are backed by the state, since their funds are also owned by the state. Even if they formally have their own funds, those are provided by the state (including the authorisation to collect funds, for example in the form of collecting interest from transaction partners). A less well-understood role of the state is that it authorises banks to lend in excess the amount of their deposits. Thereby money defined by the state is created, and the state guarantees its acceptance. The state only allows this for institutions with a banking licence. It expects banks to operate prudently, and in exchange it ensures that the money created by them is accepted. The most obvious role played by the state (central bank) is in the payment system. Beyond that, the state usually bails out banks in some form if the need arises, although the old owners may lose their ownership, and it guarantees depositors’ money.

BIS (2020c)

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Deposit insurance was originally created to protect small depositors, as part of the development of modern commercial banks’ regulatory framework in the wake of the 1929–1933 Great Depression.24 The goal was to provide a simple and cheap solution for money with a transaction function on the one hand, and a short-term, risk-free form of saving for households, while banks could use these cheap funds for extending short-term loans with maturities of a couple of months. This represented a very low maturity risk (demand deposits on the liabilities side, short-term loans on the assets side) and very low credit risk, because banks knew their customers and their business plans and markets well, and demanded that firms’ inventories or other collateral be placed behind the loans. The market for commercial banks was protected from other intermediaries, which could only take part in payment transactions through banks and were barred from engaging in commercial lending.25 In the US, up to a certain amount, bank deposit insurance overseen by the state added further guarantees for the stability of money among households, thereby preventing bank runs (by making them ‘unreasonable’) and avoiding the resulting instability. Due to the limited competition on the banking market and the banking costs arising from regulation, deposit rates were low. As a result, in the hope of greater earnings, many people with small savings in the US invested their money in money market deposits that provided larger returns, and were similarly liquid as bank deposits and could be used for payments. In times of 24

Kregel (1998).

regel shows that modern commercial banks integrated the features of the K two main forms of banks that arose over the course of history. Giro banks specialising in stable, risk-free transaction money operated the payment system, and they had no risky loans. By contrast, capital or income banks invested their customers’ savings, placed with them for investment and risk-taking purposes, to generate earnings (Kregel, 1998). Interestingly, this duality can also be observed in the case of digital assets: the former resembles stablecoins, while the latter is similar to bitcoin and other cryptocurrencies. The terms digital ‘currency’ and ‘asset’ also reflect this difference.

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crises, as most recently in the 2007–2008 great financial crisis, the state, or more precisely the Fed representing it, bailed out these unsecured deposits as well, even though it had not promised this and it had no obligation to do so. In fact, due to the huge share of long-term savings with a legitimate objective (e.g. pension savings), the stability of financial markets in general was sought to be preserved, despite any prior promise or obligation. With minor differences, the same phenomenon could be observed in Europe. Due to historical reasons, banks play a larger role in the financial sector here than in the US. At the same time, the integrated payment system emerged early on, therefore no obligatory deposit insurance was needed for macroprudential reasons, unlike in the US. Owing to the integrated payment system and the corresponding centralised interbank market, all banks that suffered massive deposit withdrawals could apply for additional funds to other banks or the central bank. The deposits withdrawn from one bank but placed at another were available on the interbank market. Therefore although the European Union stipulated the introduction of compulsory deposit insurance from the 1990s, even in the Member States where this had not been obligatory (for example in Germany), this was done for consumer protection reasons rather than on macroprudential or financial stability grounds.26 In Europe, financial markets are also less involved in self-provision, due to the larger share of non-capital reserve pension systems, i.e. pay-as-you-go schemes. In practice, the state undertakes a much larger guarantee than with deposit insurance. The regulation and the terminology suggest that banks are regular private institutions. However, the approaches emphasising the state’s role recommend viewing the banking system as if it played its money-creating and paymentconducting role granted to it by the state in a sort of franchise 26

Fratianni (1995), Schwarz (1991)

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system.27 The modern monetary systems that evolved over the course of history operate a two-tier banking system, where private banks compete with each other. This is expected to ensure greater efficiency in allocation than for example in socialist countries’ monobank systems, with their bureaucratic mechanisms. In this approach, the appearance of private digital monetary systems would pose a direct challenge to the monetary sovereignty of the state and the community. This could be an especially grave threat in the case of the service providers that can potentially mobilise a huge user base (Big Tech vs fintech). If these players have a large clout and especially if they provide cross-border digital financial services, the question of the ability of the modern state to exercise its power arises, just like, beyond transaction and macroeconomic stability issues, the question of the community’s cohesion. The consortium behind Libra and Libra2 has such a potential. If millions of users join the service, an alternative, quasi-monetary sovereign outside the reach of national jurisdictions could easily emerge, limiting countries’ ability to act, or, conversely, forcing them to take undesired action. The importance of sovereignty is the most apparent in crises. In modern market economies, crises arise periodically where the rules do not apply (the market outcomes are unacceptable), and political, discretionary decisions are needed. Let us see some illuminating examples. In Europe, states guaranteed all bank deposits during the great financial crisis, irrespective of whether deposit insurance applied to them or not, and in the US the lending of last resort was extended to money market funds as well, which in practice functioned as bank deposits but were not secured. Similar trends can be observed everywhere where small savers are active in large numbers (e.g. pension funds). Therefore, governments often support stock exchanges, too, with unique measures and central bank intervention. This is facilitated by the

Hockett and Omarova (2017)

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state’s political power and sovereignty. It is unclear how Big Tech firms without a democratic mandate could take such decisions. The analytical framework emphasising the state’s role accepts the risks that are central in the traditional transaction approach and the modern central bank approach, while complementing them with risks to sovereignty: – Taking into account consumer protection considerations in the digital world requires special attention and expertise, because the risks are also unconventional. Verifying and licensing software and fighting digital crime are new challenges to the supervisory bodies. – Macroeconomic and real economy stability risks (savings/ investment and overlending). – Financial stability (loss of market share and profitability due to the appearance of players that compete with banks in deposits and loans as well). – Weakening of monetary policy transmission (on account of the reduction in influence on investments and lending, as the share of the markets influenced by the central bank shrinks). – Sovereignty issues (as the money issued by the sovereign is used less widely, the sovereign has less influence over the establishment of the regulatory environment, ad hoc crisis management and maintaining or promoting social cohesion). Based on the frameworks listed here, the appearance of privately issued digital assets can prompt three responses from the government/central bank: – Continuing on the road taken approximately until 2019, where states do not prohibit the appearance of alternative ‘currencies’, possibly even treating them as welcome competitors. At most, similar rules are proposed to apply to them as to traditional financial institutions, who are encouraged to act in previously

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neglected areas to retain their market share, and who used to represent the main channel of the government’s policies. – While expanding the existing financial regulatory framework and applying it to digital assets, an alternative digital central bank currency is introduced as a complement, and parts of certain private banking functions are taken over in the neglected areas. Introducing competition to stimulate the traditional banking system to enhance efficiency, in a way that preserves the stability of traditional institutions, which can therefore be retained as the channel of the government’s economic policies. Within this, various institutional (direct central bank account or indirect account at the intermediaries) and technical solutions (online or offline validation, on an account or token basis) are possible. – Banning private digital currencies and introducing a central bank digital currency to restore and monopolise monetary sovereignty, which may become necessary because operating parallel monetary systems may not be without hiccups, and this can lead to instability (Kregel and Savona (2020), Kregel (2016), Positive Money network (2020)). In the past, having parallel currencies has always caused trouble, and in practice only one of them fulfilled the money function.28 It is no coincidence that during the discussion preceding the establishment of the euro area, decision-makers quickly and clearly rejected the idea

resham’s law states that ‘bad money drives out good’, because the money G that retains its value is held back by everyone, and payments are conducted with another, weaker currency instead.

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of maintaining the national currencies along with the single currency.29

4. International spillovers Digital ‘currencies’, including the central bank digital currencies potentially introduced in the future may have an impact on countries’ financial systems, forcing them to respond. They can have an especially marked effect on the room for manoeuvre of the monetary authorities and financial institutions in small, open economies. As it has been demonstrated with traditional currencies, there is a hierarchy of currencies based on how widely they are used. The ranking in this hierarchy depends mostly on (sometimes past) economic performance, which is boosted considerably by the network effect arising from the nature of money. 4.1. International risks identified based on the traditional transaction approach – Consumer protection – the negligent management or theft of customers’ assets, insufficient customer knowledge (lack of familiarity with the products) and data protection may cause problems in an international context, especially in the case of digital currencies or central bank digital currencies outside the European Union. International agreements and coordination are needed to mitigate these risks, and major central banks have

I ssing (1999) claims that the parallel use of various currencies leads to uncertainty in the standard of value function, therefore players’ activities cannot be optimally controlled. Contrary to Hayek’s proposal, the more stable currency would not necessarily drive out the more volatile one in the spirit of Gresham’s law. In fact, one of the aims with the single currency was to eliminate the uncertainties caused by the multiple currencies.

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already started to outline the framework for this under the auspices of the BIS.30 – If the digital currency of a larger private corporation or the central bank digital currency of a country becomes popular, then, depending on its popularity, it may also have domestic macroeconomic consequences, if, for example the savings of many people flow to another country, or, like in the case of the volatile bitcoin, assets are underpriced or overpriced in the domestic market or abroad, and this may influence private actors’ consumption and investment behaviour. Even in the case of a central bank digital currency, there is no guarantee that the central bank concerned could or would even want to take into account the considerations of foreign digital currency owners and their monetary authorities. – In connection with the issuers of foreign private or central bank digital currencies, it is important to monitor, regulate and, if necessary, limit the exposure of the traditional financial sector to this ‘alternative’ sector. This is analogous to the risks arising from the relations between the shadow banking system and the traditional banking system (see, for example the dominant position of European banks on the US subprime market prior to the great financial crisis and the repercussions for Europe after the meltdown, when USD/EUR swaps provided by the Fed were necessary to stabilise European banks. – New players compete internationally with the domestic traditional financial sector on the liabilities (deposit) side by offering alternative depositing opportunities, which may lead to financial instability and may prove difficult to address with domestic funds.

BIS (2020b).

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– Depending on popularity, the effect of monetary policy (transmission, financial stability policy) may be weakened among those holding money abroad. 4.2. International effects identified based on the modern, endogenous central bank approach – Allowing international lending in a foreign central bank digital currency may lead to large-scale and volatile digital capital flows across borders and fundamentally influence macroeconomic stability, in other words price stability and financial stability. The same goes for international bank lending in the case of traditional banks (see the Great Recession, in particular Hungary’s FX indebtedness). – New players may compete with the traditional banking system in lending too, threatening with a loss of market share and financial instability, if they can provide cheaper services using a credit assessment system based on artificial intelligence and foreign standards, exploiting the huge international databases available to them for free. – These actors’ massive international participation in lending may narrow the scope of central banks’ macroeconomic and financial stability policies, thereby limiting the effectiveness of national policies. 4.3. Risks identified in the approaches emphasising the state’s role International digital currencies and central bank digital currencies challenge domestic monetary sovereignty. The sovereignty of modern states varies from a legal, institutional and economic perspective. Sovereignty is influenced by the participation in the international economic integration, where sovereignty is shared and enjoyed under legal constraints. Limitations on sovereignty may be accepted at the lower levels

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of integration, too. In economic terms, small, open, converging economies have less sovereignty, which is also influenced by monetary policy and the exchange rate regime, the extent of currency liberalisation and FX indebtedness. These aspects of sovereignty also apply to digital assets: for example the exchange rate of stablecoins is tied to a basket of assets denominated in traditional currencies, so they can behave like a foreign currency. The appearance of central bank digital currencies abroad may lead to the following risks: – Consumer protection, consumer risk – in the case of a central bank digital currency this is more limited than with a privately issued asset, but consumers should be aware of the potential risks here too, which may include legal restrictions against nonresidents, or economic ones, such as the exchange rate of the digital currency against the domestic currency. –M acroeconomic stability (savings/investments and overlending) risks may arise, if domestic actors widely hold a digital currency issued by a foreign central bank, and the particular currency’s conditions differ markedly from domestic monetary conditions. – Financial stability risks (competition against traditional domestic banks in deposits and lending, but also against any domestically issued central bank digital currency). The risk is greater when the financial conditions in the issuing economy differ dramatically from the domestic conditions. – Monetary transmission may be weakened, if many residents hold their money in the central bank digital currency issued by a foreign central bank: domestic interest rate cuts may push savers towards the foreign-issued central bank digital currency, and interest rate increases may do so with borrowers. – Sovereignty issues are particularly crucial in times of crises/ extraordinary situations, when the outcomes arising from the existing rules are politically or socially unacceptable, and discretionary decisions are needed. — 63 —

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5. Conclusion The appearance of digital ‘currencies’ and assets poses a challenge to traditional financial institutions and central banks. These challenges were examined through the lens of three major approaches to the theory of money. The traditional textbook or transaction-based approach mainly shows challenges and risks on the banking system’s liabilities side, mostly of a microeconomic, consumer protection, money laundering and terrorist financing nature, which require regulation accordingly. From a macroeconomic and macroprudential perspective, the lending activities potentially affecting the banking system’s assets side may cause risks, the mitigation of which requires macroprudential and macroeconomic risk management similar to that applied by banks, if the outcomes similar to the most recent financial crisis are to be avoided. Finally, a separate section was devoted to the challenges affecting countries’ monetary sovereignty, arising from the fact that the issuance of money and the operation of the financial system are public goods that express social cohesion and are crucial for the survival of the community. By nature, this sovereignty of the community cannot be relinquished to private actors that are not authorised or controlled by the community.

References Ábel, I.−Lehmann, K.−Tapaszti, A. (2016): A pénz és a bankok ellentmondásos kezelése a makroökonómiában (The controversial treatment of money and banks in macroeconomics), Financial and Economic Review, Vol. 15 Issue 2, June 2016, pp. 33–58, https://hitelintezetiszemle.mnb.hu/letoltes/abel-istvan-lehmann-kristof-tapaszti-attila. pdf Aglietta, M. Pepita Ould Ahmed−Jean-Frančois Ponsot (2016): La Monnaie. Entre dettes et souveraineté, Odile Jacobe, Paris Bánfi, Tamás (2016): A pénz forradalma – A pénzteremtés elmétete és gyakorlata (The Revolution of Money – The Theory and Practice of Money Creation). Cenzus, Budapest, 2016

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II. Monetary theory and international spillover aspects of digital currencies Bank of England (2020): Central Bank Digital Currency: opportunities, challenges and design, Discussion Paper, https://www.bankofengland.co.uk/paper/2020/centralbank-digital-currency-opportunities-challenges-and-design-discussion-paper Bindseil, U. (2014): Monetary Policy Operations and the Financial System, Oxford University Press Bindseil, U. (2019): Tiered CBDC and the financial system, https://www.ecb.europa. eu/pub/pdf/scpwps/ecb.wp2351~c8c18bbd60.en.pdf BIS (2018): Central Bank Digital Currencies, March, https://www.bis.org/cpmi/publ/ d174.pdf BIS (2020a): Rise of the Central bank digital currencies: drivers, approaches and technologies, BIS working paper series No. 880., https://www.bis.org/publ/work880. htm BIS (2020b): Central bank digital currencies: foundational principles and core features, https://www.bis.org/publ/othp33.htm BIS (2020C): Fintech and big tech credit: a new data base, https://www.bis.org/publ/ work887.htm Carpenter, S. B.−S. Demiralp (2010): Money, Reserves, and the Transmission of Monetary Policy: Does the Money Multiplier Exist? Finance and Economics Discussion Series Divisions of Research &Statistics and Monetary Affairs Federal Reserve Board, Washington, D.C.,https://www.federalreserve.gov/pubs/ feds/2010/201041/201041pap.pdf Cœuré, B. (2019): Introductory remarks to the Committee on the Digital Agenda of the Deutscher Bundestag, https://www.bis.org/cpmi/speeches/sp190925.htm Desan, Ch. (2014): Making Money. Coin, Currency, and the Coming of Capitalism, Oxford University Press Deutsche Bundesbank (2017): The role of banks, non-banks and the central bank in the money creation process, in: Deutsche Bundesbank Monthly Report, April, 13−33. o.,https://www.bundesbank.de/resource/blob/654284/ df66c4444d065a7f519e2ab0c476df58/mL/2017-04-money-creation-process-data.pdf Diamond, D. W.−Ph. H. Dybvig (1983): Bank Runs, Deposit Insurance, and Liquidity, Journal of Political Economy, Vol. 91, No. 3 (Jun., 1983), pp. 401-419, https://www. jstor.org/stable/1837095?seq=1#metadata_info_tab_contents Dyson, B.−G. Hogson (2016a): Digital Cash. Why Central Banks Should Start Issuing Electronic Money, Positive Money, http://positivemoney.org/wp-content/ uploads/2016/01/Digital_Cash_WebPrintReady_20160113.pdf Dyson, B.−G. Hogson (2016b): Accounting for Sovereign Money. Why State Issued Money is not Debt, Positive Money, http://positivemoney.org/wp-content/ uploads/2016/03/AccountingForSovereignMoney_20160309.pdf ECB (2015): Mi a pénz?, https://www.ecb.europa.eu/explainers/tell-me-more/html/ what_is_money.hu.html

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II. Monetary theory and international spillover aspects of digital currencies ECB (2020): Reporton a digital euro, https://www.ecb.europa.eu/pub/pdf/other/ Report_on_a_digital_euro~4d7268b458.en.pdf Financial Stability Board (2020): Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements Final Report and High-Level Recommendations, https:// www.fsb.org/2020/10/regulation-supervision-and-oversight-of-global-stablecoinarrangements/ Fratianni M. (1995) Bank Deposit Insurance in the European Union. In: Eichengreen B., Frieden J., von Hagen J. (eds) Politics and Institutions in an Integrated Europe. European and Transatlantic Studies. Springer, Berlin, Heidelberg, https://doi. org/10.1007/978-3-642-57811-3_7 G-30 (2020): Digital Currencies and Stable Coins, Risk, Opportunities and Challenges Ahead, July, https://group30.org/images/uploads/publications/G30_Digital_ Currencies.pdf Garrat, R.−M. Lee−B. Malone−A. Martin (2020): Token or Account-Based? A Digital Currency Can Be Both, Liberty Street Economics Blog, Federal Reserve Bank of New York, https://libertystreeteconomics.newyorkfed.org/2020/08/token-or-account-baseda-digital-currency-can-be-both.html Gurley, J. G.−S. Shaw (1960): Money in a Theory of Finance, Brookings Institution, Washington (1960) Hockett, R. C.−S. T. Omarova (2017): The Finance Franchise, Cornell Law Review, vol. 102., Issue 5, May, https://scholarship.law.cornell.edu/cgi/viewcontent. cgi?article=2660&context=facpub Issing, O. (1999): Hayek–currency competition and the European Monetary Union, Speech by Professor Otmar Issing, Annual Hayek Memorial Lecture hosted by the Institute of Economics affairs, London, 27 May 1999, https://www.ecb.europa.eu/ press/key/date/1999/html/sp990527.en.html Kregel, J. A. (1992): Universal Banking, US Banking Reform and Financial Competition in the EEC, Banca Nazionale del Lavoro Quarterly Review, no. 182, September 1992 Kregel, J. A. (1993): Bank Supervision: The Real Hurdle to European Monetary Union, Journal of Economic Issues, vol. XXVII, No. 2., June, 667−676. o. Kregel, J. A. (1998): Past and future of Banks, Roma, Bancaria editrice Kregel, J. A. (2016): The Regulatory Future, FESSUD working paper No. 164, June Kregel, J. A.−P. Savona (2020): The Impact of Technological Innovations on Money and Financial Markets, Public Policy Brief, Jerome Levy Economic Institute of Bard College, http://www.levyinstitute.org/publications/the-impact-of-technologicalinnovations-on-money-and-financial-markets Lo, A. (1996) (ed.): The Industrial Organization and Regulation of the Securities Industry, Chicago and London Nealy, M.−A. Radia−R. Thomass (2014): Money Creation in the modern economy, Bank of England Quarterly Bulletin, Q1, 1−14. o., http://www.bankofengland.co.uk/ publications/Documents/quarterlybulletin/2014/qb14q1prereleasemoneycreation.pdf

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II. Monetary theory and international spillover aspects of digital currencies Norges Bank (2020): Status report–Norges Bank’s central bank digital currency project, https://www.norges-bank.no/en/news-events/news-publications/Reports/ Norges-Bank-Papers/2020/memo-22020-dsp/ Positive Money (2020): Central Bank Digital Currency. Opportunities, Challenges and Design. A Positive Money Response, http://positivemoney.org/wp-content/ uploads/2020/07/Positive-Money-Response-to-the-Banks-CBDC-discussion-paperMarch-2020.pdf Schwartz, A. (1991), quotes R. L. Hetzel (1991): Too Big to Fail, November-December 1991, Vol. 77, p. 3−15. o. Economic Quarterly (Federal Reserve Bank of Richmond), https://fraser.stlouisfed.org/title/economic-quarterly-federal-reserve-bankrichmond-960/november-december-1991-477369 Szalai, Z. (1998): Értékpapír-befektetés az Európai Unióban, MNB Műhelytanulmányok, (Securities investments in the European Union, MNB Occassional Papers) https://www.mnb.hu/letoltes/mt14.pdf White, L. H. (1999): The Theory of Monetary Institutions, Lawrence and White, Mass. and Oxford.

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III. Digital renminbi – Taking the US–China geopolitical rivalry to a new level? Eszter Boros – Marcell Horváth The world has been interested in the potential of central bank digital currencies for years, and in 2020, China came closest to implementing the concept. Since tests of the digital renminbi (RMB) began, more and more details have become known about the functioning of this new form of money, which provides an opportunity for re-thinking the future of the world currency. A centralised e‑RMB suitable for direct payments is the most serious challenge to the USD and the United States’ power in recent decades. The threat could primarily materialise through the circumventing of the US financial system, which would considerably reduce American geopolitical influence. The rise of the e‑RMB may be promoted by its ease of use as well as partnerships along the ‘New Silk Road’, with China at its centre. However, if the East Asian country wishes to provide a genuine alternative to the USD, a new economic model and financial market liberalisation seem to be crucial.

1. Introduction In the spring of 2020, during the hard times of the coronavirus pandemic, the announcement by the Chinese central bank (People’s Bank of China, PBoC) caught the whole world’s attention: the East Asian country started testing a central bank digital currency (CBDC) in real payments. The pilot project that was expanded to several provinces in the summer shows remarkable progress, therefore the digital renminbi (e‑RMB) is set to be the first officially introduced (fully-fledged) CBDC. The concept of central bank digital currencies has come into focus in economic policy — 68 —

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discussions in recent years (mostly as digital means of payment issued by non-state actors started proliferating), and several central banks have been looking at the option of digitalising cash, which is part of the monetary base (M0). From a geopolitical perspective, it is especially telling that out of all countries, China has made the greatest strides in bringing the concept to fruition. The forthcoming central bank digital currency raises many questions, and one of the most interesting is the potential impact on the world order. Since the United States’ leading role is known to rest on its financial system and the dollar’s hegemony, the question inevitably arises as to whether the financial innovation by China, the second largest economic power, threatens this status. The present study examines these issues starting out from the conceptual features of a world currency.31 In order to assess the prospects of the e‑RMB, Chapter 2 outlines the geopolitical situation, i.e. the major developments in today’s global politics. The chapter aims to provide some context to the development of CBDCs and shed light on China’s comprehensive economic and power strategy pursued in the past decade as well as its confrontation with the Atlantic force field, taking into account the effects of the coronavirus crisis. Chapter 3 analyses the prospects of the international adoption of the digital RMB. First, in Chapter 3.1, the concept of a world currency is defined, and then the factors securing the USD in this role for decades are listed. The chapter also reveals how the United States has been benefitting from this kind of financial dominance. After that, Chapter 3.2 describes the characteristics of the e‑RMB (as announced to date) and the circumstances of ongoing tests. Based on the currency’s features, the advantages that could lead to a dynamic rise in future

rivately issued digital means of payment, including the so-called P cryptocurrencies (e.g. bitcoin) are not discussed here, since, according to expert consensus, they cannot be considered alternatives to the national currencies issued by countries with respect to the functions of money, so they cannot realistically be expected to play the role of a world currency. (For the sake of simplicity, the study will refer to currency and FX as synonyms.)

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RMB use are identified, placing China in an even more powerful position than today. The analysis ends with the discussion of drawbacks and hurdles as well as the options for an American response. Chapter 4 summarises the paper’s conclusions.

2. Geopolitical context: developments in global power relations related to the digital currency The turn of the millennium was characterised by a unipolar world order based on the superior economic and military power of the United States. However, towards the end of the 2000s, the economic rise of certain powers in the developing world (e.g. China, India) increasingly shifted the global power relations into a multipolar direction. Developments in the wake of the COVID‑19 pandemic suggest a further erosion in American dominance and the strengthening of Asian power centres. By the end of 2020, it had become clear that China, originally the epicentre of the pandemic, had quickly put a stop to the contagion and the negative consequences of the economic shutdown. While the United States and the European Union are still struggling with new waves of the pandemic and keeping the economy running, China seems to have restored business life to normal, and it recorded positive GDP growth in 2020 (2.3 per cent) (Xinhua 2021). Beijing used the pandemic to underline its role as a global leader and strengthen its Eurasian relations. With its so-called mask diplomacy, China provided medical aid and personnel to several of its European, Asian and Latin American partners (Wong, 2020). The rapid economic recovery also helped China in boosting its role even more in supply chains (especially in South East Asia, see Jennings, 2020). Due to this, the multipolarisation seen in recent years may even take a new direction, turning into a sort of bipolar order, with the two dominant force fields in the world comprising the US‑led — 70 —

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Atlantic bloc on the one hand, and the Eurasian pole dominated by China on the other hand. China seeks to develop a new, uniquely decentralised model of economic governance, in which, nevertheless, the strands in the web of trade, investment and financing relations ultimately lead to Beijing (Shaffer–Gao, 2020). Its strategic flagship infrastructure and economic development project is the ‘Belt and Road Initiative’ (BRI). Announced by President Xi Jinping in 2013, the initiative aims to link the regions along the historical Silk Road. The BRI and its complement, the 21st Century Maritime Silk Road are part of a vast Chinese ‘network’ based on memoranda of understanding (MoUs) and trade and investment agreements as well private law contracts. It differs to a great extent from the market-oriented, US-led Western world order resting on universal institutions. The huge bloc united by the BRI is also aptly referred to as the ‘Beijing Consensus’, to contrast it with the Washington Consensus that defined Western development until recently. The New Silk Road network is illustrated in Figure 1. Figure 1. Land routes of the New Silk Road and the network of the New Maritime Silk Road RUSSIA

Moscow Rotterdam Venice

KAZAKHSTAN

Athens Istanbul

Beijing IRAN

EGYPT

PAKISTAN Gwadar

Xi’an

CHINA

Calcutta INDIA

Dalian Fuzhou

Hanoi

Djibouti Colombo

KENYA Lamu

Singapore Jakarta

Land routes of the New Silk Road New Maritime Silk Road

Source: Own editing based on the map of Asia Green Real Estate.

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Under the ‘Beijing Consensus’, China does not impose ideological or political conditions on its partners, nor does it establish economic policy expectations. (Meanwhile, the multilateral institutions in the Western world, for example the IMF, provide funding on strict economic policy conditions, and the resulting ‘reform programmes’ reflect a certain statement of economic thinking and world view.) The geopolitical agenda pursued by the Chinese government revolves around balance: mutual benefits are prioritised to maintain stable and harmonious partnerships. In other words, besides furthering its own interests, Beijing wants its partners to have enough leeway to achieve their goals and exploit the benefits of the cooperation. This may ensure a sustainable network of strong and stable allies for China, offsetting the US-centred system of alliance. The BRI is in line with the logic behind Chinese geopolitics, government planning and industrial organisation, and it is based on infrastructure creation and funding. The primary aim of building roads, railroads, ports and warehouses is to ensure the sustained take-up of Chinese capacities (surplus goods) and to develop local economies, leading to an organically united macro region. This means the birth of a new geopolitical force field, and for this, China follows the principle of ‘running in small steps’ (i.e. continuous experimental progress) – an approach already successfully applied in its domestic reforms. In this spirit, the initiative has recently been complemented with the development of non-physical infrastructure (‘Digital’ and ‘Health Silk Road’). The BRI project is key in realising China’s RMB ambitions, which in the long run may even aim to challenge the USD’s world currency status. It is common knowledge that one of the main sources of American superpower is the multi-decade hegemony of the USD in the international financial system32.

or more on this topic, see György Matolcsy (2020): The American Empire vs. F The European Dream – The Failure of the Euro (2nd edition).

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The Bretton Woods system, established in the aftermath of the Second World War, and its legacy ensure the dominance of the American currency in international trade and capital flows and among reserve currencies. (For details, see: Chapter 3.) The United States’ geopolitical strategy has traditionally been based on maintaining the Western system of alliance and ensuring the loyalty of partners scattered throughout the world (e.g. Japan, South Korea, Thailand). However, the presidency of Donald Trump brought about a certain degree of change in this approach. In the spirit of his ‘America First’ doctrine, President Trump demanded greater contribution from allies in common issues, and withdrew from multilateral platforms (e.g. Trans-Pacific Partnership, Paris Climate Agreement, Iran nuclear deal, and the suspension of American funding to the WHO during the pandemic) (Larres, 2020). Nevertheless, this does not mean that the US has renounced its superpower status, in fact, precisely the contrary is suggested by the signs. Donald Trump’s foreign policy can be interpreted as the protection of the remaining contours of the unilateral world order. This is supported by the increasingly heated rivalry with China, one of the defining characteristics of the presidential term. Trump focused first and foremost on trade, and the trade war waged through tariffs led to the signing of the Phase 1 Trade Deal by January 2020, a matter of political prestige for the president (Reuters, 2020a). Pursuant to the agreement, Beijing undertook to increase imports of American agricultural, energy and processed goods. (However, the achievement of the targets has become highly dubious after a couple of months, partly due to the economic downturn caused by COVID‑19 (CSIS, 2020).) Besides trade, the other main front of American action has been technology. The efforts to curb the rise of Chinese corporations culminated in the Clean Network Programme announced by Secretary of State Mike Pompeo in August 2020 (The Straits Times, 2020). The planned scheme seeks to eliminate all Chinese access to American information and communication networks

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(e.g. mobile applications, cloud services, internet cables and telecommunication lines). Although such a drastic severance of Sino–American economic and technological relations (socalled decoupling) is hardly possible in practice, and it would be particularly harmful for both parties (OMFIF, 2020), technology is truly key in digital financial transformation, too. It should be noted that the points of contention between the two parties are structural, they reflect long-term conflicts of interest, therefore the confrontational tone in US–China relations is likely to persist during Joe Biden’s presidency as well. The developments pointing towards a bipolar world order also affect other (regional) powers of the world. From the perspective of the Chinese digital currency, special attention should be paid to the geopolitical situation in India, a rising fintech power, as well as the Central and South East Asian regions. On the Indian and Central and South East Asian markets, exhibiting rapid growth in online services, the influence of Chinese high‑tech firms has increased considerably in recent years. Moreover, Central and South East Asia are also directly dependent on the East Asian giant due to the integration of supply chains (Mirza 2019, Boisseau du Rocher, 2020). However, India and the countries in the two other Asian regions have their own ambitions and/or unique national interests, which turn them into special ground for the Sino–US rivalry and crucial players in the acceptance of central bank digital currencies.

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3. The features of a world currency and the challenge posed by the digital RMB 3.1. The USD as a world currency and its role in the superpower status of the United States The chances for the future rise of the e‑RMB can be best assessed from the perspective of fulfilling the functions of a world currency. A world currency fulfils the major functions of money on a global scale, in other words it is used internationally as a means of circulation (exchange), means of payment, standard of value and store of value. The USD has long been able to realise these, as confirmed by history and the following recent factors: – The USD is backed by the world’s largest and most advanced economy, therefore the number, value and significance of the transactions conducted with American partners alone make it practical for economic actors to use the USD. (It has to be noted, however, that the share of the United States in world trade has shrunk significantly since the establishment of the Bretton Woods system. Back then, the US accounted for 28 per cent of global exports, which has declined to 8.8 per cent (Birch, 2020). Meanwhile, China’s share was 13.3 per cent last year (Workman, 2020), which clearly shows that it has surpassed the United States as the largest commodities trading nation in the past decade (Lo, 2020). In other words, waning American economic dominance may boost the rise of the challengers.) – The deep, highly liquid and open financial market of the USD and USD instruments ensures that those who accept this currency can open/close positions at any time, flexibly and at minimal transaction costs all over the world (International Economy, 2020). – Thanks to the overarching stability provided by American economic policy, or at least the general transparency of the

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economic policy framework, and the application of the rule of law, the USD and more broadly the assets denominated in it are high‑quality investments in general (International Economy, 2020). –C ommodities and raw materials (e.g. oil) are priced in USD all over the world (Smith, 2020). – The great degree of inertia arising from established habits and strong network effects pose an enormous challenge to any currency that wishes to compete with the USD (Smith, 2020). The American currency is a true ‘network good’: its benefits mainly stem from its widespread use. Therefore replacing it would entail substantial individual disadvantages (including increased transaction costs, technical difficulties, lost customers and business). The challenger currency will have a particularly difficult time reaching the critical mass necessary for a breakthrough. Even this incomplete list shows that the factors underlying the hegemony of the USD are closely intertwined and reinforce each other, thereby strengthening the ‘workable global consensus that the dollar system provides vital public goods’ (International Economy, 2020:12). The widespread confidence in the USD is shown by the following: – the American currency comprises a steadily high share, over 60 per cent, of central bank FX reserves (2019 Q4: 61 per cent); – at the end of 2019, 64 per cent of the securities representing outstanding international credit debt were denominated in USD; and – in the same year, approximately 45 per cent of cross-border payments used USD (ECB, 2020). (To compare: the RMB’s shares are: 2; <1; 2 per cent, respectively.)

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The USD’s world currency status provides numerous benefits to the United States, out of which the option for an exceptional but still sustainable indebtedness and geopolitical leverage deserve special mention. Both factors are especially important from the perspective of the future rise of the digital RMB. The persistent international demand for the world currency allows the US to continuously run a current account deficit (i.e. a deficit in the external financing position). The external deficit is not only an option, it is a necessary condition for an economy’s currency to become the world currency. This ensures that there are net currency outflows towards the outside world, i.e. the liquidity necessary for international transactions is available. One of the main sources of the external deficit may be an import surplus, when the economy issuing the world currency purchases more goods and services from abroad than it sells. Non-residents are willing to finance this surplus use because (future) payments are received in the world currency. In practical terms, this means that the United States can continuously consume on credit, even at an increasing pace, depending on the dollar demand of foreign partners in theory. It does not have to expect an interest rate increase typical of overindebted countries (or only less so). Lower interest rates also mean that due to international transactions being mostly conducted in the domestic currency (USD), American economic actors face only a marginal exchange rate risk (International Economy, 2020). Power benefits also arise from the fact that the world currency supply of the global economy ultimately depends on the United States. However, this is not only about the USD itself but also about the international payment system related to it. A study by the Center for a New American Security identifies six sources of America’s superpower status, four of which are tied to the financial system (CNAS, 2019). They include the dominance of the USD and the following:

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– the leading role of US financial institutions in global payments, – the global investment footprint of US investment funds and other investors, – the transparency requirements in the US financial system. Nowadays, cross-border payments are conducted through multi-stage clearing systems, and mainly American banks, and ultimately the Federal Reserve itself, are at the top of this hierarchy. The messages about payment orders handled by American correspondent banks are transmitted in the SWIFT system (Society for Worldwide Interbank Financial Telecommunication), which handles a substantial share of crossborder transactions (payments worth around USD 5 trillion daily) (Kumar–Rosenbach, 2020). Thanks to this, the United States is in an exceptional position to monitor international payments: it can detect illegal financial flows, for example money laundering and terrorist financing, and check whether international sanctions are enforced. Economic and financial coercive measures (banning transactions related to individuals/organisations/countries, investment and trade restrictions, embargoes, tariffs etc.) have become one of the most important tools of US foreign policy in the past decade, for example against Iran, Russia and China. In 2019, the United States administered 30 different sanctions programmes in total (CNAS, 2019). Even if the sanctions are not imposed with the approval of the international community, the influence of American financial institutions makes foreign actors comply with them, irrespective of whether the transactions in question are in USD or not. This is because foreign banks do not want to jeopardise their ties to American financial institutions, so they also refrain from conducting financial transactions for the sanctioned individuals and organisations. Similarly, American investment funds and their partners expect US provisions to be enforced all over the world, and American standards (transparency, disclosure requirements) are also widely expected to be applied in international business relations. Nonetheless, the — 78 —

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key to enforcement is clearly SWIFT, the point where the Chinese CBDC poses the greatest threat. 3.2. The digital RMB and its potential consequences in the geopolitical arena In the spring of 2020, the Chinese central bank reached a milestone in the development of the e‑RMB despite the coronavirus crisis. According to an announcement in April, tests of the central bank digital currency started in actual payments in four large cities (Shenzhen, Suzhou, Chengdu, Xiong’an) (WSJ, 2020a). The development of the currency officially referred to as Digital Currency/Electronic Payments (DC/EP) began in 2014, and according to central bank statements, it was accelerated in 2019 upon the news that Facebook would introduce its own digital currency (Libra) (Gulliver-Needham, 2019). Shortly after the publication of the Libra framework, the social media company proclaimed that 50 per cent of the asset would be pegged to the USD. Therefore, the PBoC views Libra as not only a risk to financial sovereignty and stability but also as a promoter of American power interests (Copeland, 2020). China’s response clearly shows that Beijing has realized the advantages of being the first mover in introducing a state-backed digital currency (Ferguson–Parker, 2020). In August 2020, the PBoC expanded testing to further large cities and regions (including two provinces neighbouring Beijing as well as the southern coast of Guangdong, Hong Kong and Macau) (WSJ, 2020b). During the trial, some of the public, for example government employees, receive their benefits in digital RMB, which they can use to pay at merchants and service providers involved in the testing. According to the PBoC, 3.1 million transactions were conducted until early October 2020, to the tune of over RMB 1.1 billion (USD 162 million) (SCMP, 2020). No official date has been set for nation-wide introduction yet, and in the spirit of an experimental approach, Chinese leaders

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are expected to be cautious about this step. Nonetheless, the launching of the e‑RMB is in line with the priorities of the 14th Five‑Year Plan (digitalisation and the social and economic role of online platforms). According to the information published so far, the e‑RMB will play a key role at the 2022 Winter Olympics (WSJ, 2020b). The e‑RMB is a cash-like digital means of payment issued by the Chinese central bank. Officials claim that it was designed to replace cash. Nonetheless, there are no plans to change the role of commercial banks, so the digital currency will reach economic actors through the banking system and popular payment service providers (Birch, 2020). (For example, economic actors may request CBDC via the e‑RMB app against the balance of their bank account or mobile wallet.) Major Chinese banks (e.g. Agricultural Bank of China, Bank of China, China Construction Bank, Industrial and Commercial Bank of China) and leading mobile wallet providers (Alipay, WeChat) also take part in the development of the currency. Due to the centralised nature of the digital RMB, the PBoC will have an overview of all transactions, therefore the new currency will differ from traditional, fully anonymous cash in this respect. Although parties sending and receiving the money will remain completely unknown to each other when using the e‑RMB, they will not be unknown to the central bank or the state for that matter (Reuters, 2019; Birch, 2020). This provides a huge real-time database of economic policy information to China (Ferguson– Parker, 2020), which can be more directly controlled and/or which is more comprehensive than information from popular mobile payment apps, commercial bank accounts or shadow banking activities. On the other hand, tangible geopolitical advantages can also be gained: if the e‑RMB became widely used in cross-border payments, it would offer China global control, similar to SWIFT. The Chinese CBDC was designed for direct transactions, which is also hugely important. In the system that also works — 80 —

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offline, payments are made directly between the parties, thereby eliminating the underlying bank clearing steps (Birch, 2020). This brings a potentially huge advantage in speed and costs compared to the traditional operation of SWIFT based on bank networks. The absence of intermediaries could make the use of RMB more attractive in large parts of the world, especially if American control is also sought to be circumvented. Several papers point out (CNAS, 2019, International Economy, 2020) that the widespread use of sanctions has recently raised eyebrows even among US allies. For example, Donald Trump’s abandonment of the nuclear deal with Iran (Joint Comprehensive Plan of Action, JCPOA) and renewed economic restrictions have caused quite a paradoxical situation for the European Union. The EU endeavoured to create its own clearing mechanism to continue trading with Iran by circumventing the American financial system. In the light of this, it is hardly surprising that powers that are on less amicable terms with the US have also made similar attempts. Russia announced in 2018 that it had developed its international financial messaging service, designed as an alternative to SWIFT (CNBC, 2018). And China established the Cross-Border Interbank Payment System (CIPS) for cross-border RMB clearing in 2015 (CNAS, 2020). (Albeit, this system follows the logic of traditional payment structures and Western banks also participate in it (Lo, 2020).) On another note, Beijing and Moscow agreed to phase out the USD from their trade with each other (Russia Briefing, 2019). This shows that the main advantages of the e‑RMB are geopolitical, all the more so because the share of cash transactions is already low in China. Residents and companies like to use the mobile payment solutions offered by Alipay and WeChat: in 2018, 83 per cent of payments were conducted digitally with mobile devices (Atlantic Council, 2020a). Therefore, the efficiency gains of transitioning to a cashless society may be dwarfed by the long-term geopolitical benefits. Beijing has sought to promote the international use of the RMB for years, and, owing to its positive features, the digital currency can act as a catalyst in — 81 —

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this regard. China’s financial measures so far (funding the BRI projects, establishing new development banks, bilateral swap agreements etc.) could become really powerful when coupled with the e‑RMB. The dedicated goals of the BRI project include the financial integration of economies along the ‘New Silk Road’ (NDRC, 2015), which Beijing wishes to do with the help of the RMB. The efforts are warranted by the fact that the Asia-Pacific region trades twice as much with China as with the United States (Smith, 2020). Moreover, the overwhelming majority of BRI investments are financed by the East Asian giant, through state-owned commercial banks and multilateral development banks under Chinese leadership (e.g. Asian Infrastructure Investment Bank, AIIB) (Shaffer–Gao, 2019). However, the strengthening of financial ties has not entailed a surge in RMB use yet. According to PBoC data, the transactions between China and BRI countries recorded in RMB (RMB 2.73 trillion) accounted for merely 5.3 per cent of all international clearing transactions of the East Asian country in 2019 (PBoC, 2020).33 Most of this (RMB 732.5 billion) came from the trade in goods, and only RMB 213.5 billion34 appeared as cross-border financing. This is because BRI lending has mainly occurred in USD (Financial Times, 2018). Target countries and infrastructure-developing companies typically preferred the USD.35 Beijing did not oppose the use of the American currency

ccording to the report, China’s total cross-border financial clearing A transactions amounted to RMB 51.63 trillion in 2019. Of this, 38.1 per cent (RMB 19.67 trillion) represented clearing transactions denominated in the Chinese currency. The RMB transactions with only BRI countries, at RMB 2.73 trillion, accounted for 5.3 per cent of the annual total.

Worth USD 31.5 billion.

ven though most construction companies are also Chinese (Shaffer–Gao, 2019). E One possible reason for preferring the USD is that the technology necessary for large-scale developments is often unavailable to Chinese companies, and it can only be obtained from Western partners in the global market.

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either, as it had massive USD reserves thanks to its sustained current account surplus (Ferguson–Parker, 2020; Lo, 2020). Yet not even China can lend in USD indefinitely, especially in the light of the economic development path announced by President Xi Jinping, who seeks to make domestic consumption the driver of Chinese growth. The pick-up in domestic demand, and the convergence of relatively less developed Chinese regions, will entail a rise in imports. Thus, the evaporation of the external surplus will limit the opportunities for traditional USD financing down the road.36 This is another reason why China should promote RMB use along the ‘New Silk Road’. There are several signs that Central and South East Asian countries are ideal for these efforts. A significant part of the region’s population does not use financial services, so there is great growth potential in the market, especially in digital (mobile payment) solutions (Ferguson–Parker, 2020; Smith, 2020). This is beneficial for the future acceptance of the CBDC, and the channels of e‑RMB transactions have already been prepared in some sense. Due to acquisitions in recent years, Chinese tech giants Tencent and Alibaba now have a major interest in the region. They have invested in local payment service providers such as Telenor in Pakistan and Lazada, bKash and Akulaku in South East Asia (and Paytm, operating in rival India, should also be mentioned) Ferguson–Parker, 2020). Currently, the RMB is difficult to access in payments outside China (International Economy, 2020), but Chinese owners can offer the option to pay in e‑RMB on popular local payment platforms. This prospect should not be underestimated, because experience has shown that ‘as infrastructure leads, the assets often follow’ (International Economy, 2020:16). Since economic actors increasingly transact with Chinese partners along the ‘New Silk Road’, after a while,

I ncidentally, the contraction of external surplus points in the same direction as the balance of payments condition necessary for the world currency status.

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they may find it convenient to use the e‑RMB payment option offered by their everyday mobile app (Birch, 2020). It should be underlined that the BRI also expands the Chinese diaspora, whose presence (e.g. in local stores) may also be encouraging (Shaffer–Gao, 2019). The remittances by migrant workers are crucial in the life of Central and South East Asian economies (Smith, 2020), which is also of considerable importance. Using e‑RMB mobile wallets may be a quick, cheap and efficient way to provide financial support to families at home. Regarding the international expansion of the new digital RMB, it is remarkable that the PBoC joined the so-called Multiple CBDC Bridge initiative in February 2021. The project, involving the Bank for International Settlements (BIS), Hong Kong, Thailand and the United Arab Emirates (UAE) as well, is seeking to create new digital ways of cross-border payments (BIS, 2021). By the way, the use of the e-RMB may not necessarily be a simple matter of choice. China is likely to expect BRI partner countries to use the e-RMB. This requirement will be especially important as the Digital Silk Road comes into focus. COVID‑19 has accelerated the shift in the priorities of China’s development strategy: the post‑pandemic recovery and foreign investments now focus on the digital economy with high value added (and less so on physical infrastructure). The Digital Silk Road initiative also aims to foster the development of 5G internet connections, data centres and the automatic systems necessary for operating electric vehicles (Ferguson–Parker, 2020; Greene–Triolo, 2020). Digital payments are pivotal in these networks, so the e‑RMB could be incorporated into the implementation ‘without anyone noticing’. Yet in order to exploit these synergies, Beijing needs to take decisions that help fulfil the conditions of the world currency status. The Chinese leadership may incur difficulties here because this requires the acceleration of the change in the economic model in several respects. One such issue is the above-mentioned

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external financing position. Economic policy has already shifted somewhat towards a consumption-driven growth model (and future external deficit) that ensures meeting the future RMB demand of the world (i.e. currency outflows). However, there are also partly contradictory stances, for example the promotion of import substitution. In that spirit, China launched its ‘Made in China’ industrial development policy in 2015, which targeted a kind of ‘self-sufficiency’ and increasing industrial value added produced domestically to 70 per cent by 2025 (Shaffer–Gao, 2019). The devastating effect of the coronavirus pandemic on supply chains as well as foreign policy tensions have recently shifted China’s attention to internal economic circulation (Reuters, 2020b; SCMP, 2020b). Nonetheless, meeting mostly domestic customer needs would scarcely be in line with the intention to circulate the RMB internationally. World currency ambitions are much more aligned with the network‑based model in which production with low value added content is outsourced to South East Asia and Africa, while China functions as a high‑tech centre. In other words, over the medium term, Chinese leaders will have to strike the right balance in the ‘dual circulation’ (domestic and external economy), which will open the door to a rapid rise in RMB use outside China. A closely related issue is that of the exchange rate and financial liberalisation. Experts agree that the international use of the RMB is mostly hindered by current Chinese capital controls (Lo, 2020). In itself, an efficient and convenient digital payment option that makes it possible to circumvent the US will not eliminate this problem (International Economy, 2020). The RMB has a managed exchange rate, which, albeit positive for investors looking for stability amidst the COVID‑19 situation (cf. Bloomberg, 2020), may make market participants more cautious overall. This could be especially true in the light of the Chinese political mechanisms, which are not quite transparent from the outside. The emergence of a large and liquid RMB market is hindered by fragmentation (the separation of the onshore and offshore markets) and lack — 85 —

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of the free use of the currency. For example, China does not allow residents to convert or transfer abroad larger sums in RMB (cf. SCMP, 2020c), and it restricts the flow of income earned in the country to financial markets, thereby also the repatriation of the profits of foreign players (Peters–Green–Yang, 2020; Kärnfelt, 2020). In recent years, Beijing has started to open up financially: for instance, stock connections have been expanded (Stock Connect Scheme: Hongkong–Shanghai–Shenzhen, Shanghai–London Stock Connection) (Lo, 2020; PBoC, 2020). Nevertheless, any further liberalisation can presumably occur only gradually, in accordance with the process of the change in the economic model and Chinese leaders’ stability efforts. Over the medium term, this limits the RMB’s ability to reach a full-fledged world currency status. However, the testing of the CBDC is an unprecedented leap ahead on this road, and the United States cannot ignore this. The development of a digital USD has not started yet. In June 2020, Fed Chair Jerome Powell said that the issue was being considered (Atlantic Council, 2020b; Coindesk, 2020). Still, despite the fact that it lags behind, Washington may be able to mitigate the impact from the future introduction of the e‑RMB. Besides the traditional factors strengthening the USD, this can be mainly achieved with the country’s geopolitical position and its network of allies. America has already stepped up its diplomatic efforts in South East Asia and India. India is part of the so‑called Quadrilateral Security Dialogue (QUAD), which is intended to offset China’s power, and in which the US, Australia and Japan also participate. The United States has recognised that it can also exploit the tensions in the South China Sea to win over the region’s countries to line up against China. However, in order to expand the scope of cooperation in security policy, the US also has to considerably increase its investments in South and South East Asia. Another key to managing the challenge posed by the e‑RMB is that the United States should mobilise its resources to facilitate the digitalisation of its economy and financial services. Some

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American politicians also argue that the US should primarily focus on strengthening SWIFT, rather than developing its own CBDC (Birch, 2020). It is probably no coincidence that SWIFT recently announced major infrastructure developments and an expansion of its services (Central Banking, 2020). The consortium aims to establish a comprehensive transaction management system in the next two years, to increase the speed and reliability of transactions and support customers’ clearing, fraud detection and IT security processes. Besides the improved efficiency of the USD‑based payment system, the CBDC developments within the Atlantic alliance may also hamper the future rise in e‑RMB use. According to the Atlantic Council (2020b), Canada and Sweden have already started CBDC implementation. Among the CBDC projects in Asian countries that are at an advanced stage, one should mention the programmes in the United Arab Emirates, Cambodia, Singapore, Thailand and South Korea, which may counterbalance Chinese developments in the region. (In 2021, Japan will also start its CBDC tests, with the primary aim of preparing for future digitalisation challenges (Japan Times, 2020). In its national blockchain strategy published in late 2019, India also mentioned the possibility of creating a digital rupee (NISG, 2019).) Nevertheless, taking into account the e‑RMB’s advantage and China’s economic power, Beijing’s digital currency will clearly be the most promising contender of the USD in the next few decades in the competition for world currency status.

4. S ummary, conclusions The three main drivers behind the developments in the 21st century are money, technology and mobility, which together, in interaction with each other, determine the paths of growth and influence geopolitical relations (MNB, 2019). A central bank digital currency is a fusion of precisely these three — 87 —

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factors, and China can use it to give additional impetus to the wave of digitalisation that increasingly pervades everyday life. Chinese tech giants (e.g. Alibaba, Tencent, Huawei, ZTE) have become dominant in trade, services, communication, healthcare, logistics, agriculture and several other sectors. These companies have transcended China’s borders (as they have been entering the Indian, South East Asian markets, inter alia). Their presence supports the geopolitical plans of the central government, namely the establishment of a regional network and the new force field of the ‘Beijing Consensus’. One of the pillars of this economic and technological paradigm shift is financial innovation, the search for the money of the future. The digital RMB can pave the way for a new, complex cooperation between regions, resting on China’s geopolitical and economic management principles. With the introduction of the e‑RMB, which is expected to take place soon, the questions surrounding central bank digital currencies will be tested in practice. Among the emerging developments, the shift in geopolitical relations is one of the most significant. The digital RMB could prove to be China’s most powerful weapon yet in its unfolding rivalry with the US, which increasingly pushes the international community towards a bipolar world order. The challenge posed by the e‑currency is special because it can undermine one of the main pillars of the United States’ power, its financial dominance. The most important ‘trick’ of the e‑RMB is direct transactions, as the system will be able to complete payments without underlying clearing transactions. This saves a considerable amount of time and cost, and also allows the traditional international payment system dominated by American banks to be circumvented. The US may lose its control over global payment transactions and thus also over the enforcement of the sanctions imposed on its adversaries. On the other hand, China could obtain an exceptional information base, which may improve the effectiveness of its economic policy and multiply its global power. — 88 —

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The e‑RMB is closely linked to Beijing’s strategic project, the ‘Belt and Road’ programme spanning Eurasia. The constellation of several factors suggests that the BRI region will be ideal for an efficient rise in international RMB use. Nowadays, the population of Central and South East Asia flock to join mobile payments, and they mostly see Chinese-owned platforms. The option to pay with e‑RMB in local apps, together with the economic ties of the ‘New Silk Road’, could make the use of the Chinese currency attractive. In fact, this will not be a simple matter of choice, as China increasingly expects the RMB to be used along the belt. The change to a new economic model (consumption-driven growth) foreshadows a decline in the huge USD reserves, which may also increasingly shift BRI financing towards the Chinese currency. The key to China’s ability to ensure the RMB’s foreign circulation is the economic transformation implemented with due consideration (striking the right balance between external and internal ‘circulation’). This outlines a unique economic and financial network, a new Eurasian force field, controlled by Beijing. However, the RMB’s sustained global success is influenced not only by the consumption-driven model ensuring currency outflows but also by other economic ‘rules’. The establishment of the very deep, liquid and open financial markets characteristic of a world currency may prove to be a tall order for Beijing. Therefore, competing with the American currency’s features will be difficult in the long run. The United States is also expected to take steps that preserve the benefits of the USD. If the US also opts for rapid digitalisation, that could be especially effective in this respect. Instead of developing a digital currency, a large-scale modernisation of SWIFT may prove to be enough in ‘cementing’ the position of the USD. Furthermore, the US has its own network of allies, which, when mobilised assertively, could influence power relations even in the regions covered by the BRI (e.g. South East Asia).

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In conclusion, the RMB still has a long way to go if it wishes to fulfil the functions of a world currency, but the potential introduction of a CBDC could undoubtedly prove to be the greatest leap forward on this road. A much more accessible and efficient form of ‘cash’ can essentially boost the medium of exchange function, and economic and financial relations along the ‘New Silk Road’, and combined with China’s ambitions could entail other forms of use as well. All in all, the digital RMB is expected to be the most promising challenger of the USD and a cornerstone of China’s rise in the decades ahead.

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III. Digital renminbi – Taking the US–China geopolitical rivalry to a new level? Center for Strategic and International Studies (2020): China’s Poor Purchasing Performance: How Should the United States Respond? 8 May 2020. https://www.csis. org/analysis/chinas-poor-purchasing-performance-how-should-united-states-respond Central Banking (2020): SWIFT Announces Major Changes to System. 17 September 2020, https://www.centralbanking.com/central-banks/financial-marketinfrastructure/7682636/swift-announces-major-changes-to-system CNBC (2018): Russia’s Central Bank Governor Touts Moscow Alternative to SWIFT Transfer System as Protection from US Sanctions. 23 May 2018, https://www.cnbc. com/2018/05/23/russias-central-bank-governor-touts-moscow-alternative-to-swifttransfer-system-as-protection-from-us-sanctions.html Coindesk (2020): US Fed Chair Says Private Entities Should Not Help Design Central Bank Digital Currencies. 17 June 2020, https://www.coindesk.com/us-fed-chair-saysprivate-entities-should-not-help-design-central-bank-digital-currencies Copeland, Rory (2020): A Global Stablecoin: Revolutionary Reserve Asset or Reinventing the Wheel? Journal of Payments Strategy & Systems, Vol. 13, No. 4 (2020), pp. 310−321. European Central Bank (2020): The International Role of the Euro. June 2020., https:// www.ecb.europa.eu/pub/ire/html/ecb.ire202006~81495c263a.en.html#toc1 Ferguson, John – Parker, Shannon (2020): Perspectives on Chinese Digital RMB Strategy. GOV97: Technology and Revolution in China and Beyond. Working Paper, 11 May 2020, http://www.johnandrewferguson.com/documents/Ferguson_Chinese_ Digital_RMB_Strategy.pdf Financial Times (2018): The Belt and Road’s Dollar Problem. 18 December 2018, https://ftalphaville.ft.com/2018/12/18/1545130791000/The-Belt-and-Road-s-dollarproblem/ Greene, Robert – Triolo, Paul (2020): Will China Control the Global Internet Via its Digital Silk Road? Carnegie Endowment for International Peace, 8 May 2020, https:// carnegieendowment.org/2020/05/08/will-china-control-global-internet-via-its-digitalsilk-road-pub-81857 Gulliver-Needham, Elliot (2019): PBOC Sounds Alarm Over Facebook’s Libra. Central Banking, 9 June 2019, https://www.centralbanking.com/fintech/crypto-assets/4307586/ pboc-sounds-alarm-over-facebooks-libra IMF (2020): World Economic Outlook, October 2020: A Long and Difficult Ascent. International Monetary Fund, October 2020, https://www.imf.org/en/Publications/ WEO/Issues/2020/09/30/world-economic-outlook-october-2020 International Economy (2020): Is the World’s Reserve Currency in Trouble? A Symposium of Views. The International Economy, Winter 2020, https://www. international-economy.com/TIE_W20_DollarRoleSymp.pdf Japan Times (2020): Bank of Japan to Begin Test of Digital Currency in 2021. 10 October 2020, https://www.japantimes.co.jp/news/2020/10/10/business/economybusiness/bank-of-japan-test-digital-currency-2021/

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III. Digital renminbi – Taking the US–China geopolitical rivalry to a new level? Jennings, Ralph (2020): How the Coronavirus Turned Southeast Asia Into China’s Top Trade Partner. VOA News, 17 June 2020, https://www.voanews.com/covid-19pandemic/how-coronavirus-turned-southeast-asia-chinas-top-trade-partner Kärnfelt, Maximilian (2020): China’s Currency Push. The Chinese Yuan Expands its Footprint in Europe. Mercator Institute for China Studies (MERICS), 9 January 2020, https://merics.org/en/report/chinas-currency-push Kumar, Aditi–Rosenbach, Eric (2020): Could China’s Digital Currency Unseat the Dollar? American Economic and Geopolitical Power Is at Stake. Foreign Affairs, 20 May 2020, https://www.foreignaffairs.com/articles/china/2020-05-20/could-chinasdigital-currency-unseat-dollar Larres, Klaus W. (2020): Trump’s Foreign Policy is Still ‘America First’ – What Does That Mean, Exactly? The Conversation, 27 August 2020, https://theconversation.com/ trumps-foreign-policy-is-still-america-first-what-does-that-mean-exactly-144841 Lo, Chi (2020): The Crypto-Renminbi Challenge to the Dollar. The International Economy, Vol. 34. Issue 2 (Spring 2020). http://www.international-economy.com/ TIE_Sp20_Lo.pdf Magyar Nemzeti Bank (2019): Long-Term Sustainable Econo-Mix. Editor: Virág, Barnabás. Magyar Nemzeti Bank book series, Budapest, 2019. Matolcsy, György (2020): Amerikai birodalom vs. Európai álom – Az euró kudarca (The American Empire vs. The European Dream – The Failure of the Euro) (2nd edition). Pallas Athéné Publishing House, Budapest, May 2020 Mirza, Charmaine (2019): Fintech: China vs. India – Compete or Collaborate? In Chin Closer (Bringing India and China Closer), 20 March 2019, https://www.inchincloser. com/fintech-china-vs-india-compete-or-collaborate/ National Development and Reform Commission (2015): Vision and Actions on Jointly Building Silk Road Economic Belt and 21st-Century Maritime Silk Road. Issued by the National Development and Reform Commission, Ministry of Foreign Affairs and Ministry of Commerce of the People’s Republic of China, with State Council authorization. March 2015., http://www.chinaembassy.hu/hu/xwdt/t1250648.htm National Institute for Smart Government (2019): National Strategy on Blockchain. Draft Approach Paper. National e-Governance Division (NeGD), India, 30 December 2019, https://4c44db83-35be-491f-a87f-fc7c6a312fd0.filesusr.com/ugd/ cc85ab_0d68282aa0f94253acc1927d80937433.pdf OMFIF (2020): U.S.-China Relations and Global Growth. Teleconference and podcast, 28 August 2020, https://www.omfif.org/podcast/us-china-relations-and-globalgrowth/ PBoC (2020): RMB Internationalization Report. People’s Bank of China, 17 August 2020, http://www.pbc.gov.cn/en/3688241/3688636/3828468/3982952/index.html Peters, Michael A. – Green, Benjamin – Yang, Haiyang M. (2020): Cryptocurrencies, China’s Sovereign Digital Currency (DCEP) and the US Dollar System. Educational Philosophy and Theory, published online: 5 August 2020., https://www.tandfonline. com/doi/full/10.1080/00131857.2020.1801146

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III. Digital renminbi – Taking the US–China geopolitical rivalry to a new level? Reuters (2019): China’s Digital Currency Not Seeking ‘Full Control’ of Individuals’ Details: Central Bank Official. 12 November 2019, https://www.reuters.com/article/ us-china-markets-digital-currency/chinas-digital-currency-not-seeking-full-controlofindividuals-details-central-bank-officialidUSKBN1XM0H2 Reuters (2020a): What’s in the U.S.-China Phase 1 Trade Deal. 15 January 2020, https:// www.reuters.com/article/us-usa-trade-china-details-factbox-idUSKBN1ZE2IF Reuters (2020b): China Pursues Economic Self-Reliance as External Risks Grow: Advisers. 5 August 2020, https://www.reuters.com/article/us-china-economy-strategyidUSKCN25031K Russia Briefing (2019): Russia, China Sign Deal to Settle All Trade In Respective Currencies And Drop Bilateral Use Of US Dollars. 1 July 2019, https://www.russiabriefing.com/news/russia-china-sign-deal-settle-trade-respective-currencies-dropbilateral-use-us-dollars.html/ Shaffer, Gregory – Gao, Henry (2020): A New Chinese Economic Law Order? Journal of International Economic Law, Oxford Academic, 30 July 2020, https://academic.oup. com/jiel/advance-article-abstract/doi/10.1093/jiel/jgaa013/5878140 Smith, Gary (2020): An End to the Love less Marriage with the US Dollar? Central Banking, 25 September 2020, https://www.centralbanking.com/central-banks/ reserves/7687411/an-end-to-the-loveless-marriage-with-the-us-dollar South China Morning Post (2020a): People’s Bank of China’s Digital Currency Already Used for Pilot Transactions Worth 1.1 Billion Yuan. 5 October 2020, https://www. scmp.com/business/banking-finance/article/3104281/peoples-bank-chinas-digitalcurrency-already-used-pilot South China Morning Post (2020b): What China’s Pivot Towards Economic SelfSufficiency Means. 4 August 2020, https://www.scmp.com/comment/opinion/ article/3095842/what-chinas-pivot-towards-economic-self-sufficiency-means South China Morning Post (2020c): China ‘Stuck’ as Rigid Controls on Capital Outflows Becoming Harder to Peel Back. 26 August 2020, https://www.scmp.com/ economy/china-economy/article/3098814/china-stuck-rigid-controls-capital-outflowsbecoming-harder The Straits Times (2020): Pompeo Shrugs off China’s Objections Over Taiwan Visit, Unveils New Actions Against Chinese Apps and Data Access. 6 August 2020, https://www.straitstimes.com/world/united-states/mike-pompeo-shrugs-off-chinasobjections-over-taiwan-visit-unveils-new-actions The Wall Street Journal (2020a): China Rolls Out Pilot Test of Digital Currency. 20 April 2020, https://www.wsj.com/articles/china-rolls-out-pilot-test-of-digitalcurrency-11587385339 The Wall Street Journal (2020b): China to Expand Testing of a Digital Currency. 14 August 2020, https://www.wsj.com/articles/china-to-expand-testing-of-a-digitalcurrency-11597385324 Wong, Brian (2020): China’s Mask Diplomacy. The Diplomat. 25 March 2020, https:// thediplomat.com/2020/03/chinas-mask-diplomacy/

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IV. The conceptual framework of central bank digital currencies Péter Fáykiss – Anikó Szombati The actual catalysts behind the increasingly serious discussion about the introduction of a central bank digital currency (CBDC) included technological progress, the rise in electronic payments as well as the appearance of the private solutions addressing the anomalies in payment systems. The way how the different countries introduce it, however, will vary considerably. It will depend largely on the particular problem that a CBDC can resolve, its relationship with monetary policy and the extent to which the central bank wishes to involve market participants in the operation of the new payment system. Besides, potential users’ needs and the differences and options between the available technologies have to be taken into consideration so that a completely new money-type can function alongside cash as used today, while ensuring that the targeted user base actually uses it. This chapter presents and categorises the public policy, economic and technological considerations that need to be taken into account when deciding about the introduction of a CBDC.

1. The main reasons and purposes of introducing a CBDC A little bit more than ten years ago, the concept of central bank digital currencies (CBDC) was linked to financial transactions between central banks and their direct counterparties, i.e. commercial banks and other professional financial service providers with access to the central bank’s instruments. The idea that the digital currency embodying a direct claim on the central

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bank’s balance sheet may appear in the transactions between financial service providers, or even in those between households and companies, is primarily due to technological progress and the spread of digital payment solutions. Nevertheless, the decision on the everyday use of a central bank digital currency beyond research, testing and pilot projects (Figure 1) should be based on a strong social consensus, and it should be carefully considered to protect the central bank’s reputation. Figure 1: International CBDC researches and pilots

Retail research and wholesale project Live retail Retail research Ongoing retail pilot Completed retail pilot Wholesale projects

Source: BIS, central banks’ websites. Status as of 30 April 2021.

1.1. The possible social and public policy considerations leading to the decision to introduce a CBDC To move the issue of a CBDC from central banks’ research teams to policy teams or even the implementing technology team, central banks should have an underlying motivation that nudges them from theoretical examination towards the — 96 —

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decision on implementation. The review of international central banking practices shows that there are four main considerations, phenomena or driving factors facilitating the introduction of a CBDC: – Potential cost savings and reduction of market frictions: the most widely considered aspect is the reduction of the costs arising from the financial and environmental toll of cash usage.37 However, the costs of cash management go hand in hand with the social costs that arise from exclusion from, or partial access to, modern, bank account-based digital payment solutions in the case of certain social groups or an even broader section of society. The CBDC can support financial inclusion by providing these groups with access to quick, cheap and secure digital payment solutions, which entails stronger digital skills, increased capacity to promote interests, greater security and more freedom in entrepreneurship for the society at large. In other words, the CBDC can complement cash for the social groups who currently have no access to the electronic payment infrastructure. Overall, it can promote the development of a socially more efficient payment system, which also involves the reduction of cash usage. – Rise in alternative forms of payment, preserving monetary sovereignty in spite of the appearance of stablecoins: within the continuous innovations affecting technology and payment systems, one announcement stood out from the rest: in 2019, the Libra Association, established by Facebook, proclaimed that it was developing a payment solution building on the global Facebook user community and offering fast, cheap and accessible service that can also be utilised in cross-border payments. The proposal drew a barrage of regulatory criticism because it would have created an alternative payment system and thus constrained monetary sovereignty in the affected

Based on a survey by Central Banking from February 2020.

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countries, and it would also have entailed financial stability risks by enabling an exit from the domestic financial system. Also, the portfolio allocation decisions of the collateral holdings backing the payment system would also have introduced a major uncertainty to bond and FX markets. Besides the regulatory pressure, the need to maintain control over local payment systems boosted local CBDC projects in numerous countries.38 Although the Libra, and later on Diem Association’s ideas have changed profoundly, Facebook’s initiative was probably a huge catalyst to the appearance of a CBDC in everyday payments within a reasonable timeframe. – Creation of an instrument suitable for targeted stimulus: the COVID-19 pandemic and the resulting constraints led to a massive economic slump all over the world. To mitigate the social impact of the significant amount of lost income and unemployment, fiscal entities decided to provide extraordinary, immediate and universal allowance in several countries. However, it was far from straightforward that this would actually get to those in need in a fast and targeted manner, and for example the US administration started distributing cheques. By contrast, in China WeChat Pay and Alipay, the two super‑apps, were used to distribute digital coupons in an easy, fast and targeted manner, and the recipients contributed significantly to restarting the economy when they spent those coupons. A universal CBDC widely available to households could be a solid basis for implementing fast and targeted stimulus measures necessary in such situations. Based on this, the creation of a digital payment solution operated by a central player has become part of the potential public policy objectives. However, it must be noted that in addition to providing a payment channel and the digital assets to households, a system

o name only the major central banks, they included the previously sceptical T European Central Bank, the Fed and the PBoC, too.

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for remote identification of citizens and record-keeping also needs to be designed and operated. – Designing a new platform for innovative services: although the existing payment systems meet the current electronic payment needs, several market innovations have targeted this area, since the pricing and efficiency of completing orders, especially in cross-border payments, needs to be improved considerably. As these solutions can only be successful in the long run when a large number of users adopt them, beyond a certain point, the appearance of new service providers limits innovation that is based on the current payment structure. Therefore, taking into account long-term development opportunities, central banks increasingly believe39 that a brand-new payment system is needed that can even manage smart contracts. It could complement the current system and gradually embrace new payment solutions and the new business solutions built on them. 1.2. Market failures potentially triggering the introduction of a CBDC based on the international literature Central banks can only be expected to make public policy intervention and a public commitment to a new, unprecedented central bank digital currency solution, if a clear market problem, failure or public policy consideration can be identified that provokes thinking outside the box and a new way of central bank action. According to the examples in the international literature, CBDC projects can be catalysed by the below social objectives and unresolved market frictions and failures: – Reduction in cash holdings, cash logistics costs and the entailing environmental impact: cash is a central bank

or example the ECB, the Bank of England or the Monetary Authority of F Singapore.

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commodity with a strong brand backed by central bank credibility, and central banks are stipulated by law to provide it. At the same time, the rise of digital payment solutions has intensified the demand for a digital payment instrument that is issued and guaranteed by the state, universally accepted just like cash, and able to fulfil the means of payment function in digital form. When this becomes widely used, most of the costs associated with collecting, handling, guarding and redistributing cash as well as replacing the necessary amount can be slashed thanks to an appropriately efficient CBDC system, and this is also reflected in the reduced environmental impact related to production and transportation.40 – Improving access to financial services and enhancing financial awareness: despite the rise in the access to bank accounts, about one-third of the world’s adult population have no access to basic financial services, and approximately 1 billion people do not even have an ID (World Bank 2020) that could be used to enter into a relationship with a bank. Therefore, it is in society’s best interest to reduce cash use in these social groups and provide an option for conducting financial transactions on more secure digital devices, mainly smartphones, that offer the possibility of greater awareness and access to other services. A cheap, universally accessible, secure and fast electronic payment system operated by a central bank can fulfil this mission. – Operating a robust payment instrument and system and ensuring access to them even in a crisis: in advanced countries, where card usage and electronic payment solutions

evertheless, further analysis of the social costs entailed by the establishment N of a CBDC system is necessary to prove this. Moreover, it is not expected to completely eliminate cash in the foreseeable future, as it cannot provide all the features (it offers anonymity, it is tangible and can be physically counted and therefore managed better) that make many people prefer cash in Central Europe, for example in Germany, Switzerland and Austria. CBDC can represent a realistic social advantage in the countries (East Asia, Central Africa) where cash distribution is difficult to organise.

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are on the rise, cash is increasingly likely to disappear from everyday transactions in the near future. However, this could make countries or communities vulnerable to malfunctions in the existing financial infrastructure, partly linked to the private sector, resulting from the uncertainty surrounding the business decisions of infrastructure providers, cyberattacks, a general outage or a natural disaster. A backup system may have to be established and maintained to ensure uninterrupted digital payments in everyday life, and this obviously has to be implemented by a central player, for example the central bank. This system would include a universally accepted and widely accessible digital payment instrument, which would be cost- and risk-free similar to cash. – Developing the market for financial services and fostering competition: the current electronic payment solutions are mostly card-based, and they create a sense of instant payment among users, while the actual settlement for stores and service providers may take days, and there is also a substantial fee payable to the card company (Bank of England 2020). A CBDC acting as an alternative to payment services could be a good starting point for promoting the establishment of a competitive market in this field as well as truly instant payment platforms with low costs. Such a platform can also support other developments and technological innovations, for example through smart contracts related to payment transactions, which allow users to initiate further processes after the payment is made, for example in connection with land registry entries or duties office records. – Reducing the shadow economy: the efforts to reduce cash transactions facilitate cost reduction related to cash management, transportation and guarding, and also the combating of the shadow economy, especially in developing countries. A CBDC framework could be a useful tool in exploring the transactions conducted tax-free or even illegally in the informal sector and enforcing the mechanisms to prevent these. This does

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not necessarily mean that the central bank or government authorities have direct access and control over citizens’ financial transactions, as in itself the digital form of transactions can partly guarantee the reduction of illegal payments.41 – Fostering economic growth, increasing the effectiveness of monetary policy: for monetary authorities, one of the main attractions of a generally accessible CBDC is that the interest paid on households’ central bank deposits ensures an immediate and direct transmission of the interest conditions determined by the central bank. However, this theoretical premise may not necessarily be implemented in practice. First, fast and complete transmission requires that a substantial share of retail deposits be held with the central bank. This would make it difficult to fulfil commercial bank functions, i.e. the quantitative, risk and maturity transformation, which also hampers the operation of other monetary policy channels and may pose financial stability risks. Second, especially in the context of the near-zero or negative interest rate environment seen in several regions in today’s economic situation, the implementation of negative interest rates through the CBDC may most likely be hindered by the opportunity to flee to cash. Accordingly, in the current economic climate, the introduction of a CBDC for monetary policy purposes is more likely when it is intended to reduce a special market friction or anomaly, such as a credit rationing problem arising from the procyclical behaviour of the banking sector, when commercial bank lending to major sectors and players in the economy may be constrained or temporarily suspended. For example, SMEs constitute such a sector. – Leading by example: improving the acceptance of innovative technologies and testing such technologies: the central bank’s innovations prompted by the introduction of a CBDC as well 41

I t should be noted that besides a central bank digital currency, this can also be ensured by central records on all payment transactions kept by the tax authority.

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as the innovations in payments, transactions and other areas fostered by the new platform may be important catalysts in the digitalisation of the financial sector and the economy as a whole. This could improve the efficiency and competitiveness of the national economy and thus indirectly support economic growth. The central bank’s commitment to modern technologies and the comprehensive testing of various technologies may also be used in public administration as stepping stones towards new initiatives, paving the way for new technologies, for example systems based on distributed ledger technology (DLT). Estonia already has extensive experience in this. Besides the financial sector, these technologies can also appear in process automation, record-keeping and numerous other areas. Finally, society’s openness and awareness can also be improved through the commitment of a credible and established institution, such as the central bank, to new technologies.

2. Foundations and expectations in connection with a planned CBDC system Central banks have been providing reliable money to the public for decades, or, in the case of certain institutions, centuries (e.g. the Swedish Riksbank). Therefore central bank money has an important public good function: (i) first, it is a uniform unit of account for determining the prices of products and services in a given jurisdiction, (ii) second, it has a store of value function, so it can be used by economic actors and individuals for amassing savings, (iii) and finally, it is also an important medium of exchange, as it can be universally used for purchasing goods and services.

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Although this is hardly reflected in general public thinking, central banks actually offer some access to the liabilities side of their balance sheet by providing money. Currently, there are two main types of central bank money: one of them is cash, which appears directly and widely at households and companies alike, and the other one is electronic central bank deposit money, comprising the funds held on the reserve and nostro accounts used by a small group of eligible counterparty financial institutions. In addition to these, there is commercial bank deposit money, held on the commercial bank accounts. However, cash usage has recently declined considerably in several countries, digital payments have been on the rise, and several new factors and other possible motivating forces have appeared (for more on those, see the previous subchapter) that may encourage central banks to issue central bank money in a new, digital form, perhaps even universally. Although there is still no generally accepted definition of central bank digital currencies, the present study mainly uses the definition by the BIS (2020). Consequently, a central bank digital currency is a digital form of central bank money that is different from balances in traditional reserve or settlement accounts (CPMI‑MC 2018). It is a digital payment instrument denominated in the domestic currency and a direct liability of the central bank. In this sense, a central bank digital currency is a third type of central bank money, which can exist alongside cash and central bank deposit money. It can support the establishment of an even more resilient financial and payment system and provide an opportunity for fostering related innovative services through its digital nature, which the current payment and cash infrastructure cannot do or only to a limited extent.

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2.1. The basics of establishing the conceptual framework for a CBDC It must be underlined that it should be up to the independent decision of individual countries and central banks when and how they introduce what type of central bank digital currency, because the conceptual framework and the specific operating framework depend largely on the given country’s legal, social and economic environment and financial system. During the development of the operating framework, decision-makers are faced with several trade‑offs and path dependence arising from decisions related to certain aspects, and the potential benefits and drawbacks need to be continuously evaluated, so there is no optimal solution for designing a central bank digital currency. Despite this complexity, certain general principles and basic expectations can be determined in relation to central bank digital currencies. The below five basic principles stand out according to the international literature (see, for example, Kahn et al. 2018, Riksbank 2018, Brunnermeier et al. 2019, Adrian–Griffoli 2019, Auer et al. 2020, BIS 2020, ECB 2020): – The introduction of a CBDC has to come with the appropriate public policy motivation. An important premise is that a CBDC should not be introduced for its own sake, it should improve social welfare as much as possible, either by addressing a clearly identifiable market failure or by mitigating market frictions in certain areas. – It should not threaten the central bank’s main monetary and financial stability objectives. While designing a CBDC, it must be borne in mind that the appearance of the new central bank money should not have a negative impact on overall monetary policy or the stability of the financial system, and it should not hinder the central bank in fulfilling these mandates. First, the ‘unity’ of the currency should be ensured (the CBDC should be freely convertible to other types of money), and second,

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the conceptual framework should be designed in a way that addresses any negative effect of the CBDC on monetary and financial stability objectives. – It should be complementary. The introduction of a CBDC is a completely new challenge to central banks. It should be designed to have a complementary, parallel nature alongside the already available other types of central bank money, including cash, in other words it should not drive those out, and it should work in a supplementary system that works in parallel to the existing types. In particular, the public’s access to cash must not be compromised. – It should improve efficiency. An important principle in designing the conceptual framework of a CBDC is that it should improve social welfare, either through increasing the efficiency of payment solutions (by offering a competitive payment alternative to cash and other forms of payment), or through other positive externalities (for example the reduction of tax evasion or money laundering risks). – It should support innovation. Finally, another important element of the introduction of a CBDC is that the concept should foster innovation in some form, by the technology used, by strengthening digital skills and competences, or by providing a platform for the introduction of new innovative services. Of course, considerations other than the five listed above may also have to be taken into account when designing a CBDC concept. Nevertheless, these are general principles that are applicable for a wide range of CBDCs, and they help make the introduction and operation sustainable and successful over the long term.

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2.2. Expectations identified in connection with a planned CBDC system Besides the basic principles described in the previous section, some core functional expectations can also be identified in connection with a CBDC concept. These expectations should be classified along three main dimensions: (i) central bank expectations for a CBDC system), (ii) customer needs and (iii) market considerations. 16 basic functional expectations can be identified along the three dimensions (Figure 2): i. Central bank expectations: From a central banking perspective, the CBDC payment system is expected to be resilient and secure, and the currency should be convertible to other forms of money in line with the central banking functions. Another important aspect is scalability, in other words there should be an option to gradually expand the system depending on the intensity of demand, and it should be able to handle considerably greater volumes and transaction numbers. Central banks also expect the design of the CBDC to be in line with the legal environment on issuance and every other related legal requirement (e.g. anti-money laundering and counterterrorist financing and data processing rules). ii. Customer needs: Customers expect several features from a CBDC; however, the critical nature of these expectations depends largely on the potential user base. First, customers wish to use a fast, user‑friendly, easily accessible and cheap (cost-effective) service. Second, the service should be available on a 24/7/365 basis, relatively easily. iii. Market considerations: Those designing a CBDC should be mindful of market considerations, too, because this enables the creation of a framework that is interoperable, flexible and suited for encouraging the development of new innovative services. In other words, the CBDC should operate in a system that is interoperable with other payment systems, flexible

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and modularly expandable. Furthermore, it should exploit comparative advantages and foster competition in auxiliary services. It should be noted that even though these basic functional expectations are generally applicable, their importance, dominance and critical nature obviously depend largely on the CBDC’s entire design framework, especially the user base. For example in the case of a CBDC with a primary wholesale focus, resilience, security and scalability are crucial, while costeffectiveness and user-friendliness are not necessarily vital, albeit important aspects. By contrast, in a CBDC system mainly geared towards households, the significance of the expectations about user-friendliness, inclusivity and modularity may increase. Figure 2: Basic functional requirements for a CBDC system

Central bank expectations

• • • •

Resilient Secure Scalable Convertible

Customer needs

• • • •

Fast • Easily accessible and inclusive User friendly within given multitude Cost-efficient • Transparent 7/24 availability

Market considerations

• In line with legal requirements (legal authorization, GDPR, AML, etc.)

• Exploits • Interoperable comparative • Flexible advantages • Modularly expandable • Increases competitiveness

Source: own edit based on BoE, ECB, BIS

According to the international literature, there are seven distinct decision steps that should be considered while designing a CBDC (Figure 3). It should be noted here that some of the decisions can be made relatively independently, while others may involve — 108 —

IV. The conceptual framework of central bank digital currencies

decisions options that are already partly determined by earlier decisions: I. The fundamental goal, which can stipulate the motivation for the CBDC’s introduction, i.e. the market failure that it is intended to be mitigated. II. Accessibility, which determines which economic and social actors will have access to the CBDC. III. Monetary policy nature, which should lay down the key monetary framework, i.e. whether the instrument is active, neutral or flexible from the perspective of monetary policy, as well as any constraints (e.g. on the amount held on an account, transaction size or number). IV. Form of the CBDC, which should include the form of money (cash or deposit money) it is equivalent to, and the functions it can have accordingly. V. Operating framework, which determines the players that take part in the operation as well as the central bank’s functions. VI. Anonymity, namely whether anonymous transactions can be conducted and the framework for that (account‑based or token‑based approach). VII. The technology used, i.e. whether the system would operate using the traditional infrastructure, or a new system, possibly one based on distributed ledger technology, should be developed.

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Is it feasible on traditional infrastructure? Is the use of blockchain/DLT justified?

VI. ANONYMITY

Are anonymous transactions enabled? Account-based or token-based operation?

V. FRAMEWORK IV. FORM III. MONETARY POLICY NATURE

What actors are involved in the operation? What functions does the central bank perform? What form of money does it replace? Cash or bank money? Deliberately effective, neutral or flexible? Who is able to transact with it?

II. ACCESSIBILITY

What is the basic purpose?

I. FUNDAMENTAL GOAL

Independent decision

VII. TECHNOLOGY

Partially determined

Figure 3: Decision ‘steps’ in designing a CBDC

Source: Authors’ work.

The cascaded structure shows that these decision points build on each other to a great extent. On the three first ‘steps’ (the fundamental goal of the CBDC, accessibility, monetary policy nature), there is considerable freedom to choose along the dimensions, however, once the decisions are taken, the form, the framework, anonymity and the technology to be used may be partly determined.

3. Potential user groups of a CBDC An important question in connection with the introduction of a CBDC is which user groups should have access to it. In the design stage of a CBDC project, after the fundamental goal of the introduction is determined (reduction of market frictions, other public policy objective), the group of economic and social actors having direct or indirect access to the CBDC should be carefully considered.

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– Households or a special retail segment: Similar to cash and commercial bank deposit money, one option is to give the entire public access to the CBDC. In such a universal scenario, all citizens would get access to the liabilities side of the central bank’s balance sheet in addition to cash use. Another option is to grant access to a specific group rather than the entire population. This may be warranted in cases where a market failure can be identified in connection with a specific, distinct social group, and it can be mitigated with the introduction of a CBDC. For instance there is a massive share of households in several developing countries that never or only rarely use financial services, and their financial inclusion can be implemented with a CBDC designed for this purpose. In such a case, access does not have to be granted to the entire population, but rather only to the particular social group. Within the general household group, a separate segment may comprise non-residents, for example those who arrive to the given country as tourists. Since here quantitative restrictions may also be applied to maintain monetary sovereignty, such a decision requires independent reflection and an assessment of how this relates to the fundamental goal of the introduction. – SMEs: In connection with the introduction of a CBDC, there may be a market failure for SMEs that could be mitigated by the introduction and the appearance of the services related to that. Of course, access does not have to be exclusive, it can be granted to other social groups, too. With SMEs, the market friction or failure that could be mitigated with the introduction of a CBDC may primarily arise in connection with the services related to lending and cross-border payments, and some new, innovative solutions may emerge enabled by the CBDC framework. – Corporates: In the case of corporations, there are two main considerations in connection with CBDC access. First, similar to SMEs, the introduction could be an innovative solution in cross-border payments, and obviously this works best if

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a specific group of the central banks concerned participate. Second, innovative corporate solutions can already be identified that cannot be implemented in the current infrastructure, or only with difficulty. Examples include smart contract solutions related to corporate bond issues, or stock financing also implemented in a smart contract framework. An appropriately designed CBDC solution could provide a platform for this purpose, which can be used by the existing financial institutions to develop new services. – Payment service providers: As indicated above, payment service providers typically have access to central bank funds through the electronic central bank deposit money, which refers to the reserve and nostro accounts applicable to a small group of actors, mainly eligible counterparty financial institutions. The introduction of a CBDC can mainly affect this group by allowing them to develop new, innovative services on the resulting platform (e.g. download-based micropayments), thereby improving the efficiency and competitiveness of the financial system. – Other, non-payment institutions: Generally, other, nonpayment institutions (e.g. insurers and pension funds) currently have direct access to cash and commercial bank deposit money. In their case, similar to corporates, access to a CBDC system can mainly represent value added in connection with cross-border payments and the establishment of a platform suited for the development of innovative services. – Municipalities: Similar to most economic actors, municipalities currently have direct access to cash and commercial bank deposit money. Therefore, it should be considered whether to grant municipalities access to a potentially introduced CBDC. This may be warranted if a CBDC becomes widely used in the economy, for example on account of widespread access among households, or if a major market friction can be identified in the case of the financial services provided to municipalities in the — 112 —

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given country (for instance smaller municipalities may find it more difficult to access financial services). Of course, the goal of the CBDC’s introduction should be borne in mind when determining potential users. However, this is typically not a major constraint, it rather stipulates the group that should be definitely granted access. For example if a central bank plans to introduce a CBDC to address a market problem mainly seen in the retail segment, it may of course grant access to other actors (e.g. SMEs or even municipalities) besides households. Figure 4: Relevance of each design dimension based on accessibility Monetary policy nature

Converti bility

Offline operation

Crossborder usage

Households or special retail segment

Additional Anonimity services, involving market players

Technology

SMEs

Corporates

Payment service providers Other, non-payment institutions

Municipalities

Note: In the figure, design dimensions are marked as follows: relevant – full circle, medium relevant – half full circle, less relevant – empty circle. Source: Authors’ work.

Of course, the relevance of the design dimensions presented above varies considerably, depending on the economic and social actors that have access to the CBDC. For example the monetary policy nature of the CBDC is a very important dimension for — 113 —

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households and companies, but less so in the case of financial institutions, most of which already have access to central bank funds. In a similar fashion, anonymity and offline operation can be important dimensions with a CBDC focusing on households, but it is completely irrelevant with a central bank money available to corporations and payment service providers. All in all, the central bank and decision-makers in a given country should design the operating framework for a central bank digital currency by identifying the social goal related to the CBDC introduction, using that to determine the group that has potential access, and taking into account the country’s legal, social and economic environment as well as the features of the financial system.

4. Questions related to the form and operating framework of a CBDC While designing the conceptual framework for a central bank digital currency, the establishment of the fundamental goal(s) and accessibility should be followed by decisions on the monetary policy nature, form and operating framework of the CBDC. The monetary policy dimensions are discussed in a separate study, so here only two key aspects are mentioned briefly: (i) quantitative restrictions and (ii) interest. i. Quantitative restrictions: These constraints can be general or determined along various dimensions. For example, quantitative restrictions can be calibrated for the amount of money held on an account, transaction size, the volume of transactions per month or the size of offline transactions, even at the counterparty level. In the latter case, counterparties need to be identified individually, which also affects the structure of the whole system. ii. Interest: Interest is one of the most crucial monetary policy aspects in designing a CBDC concept. It can be used by the — 114 —

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central bank to influence the demand for the CBDC fairly directly, and it also partly determines the whole system, for example by excluding anonymity (when interest is paid, anonymity may be difficult to ensure because tax is payable on interest). With interest, the CBDC would be more like commercial bank money, while without it, it would be more like cash. 4.1. Determining the form of a CBDC as a type of money The form of the CBDC can be partly constrained by the decisions taken by the central bank about the fundamental goal, accessibility and monetary policy nature of the CBDC to be introduced. Of course, these constraints should be taken into account when designing a particular CBDC, because it is especially true about central bank digital currencies that there is no one‑size‑fits‑all approach, and the framework of the given CBDC depends largely on the country’s legal, social and economic setting and financial system. In connection with the CBDC’s form, decisions must be taken along the following dimensions: – Convertibility: A crucial aspect is whether the central bank wants to allow full convertibility with cash, commercial bank deposit money or both. If cash can be converted to CBDC, the central bank needs to implement major infrastructure developments and ensure availability (e.g. establishment and maintenance of branches and/or ATMs), which may significantly increase the costs of introducing a CBDC. – Offline operation: Offering offline operation for a CBDC (allowing it to be used everywhere, under all conditions) can be considered a convenience service, or it can be seen as a vital feature of a backup system used alongside cash. Countries or communities could become vulnerable to malfunctions in the existing financial infrastructure, and to cyberattacks, — 115 —

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a general outage or a natural disaster. A backup system has to be established and maintained to ensure uninterrupted digital payments in everyday life, and an important function would be its ability to handle offline transactions under certain conditions (e.g. a given number of transactions or maximum transaction size). – Access by non-residents: When designing a CBDC, central banks and decision-makers probably focus on residents, but besides local operation, it may be considered whether the central bank should offer access to non-residents. This may take the form of providing access to non-residents in the given country (e.g. tourists, non-resident workers) or, with an even larger scope, allowing the CBDC to be used abroad or in crossborder transfers. Of course this issue is rather complex, and most central banks are not expected to treat it as a priority during the introduction of a CBDC, so only gradual ‘easing’ is expected in this field (exceptions include the central banks whose currency (USD, EUR, CNY or even CHF) is already used widely abroad, either as cash or as deposit money, therefore their central bank digital currency should also support the current role of the traditional currency in international payments or its more widespread use in the future). 4.2. Potential operating framework of a CBDC The main question regarding the operating framework of a CBDC is which institutions should participate in its operation, and how these institutions are linked to the system as a whole. Three main models can be identified when it comes to operating frameworks: (i) the direct, (ii) hybrid and (iii) indirect models (Figure 5, see, for example, CPMI MC 2018, Auer-Böhme 2020, Auer et al. 2020, ECB 2020). i. Direct model: In this operating framework, customers directly deal with the central bank, and they have claims on the central bank. The CBDC is issued by the central bank, account — 116 —

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balances are recorded there and the various payment services and other financial services, if any, are used there, too. This requires major development and operating expenses from central banks (account-keeping system, mobile application and internet banking platform, remote customer identification tasks related to AML requirements, fraud prevention etc.), and, depending on the size of the group with access to the CBDC, this could exert a substantial effect on the market. ii. Hybrid model: In the hybrid model, the claims are still on the central bank, but an intermediate service provider is added to the scheme to allow some operational tasks to be outsourced to one or more market participants. This payment service provider (PSP) may provide the mobile application and the internet banking platform, customer service, it can even handle the remote customer identification tasks related to AML requirements, and it may take over fraud prevention functions as well. In this model, the competitive market is preserved in some sense, since the players can compete with each other in the quality of services and through the incorporation of new services. Nevertheless, the development of a sustainable business model for market participants is a major challenge, as customers may not necessarily be willing to pay a large service fee in addition to banking service charges. iii. Indirect model: In the indirect model, the claims are on a market participant rather than the central bank. Here, the market participant holds liquid assets as collateral to cover all the amount of CBDC held with it by customers, preventing itself from the ability to create money, unlike in today’s banking model. In such a scenario, the model would be practically similar to today’s electronic money institutions, the only exception would be that the institutions would hold the liquid collateral of the CBDC with the central bank. In the indirect model, most of the operational tasks are delegated to market participants, and the central bank is mainly left

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with recording stock outstanding and collateral as well as controlling the money supply. Since in this model the claims that arise are not against the central bank, some experts do not even consider this form of money as CBDC (for more details, see BIS 2020). Figure 5: The possible role of the central bank and the market players in the operation of the CBDC

Issuance

Direct model

Hybrid model

Indirect model

Central bank

Central bank 100% collateral

Account

PSP operator

Financial institutions

Payment service Households and enterprises Direct claim on the central bank

Direct claim on the central bank

Direct claim on the market player

Source: Authors’ work based on BIS, IMF, BoE, ECB, Riksbank.

Besides the basic structure of the operating model presented above, there may be several supplementary dimensions in connection with a CBDC. One question is whether external parties (either supervised or non-supervised institutions) can develop additional services on the platform that constitutes the CBDC’s framework (provided, of course, that the technology of the given platform enables this). Just like services, the issue of infrastructure is also important. The infrastructure of central bank–market participant relations should be determined (e.g. traditional relations, dedicated API access to certain elements — 118 —

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of the system). These questions are relevant, all the more so because the level of services offered by the central bank and the associated parties (the channels through which it can be accessed, the convenience services offered by the central bank, typically in the form of commercial banking services, whether new, innovative solutions can be integrated into the platform, whether it can manage smart contracts etc.) influences the extent to which the CBDC is used, which could have monetary policy and financial stability implications. Finally, an additional topic needs to be mentioned in connection with operation, namely lending. The current international literature discusses this in less detail (see, among others, Auer et al. 2020, Adrian−Griffoli 2019, ECB 2020, BIS 2020), but it should be addressed because of certain public policy objectives and central banking and market effects. Lending through the CBDC practically enables certain market actors to access not only the central bank’s liabilities side (similar to cash) but also, to some extent, its assets side. This is partly true even today, one only needs to think of the current central bank bond purchase programmes, but with a CBDC, that instrument could be much more direct, faster and even cheaper. With respect to lending, the operating model can be direct, hybrid or indirect (Figure 6). In the indirect model (A), the central bank only manages a quasi‑credit account for the participants, while in the direct and hybrid models (B), it has more varied tasks (e.g. scoring and credit rating, collateral valuation, disbursement and repayment records, workout, portfolio management).

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Figure 6: Possible role of the central bank and market players regarding a CBDC with lending function

Credit register

Loan disbursement

A) Central bank manages one single credit account Commercial banks’ mobile bank and internet bank

Account management

B) Direct Access

Mobile bank and internet bank

Source: Authors’ work.

5. Considerations related to the anonymity of transactions and account balances 5.1. The necessity of anonymity and the aspects to be considered The retail CBDC scheme available to the wider public should enable widespread use through its simplicity, attractive cost level and functionality. When an alternative to cash transactions is sought, transactions should be simple and smooth as well as anonymous, and the latter can largely determine the popularity of a CBDC.

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Although the anonymity of cash transactions was a matter of course until the 2000s, the global regulatory focus in the wake of the 2001 terrorist attacks resulted in tighter rules for customer identification in the case of larger transactions (KYC) to reduce money laundering (AML) and terrorist financing risks to a minimum, which affected both cash and electronic transactions. These control mechanisms would obviously apply to CBDC transactions, too, beyond a certain amount, to prevent the new payment solution from facilitating illegal transactions. However, a system operated with such mechanisms is highly complex and requires continuous control from the operator, which is compounded by the burden related to processing and storing the obtained data as well as maintaining steady one-toone relations with customers. Since such systems are operated by already existing payment service providers and commercial banks, several central banks (BoE, ECB, PBoC etc.) plan to fulfil this role with the cooperation of the private sector in the long run. So, an important decision point when designing the CBDC scheme is whether to allow anonymous, uncontrolled transactions, and whether different limits can be integrated into the system to distinguish riskier transactions. 5.2. The levels and extent of anonymity, and conceptual (multi-stage) frameworks At one extreme of the theoretical framework, there are fully anonymous transactions, which replicate the fast and unconditional experience of cash transactions (Figure 7). In this case, customers do not need to have an account under their name, they can initiate payments among each other from their digital wallets. These are referred to as token‑based systems, because the digital wallet or storage platform can be a mobile application or digital transmitter, for example an anonymous bank card. The existing AML rules only allow such schemes with strict

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constraints. In the EU, the 5th Anti-Money Laundering Directive42 limits anonymous balances to EUR 150, with a requirement to subsequently check the cardholder’s transactions. However, placing quantitative restrictions on anonymous transactions should not only be considered to eliminate illegal dealings, it is also important in enabling the traceability of offline transactions. This is because in order to facilitate the legal authorisation of the transactions conducted during any interruption in the link between the clearing system and the counterparties providing the payment platform, the number and size of such transactions should be limited to the absolute minimum that allows legitimate use even under extreme conditions (e.g. in the event of a natural disaster). At the other extreme of the theoretical framework is full customer due diligence and identification, which is already compulsory for payment service providers and commercial banks in the case of electronic payment transactions. In this case, the requirement to complete due diligence on customers when they enter the system and even after that at regular intervals, coupled with continuous transaction monitoring, places a considerable extra burden on all system operators, which may include central banks here. At the same time, users also have to acknowledge that their CBDC transactions are constantly monitored and recorded, and may even be suspended in suspicious cases. The social acceptance of such a system can depend on how citizens feel about central registers. Therefore, striking the right balance between the opportunities

irective (EU) 2018/843 of the European Parliament and of the Council of D 30 May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, and amending Directives 2009/138/EC and 2013/36/EU (Text with EEA relevance).

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offered by technology and customers’ need for anonymity is key to the success in any retail CBDC system.43 Figure 7: Possibilities of anonymous transactions and customer identification in CBDC models Identified transactions

Controllable anonymity

Anonymous transactions

Complete customer due diligence

Multilevel customer due diligence

No customer due diligence

Unlimited number and volume of transactions

Multilevel restrictions

Limited number and volume of transactions

~ commercial bank money

~ PBoC DC/EP

~ cash

Increasing money laundering risks

Increasing data handling burdens

Source: Authors’ work.

A possible implementation of the middle ground between the two extremes is offered by the so-called controllable anonymity used by the PBoC’s Institute of Digital Currency,44 which assigns pre-determined, gradually tightening due diligence requirements to the transactions increasing in size, thereby ensuring a sort of graduality to find the sweet spot between smooth transactions and the growing administrative and data processing burden arising from the increasing money laundering risks. There are three grades, with gradually increasing limits on account balances and

he ECB’s household questionnaire on this topic also seeked to learn more T about these preferences. (https://www.ecb.europa.eu/euro/shared/files/ Questionnaire_on_a_digital_euro.pdf)

h ttps://www.bloomberg.com/news/articles/2019-11-13/pboc-wantscontrollable-anonymity-in-china-s-digital-currency

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individual transaction sizes, depending on whether the account holders identify themselves with another bank account, a copy of their ID or a transaction from another bank account. The system distinguishes between the accounts held with a payment service provider and those held with commercial banks, and of course only the latter can have full functionality and the highest limit. This allows transactions in everyday life to be simplified and extended to a wide range of service providers, while more unusual and complex transactions come with stricter identification requirements.

6. Design considerations related to the technology used The two, radically different versions of CBDC are the wholesale type used among financial institutions, and the widely used CBDC available to the general public. Since technological challenges are mainly faced during the preparation and introduction of the latter due to the number and considerable diversity of users, this chapter focuses on the questions and main parameters related to this. Nevertheless, where relevant, the technological issues tied to a CBDC used among professional financial actors will also be pointed out and discussed. 6.1. Presentation of the potential participants in the ecosystem In the case of a widely used retail CBDC, cooperation between several partners and ensuring an uninterrupted service are required for the establishment and operation of the system. The members of the smallest ecosystem by functions:45

Of course, more than of these functions may be fulfilled by the entities.

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– Central bank: the conceptual designer of the system, owner of the decisions and responsibility. – Operator(s): operator of the physical underlying system and any service units and functions, the actor in charge of technical operation. – Payment service providers: depending on the model, they are responsible for user registration and interaction, the continuous operators of individual KYC and AML procedures, main points of contact towards users and the sources and users of potential new innovations. They may comprise commercial banks, payment service providers or even tech firms to maintain the possibility of market innovation and market diversity. – Banks: besides the functions described at payment service providers, they ensure convertibility between the CBDC and the money issued by commercial banks, possibly even for foreign CBDCs. In a broader sense, the supporting ecosystem may also include the suppliers of the physical devices that are part of the physical infrastructure and necessary for retailers and users, the developers of services and apps, or even the external suppliers taking part in data analysis and communication. 6.2. Design considerations related to the technology used during the introduction of a CBDC As described above, the decision points related to the design of the CBDC system motived by public policy goals affect several other design dimensions. Therefore these can be considered predetermined features when choosing the technology to be used. Nonetheless, the currently available technologies obviously limit the choice, just like the absence of reliable testing experience that would pave the way for their robust and large-scale application.

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6.2.1. Expectations from the technology to be applied The technological challenges posed by a widely used retail CBDC system are definitely new compared to earlier systems, because a very large user base needs to be served in almost real time, continuously, without errors, and the system has to be deployed relatively quickly after the decision is taken, without the adjustment opportunities available in earlier, evolutive processes. Therefore, there is a special focus on feedback and testing at the design and implementation stages.

The theoretical requirements to be considered during the design stage are as follows (BIS 2020): – Convenient and accessible: the system has to provide the already available user experience, in physical and online shopping alike, as well as during peer‑to‑peer transactions. Depending on mobile penetration and the number of phones in use, tap-to-pay can be achieved with mobile phones, wearables or portable digital devices, for example stored-value cards. Some of these devices need to work offline as well. The old and the disabled should also be able to conduct payment transactions. – Resilient and secure: the system has to ensure full protection against unauthorised access, attacks and phishing on both the clearing system and the user side. Advanced and continuously developed cryptographic procedures need to be provided to record transactions and user balances in real time. The recordkeeping system has to be highly resilient, which may require system redundancy in the case of central clearing, or enhanced protection at the nodes in the case of distributed ledger solutions. – Fast and scalable: the system should be able to simultaneously complete transactions for a huge number of users at reasonable costs, i.e. its throughput has to be large. Moreover, the technology should also ensure that even if the initial number of transactions surges, the system will not reach full capacity

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soon, since innovative solutions may considerably boost user demand, for example with the rise in micro payments related to media consumption. – Interoperable: the system obviously has to function at all the players taking part in its operation and in maintaining customer relations, both online and offline, and it has to provide a link to the existing payments infrastructure, for example in the form of convertibility to commercial bank money or cash. Furthermore, it should enable the connection to platform-based business models and new, CBDC-based developments. Users should also have the option to switch between service providers, because that is the only way to ensure a customer-driven approach and continuous innovation. – Flexible and adaptable: the system has to work in line with the current and future functions of money, while adequately responding to the often conflicting requirements. It should be flexible by design and remain so. 6.2.2. Path dependence and innovation opportunities When deciding on the technology to be used, the continuous and uninterrupted operation of the existing payments infrastructure should be ensured until the deployment of the new system, and the operating costs and environmental impact of the final system or systems should remain acceptable.

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Increasing complexity

New system in an innovative approach (e.g.: DLT-based)

New system on traditional basis Expansion of current

Increasing development requirement

Figure 8: Possible directions of a CBDC infrastructure development

Source: Authors’ work.

Based on the time required for implementation and the project’s complexity, the least amount of effort is required when the existing systems are expanded, enabling them to manage individual retail accounts (Figure 8). In this case, capacity requirements may be reduced if some of the clearing and account management functions are outsourced to authorised payment service providers or commercial banks. However, beyond a certain number of users, the time required for the development and the need to ensure uninterrupted operation may call for designing a new system based on the traditional infrastructure. This leaves more doors open to establishing new connections with new service providers or to widen the user base, possibly even abroad, without compromising the reliability of the technology. However, if the CBDC project was motivated by the need for the new platform to enable the development and propagation of innovative services, smart contracts and programmable functions,

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the traditional technology may have to be surpassed. Distributed ledger technology (DLT) offers market participants an opportunity to link the clearing and settlement of payment transactions to further automatic and real-time transactions, registrations and other operations, the completion of which can be verified by all the parties controlling the ledger system, validating it on a majority basis. If the ledger is controlled by a low number of special clearing nodes, the negative experiences regarding the time required for clearing usually cited in connection with the distributed ledger technology may not be relevant, because the system’s throughput may be greater than today’s systems’ by orders of magnitude.46 Figure 9: Possible long-term targets for the design of the CBDC core system I. The new system replaces the existing system(s)

II. The new system supplements the current infrastructure

After a successful pilot period, the old system will be phased out

The old and the new systems run in parallel with different functionality and focus

III. Back-up system alongside the traditional infrastructure

Source: Authors’ work.

When a new system is set up as the core CBDC system, the longterm relationship between the existing and the new system should also be considered (Figure 9). The new system may be required to supplement the existing one, ensuring the new functionality while the old system reliably operates. The new system may also have

or example see nanopay’s nanorail ledger system, which can complete up F to 50,000 transactions per second (TPS). (www. nanopay.net)

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to be able to take over the functionality of the existing system in a crisis (e.g. cyberattack, natural disaster, extensive power failure), and be able to ensure the uninterrupted operation of the digital payments infrastructure. 6.2.3. Considerations when deciding between a centralised and a decentralised core system The appearance of bitcoin in 2008 marked the emergence of an early forerunner to central bank digital currencies, as it sought to popularise a new, digital means of payment without any central clearing system or records, where transactions are finalised and cleared with the approval of the majority of verified participants or nodes. However, this comes at a price: the finalisation of transactions requires time and energy, so this technology is not really suited for the digital version of cash transactions in terms of the customer experience. Bitcoin’s features mentioned above and the fact that it is not backed by any government or economy that would ensure the stability of its value basically exclude it from among the public blockchain solutions to be considered when designing a CBDC. However, the distributed ledger technology itself should not be dismissed at all.

This is because when clearing occurs with many parties, the process does not necessarily have to rely on the common judgement of a large number of players that are difficult to identify. So-called private blockchains with a distributed ledger solution can be created where writing and validation rights can be distinguished, and where these rights are distributed among a low number of verified actors (Figure 10).

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Figure 10: Main differences between private and public blockchains

Public

• Many, unknown participants • Reading and writing rights • Platform dependant consensus mechanism

Private

• • • •

Limited number and known validators Centralised writing rights Public or restricted reading rights Multiple algorithms for consensus

Source: Authors’ work.

A special implementation of private blockchains is the so-called centralised ledger technology (CLT), where a central actor is responsible for operating the system and storing data, while information is also recorded and transactions are validated at the limited number of other participants in the blockchain. Due to the distributed ledger nature, this preserves simultaneous and multiple validation and greater recovery capacity, while transactions can be processed and completed in real time without major compromises. Another big advantage of the CLT technology is that it can ensure offline operation for a limited time, since the transactions recorded by the distributed nodes are protected from external manipulation with cryptographic tools and can be recorded in the central ledger when the online connection is restored.

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The option for multi-actor, simultaneous validation and for the linking of payment transactions with other settlement obligations stipulated in a smart contract make distributed ledger technology on a private blockchain especially attractive when implementing so-called wholesale CBDC solutions among financial institutions. Several central banks (SNB, BdF, Bank of Canada) have made great progress in experimenting with the development and deploying of such solutions. Besides simplifying and accelerating money and capital market transactions, this solution may greatly facilitate cross-border wholesale payment transactions and real time settlement. Numerous central banking projects have been set up in international cooperation (e.g. Project Stella, Project Inthanon-LionRock) to implement this. Table 1: Technology features of centralised and partially decentralised systems Expansion of current infrastructure

New system on traditional basis

CLT, private blockchain

Supplementary to the current system, complex

Moderately complex

Lower complexity

Closed, permissioned

Closed, permissioned, but certain parts can be opened

Speed

High (transaction) Low (value chain)

High (transaction) Medium (value chain)

Settlement finality

Well-defined, well-interpreted legally

Depends on the exact operational model, can be well-defined

Single point-offailure, but the vulnerabilty of the central actor is critical

Single point-offailure, but the vulnerability of the central actor is critical

More resilient on an ecosystem level

Older core system can be a risk

Longer term sustainability is questionable

Risks of technology are partly unknown

Core system architecture

Accessibility

Security, resilience

Major risk factor

Source: Authors’ work.

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During the introduction of a widely used retail CBDC, when the underlying system needs to be chosen, the solutions based on a private blockchain should also be considered, because, mainly on account of the low complexity and the resulting lower operational risk and vulnerability, this may have a huge advantage over centralised solutions (Table 1). Nevertheless, the novelty of the technology and the scant experience about using it in everyday payments make most decision-makers vary, and no major central bank has publicly committed itself to this technology yet. In itself, the introduction of a CBDC does not require new technology, it can be implemented through the extension of the existing infrastructure or by placing the latter on a new footing. According to the international literature, the opportunities offered by the new technologies are explored in most projects to ensure that conscious decisions are taken on the system’s limits and the options for further action offered by the system’s structure.

References Adrian, T.-T. Mancini Griffoli (2019): The rise of digital money, IMF FinTechNotes, no 19/001, July. Auer, R.-R. Böhme (2020): The technology of retail central bank digital currency, BIS Quarterly Review, March, pp 85–100. Auer, R.-G. Cornelli-J. Frost (2020): Rise of the central bank digital currencies: drivers, approaches and technologies”, BIS Working Papers, no 880, August. Auer, R. P. Haene-H. Holden (2020): Multi CBDC arrangements and the future of cross-border payments, BIS papers, forthcoming. Bank of Canada (2020): Contingency planning for a central bank digital currency, February. Bank of Canada and Monetary Authority of Singapore (2019): Enabling cross-border high value transfer using distributed ledger technologies, May. Bank of England (2020): Central bank digital currency: opportunities, challenges and design, March. Bank of Thailand-Hong Kong Monetary Authority (2020): Inthanon-LionRock: leveraging distributed ledger technology to increase efficiency in cross-border payments, January.

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IV. The conceptual framework of central bank digital currencies Bech, M.-R. Garratt (2017): Central bank cryptocurrencies, BIS Quarterly Review, September, pp 55– 70. Bindseil, U. (2020): Tiered CBDC and the financial system, ECB Working Paper Series, no 2351, January. BIS (2020): Central bank digital currencies: foundational principles and core features, Report no 1, October Boar, C.-H. Holden-A. Wadsworth (2020): Impending arrival – a sequel to the survey on central bank digital currency, BISPapers, no 107, January. Bossone, B. (2001): Should banks be narrowed?, IMF Working Papers, WP/01/159, October. Brunnermeier, M.-H. James-J-P. Landau (2019): The digitalization of money, NBER Working Papers, no 26300, September. Committee on Payments and Market Infrastructures (2018): Cross-border retail payments, February. Committee on Payments and Market Infrastructures (2020): Enhancing cross-border payments: building blocks of a global roadmap, July. Committee on Payments and Market Infrastructures and Markets Committee (2018): Central bank digital currencies, March. Committee on Payments and Market Infrastructures and World Bank Group (2020): Payment aspects of financial inclusion in the fintech era, April. Committee on Payment and Settlement Systems (2003): The role of central bank money in payment systems, August. European Central Bank (2020): Report on digital euro, October. European Central Bank and Bank of Japan (2019): Synchronised cross-border payments, June. European Central Bank and Bank of Japan (2020): Balancing confidentiality and auditability in a distributed ledger environment, February. Ferrari, M.-A. Mehl-L. Stracca (2020): Central bank digital currency in the open economy, forthcoming. G7 Working Group on Stablecoins (2019): Investigating the impact of global stablecoins, October. Kahn, C.-F. Rivadeneyra-R Wong (2018): “Should the central bank issue e-money?”, Bank of Canada Staff Working Paper, 2018-58, December. Sveriges Riksbank (2018): The Riksbank’s e-krona project, report 2, October. World Bank (2020): Digital Financial Services, April.

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V. Digital turnaround in monetary policy? – The monetary policy aspects of central bank digital currencies Dániel Felcser – Zsolt Kuti – Gergő Török The wave of digitalisation seen in recent decades has reached central banks too. Besides the decline in the demand for cash, monetary policy also has to face external challenges in the future, and in this context central banking discourse has increasingly included the concept of central bank digital currencies (CBDCs). The introduction of a CBDC means that the central bank provides nonfinancial actors access to its balance sheet. A deposit‑taking central bank only accepts deposits from non-financial actors, while a creditor central bank lends directly to the private sector. Should the central bank implement the CBDC as an interest‑bearing asset, it would gain a new monetary policy instrument for bypassing money markets and directly influencing the behaviour of non-financial actors. In the case of a creditor central bank, monetary policy transmission could strengthen further because the volatility of business cycles can be better mitigated through central bank lending. Moreover, a CBDC can also facilitate the introduction of even more accommodative and targeted monetary policy instruments. However, CBDCs currently exist only as a theoretical concept, so there are no experiences about their impact on monetary policy and the real economy. Introduction is a highly complex and fairly unpredictable process, compounded by the issues of operational implementation as well. It raises adjustment issues for the banking system and, in the case of a creditor central bank, it may lead to the build‑up of credit risk on the central bank’s balance sheet. Due to the above, CBDCs’ benefit–cost balance can only be estimated with a great degree of uncertainty. — 135 —

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1. Introduction – What are central bank digital currencies? 1.1. Introductory thoughts The digitalisation seen in the past decades has also had a massive impact on the monetary system, and therefore monetary policy has to face new external challenges. Virtual currencies such as bitcoin appeared, so money and the financial infrastructure can now be created and operated without financial actors and central banks. This could also mean that central banks may lose control over money issuance and interest rate setting. As electronic payments and new technological solutions became widely used, and cash use declined in some countries, the need arose among households and non‑financial actors to access safe central bank money electronically too. Currently, cash is the only risk‑free option for holding money that is widely available and represents a claim on the central bank. As part of the above processes, the concept of a central bank digital currency (CBDC) arose in economic literature and among central banks. A CBDC is a type of non‑physical (electronic) money issued by the central bank for economic agents. The potential introduction and widespread adoption of such currencies could fundamentally change our monetary system and central banks’ monetary policy.

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1.2. A new challenge for central banks In recent years, a number of more or less independent factors have emerged that could reduce the efficiency of the monetary policy transmission mechanism in the longer run: 1. The potential widespread use of virtual currencies, and the rise of technology companies and online commerce. 2. The emergence of a cashless society and the loss of access to central bank money. Although they are currently unable to fulfil the basic functions of money, virtual currencies (such as bitcoin) have been designed to enable transactions by circumventing traditional financial actors. The benefits offered by them have not been realised yet, but it cannot be ruled out that a virtual currency could once appear that becomes highly popular. Another factor is that tech giants (e.g. Facebook, Google and Amazon) hold increasing market power. If these corporations start offering account‑keeping services besides their main activities, consumers will conduct some of their financial transactions via those accounts. Since the buyer and the seller are in the same ecosystem, no funds move between banks during the transactions. Ultimately, Facebook also attempts to achieve this with its Libra project, during which the company is set to create its own infrastructure with its own, independent currency. In these cases, the efficiency of the monetary policy transmission mechanism could decrease, as economic agents prefer these assets to traditional legal tender when they need to pay. The extent of this decline depends on the amount of goods and services available in the ecosystems. Under such a scenario, the changes in monetary conditions would be felt much less, which would lead to a weakening of monetary policy’s efficiency and the anchoring of expectations.

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Digitalisation has also transformed everyday financial habits, and therefore several central banks have seen the demand for cash fall, in some cases dramatically. If cash disappeared, nonfinancial actors would be unable to hold a risk‑free means of payment. First, this entails operational risk because all transactions would be conducted electronically, through a single infrastructure, and second this would make it difficult for certain participants to complete payments. Therefore, the issuance of central bank digital currencies often comes up in connection with Sweden, where unique processes can be observed in payments, for various reasons: Sweden has one of the lowest cash‑to‑GDP ratios, coupled with one of the highest number of electronic payments per capita, while money demand diminishes even in nominal terms (it has halved since 2007) (Riksbank, 2017). The Swedish central bank has made rapid progress in research (Riksbank, 2018) and testing (Riksbank, 2020) regarding the introduction of the so‑called e-krona and its impact. The Riksbank examines the possibility of digitalising cash, which would offer an alternative to economic agents that could be used to hold risk‑free central bank money even when cash will no longer be ‘generally accepted’. It is uncertain to what extent the factors described above threaten the efficiency of the monetary policy transmission mechanism in the longer run, just like the question of what the best central bank response to this could be. What is certain, however, is that the appearance of virtual currencies has introduced a new type of money, and an even more innovative category, the concept of central bank digital currencies has entered economic discourse as a potential solution.

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1.3. Classification of the different forms of money and the concept of central bank digital currencies The different forms of money and their development can be examined along four main aspects when defining central bank digital currencies: 1. Issuer 2. Form (electronic or tangible) 3. Anonymity 4. Accessibility One important aspect is whether the given money is issued by the central bank or another organisation, as money that represents a claim on the central bank is risk‑free and its acceptance is guaranteed by law. Currently, the only form of money representing a claim on the central bank that is available to all economic agents is cash (Figure 1). Even though commercial bank deposit money can be converted to cash, it represents a claim on the commercial bank (for central bank money). Since commercial banks may become insolvent in certain cases, commercial bank money is not risk‑free.

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Figure 1: A system of different categories of money Digital

Central bank issued

Internet money Bank deposit

Central bank reserves and settlement account

Central bank deposit account

CBDC (only for a limited group of partners)

CBDC (universally accessible)

Virtual money

Cash

Widely accessible

Community money

Peer-to-peer

Of course, nowadays in a digital age, usability is also heavily influenced by the fact whether money is stored electronically or in physical form. At present, economic agents can only conduct electronic payments by using deposits held at commercial banks. Nevertheless, cash has not had a viable alternative in fast, peer-to-peer, small amount transactions, but the appearance of mobile apps (e.g. Alipay, WeChat, Revolut or Swish in Sweden) marked a turning point in this. Another crucial feature is anonymity, which is usually regarded as an advantage (or disadvantage, depending on the viewpoint) of cash over electronic forms of money. Anonymity is also a major — 140 —

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feature of many virtual currencies, because the currently available electronic payment methods (bank transfer, card payment) cannot be anonymous (now). The fourth characteristic is accessibility, i.e. whether a given type of money is widely available (to consumers and companies) or it is accessible only to a small group of users (e.g. commercial banks, the state). Central banks already issue electronic central bank money, but it is only available to central bank counterparties (and some public entities). (The central bank keeps an account for commercial banks, where for example the transfers among banks are recorded, along with the results of central bank operations.) Based on the above, a CBDC can be defined as central bank‑issued legal tender that is electronic, widely accessible and accepted (also by consumers and non-financial corporations, which may not necessarily include non‑residents). The central bank can decide whether to allow anonymity, in other words this aspect depends on the central bank’s intention and the way the CBDC system is implemented. It should be stressed once again that as CBDCs are central bank‑issued, they are considered a claim on the central bank and thus a risk‑free form of money. 1.4. Possible ways and aims of introducing a CBDC From a conceptual perspective, a CBDC can be introduced in three principal ways. The differences between the methods are not only technological, they also differ in fundamental considerations reflecting the aim of the central bank with introducing the CBDC. As a result, the various versions exert a vastly different monetary policy impact. The main premise of the register- or account-based approach is that central banks can keep accounts for not only a limited group (such as commercial banks or the state) but also for a wide range of consumers, potentially millions of people. This method allows larger sums to be used and held securely on an electronic account, so it mostly resembles commercial bank accounts. Accordingly, — 141 —

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this solution can mainly be used if the central bank wishes to substitute commercial bank deposit money, providing risk‑free central bank money to economic agents and employing the CBDC as a monetary policy instrument. The other implementation method is the value‑based approach. The essence of this is that the central bank money is recorded on a device (card) or (mobile) application, similar to today’s prepaid cards. This solution is mainly useful for retail, anonymous payment transactions. In such a scenario, the CBDC primarily substitutes cash, it is not a monetary policy instrument, and the balance presumably does not bear interest.

2. The impact of introducing a central bank digital currency on the central bank’s operating environment The introduction of a CBDC would have a major impact on the entire banking and financial system, which is crucial from the perspective of monetary policy transmission. The CBDC may affect commercial banks’ funding costs, lending capacity and thus also the development of credit cycles, and it can also influence economic growth. Also, its introduction may transform the balance sheets of some participants. Before presenting the central bank’s monetary policy with a CBDC, the major changes have to be described. 2.1. Opening the central bank’s balance sheet and issuing a CBDC The introduction of a CBDC also means that the central bank provides non-financial actors access to its balance sheet,47 which can happen in two ways. In the first case, the central bank only 47

lthough non-financial actors already have access to the central bank’s A balance sheet through cash, the paper refers to digital access.

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opens the liabilities side of its balance sheet, allowing deposits to be placed on the accounts kept by it (deposit‑taking central bank). In the second case, besides facilitating the liabilities-side deposits, the central bank provides access to its assets side, meaning that it also grants loans to non-financial actors (creditor central bank) (Figure 2). Figure 2: Access to the balance sheet of deposit-taking and creditor central banks Central bank partner group Assets

Current (no CBDC)

After the introduction of CBDC

Commercial banks

+ Nonfinancial private sector (credits)

Creditor central bank

Liabilites

Commercial banks General government

+ Nonfinancial private sector (deposits)

Deposit-taking central bank

Source: Authors’ work.

In the case of a deposit‑taking central bank, the CBDC is created by participants converting cash and depositing the CBDC on their central bank account, or they transfer their commercial bank deposit money from their commercial bank account to the central bank. Some argue that the central bank should design the CBDC framework in a way that only a limited amount of — 143 —

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central bank digital currency is created to protect commercial bank deposits. In such a case, the central bank would only credit the CBDC on the accounts against some collateral, for example government securities (Kumhof, 2018). However, this could be circumvented with an operation carried out by commercial banks,48 so making the creation of CBDC subject to this condition does not materially influence the amount of commercial bank deposit money flowing into it. The popularity of a CBDC is probably determined by a combination of several other factors, for example the relative interest rate compared to bank deposits and cash, confidence in commercial banks and the central bank as well as the quality and pricing of account‑keeping services. It should be noted that with a deposit‑taking central bank, the amount of money in circulation does not change due to the transfer of the CBDC to the account, only its structure changes, i.e. the entity that keeps it on their balance sheet and the balance sheet item where it is kept. In the case of a creditor central bank, the deposit‑placing option is complemented with central bank lending, because concurrently with the crediting of the loan on the assets side, the loan amount appears on the liabilities side, too (in line with the endogenous money theory), and therefore new money, CBDC is created. Unlike in the deposit-taking scenario, the CBDC created through the lending of the creditor central bank increases the amount of money in circulation.

hen a customer initiates a transfer into CBDC, the commercial bank first W buys government securities for the given amount and then transfers that to the account of the central bank, which, in exchange, credits CBDC to the customer’s account. The outcome is the same, only the operation is more complex.

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2.2. Changes to the operation of commercial banks The introduction of a CBDC affects the entire financial system, therefore it would greatly influence how commercial banks function, which would also have monetary policy implications. When an account‑based CBDC is introduced, the central bank performs account‑keeping services to economic agents, inevitably becoming a ‘competitor’ to commercial banks. Therefore, some of the accounts held with commercial banks may be terminated, and at the same time payments and other services would be taken over by the central bank, which could reduce commercial bank revenues. When the central bank competes in account‑keeping services, commercial banks’ funding costs may increase, as the introduction of a CBDC could lead to an increase in deposit rates. The advantage of deposit money over cash is that it can be used more conveniently, in electronic payments. The introduction of a CBDC would eliminate this advantage of commercial bank deposit money, forcing commercial banks to pay higher interest on the deposits placed with them. If the central bank pays interest on the CBDC, that sets the minimum level of risk‑free interest rate available in the economy. This may raise deposit rates, because the interest paid by commercial banks on the deposits placed with them must be higher than the CBDC rate. Another aspect that needs to be examined is central bank standing facilities, in other words whether the central bank is willing to lend to commercial banks. When funds flow out from commercial banks (currently, this can take the form of a depositor transferring money to another bank or withdrawing cash; in the case of a CBDC, something similar happens when customers convert their deposits to CBDC), upon settlement, the commercial bank reduces central bank liquidity or it has to borrow from the central bank (this is called standing facility) (Figure 3). This is one of the factors that allow commercial banks to lend and create money. — 145 —

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Figure 3: Impact of the flow of demand deposits to CBDC on the size of the central bank’s balance sheet

There is sufficient liquidity in the banking system Deposit-taking central bank There is insufficient liquidity in the banking system

There is a realignment from bank reserves to the CBDC. The size of the central bank balance sheet does not change. Commercial banks need refinancing. The central bank balance sheet is rising.

Source: Authors’ work.

If standing facilities are available to commercial banks, the latter’s lending processes may be reflected on the central bank’s balance sheet, as borrowers may wish to transfer the loan amount to their more secure CBDC account. In this case, commercial banks do not have to be concerned about illiquidity, because they know that the central bank grants them credit upon request. However, if the loans extended by commercial banks are in default, commercial banks cannot meet their obligations against the central bank, and the credit risk appears on the central bank’s balance sheet. Commercial banks’ non-performing loans can quickly lead to moral hazard (one only needs to think of the ‘too‑big‑to‑fail’ problem) when banks undertake excessive risks due to short-term profit considerations. Moreover, this can also undermine the efficiency of the monetary policy transmission mechanism, as lending processes would respond less to changes in the interest rate environment, because, owing to moral hazard, they would have other motivations.

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However, if standing facilities are not available to commercial banks, the size of deposits and other liabilities previously collected limits commercial banks’ lending capacity. This could curtail lending too much, which jeopardises economic growth and may also influence the efficiency of monetary policy. Furthermore, the lack of availability may also lead to increased volatility in the interbank rate due to deposit outflows. 2.3. Transformation of the balance sheets of each actor To analyse the monetary policy effects, it should be examined how the balance sheets of the different actors would be transformed following the introduction of a CBDC. This chapter presents today’s monetary system, before turning to the effects of a CBDC issued by a deposit‑taking central bank. Balance sheets in today’s monetary system Figure 4 shows the balance sheets of the various sectors, with a special focus on how they change when commercial banks lend to the non-financial private sector. For simplicity’s sake, the figure concentrates on domestic developments and does not include non-residents. In today’s monetary system, when commercial banks extend a loan, they also create deposit money. As a result, lending increases the balance sheets of the banking system and the private sector, as credit and deposits expand in parallel (dotted area). However, the central bank’s balance sheet is unaffected by lending.

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Figure 4: In the current monetary system, credit is created by crediting it as a deposit Central bank Assets

Foreign exchange reserves Credits for commercial banks Others (net)

Liabilites Cash

Commercial banks' deposits

Commercial banks Assets Central bank deposits

Private sector

Liabilites

Assets

Central bank credits

Cash

Liabilites

Others (net) Credits↑

Deposits↑ Deposits↑

Debt of general government (net)

Credits↑ Demands on general government (net)

Note: The balance sheets in this chapter are for illustrative purposes only, the relative proportions of the items are not necessarily realistic. Dotted areas indicate changes in balance sheets. Source: Authors’ work.

Deposit‑taking central bank If the central bank introduces a CBDC, the CBDC can drive out cash and/or deposits, which transforms participants’ balance sheets (Figure 5). As the private sector withdraws deposits from the banking system, commercial banks have a financing requirement against the central bank. In other words, the central bank would provide more credit to commercial banks, thereby indirectly financing the private sector, which would mean an indirect credit risk and increase the central bank’s balance sheet. With a deposit‑taking central bank, commercial banks would continue creating money, but some of the credited deposits may flow to the CBDC, so banks may need refinancing from the central bank.

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Figure 5: Transition to the deposit‑taking central bank system Central bank Assets

Liabilites

Commercial banks Assets

Liabilites

CBDC↑↑

Credit for Commercial commercial banks' banks deposits ↑ Others (net)

Liabilites

Cash↓

Cash↓ Foreign exchange reserves

Private sector Assets

Central bank Central bank deposits credits↑

Credits

CBDC↑↑

Others (net)

Deposits↓ Deposits↓

Demands on general government (net)

Debt of general government (net)

Credits

Source: Authors’ work.

3. Monetary policy transmission and the operation of conventional monetary policy The previous chapters examined how the introduction of a CBDC influences the operation and balance sheet of the different actors and how it affects the real economy. This chapter takes a look at monetary policy transmission and the possibility of a new instrument, i.e. the interest paid on the CBDC. The account‑based CBDC that is available to a wide range of partners exerts the greatest monetary policy impact: its introduction makes the central bank toolkit more complex, enabling the central bank to directly influence the behaviour of non-financial actors, along with money market conditions. A CBDC can facilitate new monetary policy instruments and unconventional instruments hitherto existing only in economic theory.

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3.1. Monetary policy objectives and instruments If the central bank issues a CBDC, it needs to decide about other important aspects, therefore its set of instruments potentially becomes more complex. Besides the two former types of central bank money, i.e. cash and commercial bank reserves, a new, third type appears, with potentially different conditions than the former two. Thus, there are three types of money supplied by the central bank. If the CBDC is introduced, the central bank needs to decide on the following: 1. the exchange rate between the CBDC and cash and commercial bank deposit money; 2. whether to determine its amount or price (interest rate); 3. whether the CBDC should bear interest, and if yes, how; 4. whether there should be quantitative limits for individual money holders. Although this may seem trivial, if there is a fixed exchange rate between cash and the CBDC (for example one unit of the digital currency equals one unit of cash or commercial bank deposit money), the central bank needs to decide whether to determine the amount or interest rate of the CBDC to preserve market equilibrium.49 If the central bank decides to pay the holder interest on the CBDC, a new monetary policy instrument could be utilised that allows the central bank to be in direct contact with households and non-financial corporations (ECB, 2020). However, in this case, the amount of CBDC in circulation is determined by the demand from economic agents (just like with cash nowadays).

hen the amount of the CBDC, or supply, is limited, for example in W a financial stress, the holders may be willing to pay more than one unit of cash or commercial bank money for one unit of CBDC. If the central bank wants to maintain the 1:1 exchange rate, the supply of the CBDC cannot be fixed.

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The central bank can also decide to limit the amount held on individual CBDC accounts based on some consideration (for example tying it to median income due to macroprudential considerations), which may have two aims. First, it can curb the flow of commercial bank deposits and thus slow down the expansion of the central bank’s balance sheet, and second, in times of financial turbulence, ‘digital bank runs’ (when actors suddenly want to convert huge amounts of commercial bank deposits to CBDC) can be prevented. Nonetheless, here the efficiency of the CBDC is much lower in terms of monetary policy, so central banks need to assess the significance of the different considerations. 3.2. The impact of central bank digital currencies on the current transmission channels Among the monetary policy transmission channels, the interest rate and risk-taking channels would be most affected by the introduction of a CBDC. In line with Balogh–Horváth–Kollarik (2017), the (broad) interest rate channel includes not only the traditional interest rate channel but also the credit channel. Since, at least in the versions where the commercial bank money and the CBDC are convertible, the banking system’s money-creating and lending capacity may change, the transmission of the central bank’s interest rate conditions through the banking system may also vary. And this concerns mainly the above-mentioned two channels. Keeping everything else constant, using a CBDC could lead to tighter monetary conditions. The interest rate on demand deposits has been typically below the central bank base rate (Meaning et al., 2017), and it was near the bottom of the interest rate corridor in the past decade. However, the introduction of the CBDC could result in rising funding costs for banks in two ways. – First, as the CBDC has better liquidity characteristics than cash, it should have a higher equilibrium price than cash. In this case, — 151 —

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the price of the CBDC is its opportunity cost, i.e. the differential between the interest rate on demand deposits and the CBDC interest rate. Therefore if the central bank continues to pay zero interest on the money issued by it, the interest rate of demand deposits would climb. – Second, in the version where the central bank would provide refinancing to the banking system to replace the outflow of deposits, some of the demand deposits bearing interest below the base rate would be replaced by loans bearing interest at (or above) the policy rate. However, the greater competition for keeping deposits may also prompt commercial banks to quickly adjust the interest on the demand deposits collected/created by them when the central bank changes its own interest rate conditions. 3.3. The CBDC as a new monetary policy instrument If the central bank decides to pay interest on the CBDC, it has a new monetary policy instrument in its toolkit. Changes to the interest on the CBDC are directly felt by CBDC account holders, whose consumption and saving decisions are therefore adjusted to the changed interest rate environment more quickly. A potential benefit of this new instrument is that the central bank would be able to shape consumption and investment developments more efficiently and separately (Figure 6). It would be in direct contact with non-financial participants thanks to the CBDC interest rate, any change in which would urge households to fine‑tune their consumption decisions. Meanwhile, the base rate could be used to influence companies’ investment decisions through shaping money market rates and lending rates.

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Figure 6: Separation of investment and consumption processes Investments

Base rate

Interest rate of CBDC

Monetary policy Consumption

Source: Authors’ work.

Yet it is uncertain whether the changes to the interest rate of the CBDC weaken or strengthen the impact of the adjusted money market rates, or whether it does not influence their impact. Moreover, if money markets need some time before adjusting to a changed interest rate environment, the question arises whether the effect of the central bank’s rate‑setting decision reaches the economy in waves (CBDC account holders adjust first, then traditional channels exert their impact) (Figure 7).

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Figure 7: Channels of the different interest rates Investment

Internal delay

Real economic effect

Base rate

Interest rate perceived by economic agents

Revaluation in financial markets

Central bank decision

Reálgazdasági reakció

Interest rate of CBCD

Consumption, saving

Source: Authors’ work.

Case study: Reducing the interest on the CBDC If the central bank cuts the CBDC’s interest rate, it makes sense for commercial banks to reduce deposit rates as well. If commercial banks decrease deposit rates less (Figure 8), money holders may find it better to hold their money in commercial bank deposits rather than CBDC. Meanwhile, commercial banks also benefit from collecting deposits to repay their central bank loans, because this entails a lower interest burden. So the cuts to the CBDC interest rate boost deposits and reduce CBDC holdings (Figure 9). All in all, the lowering of the CBDC interest rate leads to a contraction of the central bank’s balance sheet as CBDC flows to commercial bank deposits, while the efficiency of interest rate transmission is maintained.

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Figure 8: How deposit rates respond to a reduction of the interest on the CBDC Interest rate of CBDC

Decrease by 10 basis points

Interest rate of deposits

Base rate

Decrase by less than 10 basis points

Source: Authors’ work.

By reducing the interest on the CBDC, further monetary easing can be achieved. First, the interest realised on the private sector’s CBDC holdings can be directly reduced, which can primarily influence consumption and savings. Second, among commercial bank liabilities, deposits start crowding out central bank funds, while the former are cheaper. This could decrease banks’ average cost of funds, leading in turn to a drop in lending rates. Figure 9: By reducing the interest rate of the CBDC, liquidity flows from the CBDC to cash and deposits Central bank Assets

Liabilites

Commercial banks Assets

Liabilites

Central bank Central bank deposits credits ↓ CBDC↓↓

Credits for Commercial commercial banks' banks↓ deposits Others (net)

Liabilites

Cash↑

Cash↑ Foreign exchange reserves

Private sector Assets

CBDC↓↓ Credits

Others (net)

Deposits↑ Deposits↑

Debt of general government (net)

Credits Debt of general government (net)

Note: It was assumed that the general government balance would not be affected by the measure. In reality, however, it is likely that both private sector debt and central bank claims would increase (for example, through the issuance of government securities or the sale of central bank government securities). Source: Authors’ work.

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3.4. Special issues related to creditor central banks The main difference between deposit-taking and creditor central banks is that in the latter case, the central bank allows non-financial actors to access not only the liabilities side of its balance sheet but also the assets side. In practical terms, this means that the central bank lends directly to the private sector. As a result of central bank lending, the newly disbursed loans increase the size of the central bank’s balance sheet, and their repayment reduces it. If this process is examined across business cycles, it can be assumed that the central bank’s balance sheet changes in line with the business (and credit) cycles: when lending picks up in an upswing, this process is partly reflected on the central bank’s balance sheet. While deposit‑taking central banks only become ‘competitors’ to commercial banks in account‑keeping, creditor central banks also compete in lending. However, it is unclear what considerations would inform the decision of private actors when choosing between borrowing from commercial banks or the central bank. If central bank lending is only moderately popular, the current operation of commercial banks does not change much, but the more popular it is, the smaller the market share remaining for commercial banks, which could reduce market competition. Direct central bank lending could have various advantages for monetary policy. When economic growth slows down, commercial banks’ risk appetite usually declines, too, which further deepens the slump. If in such a situation the central bank does not cut back lending or does so only slightly or it compensates for the reduced amount of commercial bank loans, the economic downturn can be reduced.

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From the perspective of the efficiency of monetary policy, central bank lending raises two questions. First, it may increase the efficiency of transmission, as it directly influences lending processes through setting lending rates, and second, commercial banks also adjust to the changed central bank lending rates due to market competition. Moreover, even if money markets do not operate properly for some reason, the efficiency of interest rate transmission may be maintained nevertheless, and money markets do not need to reprice. In normal times, money market repricing can occur faster and more efficiently overall (Figure 10). Figure 10: Monetary transmission without money market repricing Internal delay

Real economic effect

Base rate

Central bank decision

Interest rate perceived by economic agents

Revaluation in financial markets

Real economic response

Interest rate of CBDC

Consumption, saving + Investment

Source: Authors’ work.

On the other hand, the efficiency of central bank lending can be weakened by several factors. From an operational viewpoint, most central banks do not have the infrastructure necessary for lending: they have no countrywide branch network or the

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necessary headcount, and the scant experience in lending and the lack of familiarity with customers may also be limiting factors. Furthermore, some kind of moral hazard arises for central banks, too, if they start overlending due to some consideration unrelated to the central bank mandate. Direct and not sufficiently prudent lending to the private sector may entail substantial credit risk on the central bank’s balance sheet, which could significantly undermine the efficiency of monetary policy transmission under adverse circumstances. One should also mention the potential effect of creditor central banks and the CBDC on fiscal policy. First, if CBDC flows onto the central bank’s balance sheet due to commercial banks’ lending processes, and the central bank extends loans to commercial banks in exchange, it has to run an indirect credit risk. Second, if the central bank engages in lending, direct credit risk builds up on its balance sheet. If the ratio of non-performing loans increases in a crisis, ultimately losses could arise on the central bank’s balance sheet. If the central bank needs recapitalisation due to the losses, the room for fiscal manoeuvre could become limited (depending on the regulations in effect, although the Czech central bank operated with negative equity), which may make it difficult or even impossible to pursue a countercyclical fiscal policy, and the downturn could deepen (Figure 11). Granted, these risks can be mitigated by the collateral valuation system (haircuts), and credit institutions’ own funds may also provide a line of defence to the central bank.

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Figure 11: Potential effects of an economic downturn

Economic downturn

Increase in non-performing loans

Loss at the central bank

The room for maneuver of fiscal policy is narrowing

Source: Authors’ work.

Central budget covers the losses of the central bank

4. The CBDC as an unconventional instrument In the recent decade, the renewal of central bank instruments was also warranted by crisis management. Central banks first attempted to mitigate the adverse economic effects of the 2008 financial crisis using traditional monetary policy instruments: robust rate-cutting cycles were started and liquidity-providing instruments were expanded (MNB, 2017). Even in the decades prior to the 2008 financial crisis, the gradual decline of inflation was coupled with decreasing policy rates, therefore central banks quickly hit the lower bound of nominal interest rates while attempting to provide the necessary monetary easing. Conventional interest rate policy did not prove to be sufficient in crisis management, and consequently central banks increasingly used new, unconventional instruments to further ease monetary conditions (Karácsony–Kuti–Török, 2019).

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With persistently low real interest rates, monetary policy is more likely to hit the lower bound of nominal interest rates in the future, too (Figure 12). The additional impact of the programmes similar to those used in earlier times could gradually diminish (BIS, 2017), therefore targeted instruments could increasingly come into focus. Their targeted nature also means that central banks can use several instruments on several markets at the same time to improve monetary policy transmission. One theoretically possible way to expand the room for manoeuvre is the introduction of a central bank digital currency. Figure 12: The rate of central bank base rates in countries around the world

Policy rate (percent) -0,75

10+

Note: darker color indicates lower interest rates (April 2021 data). Source: own editing, tradingeconomics.com.

The introduction of a CBDC can facilitate the application of new monetary policy instruments that have only existed in theory and that could mainly be used when the lower bound

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of nominal interest rates is reached. Yet the current monetary framework provides an opportunity for using a wide range of central bank instruments besides the ‘usual’ unconventional ones, as central bank responses to the coronavirus pandemic demonstrate. It can be seen that in itself the CBDC could act as a fine‑tuning instrument exerting its effect through the traditional transmission channels as described above, which could support monetary policy transmission and establish a direct link between the central bank and non-financial participants. The introduction of a CBDC may also facilitate the introduction of even more accommodative and targeted monetary policy instruments. It should be underlined that these are mostly theoretical concepts that have already been discussed in economic thinking and the literature, and there are great uncertainties as to their efficiency and transmission. The two instruments below could function as brand new and independent instruments, but it should be borne in mind that their implementation also raises legal issues. 4.1. Using deeply negative interest rates If CBDC was the only type of central bank money available to everyone (i.e. cash disappeared), in theory the lower bound of nominal interest rates could be eliminated. Currently, the zero yield on cash means the lower limit to bank deposit rates.50 If cash disappeared, the alternative form of liquid saving would be CBDC, and the central bank can pay negative interest on that, especially in the case of extreme shocks, to ensure price stability (Dyson–Hodgson, 2016; Goodfriend, 2016; Bech–Garratt, 2017). The idea behind using deeply negative interest rates is that the substitution effect (if interest is the price for future saving)

The effective lower bound is slightly below zero, as holding cash entails costs.

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is strong, therefore households increase their consumption spending and reduce their savings. Ultimately the central bank would support the economy and facilitate the rise in inflation by boosting aggregate demand. However, using negative interest rates raises several issues, as there can be numerous unintended side effects: – Consumption may not be encouraged if the income effect can exceed the substitution effect. This means that negative interest rates decrease the value of long-term savings (for example in the case of pension savings, more has to be put aside in the present to achieve a given pension payment), which reduces current consumption, therefore this measure would be contrary to the intentions. – The feasibility of negative interest rates can be uncertain even when a CBDC is used. Economic agents may opt for other money substitutes that are a better store of value (Keynes, 1936, p. 382). Residents can flee negative interest rates even in the absence of cash by conducting transactions and keeping their savings in a foreign currency. (This has become easier in recent years, one only has to think of the Revolut app, which can be used to digitally and conveniently convert any currency.) – Finally, it should be noted that the negative interest paid by money holders would mean implied taxation. This would be completely contrary to central banks’ crisis management practices, according to which they seek to manage an economic crisis by providing the necessary liquidity. Furthermore, such a step would probably reduce the social acceptance of a CBDC, which would have longer-term negative consequences on its use. 4.2. The concept of helicopter money With a CBDC, it would be technically easier for the central bank to use helicopter money than nowadays. The concept got its name from Friedman’s (1969) thought experiment where — 162 —

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real economy actors (households) receive transfers from the central bank, in other words the central bank would credit a certain amount to households’ CBDC accounts. This is not only about the expansion of money supply and liquidity (and the corresponding drop in interest rates), but also about the directly received disposable income of households. If a major portion of economic agents, or all of them, have a CBDC account, it is technically easier for the central bank to give them money to influence their consumption decisions. However, there are several arguments against using helicopter money. Issues could arise if households use up the money received from the central bank quickly and at the same time, because this concentration of increased demand leads to excessive inflationary pressure, which could be even stronger when coupled with a supply shock. Furthermore, some households may use the amount received as savings, purchasing financial or real assets, which may threaten with bubbles on the affected markets. Nevertheless, the above problems can be addressed by choosing the right way of implementation (Hampl, 2018). Sudden surges in demand and the conversion of helicopter money into savings could be prevented by setting a time limit on utilising helicopter money and the amount that can be spent during that period could be limited by the central bank (for example there would be six months to spend it, in fixed maximum monthly instalments). In such a case, consumption could be better smoothed in a crisis, leading to a smaller downturn in consumption. In addition, the central bank can also determine the areas where the money can be used, which can prevent asset price bubbles. But using helicopter money also raises legal issues: if the losses of the central bank are covered by the budget, even if the central bank seems to provide money to economic agents directly, the general government also takes part in the process. This raises

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the issue of monetary financing.51 Second, as helicopter money is a sort of transfer to households, this is a quasi-fiscal activity, which should not be performed by the central bank, even if driven by monetary policy considerations. 4.3. The CBDC and the basic credit line Recently, the idea of a basic central bank credit line entered economic thinking, as an alternative to universal basic income. The implementation of a basic central bank credit line can be facilitated and promoted by the existence of a CBDC, and this could have several advantages. A possible way of implementation would be to automatically make the basic central bank credit line part of private sector CBDC accounts. This would provide a predictable, sustainable and stable line of credit to all participants in the private sector. For non-financial corporations, this would serve as a sort of safety net in temporary difficulties, or it could be used to finance an investment. For households, it can help smooth consumption, for example in brief periods when income declines for some reason. And it can also contribute to the establishment of new businesses when it can be used as equity, because the overall willingness to enterprise may boost economic growth. Furthermore, the basic central bank credit line can also act as an automatic stabiliser. In an economic shock, when a company faces a temporary but sudden drop in its revenues, the credit line offers a lifeline to the otherwise viable business. For example, the first wave of the coronavirus pandemic was such a shock, when many firms in all walks of business life suddenly found themselves in a difficult situation due to the shutdown.

urrently, Article 123 of the Treaty on the Functioning of the European Union C prohibits monetary financing in the EU.

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5. Conclusion The central bank digital currency can be realised in various schemes, which have vastly different effects on the economy and monetary policy. The challenges relevant from a central banking perspective can determine whether a CBDC would rather replace cash or commercial bank money. The greatest monetary policy effect is exerted by a widely available, account‑based and interest‑bearing CBDC. The main question is whether the central bank would only collect deposits (deposit‑taking central bank) or lend, too (creditor central bank). The potential introduction of a CBDC would also expand the central bank’s set of instruments. It would allow the central bank to deal directly with households and non-financial corporations and thus directly influence their economic decisions. If the CBDC also bears interest, any change in interest rates through the CBDC appears immediately in the real economy, without the lag of money markets. This helps the central bank to more directly influence consumption and saving decisions, while investment and lending processes can be controlled in a targeted manner with the conventional instruments. A creditor central bank lends directly to the private sector. Central bank lending can improve the efficiency of the monetary policy transmission mechanism, as there would be no need for money market repricing, and the interest on central bank loans would be a kind of benchmark rate to which commercial banks would need to adjust. The advantage of this is that if not properly functioning money and credit markets slowed down economic growth, the central bank could mitigate the economic impact directly, by shaping lending processes. However, several potential risks can arise, because direct lending to the private

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sector could lead to a build‑up of substantial credit risk on the central bank’s balance sheet, which could constrain the room for manoeuvre of monetary policy and even fiscal policy under adverse circumstances. The appearance of a CBDC enables the application of several unconventional instruments, which have only existed in theory, when the lower bound of nominal interest rates is reached. Such new instruments include deeply negative central bank rates and helicopter money. However, in the absence of empirical experiences, their actual impact mechanism can only be estimated with a great degree of uncertainty. Overall, the implementation of a CBDC could result in significant changes in the operation of central banks and monetary policy. If risks are assessed and managed appropriately, a central bank digital currency can be central element in a new, more efficient and more targeted monetary policy framework.

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References Balogh, A.–Horváth, Zs.–Kollarik, A. (2017): A hagyományos monetáris politikai transzmisszió (Traditional monetary policy transmission), MNB Handbooks No. 17, September 2017. Bech, M.–R. Garratt (2017): Central bank cryptocurrencies, BIS Quarterly Review, September 2017. BIS (2017): QE experiences and some lessons for monetary policy: defending the important role central banks have played, Bank for International Settlements. BIS (2018): Central bank digital currencies. Bank for International Settlements. Dyson, B.–G. Hodgson (2016): Digital cash: why central banks should start issuing electronic money, Positive Money. European Central Bank (2020): Report on a digital euro, October 2020. Friedman, M. (1969): The Optimum Quantity of Money. In: Milton Friedman: The Optimum Quantity of Money and Other Essays, Transaction Publishers, New Brunswick, New Jersey, 2007, pp. 1–50. Goodfriend, M. (2016): The case for unencumbering interest rate policy at the zero bound, Paper presented at the Economic Policy Symposium at Jackson Hole. Hampl, M. (2018): A Digital Currency Useful for Central Banks?, Speech, https:// www.mojmirhampl.com/detail-28/a-digital-currency-useful-for-central-banks Karácsony, T.–Kuti, Zs.–Török, G. (2019): Egy cél – egy eszköz helyett több cél – több eszköz (Multiple instruments, multiple goals rather than one instrument, one goal), Külgazdasági folyóirat, Vol. 63, 2019/7−8. Keynes, J. M. (1936): A foglalkoztatás, a kamat és a pénz általános elmélete (The General Theory of Employment, Interest and Money), Közgazdasági és Jogi Könyvkiadó, Budapest, 1965. Kumhof, M.–Jakab Z. (2016): The Truth about Banks. Finance & Development, International Monetary Fund. Kumhof, M.–Noone, C. (2018): Central bank digital currencies — design principles and balance sheet implications, Bank of England Working Paper No. 725. Magyar Nemzeti Bank (2017): A Magyar út – Célzott jegybanki politika (The Hungarian Way – Targeted Central Bank Policy). Book series of the Magyar Nemzeti Bank on economics and monetary policy, Budapest, 2017. Available: https://www.mnb.hu/ en/publications/mnb-book-series/the-hungarian-way-targeted-central-bank-policy Meaning, J.–J. Barker–E. Clayton–B. Dyson (2017): Broadening narrow money: monetary policy with a central bank digital currency, Manuscript. Riksbank (2017): The Riksbank’s e-krona project, Report 1. Sveriges Riksbank. Riksbank (2018): The Riksbank’s e-krona project, Report 2. Sveriges Riksbank. Riksbank (2020): The Riksbank’s e-krona pilot, Sveriges Riksbank.

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VI. Will the central bank digital currency be the new cash? – The place of central bank digital currencies in the monetary system Anna Boldizsár – Kálmán Árpád Marincsák – Balázs Sisak – Daniella Tóth For centuries, central banks have provided banknotes and coins to everyone from households to companies to public institutions to ensure smooth economic processes. However, cash has been steadily losing its significance in recent decades, in fact, sometimes even withdrawing large-denomination banknotes is mulled, for example in Kenneth Rogoff’s famous work. As a result of technological progress, digital solutions now offer a convenient and secure alternative to cash use, which may facilitate the successful introduction of a central bank digital currency (CBDC). In recent years, more and more central banks have looked at the possibility of issuing a CBDC, and the Swedish and Chinese central banks have already launched pilot projects. The present study describes the motives of cash demand that can be reduced by the appearance of a CBDC, and whether based on that the CBDC can be a substitute or complement to banknotes. The second half of the paper seeks to find out how much the emergence of a CBDC could increase the room for monetary policy manoeuvre.

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1. Introduction In recent years, the potential issuance of a central bank digital currency (CBDC) has received increasing attention in the international literature. First, it should be clarified what exactly is meant by CBDC. The exact framework of central bank digital currencies can vary considerably across countries, there are many potential versions depending on the reason for introduction and features of the given country’s payment and financial system (Bank of England, 2020). The specific form of a central bank digital currency heavily influences how its introduction affects the payment system and thus also the economy. The main dimensions of a central bank digital currency are as follows (Richards et al., 2020): – The role of the central bank and the private sector in issuance: In a one‑tier system only the central bank issues the CBDC, while in a two‑tier system the private sector also participates in issuance. The studies published so far prefer the two‑tier system because banks have the experience and the infrastructure to reach customers. – Account‑ or token-based system: The account‑based system requires that a record be kept of balances and transactions of all CBDC holders. In such a scenario, the CBDC is a personal claim on the central bank. By contrast, in a (digital) token‑based CBDC system, the CBDC refers to a digital token issued by, and representing a claim on the central bank, similar to a digital banknote. Token holders have a claim on the central bank, and the CBDC would not be associated with specific accounts. – Online and/or offline use: Most electronic payment methods can only be accessed through telecommunication devices with an internet connection. However, a CBDC scheme can be designed

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to be available offline (at least temporarily), which provides great flexibility to the system (ECB, 2020). – Interest-bearing or non-interest-bearing instrument: The CBDC can be non-interest bearing like cash, but several central bank studies considered assigning a positive or even negative interest rate to it. –D egree of anonymity: The various payment methods have different privacy levels: while cash payments ensure full anonymity, with account‑based payments the identity of the parties is known to the institutions in the intermediary system. A token‑based CBDC would have a level of anonymity similar to cash. – Centralised or decentralised clearing: The various cryptocurrencies usually function based on a decentralised ledger system, however, a completely open network would probably not be efficient and secure with a CBDC. This would call for some degree of centralisation. Based on the above dimensions, the potential versions of a CBDC can be found between two extremes. At one end, the CBDC mostly resembles cash. In this case, the CBDC is issued by the central bank, it is not associated with an account, can be used offline, does not bear interest and ensures almost complete anonymity to users. At the other end of the spectrum, the CBDC is more like electronic deposit money, banks also participate in issuance, the CBDC can be linked to an account, it can only be used online, it bears interest and the identity of users is known at least to the institutions involved in the transaction. However, there are several different solutions between these two extremes. Central banks can establish a framework for the CBDC that is best aligned with their objectives and the features of their financial system. The effect of the CBDC’s introduction on the payment system ultimately depends on which extreme

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the CBDC framework is closer to. According to the literature, countries are most likely to implement the CBDC with a hybrid solution between the two extremes. Because then CBDC would have some features of cash and some features of deposit money, its introduction could affect the use of cash as well as bank money. The present paper examines the various CBDC versions in terms of which financial instruments they resemble, the instruments they can substitute based on the different functions, their impact on the demand primarily for cash but also for other relevant financial instruments and thus also the different monetary aggregates (e.g. M1, M3) based on their characteristics, and their effect on the velocity of money and thus also the economy.

2. The features of cash relevant from the perspective of a CBDC With the introduction of a central bank digital currency, cash would have a competitor as a payment and saving instrument that is also issued by the central bank. The question is how a CBDC resembles cash beyond that, how it differs from the latter, and whether the appearance of a CBDC influences cash holding at all. Therefore it should be examined why economic agents hold cash and how a central bank digital currency can influence the motives for holding cash.

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Figure 1: Cash as a share of GDP in some country (2019, percent) Eurozone: 10.3% USA: 8.2% Canada: 4.1%

1.1 1.3

2.7

3.5

9.9 10.5 13.0 6.9 7.7 14.5

Source: National central banks.

Cash holding is primarily motivated by three factors: the transactions demand for money, hoarding and accumulation from untaxed income. Currency in circulation is determined by the cash demand of economic agents, namely households and companies. Yet cash plays a wide range of roles in the economy: it is used in payments and it is also crucial in wealth accumulation. Due to its anonymity, cash is ideal for legal transactions but also — 172 —

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for illegal ones, therefore the cash demand of the hidden economy also influences the development of holdings. Accordingly, holding cash may be motivated by transactions and hoarding, or it may be related to the hidden economy. Since the different motives for holding cash cannot be observed directly, their development can only be estimated indirectly. 2.1. Transactions demand for money The transactions demand for cash is the amount of cash necessary for cash payment transactions, i.e. purchasing goods and services, and wealth kept in cash is the result of economic agents’ portfolio decisions. The transactions demand for cash is related to consumption, and it is also affected by the availability of electronic payment methods. Due to the rise in electronic payment solutions (e.g. bank transfer, card, mobile), less and less purchases are made with cash, which points towards a contraction in the transactions demand for cash (Figure 2). The expansion in nominal consumption has a contrary effect, as the increase in the value of purchases is positively correlated with banknote holdings. Nominal cash holdings expand in most advanced countries, even though the value of electronic payments also climbs at a fast pace.

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Figure 2: The cash‑to‑GDP ratio and the ratio of electronic payments (percent)

The value of electronic payments as the share of POS payments

100

Norway

Sweden

80 70

China

Czechia

Croatia

Hungary

40 Poland

30 20

Romania

10 0

0.0

2.0

4.0 6.0 8.0 10.0 12.0 Cash to GDP (2015-2019 average)

Bulgaria 14.0

16.0

Note: The proportion of electronic payments is estimated (2015−2019). Source: ECB, national central banks, Eurostat.

2.2. Hoarding function In the years after the 2008 economic crisis, the cash-to‑GDP ratio increased in all the countries under review, with the exception of the Nordic countries that had already been characterised by small cash holdings. This is attributable to the changed portfolio composition of households in the declining inflation and yield environment after the crisis. During portfolio restructuring, there was a shift towards liquid instruments, especially cash and demand deposits, and this affected both advanced and emerging countries. Since the opportunity cost of holding cash was considerably reduced as yields dropped near zero, households presumably increased their cash savings mainly for storing wealth. Cash holding for saving purposes is closely related to the proportion of purchases for which households use cash, especially

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in the case of large value transactions. For example if property is bought at least partly from cash, then it makes sense to keep savings allotted for future property purchases in cash, especially in a low yield environment. Paying large sums in cash may be motivated by diverse factors. Disregarding personal preferences and the role of the shadow economy, such transactions may entail huge bank fees (Turján et al., 2011). Another main reason may be the absence of an appropriate electronic payment alternative. In most European countries, bank transfers took hours or even days to complete until recently, so they were not a viable option for home purchases. However, the introduction of instant payments in Hungary in 2020 enabled electronic payments in practically all situations from a technical perspective. Figure 3: Cash‑to‑GDP ratio in some countries (figures represent 2019 values; percent) Hungary

China

Czechia

13.0

Japan

7.8

19.3

Denmark 10.5

Canada

Croatia 2.7 4.1

USA

7.7

8.2 10.3

6.9

9.9

2010 2019

Bulgaria

14.5

1.1 1.3

Poland

Turkey

Romania Norway

Sweden

Source: Eurostat, national central banks’ websites.

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2.3. The cash demand of the hidden economy The size of cash holdings in less developed countries is partly explained by the share of the hidden economy. Based on international data, the share of the hidden economy and cash holdings in the economy are positively correlated (Figure 4), as most transactions in the hidden economy are conducted in cash. In Central and Eastern European and Baltic countries, where the average share of the hidden economy within the whole economy is 20−25 per cent, cash holdings are usually larger than in advanced Western European countries. 2.4. The functions of cash and the CBDC The effect of central bank digital currencies on cash holdings depends largely on the exact conditions under which they are introduced. To allow the introduction of the CBDC to significantly influence the demand for the different types of money, it must be widely available, just like cash. Therefore the financial intermediary system has to have an interest in circulating the CBDC, so most central banks are considering a solution where banks and financial service providers recirculate the CBDC to individual users, similar to cash. The CBDC can considerably reduce the transactions demand for cash if it is more attractive than the available market‑based electronic payment solutions or cash (for example due to lower fees, simple and convenient use, a great degree of anonymity or the option for offline use). However, it has a more muted impact on cash hoarding and to the hidden economy because the main drivers behind these, such as complete anonymity and tangibility, are not ensured by a CBDC at all, or only to a limited degree. To better assess how much a CBDC can substitute cash, the different means of payment should be compared along their functions. What are the functions in which a CBDC offers something new compared to other assets? This will be examined in the next chapter. — 176 —

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Figure 4: The relationship between the cash‑to‑GDP ratio and the ratio of the shadow economy

Cash to GDP (2017; percent)

16 14 10

AT NL

8 4

NO 0

BE DK

FI DE IE

HU SI EE ES IT PL MT

LT CY RO HR

y = 0,4895x + 1,9112 R²= 0,42484

5 10 15 20 25 Size of shadow economy as share of GDP (2017; percent)

Note: The size of the shadow economy is based on an estimate. Source: Eurostat, national central banks, Medina–Schneider (2019).

3. Substitutability between cash and a central bank digital currency There are shared features between traditional cash, electronic payment instruments and a CBDC, but a more in‑depth examination in real‑life situations shows several differences (Table 1). 3.1. Representing a claim One important characteristic is that cash is not linked to an account, while deposit money is; a central bank digital currency can be either of the two. Second, in modern economies, among the traditional forms of money, deposit money is a claim and a liability, since the money held at commercial banks is a liability for the banks and a claim for the account holders. Banknotes can also be considered to represent a sort of non‑convertible claim, as — 177 —

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they are a claim for the holder of the given banknote and a liability for the central bank. A central bank digital currency can have both features: if a token‑based version is introduced, it will resemble cash, while an account‑based version would be more like deposit money. Table 1: Comparison of a CBDC and traditional forms of money along their functions Cash Represents a claim Store of value

Deposit money

CBDC

yes

non-bearing

bearing

either

Exchange

yes

Clearing

yes

complete

partial

yes

either

limited

high

none

some

potentially

Anonymity Associated with an account Security Perceived costs

3.2. Basic functions of money When examining the three basic functions of money, a significant difference can be detected between traditional forms of money and central bank digital currencies in terms of the store of value function. As money can be used to transfer purchasing power from the present to the future, one of its main functions is that it stores value in the short and the long run. The second function of traditional money is that it acts as a medium of exchange, in essence it is uniformly and widely accepted by economic agents as a means of payment. Finally, the third is the unit of account function, which means that it is a universally accepted standard of value in society, facilitating calculations for economic agents and enabling the comparison of the prices of goods and services. Besides the widely used means of payment, there may be assets in an economy that are able to fulfil some of the above three main functions at a given time and place. For example real estate can be a good store of value, but as its value

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varies between economic agents, its medium of exchange function is not as efficient as that of cash, and it cannot be used adequately as a unit of account. Therefore the examination here is narrowed down to monetary assets. Based on Table 1, cash and deposit money mainly differ in their store of value function. Since cash does not bear interest, compared to an interest-bearing asset it may be costly to hold in the long run. By contrast, deposit money is usually considered interestbearing, although the yield on demand deposits is currently barely above zero. With a CBDC, both are possible, but most central banks prefer the non‑bearing version for now. Accordingly, bank (time) deposits currently fare better in the store of value function, therefore they are the best fit for long‑term savings among the options listed here, when only interest losses are taken into account. Cash payments ensure complete anonymity, meaning that the information about the payer and the beneficiary are not directly available to public institutions. With a CBDC, it is up to the central bank to decide on the degree of anonymity: most central banks intend to introduce a system where CBDC customer data remains private. Nevertheless, there is a possibility for the central bank to know the information about the parties to a payment transaction, therefore the anonymity offered by a CBDC falls short of cash from the perspective of the potential users. 3.3. Other important features Despite the opportunity cost, economic agents often hoard cash. This may be attributable to the high liquidity of cash, its complete anonymity and convenience as well as the regulatory environment (e.g. transaction tax). To evaluate to what extent a CBDC can substitute cash, one should be aware of cash holders’ motives. Consequently, several papers in the international literature have dealt with the motives of cash holding, not only seeking the

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specific preferences but also using the data to simulate the impact of the changed environment. The literature often approaches the motives of holding cash from the functions fulfilled in payments. Economic agents often prefer cash to electronic payments in payment situations, especially in retail transactions (Wakamori et al., 2013). Wakamori et al. attempt to find out whether shoppers truly prefer using cash or merchants restrict card usage. In retail transactions, the dominance of cash usage can be attributed to two factors. First, the demand factor of shoppers, because cash is easy to use and transactions are relatively fast. However, this is less and less true as contactless card payments are on the rise. Another important factor in cash payments is on the supply side: merchants often do not accept cashless payments, especially in retail transactions. (Yet this also seems to be on the decline in recent years.) According to the survey published in the paper, if all merchants accepted cards for payment, cash usage would drop but nonetheless remain substantial. The popularity of cash is mostly linked to consumer preferences. It has to be noted, though, that recent years have seen major changes in this respect in Hungary and elsewhere. The tap‑and‑pay option is now widely used, as it provides a faster and more convenient experience than cash. Hence, consumers are more inclined to use their cards, and merchants also increasingly provide a card payment option. In Hungary, this process was further facilitated by the widespread adoption of online cash registers in the retail and services sectors, which greatly reduces the possibility of tax evasion and thus also the rejection of card acceptance among merchants. Furthermore, the introduction of instant payments means that merchants can provide electronic payment options, potentially for a fraction of the costs incurred earlier for card acceptance.

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3.4. The necessity of involving banks A recent study (Huynh et al., 2020) examines the impact of the introduction of a hypothetical CBDC on consumer preferences. Several CBDC option were designed. In the first, the CBDC has features resembling cash, in the second it has features resembling deposit money, and in the third case it has the best features of cash and deposit money. The simulation results show that CBDC payments may amount to no more than 25 per cent of all transactions. According to the authors of the study, this occurs when the CBDC combines the most useful characteristics of cash and deposit money, in other words, if the consumers find the features of the CBDC to be the most favourable from the perspective of the perceived costs, convenience, anonymity and security. The authors argue that the CBDC should have much better features along these dimensions if it is to completely replace traditional payment methods. They stress that the establishment of the acceptance network is crucial in the success of the new payment instrument: as long as merchant acceptance is below 60 per cent, the share of CBDC transactions remains under 10 per cent. Precisely because of this, in their publication (Fan Yifei, 2020), the People’s Bank of China argued for the two‑tier system actively involving banks, mainly based on the following considerations: – Commercial banks have established IT systems, processes and services for customer relations and for processing huge amounts of data rapidly that have stood the test of time, and they also have qualified staff. Building a similar system under the aegis of a central bank would incur exorbitant costs. The popularity and penetration of a CBDC would increase more quickly if people could access it through commercial banks, as customers are used to conducting their finances in commercial banks (in the branches operated by the banks that are not otherwise available to the central bank) or their online platforms.

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– The two‑tier model would also diffuse risks in the system. Although central banks have extensive experience in developing payment and settlement systems, these systems were designed for a finite number of participants. However, the CBDC would be widely used, so players that can manage this, i.e. financial intermediaries, are also needed. – The two‑tier model would not disrupt financial intermediation, while in a one‑tier system the central bank would directly approach the public, thereby competing with bank deposits. This is because a CBDC would offer greater credibility and security than bank deposits, and commercial banks could be crowded out from the deposit‑taking and savings market, which could undermine their lending capacity. They would increasingly rely on the interbank market for borrowing, leading to a rise in funding costs, which would adversely affect financial intermediation and ultimately the real economy. In the end, central banks would have to support commercial banks to maintain their lending capacity and preserve the health of the financial system. The success of a central bank digital currency not only depends on the features of the new means of payment (e.g. whether it is more like cash or deposit money), an appropriate acceptance network is also essential. The economic environment and the conditions of use into which the new means of payment is sought to be incorporated should also be examined. The following chapter describes how the new currency can be integrated with the financial intermediary system.

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4. Incorporation of a CBDC into the financial intermediary system Both a central bank digital currency and cash are issued by the central bank, but they differ in one crucial aspect, tangibility. It follows from this difference that a central bank digital currency cannot fully replace cash, but it can complement the latter. Of course, there are countries (e.g. Sweden, Norway) where cash is not really necessary anymore, which is favourable for the introduction of a CBDC, although from other aspects it remains an issue to be solved (ECB, 2020). Although a CBDC, as legal tender, can be considered liquid, too, it only offers partial anonymity when compared to cash. On the other hand, cash lags behind the CBDC in terms of security, as it can be more easily destroyed, stolen or lost. From the perspective of security, central bank digital currencies are more like deposit money, although a token‑based CBDC can also be stolen or lost. The economic agents to whom the security of an asset is crucial and have no commercial bank ties have the option to switch from cash to the central bank digital currency. But is a digital substitute to cash really necessary when cash demand is at all-time highs? 4.1. Change in the demand for money Payment habits have changed considerably all over the world in the past couple of decades, but cash holdings continue to grow, in fact, this growth accelerated after the 2008 crisis. Why do cash holdings continue to significantly expand even while card payments are on the rise? One of the most often cited arguments is that the speculative motive has intensified all over the world, attested by the fact that the demand for large‑denomination banknotes increased the most (BIS, 2018; Figure 5). In addition, in the low yield environment seen in recent years, it was rational to keep savings

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in non-interest bearing instruments. Accordingly, cash demand increased in most countries. However, in less cash‑intensive countries (such as Norway and Sweden), cash holdings continued to diminish despite the low yields. This is probably attributable to the fact that the share of cash payments had already declined to such a low level that it had a negative effect on hoarding cash. In these countries, the question now is whether cash really fulfils its role in the payment system. Ensuring the circulation of cash entails high fixed costs, therefore it becomes increasingly expensive as turnover declines. Below a certain point, it is less and less worth it for economic agents to deal with cash. Figure 5: Cash and the largest denominations as a share of GDP 16

Per cent

0 Bulgaria

2 Hungary

Czechia

Eurozone

Poland

USA

Croatia

Romania

Canada

Denmark

Sweden

Norwy

Other denominations Largest denomination

Note: In the case of Canada, Sweden, the Czech Republic and Romania, the two largest denominations were taken into account. Source: National central banks, IMF, Eurostat, ECB.

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Accordingly, the increasing popularity of cash as a wealth accumulation instrument is only illusory. Although demand has increased in the times of low interest rates, this could change if yields increase or a more attractive alternative for saving emerges. Nevertheless, nowadays the role of cash in transactions is diminishing almost everywhere, which will presumably reduce wealth accumulation in cash over time, similar to the situation in Scandinavian countries. 4.2. Cash and the CBDC – Substitute or complement? In the countries with muted cash demand, where cash is on the backfoot, a central bank digital currency could be a solution to maintaining a risk‑free payment alternative provided by the central bank. Still, the exact framework and availability of a central bank digital currency are crucial when it comes to substituting cash (Engert, Fung 2018). A CBDC can fulfil similar functions in payments as cash if it is readily available, even offline, is cheap and can be used widely. In cash‑intensive economies, a central bank digital currency can help reduce cash-dependence. Cash holdings are typically larger in the countries where confidence in the financial system is weak. A central bank digital currency can be a safe solution for those who do not trust bank services and are also afraid to accumulate large quantities of cash at home. The adoption of a CBDC can also be facilitated if payments with it can be conducted for free, just like with cash. A central bank digital currency can substitute cash in payment transactions, and act as a complement to the latter with respect to the speculative motive. As described above, cash gradually loses its role in point-of-sale transactions. Therefore in the long run, a safe asset provided widely by the central bank may be needed that can be an alternative to deposit money payments based on banks’ systems. At the same time, the hoarding function of cash may persist, as the partial anonymity of a CBDC, as well — 185 —

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as the lack of tangibility or offline payments are major competitive disadvantages against cash. The People’s Bank of China (PBoC) shows a keen interest in introducing a central bank digital currency, and one of the main aims of the central bank is to provide an alternative to the non‑bank alternative payment instruments that are hugely popular in China (e.g. WeChat, Alipay). However, thanks to electronic payment instruments, cash holdings have also declined in China, although they are still sizeable by international standards (Figure 3). Accordingly, the PBoC has shifted towards a system that would primarily offer a solution for retail payments. In September 2020, the central bank ran a pilot project of the digital legal tender with a limited number of users. The components of the new system are listed below. – The digital yuan can primarily be used in retail transactions. – It does not bear interest. – It is built on the existing infrastructure of commercial banks. – It ensures controllable anonymity, where only the central bank knows the transaction data. A widely used CBDC with similar conditions can probably significantly reduce cash demand through the transaction function. However, the motives related to speculation and the hidden economy can keep the demand for banknotes high.

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5. The impact of a CBDC on the amount and velocity of money In itself, a central bank digital currency does not change the amount of money in circulation, only if it is coupled with lending. A CBDC issued by the central bank as funds does not affect the balance sheet total of the central bank, only the balance sheet’s composition, therefore the money supply does not change either. But if the central bank lends directly to economic agents, in the form of a central bank digital currency, the central bank’s balance sheet and thus also money supply grow. 5.1. CBDC without central bank lending The impact of a central bank digital currency on monetary aggregates depends largely on its features and availability: when issued directly by the central bank as funds, it can be considered part of the monetary base, and it would be part of M0 as a non‑interest bearing deposit (Figure 6). In itself, the introduction of a central bank digital currency as an alternative to cash or bank deposits would not entail a rise in the money supply, it would merely cause a realignment among the components of monetary aggregates, depending on whether the CBDC substitutes cash or bank deposits. The introduction would only boost money supply if economic agents received the CBDC as additional funds, for example as a loan or helicopter money. Another important question when examining the impact on monetary aggregates is the CBDC’s availability in cross-border scenarios, because in certain economies, extending the use of the central bank digital currency for cross-border transactions may entail the substitution of the domestic currency, destabilising monetary aggregates (BIS, 2018).

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Figure 6: The emergence of a central bank digital currency in the monetary system Central bank Cash Assets

Commercial banks

Private sector Cash

CBDC Reserves

Reserves Loans

Deposit

CBDC

Deposit

Capital, bonds

Loans

Note: Based on Fiedler et al. (2019).

5.2. CBDC issuance through central bank lending The introduction of a central bank digital currency tied to loans allows the central bank to directly provide funds to economic agents. Central banks use their unconventional instruments to extend funds to economic agents by bloating their balance sheets, which requires the intermediation of the banking system. However, a central bank digital currency enables central bank lending incentive programmes to finance users directly, thereby increasing the targeted nature and efficiency of such schemes. CBDC issuance combined with central bank lending increases the money supply through the central bank’s balance sheet (Figure 7). Figure 7: The emergence of a central bank digital currency linked to central bank lending in the monetary system Central bank

Commercial banks

Private sector

Cash

Cash M0

Assets CBDC CBDC loan

Reserves

CBDC

Capital, bonds

Reserves Loans

Deposit

Note: Based on Fiedler et al. (2019).

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Loans

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5.3. The impact of a CBDC on the velocity of money Besides the effect exerted on the monetary aggregates, another important aspect is the impact of a central bank digital currency on the velocity of money. In macroeconomic thinking, the velocity of money can be interpreted as the result of an identity, showing the number of times the amount of money in circulation revolves during the realisation of income, i.e. the selling of the output goods and services, in other words, the amount of real output sales mediated by it over one unit of time. The indicator, which had been estimated as the ratio of output and the money supply, becomes directly observable due to the appearance of a central bank digital currency as the transactions conducted with it are known. This can produce a vast new information base, thereby contributing to a more nuanced understanding of how the economy operates and thus improving the efficiency of economic policy measures. This is because with the appropriate analytical procedures, central banks can use the newly available information to enhance their macroeconomic projections and liquidity and reserve management methods as well as determine the actual velocity of money (Mancini-Griffoli et al., 2020). Familiarity with, and direct observation of, the velocity of money also entails important opportunities for stimulating the economy. If the implemented CBDC system allows this, the large database of transactions helps identify the economic segments where economic policy stimulus is needed, and the microdatabase facilitates a better understanding of supply and demand conditions, and perhaps even incentives pointing towards growth and economic development objectives can be introduced. When rearranged, the Fisher equation yields the economy’s output as the product of the amount of money in circulation and the velocity of money. In the past decade, central banks sought to stimulate the economy through quantitative easing by boosting the money supply, and as a ‘side effect’, the velocity of money decreased, in other words, — 189 —

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instead of output growth, a realignment was achieved between velocity and the money supply. In their paper, Copic and Franke (2020) show that in theory, ceteris paribus, output can be increased by boosting velocity, which may be facilitated by the targeted use of a central bank digital currency. First, the increase in the velocity of money is influenced by financial innovation and falling transaction costs (Higgins, 1978), and it can be supported by the appearance of a central bank digital currency, and second, economic agents can be directly activated and the economy stimulated by encouraging financial transactions or discouraging accumulation. In other words, the introduction of a central bank digital currency holds enormous potential, which, when exploited, could prove favourable for the entire monetary system. A central bank digital currency can induce positive change in accelerating transactions, improving the quality of financial services, enhancing central bank projections and facilitating more efficient asset allocation. However, these are only theoretical possibilities for now, and their realisation depends heavily on the features and penetration of the CBDC. Tapping this potential and using the available data requires a large, well‑functioning system that can open up a new transmission channel for the central bank and become an important monetary policy instrument.

6. The impact on monetary policy The central bank digital currency substituting cash is basically neutral from a monetary policy perspective because cash is a non‑interest bearing instrument. Therefore, a cash‑substituting CBDC can fulfil the same functions as cash, only in electronic form, so it has no impact on monetary policy transmission (Riksbank, 2017; BIS, 2018). At the same time, it can also become a monetary policy instrument if some interest or fee is charged on the means of payment depending on time and the unused — 190 —

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amount, or if economic agents get a cashback on the amounts spent. However, in itself the extent of the monetary impact does not depend on whether the CBDC bears interest or not, but rather on its conditions and interest conditions compared to average bank deposits. Yet financial stability aspects should also be taken into account when these conditions are defined. In theory, the introduction of a central bank digital currency can increase the room for monetary policy manoeuvre, as with an interest‑bearing CBDC, interest can also be reduced into negative territory (Dyson–Hodgson, 2016). Nevertheless, in itself this does not make a CBDC an attractive alternative to cash, and therefore the contraction of cash is an essential condition for increasing room for manoeuvre. That is why the conditions under which the central bank digital currency is introduced are important to determine. During implementation, crucial aspects include whether anonymity is ensured, whether the currency is value‑ or account‑based, the degree and conditions of availability as well as the sectors that have access to the payment instrument. Depending on these, the balance sheets of the central bank and commercial banks may change, which affects commercial bank lending and the efficiency of monetary policy transmission (BIS, 2018). Furthermore, different cash ratios and saving purposes can assign different roles to the CBDC. Monetary policy implications depend on the type of central bank digital currency. A deposit‑taking central bank reaches savers more easily, which could strengthen the transmission mechanism. The central bank digital currency can be used by the central bank to directly influence the behaviour of participants, because money market repricing is excluded from the transmission mechanism, therefore the interest rate on the CBDC directly affects real economy actors without the involvement of commercial banks and financial markets. A creditor central bank has an even more direct link to the real economy, since it can directly lend to the real economy without the banking system, which can be key in

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a crisis, and monetary policy transmission can be accelerated (BIS, 2018, Barrdear–Kumhof, 2016). New technologies offer an opportunity to turn the CBDC into a monetary policy instrument. Until recently, the velocity of money had been a relatively abstract concept in economics. The main reason for this is that it is impossible to mark each and every banknote, therefore the number of times they exchange hands cannot be tracked, so models used a predetermined velocity of money. Still, some technologies underlying digital currencies facilitate the examination and even the influencing of the velocity of money. The central bank can affect consumer spending and thus also the circulation of the CBDC with so‑called ‘demurrage fees’. Demurrage fees are charged if an amount held in a specific asset is not used within a stipulated period (Copic–Franke, 2020). A similar system is used in Hungary with the SZÉP Card, where fees are charged on the unspent amount after a certain time. When a fee applied, the digital currency’s store of value function would diminish and the zero lower bound would be less rigid. This can be interpreted as a sort of negative interest rate, activated after a certain amount of time (Buiter–Panigirtzoglou, 2003). However, this has been quite difficult to implement with physical means of payment. The advantages of introducing demurrage fees are mainly reaped during economic downturns, when the velocity of money is lower than in an upswing (Anderson et al., 2014; Friedman–Schwartz, 1963; Végső–Bódi, 2020). That is when demurrage fees can be introduced or increased, thereby boosting the velocity, which can strengthen monetary policy transmission and ultimately help economic recovery. The demurrage fee can be implemented linearly or progressively, but it should be lower than the cost arising from holding the alternative asset, cash. This would ensure that the demurrage fees do not divert amounts from the CBDC to other payment or wealth‑storing instruments. It has to be noted, though, that in certain countries, similar alternative

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assets, such as cash, have a larger holding cost on account of storage costs (physical storage, guarding, accounting) and handling costs, i.e. the costs of obtaining cash (Assenmacher– Krogstrup, 2018; Rogoff, 2014). Outflows can also be hindered by complementing the CBDC with measures that make it more expensive and difficult to use cash. Such measures include the withdrawal of large‑denomination banknotes from the economy (Rogoff, 2014). As cash is crowded out, transmission strengthens and ultimately financial inclusion in society can increase, because lower‑income individuals and older generations typically use electronic payments less. Lower‑income actors hold a major portion of their wealth in cash, which would flow into the central bank digital currency after its introduction. Since such households generally have no reserves and spend most of their income on consumption, the demurrage fee introduced for CBDC holding to increase the velocity of cash would not affect them considerably. Accordingly, the distributional effect does not necessarily take hold, while the effect of the current monetary policy instruments on inequality is uncertain (Amaral, 2017; Dolado et al., 2018). There are other possibilities for boosting velocity and improving the efficiency of monetary policy transmission. For example, consumers would receive some cashback in proportion to their CBDC spending. This would encourage them to consume more, as they are refunded a portion of each spent unit. (Some credit cards use this solution, but they are not available to everyone, and they incur high costs.) Since the central bank issues the CBDC, it can determine the currency’s cost structure and influence the extent to which the CBDC contributes to the change in the velocity. If the cashback is raised, velocity can rise, along with economic output. Alternatively, if the cashback is reduced, velocity and growth diminish. Accordingly, the stimulus would appear soon in the economy, directly at the consumer or company, in the targeted sector (Copic–Franke, 2020). This would ultimately strengthen

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monetary policy transmission, which would help the central bank in reaching its objective more efficiently. However, the scheme would significantly influence the central bank’s profits, which may even constrain the room for fiscal manoeuvre of the government.

7. Conclusion Rapid technological progress brings solutions within reach that were inconceivable just a decade ago. This trend also affects central banks’ operation. For example central bank digital currencies enable the central bank to improve the security of the financial system while its objectives are achieved faster and more directly. Cash is constantly losing ground to new solutions such as card transactions combined with instant clearing (e.g. traditional plastic cards), mobile payments (e.g. virtual cards, text‑to‑pay solutions) or payments in an application (e.g. WeChat). Although the current trends suggest that the store of value function of cash may persist, its significance may decline based on the experience from advanced Nordic countries. Therefore, the option of a central bank digital currency has acquired new significance for central banks, as it provides a similar level of security and convenience as electronic payment instruments, but is also legal tender whose functioning and acceptance are ensured by the central bank under all circumstances. Besides, a central bank digital currency can be effective in expanding the room for monetary policy manoeuvre. This is because it provides an opportunity for ensuring wider financial inclusion and influencing the velocity of money, which strengthens monetary policy transmission through consumption.

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References Anderson, R.–Bordo, M.–Duca, J. V. (2014): Money and velocity during financial crises: From the Great Depression to the Great Recession, https://www.frbsf.org/ economic-research/files/S04_P1_JohnVDuca.pdf Andolfatto, D (2018): Assessing the Impact of Central Bank Digital Currency on Private Banks, Federal Reserve Bank of St. Louis Working Paper No. 2018-026B,https:// s3.amazonaws.com/real.stlouisfed.org/wp/2018/2018-026.pdf Assenmacher–Krogstrup (2018): Monetary Policy with Negative Interest Rates: Decoupling Cash from Electronic Money, IMF Working Papers 18/191, International Monetary Fund, https://www.imf.org/-/media/Files/Publications/WP/2018/wp18191. ashx Bank of England (2020): Central Bank Digital Currency: Opportunities, Challenges and Design, Discussion Paper, March,https://www.bankofengland.co.uk/-/media/ boe/files/paper/2020/central-bank-digital-currency-opportunities-challenges-anddesign.pdf BIS (2018): Central bank digital currencies, Bank for International Settlements Committee on Payments and Market Infrastructures, https://www.bis.org/cpmi/ publ/d174.pdf Buiter–Panigirtzouhlou (2003): Overcoming the zero bound on nominal interest rates with negative interest on currency: Gesell’s solution, Economic Journal, 113(490): 723-746.,http://eprints.lse.ac.uk/848/1/liqnew.pdf Copic, E.−Franke, M. (2020): Influencing the Velocity of Central Bank Digital Currencies, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3518736 Dr. Turján, A.–Divéki, É.–Keszy-Harmath, Z.–Kóczán, G.–Takács, K. (2011): Semmi sincs ingyen: A főbb magyar fizetési módok társadalmi költségének felmérése (Nothing is free: A survey of the social cost of the main payment instruments in Hungary). MNB Occasional Papers No 93., https://www.mnb.hu/letoltes/mt93.pdf Dyson–Hodgson (2016): Digital cash: Why central banks should start issuing electronic money, Positive Money, http://positivemoney.org/wp-content/ uploads/2016/01/Digital_Cash_WebPrintReady_20160113.pdf Engert, W.,-Fung, B.-Hendry, S. (2018): Is a cashless society problematic?, Discussion Papers 18−12, Bank of Canada,https://www.bankofcanada.ca/wp-content/ uploads/2018/10/sdp2018-12.pdf European Central Bank (2019): Exploring anonymity in central bank digital currencies, December 2019, https://www.ecb.europa.eu/paym/intro/publications/ pdf/ecb.mipinfocus191217.en.pdf European Central Bank (2020): Report on a digital euro, https://www.ecb.europa.eu/ pub/pdf/other/Report_on_a_digital_euro~4d7268b458.en.pdf Fan Yifei (2020): Some thoughts on CBDC operations in China, https://www. centralbanking.com/fintech/cbdc/7511376/some-thoughts-on-cbdc-operations-in-china

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VI. Will the central bank digital currency be the new cash? Fernández-Villaverde, J.-Sanches, D.-Schilling, L-Uhlig, H. (2020): Central Bank Digital Currency: Central banking for all?, National Bureau of Economic Research Working Paper No. 26753, https://www.sas.upenn.edu/~jesusfv/Central_Banking_All. pdf Fiedler, S.-Gern, K.-Stolzenburg, U.-Gerba, E.-Rubio, M.-Kriwoluzky, A.-Kim, C.Claeys, G.-Demertzis, M.: (2019):Future of money, Policy Department for Economic, Scientific and Quality of Life Policies Directorate-General for Internal Policies PE 642. 364–November 2019, https://www.europarl.europa.eu/cmsdata/190218/IPOL_ STU(2019)642364_EN-original.pdf Friedman, M.–Schwartz, A. J. (1963): A Monetary History of the United States 1867−1960, Princeton University Press Huynh, K.-Molnar, J.-Shcherbakov, O.-Yu, Q. (2020): Demand for Payment Services and Consumer Welfare: The Introduction of a Central Bank Digital Currency, Bank of Canada Staff Working Paper 2020-7, https://www.bankofcanada.ca/wp-content/ uploads/2020/03/swp2020-7.pdf Mancini-Griffoli, T.-Peria, M. S. M.-Agur, I.-Ari, A.-Kiff, J.-Popescu, A.-Rochon, C. (2018): Casting Light on Central Bank Digital Currency, International Monetary Fund Staff Discussion Note, https://www.imf.org/-/media/Files/Publications/SDN/2018/ SDN1808.ashx Medina, L.−Schneider, F. (2019): Shedding Light on the Shadow Economy: A Global Data base and the Interaction with the Official One, CES ifo Working Papers,https:// www.econstor.eu/bitstream/10419/214983/1/cesifo1_wp7981.pdf Richards, T.−Thompson, C.−Cameron, D. (2020):Retail Central Bank Digital Currency, RBA Bulletin, September 2020, https://www.rba.gov.au/publications/bulletin/2020/ sep/pdf/retail-central-bank-digital-currency-design-considerations-rationales-andimplications.pdf Riksbank (2017): The Riksbank’s e-krona project, Report 1, https://www.riksbank.se/ globalassets/media/rapporter/e-krona/2017/rapport_ekrona_uppdaterad_170920_eng. pdf Rogoff (2014): Costs and Benefits to Phasing Out Paper Currency, NBER Macroeconomics https://scholar.harvard.edu/files/rogoff/files/c13431.pdf Végső, T.–Bódi-Schubert, A. (2020): A koronavírus-járvány hatása a készpénzállomány változására 2020. január−augusztus folyamán (The impact of the coronavirus pandemic on changes to cash holdings in January–August 2020), https://www.mnb. hu/letoltes/a-koronavirus-jarvany-hatasa-a-keszpenzallomany-valtozasara-2020januar-augusztus-folyaman.pdf Wakamori, N.−Welte, A. (2017): Why do shoppers use cash? Evidence from shopping diary data, Journal of Money, Credit and Banking, 49(1), https://www.bankofcanada. ca/wp-content/uploads/2012/07/wp2012-24.pdf

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VII. Financial stability aspects of the introduction of a central bank digital currency Zénó Fülöp – János Szakács – Péter Szomorjai – Balázs Varga – Márton Zsigó The introduction of a central bank digital currency can positively impact financial stability among other central bank objectives, including by maintaining the competitiveness of the financial system and making a quasi-risk-free digital payment instrument available to participants in the real economy. At the same time, this new technology can significantly transform banking business models depending on its objectives and the range of payment, saving and possibly lending services taken over by the central bank from commercial banks. This may entail new banking and systemic risks. For the potential introduction of central bank digital currency, it is necessary to start assessing these risks and preparing regulatory and supervisory tools for their mitigation and for the uncertainties of a new setup.

1. Introduction Central banks are increasingly using digital solutions to fulfil their functions. New solutions can not only increase operational efficiency but can also bring about fundamental changes in the activities of the financial system and central banks. One notable example would be the introduction of central bank digital currency (CBDC). In our study, we deal with the effects of this on financial stability objectives.

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First we examine the potential benefits of introducing central bank digital currency in terms of financial stability. These advantages arise mainly through improvements to the functioning of the payment system. The achievement of financial stability objectives can be supported by the diversification of payment systems, the emergence of new digital services, and increased competition and efficiency in the banking system. In addition to the benefits, we will review in detail how CBDC would affect the balance sheet and risks of the banking system. Given that the vast majority of central banks have not committed themselves to certain specific variants of CBDC implementation, we examine the effects in general and look into the particular cases of three different alternatives of design: the model of the digital central bank cash substitute, the deposit-taking central bank and the creditor central bank. In addition to disintermediation (a narrowing of the role of the banking system in financial intermediation), the introduction of CBDC can also induce changes that give rise to unprecedented risks. In the study, we will discuss the transformation of the mechanism of bank runs and examine system-critical central bank activities that may occur in parallel with the spread of CBDC use. Finally, we also mention which directions of the renewal of the financial and prudential regulation introduced in recent years tailored to the current setup of banking operations should be reevaluated in the future with regard to the systemic changes brought about by central bank digital currency and the support for the spread of CBDC.

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2. The possible contribution of central bank digital currency to the stable and efficient functioning of the financial system The introduction of CBDC has various potentials and can also be an effective tool for achieving financial stability objectives, depending on technological implementation and the new framework. These advantages are mainly due to the impact of central bank digital currency on payment systems and payment habits (Figure 1). However, in order to exploit the benefits, CBDC must be reliable, resilient and secure, and also a fast, simple, efficient and easily accessible tool for users. Below we look at some of the key benefits of central bank digital currency for financial stability.52 The introduction of a new payment instrument will result in diversification and increased competition in the market for payment services. Payment systems have evolved at an extraordinary pace in recent years, driven by increased market demand and the spread of electronic (cashless) payments. The launching of instant payment systems around the world (including the instant payments introduced by the MNB) seen in recent years also fits well into the tendency. With the introduction of CBDC, a new alternative is emerging, reducing the criticality of existing payment systems, potentially making them even more secure and resilient, thereby increasing financial stability. The CBDC would provide an additional, potentially widely available substitute payment method in case the operations of other critical parts of the payment system were under distress or shut down. Barrdear and Kumhof (2016) emphasise that the increasing number of payment options brings about an increase in competition. Increased competition has a positive impact on the economy through safer, cheaper payment alternatives, which can also lead to a more stable financial system that is better adapted to shocks.

he possibility of introducing CBDC has been addressed in a number of T studies, including by the Bank of England (2020).

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Figure 1: Potential financial stability benefits of CBDC through its impact on payment systems and habits

Supporting a more resilient payment system

Supporting innovation and competition in payments

Meeting future payment needs

Improving the availability and usability of central bank money

Addressing the decline in cash use

Supporting cross-border payments

CBDC

Mitigating the risks of excessive spread of private digital currencies

Decreasing counterparty risk

Source: Authors’ compilation based on Bank of England (2020).

The emergence of digital payment solutions from the private sector is difficult to control, and their uptake on a broad scale may therefore pose a risk to financial stability. The introduction of a CBDC may reduce the prominence of less controlled technologies, thus preventing the development of risks. Numerous digital currencies are currently available on the market, but their uncontrolled spreading could lead to an increase in financial stability risks. Unlike commercial bank money, digital currency may escape the scope of financial regulation and supervision; customers are not protected in the event of a potential default or

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devaluation (volatile exchange rate), and the various e-currencies also do not ensure interoperability. Wierts and Boven (2020) also address the issue of how CBDC offers an alternative to other digital currencies. With the introduction of CBDC, the popularity of these currencies can be reduced and the market for innovative currencies can be controlled, whereby financial stability is increased. CBDC is a reliable and secure payment service compared to digital money substitutes issued by other financial enterprises, institutions or developers (e.g. cryptocurrencies, stablecoins and other virtual currencies). Depending on its design and definition, CBDC may have a cash-substitute function in response to future payment needs, supporting the benefits of electronic payment systems. Currently, central bank money is only available in the form of cash for households and companies. Central bank digital currency would provide an opportunity to store it and use it electronically. Central bank money has a key role in maintaining monetary policy and financial stability objectives by ensuring, in its capacity as riskfree money, final payments in legal tender in the economy. Appearing as an electronic form of cash, it would provide this feature in a more widely available form, ideally under appropriate infrastructural conditions. Payment systems must also keep pace with the development of the digital economy. The coronavirus pandemic has given the latest boost to digitalisation. The CBDC could potentially move forward the adaptation to these needs which have come to the fore recently. These new solutions can strengthen digitalization by strengthening competition in the banking sector, improving efficiency and sustainable income-generating capacity. Direct settlement within the central bank may reduce the role of loan collateral. Another argument in favour of the introduction of CBDC concerns the efficiency gains in financial transaction

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settlement systems, whereby operational and counterparty risk, liquidity risk and loan collateral can be reduced. The underlying risks of current multi-level payment systems include counterparty risk, i.e. the risk that the counterparty becomes insolvent, and fails to meet its obligations. In addition to counterparty risk, another mean of managing liquidity risk is to request loan collateral, which typically comprises high-quality instruments such as sovereign debt. With the introduction of central bank digital currency, payments can also be settled directly between the counterparties in the books of central banks. According to Barrdear and Kumhof (2016), this helps to avoid counterparty risk and thus to reduce the role of loan collateral. The volume of unencumbered, high-quality assets available would increase as collateralized transactions could be substituted by direct payments settled with CBDC which could entail significant macroeconomic and stability benefits, for example through potentially widening borrowing opportunities. The introduction of CBDC can also improve the efficiency of crossborder payments in the long run. Cross-border payment options are currently relatively costly and comparatively slow. Although many new payment service providers (e.g. TransferWise, Revolut) offer solutions in this regard, their operation is much less secure and mature compared to the banking system, which is subject to strong regulatory and supervisory and consumer protection expectations. According to Codruta-Henry-Amber (2020), increasing the efficiency of cross-border payments can be one of the main motivations for introducing central bank digital currency. One of the roles of central bank digital currency in the longer term may be to offer a solution to cross-border payments, i.e. a faster, cheaper and safer alternative to the technology currently available. Depending on the chosen solution, the introduction of CBDC may make available settlement processes where payment in one currency is finalized only by payment in the other currency (Payment-versus-Payment, PvP) or when delivery (e.g. on the

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securities market) is made at the same time as payment (Deliveryversus-Payment, DvP), thereby eliminating settlement risk and open positions. Ousméne (2020) highlights in his study that the introduction of the technology can also have a significant positive impact on the foreign exchange trading market. At the same time, central banks would have a greater role to play in operating the payment system, which carries a potential operational risk. In order to exploit the positive effects, it is necessary to develop communication and cooperation between the central banks, as well as to create interoperability between the systems, which may be a longer-term step following the deployment of each national CBDC. To summarise, the successful introduction of central bank digital currency can help to create a more competitive and innovative financial environment, bringing efficiency improvements in payments and strengthening financial stability. Depending on the technological realisation, it may open up new possibilities, and its introduction may address several risks that may arise in the near future. These include the shift of payment flows and savings to unregulated cryptocurrency markets or the spread of uncontrolled payment service providers. The introduction of CBDC can contribute to the improvement of the innovative capacity of the banking system and to strengthening the level of competition, which is the basis for the development of the financial system, ultimately improving the customer experience that can be potentially achieved (security, new technological solutions, convenience). In some markets where the stability of the banking system poses a risk to depositors (for example due to the lack of deposit insurance), CBDC may offer a safer alternative.

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3. Potential financial stability risks in introducing CBDC The advantages of introducing central bank digital currency shown so far can be properly exploited if the risks involved in its introduction can be successfully identified and managed either through the development of a CBDC operating framework or through regulatory solutions. Kiff et al (2020) identifies three main categories of risks that may arise from the operation of CBDC (Figure 2), which comprises the types of strategy and political risks (financial payment system, consumer protection, price stability, financial stability, financial integrity, financial inclusion, economic growth), financial market risks (liquidity, credit, exchange rate) and operational risk (fraud, legal risk, IT, consumer behaviour, third party, process). The risks included in the three groups may also affect the reputational risk of the central bank and the entire banking system. How and to what extent the above risks arise will be significantly influenced by the technological designs under which CBDC will be implemented, the possible limitations and conditions under which it will be available to users and the extent of its uptake among users. Certain risks may increase at the start of implementation, given the possibility for errors to surface during the transition period that cannot be completely eliminated during pilot tests. With the introduction of the CBDC, cyber risks and operational risks cropping out, and critical system failures may also compromise financial stability. During the transition period potential risks (e.g. liquidity risk) may also increase on the side of the banking system in the event of a shock-like transition. A gradual and carefully managed introduction, as well as the prior use of detailed pilot projects, are therefore critical. Of these risks, we will focus on the potential evolution of risks to financial stability following the introduction of CBDC.

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Figure 2: Risks of introducing CBDC Strategy and policy risks • Payments Systems • Consumer protection • Price stability • Financial stability • Financial integrity • Financial inclusion • Economic growth

Reputational Risks Operational Risks • Fraud and security, cyber risk • Legal risk • IT infrastructure • Culture, consumer behaviour • Third party risk • Process management

Financial Risks • Liquidity • Market • Credit

Source: Kiff et al (2020), authors’ compilation.

3.1. Potential narrowing of the role of the banking system in financial intermediation A major part of the financial risks and financial stability issues associated with the introduction of the CBDC stem from the fact that the central bank can take over different financial intermediary functions from commercial banks depending on the objectives pursued through CBDC. The transformation and sustainability of commercial banks’ business models may be significantly affected by the decline in banking activities, the so-called banking system disintermediation. Given that the vast majority of the central banks addressing the issue have not yet committed themselves to the specifics of CBDC design and have not decided on the detailed objectives to be achieved, we will endeavour to examine, in a general and broad approach, the risks that the introduction

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of CBDC in different forms could entail for the functioning of the banking system. Examined in this general framework, the degree of stability risks associated with disintermediation can best be determined by (1) the level of demand for central bank digital currency; (2) the extent to which this demand causes a change in the balance sheet of the banking system; and (3) the extent to which the profitability of the sector is affected. For example, if the CBDC is designed to have such features that it is an attractive alternative to cash transactions the functioning of the banking system may be less affected by its introduction, and financial stability risks may remain moderate. However, if the introduction of CBDC represents serious competition for bank deposits and related payment services, the refinancing of deposit withdrawals from commercial banks, as well as the declining profitability of the banking system as a result of the loss of fee income and increased cost of funds, will be the main source of stability risks. The outflow of bank deposits in the event of the introduction of central bank digital currency may take one of two extreme values. If the CBDC design is primarily aimed at reducing cash holdings (which is the liabilities of the central bank), there may not be a meaningful transfer of deposits from the banking system to the new central bank currency. Conversely, the entire holding of bank deposits could get substituted by a CBDC that is similar to current account deposits but more attractive in its parameters. However, this latter scenario would run into obvious funding and liquidity constraints in terms of the current business model of the banking system; accordingly, in our analysis we will also try to take into account the regulatory framework reflecting the current form of operation.

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Meanwhile, in the event of a larger deposit outflow, the central bank would also be forced to adjust significantly, since in such a situation the banking system would rely on permanent central bank financing to an extent that goes beyond the possibilities of the “peacetime” central bank policy instruments. Another decision point is by what means the central bank is willing to mitigate the possible impact of changing balance sheet structures on the financing of the private sector. The central bank may increase its exposures to commercial banks (whether secured or unsecured) or may even finance private sector actors directly (in the form of bond purchases or even direct lending). Accordingly, in this study we also aim to provide a brief outline of the possibilities of central bank adjustment. Examining the stability effects of introducing CBDC, the primary criterion is therefore whether, with the introduction of the CBDC, the central bank opens only the liability side of its balance sheet to non-financial actors (deposit-taking central bank) or offers access to its asset side in addition to the liability side deposits, which means that it provides loans to non-financial actors (creditor central bank). While the liquidity risks posed by deposit withdrawals from the banking system may dominate in the case of the deposit-taking central bank, in the case of the creditor central bank, the loss of revenue due to the market lost by the commercial banks may increase the stability risks, while the central bank also faces new risks in its balance sheet, profit and loss, and operations. In view of the above, the financial stability effects of the introduction of CBDC are presented in our analysis through possible changes in the balance sheet of the central bank and the banking system along the following scenarios. I. Financial stability aspects of introducing cash substitute CBDC. II. Impact of introducing CBDC on financial stability in the case of a deposit-taking central bank.

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III. Impact of introducing CBDC on financial stability in the case of a creditor central bank. If a specific design of the CBDC is introduced, it may not be purely one of the above scenarios, but rather a partial realisation or a combination of these scenarios; nevertheless these cases are discussed separately for a simpler presentation of the stability effects. While individual chapters focus primarily on the stability risks to the banking system, we also highlight the possibilities of central bank adjustment, and draw attention to the risks of stronger participation by the central bank.53 3.1.1. Financial stability aspects of introducing cash substitute CBDC From a banking system perspective, the simplest case is when the newly introduced central bank digital currency is aimed only at replacing cash holdings. In this case, assuming that the introduction of “digital cash” does not affect the willingness of economic agents to hold bank deposits, only the central bank’s liabilities will be reorganised. In this case, CBDC holdings will increase to the same extent as cash holdings decrease, while the balance sheet of the banking system will remain unchanged (Figure 3). In this case, financial stability risks to the banking system do not arise either in terms of financing or in terms of profitability.

t the same time, our analysis is static in that we present a hypothetical A equilibrium after introducing CBDC and do not address the changes in balance sheets over time after introduction. It is also assumed that the demand for CBDC is continuously controlled by the central bank by defining and fine-tuning the design criteria, therefore the states presented can be achieved according to the intention of the central bank.

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Figure 3: Impact of cash substitute CBDC on the simplified balance sheet of the central bank and the banking system Central Bank Assets

Reserves

Banking System

Liabilities

Assets

Banks' deposits

Deposits at CB

Cash ↓

Liquid securities

CBDC↑

Liabilities

Retail and corporate deposits

Loans

Equity

Source: MNB.

3.1.2. Impact of introducing CBDC on financial stability in the case of a deposit-taking central bank Adjustment without loss of lending activity If the introduction of CBDC leads to a transfer of bank deposits into the new central bank money, the banking system has several options to adjust. If banks can easily find funds to replace outflowing deposits, then it can be assumed that the balance sheet of the banking system does not decrease substantially, and the amount of loans in the balance sheet of the banking system remains unchanged. If deposit outflows are replaced by unsecured wholesale funds (e.g. an interbank deposits or funds raised from bond issuance), the liquid assets of the banking system do not change either (Figure 4). Accordingly, in this case, the balance sheet of the banking system is only reorganised on the liabilities side, while the balance sheet of the central bank increases by the amount of CBDC issued.

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Figure 4: Effect of CBDC with deposit outflows and unsecured wholesale funding Central Bank Assets

Reserves ↑

Banking System

Liabilities

Assets

Banks' deposits

Deposits at CB

Cash

Liquid securities

CBDC↑

Liabilities

Retail and corporate deposits ↓

Loans Wholesale funds ↑ Equity

Source: MNB

However, reorganisation may require a sacrifice in profitability. The price of unsecured wholesale funds may substantially exceed the cost of funds associated with deposit outflows. Revenues from payment services lost as deposits decrease may impair the profitability of the sector to a greater extent than the increase in the cost of funds, which can also greatly contribute to an increase in institutional concentration, for example through the exit of certain players from the market or through mergers. As a result of all these factors, the profitability of the banking system decreases, which may direct its lending activities towards more risky transactions with higher returns. At the same time, decreasing margins and the competition for deposits can also be seen as a positive development in a less competitive banking system. The wholesale funds raised may also lead to an increase in stability risks as those funds may vary significantly in maturity, concentration and denomination compared to customer deposits. Shorter maturities and higher concentration may lead to an increase — 210 —

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in renewal risks and maturity mismatch stretching in the balance sheet of the banking system. Finally, if wholesale funding is carried out through foreign currency borrowing, it may, in addition to the aforementioned risks, lead to an increase in short-term external debt and an increasing imbalance in the currency structure of the balance sheet. However, it is important to note that macroprudential regulation can contribute to the management of these risks, setting limits to in the balance sheet adjustment explained here. For example, in the Hungarian regulations, the requirement on the foreign exchange coverage ratio (FECR) limits the mismatch between foreign exchange assets and liabilities to 15 per cent of the balance sheet total, while the regulation on the interbank funding ratio (IFR) limits the liabilities from financial corporations to 30 per cent of the balance sheet total. The maturity match of foreign currency liabilities is currently ensured by the foreign exchange funding adequacy ratio (FFAR) requirement, while by 2021 banks will have to comply with the NFSR regulation at European level. Overall, these rules can limit both how and to what extent the banking system adjusts on the liabilities side.

Central Bank Assets

Liabilities Banks' deposits

Reserves

Loans to banks↑

Cash

CBDC↑

Liquid assets of the banking system

Figure 5: Effect of CBDC with deposit outflows and secured central bank refinancing

Regulatory requirement for liquid assets Source: MNB

Banking System Assets

Liabilities

Deposits at CB Liquid securities↓ Encumbered sec.↑

Loans

Retail and corporate deposits

Loans from CB↑ Wholesale funds ↑ Equity

↓

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If, due to the above constraints or for other reasons (for example, excessive cost to raise funds from the market), outflows of deposits could no longer be made up by wholesale funds, banks could also finance the missing funds through secured central bank loans (Figure 5). However, apart from a further increase in the cost of funds, this also leads to encumbrance of securities, which reduces free liquidity in the banking system. the balance sheet adjustment financed from secured central bank loans can only be sustained within the scope of assets available as collateral in the banking system.54 What would this mean for the Hungarian banking system? In the case of the Hungarian banking system, the liquidity surplus above the regulatory minimum within which balance sheet adjustment can take place without violating the LCR rules has fluctuated around 15–20 percent of household and corporate deposits at sector level in the last two years. Given that the volume of these deposits amounted to HUF 21 000 billion at the end of August 2020, this maximum adjustment is already very significant. It can be assumed that until the liquidity of the banking system does not fall close to the regulatory minimum, the banking system will not be forced to reduce its lending activity drastically. However, the lower liquidity generated by the adaptation reduces the shock resilience of the banking system, and permanent central bank financing may require the expansion of the central bank’s policy instruments to include long-term secured loans that are commonly used, also outside crisis episodes. As a next step in the analysis, consideration may be given to the extent to which the central bank is able to neutralise the negative consequences of financing available to the banking system in decreasing volumes and at relatively higher prices as the demand for CBDC increases in line with its monetary policy objectives by lowering interest rate levels. The impact on central bank room to manoeuvre and on bank profitability may also vary considerably

ntil liquidity falls close to the regulatory minimum, which is currently U defined in the LCR regulations at the European level.

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depending on the specificities of the banking and financial system. For example, as Bindseil (2020) demonstrates, monetary policy space may come under stronger constraints due to a relatively higher proportion of capital markets in the financing of the real economy, while the response of interest rate margins to changes in the level of interest rates will also be shaped by the complex effects of the structure of the banking market (see, for example, Ennisetal [2016]). Adjustment with the contraction of the balance sheet of the banking system When the banking system’s liquidity approximates the regulatory minimum, the central bank may consider extending eligible assets (for example to corporate loans) to increase the banking system’s liquidity. This slightly increases the banking system’s scope for adjustment, but the excess outflow of deposits already leads to a contraction of the balance sheet of the banking system (Figure 6). Indeed, when the possibilities of raising wholesale funds are exhausted and reserves in liquid assets are used up, the banking system will also be forced to reduce its other assets, such as its loan portfolio. This causes a contraction of the sector’s balance sheet, which can, ceteris paribus, also lead to sacrifices in terms of economic growth.55

At this point, however, the role of the central bank also changes noticeably, as the risk of the sector taking loans from commercial banks, albeit indirectly, is also reflected in its balance sheet by the wider inclusion of corporate loans in the scope of eligible assets. Moreover, due to the information asymmetry, there is a moral hazard on the part of commercial banks, which could drive institutions with already deteriorating profitability even

he relationship between financial intermediation and economic growth is T discussed in detail by Levine (1997).

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more towards riskier credit transactions.56 The fact that a bank is increasingly indebted to a state-owned institution also points in the same direction, so its decisions are more likely to be characterised by a soft budget constraint. Furthermore, if they are completely excluded from the operating framework of CBDC, banks are also forced to rely on a narrower range of information for their credit approval and monitoring, as they may observe fewer deposit movements in the case of those customers who are primarily transacting or saving using CBDC.

Central Bank Assets

Liabilities Banks' deposits

Reserves

Loans to banks ↑

Cash

CBDC ↑

Liquid assets of the banking system

Figure 6: Effect of CBDC with deposit outflows, broadening of eligible assets and decreasing lending activity Banking System Assets

Liabilities

Deposits at CB Liquid securities↓ Encumbered sec. and / or loans ↑

Retail and corporate deposits ↓ Loans from CB ↑

Loans

Wholesale funds ↑ Equity

Regulatory requirement for liquid assets Source: MNB

xpectations for CBDC to appear as a risk-free instrument typically anticipate E an increase in risk. However, Wierts and Boven (2020: 23) note that it is possible, at least theoretically, that in risk competition, some institutions may, by contrast, compete with the alternative of quasi-risk-free CBDC by reducing their risk.

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Adjustment with “automatic” unsecured central bank refinancing The central bank also has the theoretical possibility to automatically finance the banking system with uncovered loans to a virtually unlimited extent (Figure 7). With such automatic refinancing, even an extreme case could be envisaged in which banking system deposits would get transferred entirely into CBDC.

However, this scheme carries a number of risks, regardless of difficulties with legal feasibility.57 Indeed, in this case, the default risk of the banking system would be largely transferred to the central bank’s balance sheet, which would further strengthen the above-mentioned moral hazard. As a consequence, and given the increasing information asymmetry between the central bank and the banking system, the efficiency of financial intermediation would deteriorate significantly, which would not be desirable for economic growth either. Figure 7: Effect of CBDC with unsecured central bank refinancing Assets

Banking System

Liabilities Banks' deposits

Reserves

Loans to banks (unsecured) ↑

Cash

CBDC ↑

Liquid assets of the banking system

Central Bank

Assets Deposits at CB Liquid securities

Loans

Liabilities Retail and corporate deposits ↓

Loans from CB (unsecured) ↑ Equity

Regulatory requirement for liquid assets Source: MNB

his solution contravenes the prohibition of monetary financing under the T current EU rules and is therefore not feasible under the current regulatory framework.

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3.1.3. Impact of introducing CBDC on financial stability in the case of a creditor central bank Although it can be seen from the previous chapter that the credit risks of the banking system gradually appear in the balance sheet of the central bank also in the case of the deposit-taking central bank as the demand for central bank digital currency increases, a CBDC scheme is also possible where the primary objective is for the central bank to lend directly to certain economic agents. Central banks are already involved in the financing of the private sector, for example through the purchase of corporate bonds. However, this option could be a solution primarily for large or medium-sized enterprises, while for small and micro enterprises or households, the introduction of a significant volume of depositside central bank digital currency would leave a significant part of the potential credit demand that would be excluded from the commercial bank balance sheet unsatisfied.58

However, the extension of central bank digital currency may also allow the central bank to lend directly to companies or households.59 In this case, the volume of transactions financed by the central bank will increase as the credit portfolio of the banking system decreases (Figure 8).

ltimately, this is due to the fact that the composition of the assets of U a commercial bank differs significantly from the composition of the asset side of the central bank balance sheet – even after the unconventional measures of the central bank in recent years. Thus, if the central bank “invests” the funds obtained through CBDC along its previous balance sheet structure, many sectors will face financing shortages.

irect lending by the central bank can obviously be introduced not only D as an “extension” of liabilities-side central bank digital currency, but also independently.

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Figure 8: Effect of CBDC in the case of a creditor central bank Banking System

Liabilities Banks' deposits

Reserves

Cash

Loans to households↑ Loans to corporates ↑

CBDC ↑

Liquid assets of the banking system

Central Bank Assets

Assets Deposits at CB Liquid securities

Liabilities Retail and corporate deposits ↓

Loans↓ Equity

Regulator requirement for liquid assets Source: MNB

As the CBDC introduced for lending purposes may exclude certain credit segments from the banking system even in their entirety, the diversity of the banking product portfolio will also be reduced and a narrower range of activities and lower profitability may lead to increased competition and, in this context, concentration of the sector. This is not a clearly unfavourable development in terms of the stable functioning of the banking system, as it may also result in more cost-effective operations. On the other hand, banks can compensate for loss of income by lending to more risky customers, which can certainly be considered disadvantageous from a stability point of view. At the same time, it is also possible that the central bank may be able to satisfy the credit demand of economic agents, in a targeted manner and under conditions optimal for the fulfilment of the central bank’s objectives, which are not reached by the product supply of financial intermediaries in the market, at least temporarily, or because of a market failure affecting their operations. In this case, lending by the central bank would only — 217 —

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complement the activities of commercial banks and thus would not have a significant impact on their balance sheet either. Another important question is how efficiently the central bank can perform the lending tasks undertaken by it in the above cases, because the inefficient allocation of resources can lead to sacrifices in terms of economic growth. A wider direct lending activity by the central bank would entail significant organisational and operational needs (IT systems, front and back office administrators, credit approval processes, decision-making, risk management, monitoring, work-out, etc.). Currently, for example, the Hungarian banking system employs a workforce of almost 36,000 employees, with a major proportion carrying out lending and related work processes. Accordingly, introducing CBDC for lending purposes could be a reasonable and feasible alternative for a narrower credit segment, with the aim of addressing some well-defined market failure. 3.2. Other potential transformations in banks’ systemic risks Transformation of deposit flight and bank runs An extreme materialisation of the liquidity risks outlined above is the occurrence of a deposit flight or a bank run. The risk of this is as old as the banking system, but the availability of CBDC, depending on its design, can bring about a significant change in the withdrawal possibilities available for bank depositors. The clear reconstruction of the root causes of bank runs is a complex task, in which the weak financial position of banks, the selffulfilling expectations of depositors and panic all play a role.60 However, it can be assumed that depositors are more prone to opt for the withdrawal of their deposits if they can do so at a lower switching cost and more conveniently (Brown et al. [2013, 2020]), in which, among other factors, easy access to digital channels can

or example, see Calomiris & Gorton (1991) for an overview of the suspected F causes of bank runs, among many other studies on the subject.

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now play an important role. The risk of digital or ‘one-click’ bank runs should be taken into account by the regulatory authorities, see, for example.61 An efficient, customer-friendly and risk-free CBDC, which is beneficial in many respects, can be a new, easily accessible alternative for bank depositors who wish to withdraw their savings from the banking system in a crisis of confidence affecting banks. In addition, CBDC may offer certain advantages over many other forms of savings, such as the possibility to purchase electronically, thus potentially offering an increasingly attractive medium of exchange or store of value alternative compared to traditional (more appropriately termed historical today) outflows of cash deposits (see also Juks [2018], Chapter 5). Ideally, the central bank maintains the confidence of savers even during periods of financial stress, and the more successful and widespread the CBDC, the more obvious the choice for customers to convert bank deposits into central bank money.62 Furthermore, a characteristic of the operation of CBDC, as far as those implementations are concerned which offer unrestricted depositor access and are not priced in ways that would provide disincentives for mass conversion, is that the central bank money flowing from more vulnerable banks does not end up at other banks or other financial corporations, thus reducing the reserves of central bank money in the banking system.63 The increased risks of deposit flight and the liquidity in central bank money available in the system may also increase the significance of the central

reminder by Cœuré (2018) of European banking disintermediation trends A in favour of digital currencies and non-bank financial service providers, but also Panetta (2018) arrived at a similar assessment.

ee the investigation and hypotheses by Schoors et al. (2019) about the role S that a familiar, local alternative bank can play in depositors’ withdrawal decisions in a crisis of confidence.

J uks (2018) presents one of the rare experiences of similar, so-called aggregate bank runs through the example of the Swedish banking system during the 2008–2009 crisis.

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bank’s function as lender of last resort in respect of individual institutions or even the banking system as a whole. With the introduction of CBDC, the increased risk of bank runs can be mitigated through the application of appropriate planning solutions. First, in the context of practical implementation, consideration may be given to quantitative or other restrictions on the aforementioned CBDC conversion, or to the use of pricing to discourage customers from hoarding CBDC assets (see, for example, Bindseil’s (2020) proposals on, inter alia, twotier interest payments). At the same time, Mancini−Griffoli et al (2018) also point out that designs that limit the total amount of CBDC available at system level rather than individually based on the demand of individual customers, or determine the price of CBDC based on the growing aggregate demand, may have an adverse effect by intensifying the occurrence of bank runs. Indeed, these may encourage depositors to convert their bank deposits into central bank money in advance of others (based on the first mover advantage mechanism also known from the description of bank runs). The possibilities for central bank intervention are nevertheless broadened by the fact that, according to the findings of Brunnermeier and Niepelt (2019), the central bank can obtain information about deposit flights reflected in CBDC conversion relatively early compared to obtaining information about any large deposit outflows affecting other financial instruments. It should be noted that potential risks deserve particular attention during the possible introductory period of a CBDC, as the emergence of the new alternative may lead to concentrated withdrawal of deposits in the banking system within a short period of time. Conversely, Brunnermeier and Niepelt (2019) discuss the application of a design, whereby the central bank plays a significant role in the financing of commercial banks by replacing deposits flowing towards CBDC. As central bank financing increases, the losses associated with a potential bank run are increasingly borne by the central bank alongside the depositors remaining

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with the given commercial bank (in other words, the costs of a bank run are increasingly internalised by the central bank). Undertaking the highly concentrated central bank financing, the central bank may be more credibly committed to maintaining central bank financing, reducing the risk of bank runs as it reduces the incentive for other depositors to withdraw deposits. Withdrawal would be reinforced by expectations of the opposite behaviour, i.e. the intention of other depositors to withdraw their deposits.64 Abstracting from the specific alternatives of design, consideration may also be given to the additional market or regulatory mechanisms through which CBDC may influence the risk of bank runs, or on the contrary, the cases in which its operation does not have a special impact on the risk at issue. Mancini−Griffoli et al (2018) note, for example, that traditional withdrawal signals such as lines snaking in front of branches or ATMs, which can contribute to the spread of panic, do not occur in the case of CBDC (however, this is also the general characteristic of digital bank runs, where signal information is spread in digital media spaces). On a theoretical level, however, the presence of CBDC in the financial system is considered neutral in macroeconomic situations where depositors in vulnerable small open economies would be fleeing the domestic currency and quasi-risk-free assets denominated therein (e.g. currency and debt twin crises). In such cases, CBDC may also fall victim to the crisis of confidence. Finally, it can be assumed that the incentive to withdraw deposits

his statement is also linked to the problem of whether the losses incurred T by the central bank can induce a run on the central bank for central bank money if neither the fiscal policy is ready, nor the monetary instruments can be used to cover the losses of the central bank. Fernández–Villaverde et al. (2020) provide a formalised discussion of the problem through a model assuming such a world state, and conclude that subject to certain rules on the composition of central bank assets, the central bank can reduce the risk of bank runs against it, while possibly approximating the supply of liquid deposit-type CBDC assets, generated through maturity transformation, to the market.

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can be reduced by strengthening the Deposit Guarantee Scheme, but this may also have an undesirable effect. If uninsured, typically larger institutional depositors abandon bank deposits in favour of CBDC, depositors’ monitoring of banks may weaken further as a result. The ability and incentive of the insured group of depositors remaining with the bank, with typically smaller deposits, may be more moderate in controlling the risk taking of the bank.65 System-critical activities and the transformation of systemically important institutions Another important condition for safeguarding financial stability is that systemically critical financial services, such as the operation of payments, remain uninterrupted and continuously accessible to real economy customers. The various designs of CBDC can transform financial connectivity and also extensively rearrange the operational tasks and the related roles of service provider and developer between the central bank and market participants according to new structures. As a consequence, credit institutions, institutions specialising in the operation of financial infrastructure, companies offering payment services, or the innovators developing them, may also see changes in their systemic importance.

The central bank may decide to entrust the development and realisation of operational, business and other tasks related to the functioning of the CBDC to efficient, competitive market participants with experience in terms of related risk taking (operational, reputational, financial, etc.). Auer and Böhme (2020) outline three operational models through which the allocation of different operational tasks between the central bank, financial corporations participating in the provision of CBDC services and end-user customers can be discussed.

I n their assessment, Wierts and Boven (2020: 24) also discuss the interaction with deposit insurance, assuming a similar substitution between CBDC and uninsured deposits.

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i. Indirect model: in this design, commercial banks would continue to play an important role in retail payments as service providers. Customers CBDC assets would constitute a claim on banks maintaining an extensive financial relationship which, for example, might include the initiation and receipt of customer orders, the resolution of legally disputed issues, customer due diligence and identification (KYC) obligations, customer communications and service development would remain the responsibilities of commercial banks. ii. Hybrid model: in this case, customers’ CBDC assets are direct claims on the central bank in terms of the legal-financial relationship, but the so-called payment service providers (PSP, or payment interface providers, PIP) provide the information technology services through which they communicate with the customer and execute customer orders. In the event of an operational disruption to a PSP, portability should be legally and technologically feasible so that the customer relations of the dysfunctional service provider can be taken over by an operating service provider as soon as possible. iii. Direct model: such CBDC design does not only entail customers’ claim on the central bank, but the central bank also builds and operates a payment infrastructure and assumes the associated risks. Cases (i) and (ii) above involve outsourcing the provision of services related to CBDC flows to third parties, and moreover the engagement of market suppliers (such as cloud providers) may also complement case (iii). Among third parties, the central bank needs to identify “critical service providers” (CPS, as referred to in Kiff et al. [2020]) whose disruption, discontinuation or bankruptcy could result in a serious deterioration in the continuous availability or, in a broader sense, even in the competitiveness of the CBDC service. This may be wider group than the PSPs referred to previously. For example, a critical role may be occupied by IT specialists (such as software developers — 223 —

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and maintainers or network service providers) related to the system. Overall, depending on the CBDC model applied and its precise implementation, the number of market participants with a prominent role in financial stability may increase significantly, the regulation and supervision of which is traditionally not one of the foremost competencies of a central bank. Novel systemic risks: threats to cybersecurity The scope of systemic risks changes along with the continuous transformations of the financial system and innovations, so that existing types of risk need to be given new interpretations, or emerging or intensifying types recognised in a novel context. Depending on its design, the introduction of CBDC can not only lead to a change in the business models of financial intermediation, but it also represents a large-scale IT undertaking whose innovative technologies deployed for the implementation of payments may be associated with specific risks.

CBDC designs could possibly include cases where, due to the increase in the tasks of the central bank, implementation would require a drastic increase in the IT resources and infrastructure available to the central bank, and the expert workforce, with arrangements for the newly emerging extensive business and related risk management tasks. This creates a number of new risks associated with operation. Operational risks to the CBDC payment infrastructure that may disrupt business continuity are also systemically relevant, as safeguarding the security of payment infrastructures is a financial stability objective even today. The central bank should also verify compliance with the anti-money laundering and customer identification requirements and, where appropriate, comply with them itself. Accordingly, designs of the CBDC that may render the verifiability of AML/ CFT66 requirements uncertain and thus threaten the sustainability of the operation of the system also pose a systemic risk.

Anti-Money Laundering and Combating the Financing of Terrorism

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With the rapid digitalization of the financial system, micro and macroprudential supervision is also paying increasing attention to mapping cyber risks. Paraphrasing the Cyber Lexicon compiled by the Financial Stability Board (FSB, 2020), which is often cited in the context of financial stability, cyberspace refers to information systems, procedures and networks and interactions of participants and operators that often handle sensitive data. Cyber incidents, whether due to deliberate attacks or to unintended errors, are incidents that jeopardise the data of the information system, as well as its information management and security procedures. Unintended errors may pave the way for attacks or, in the absence of transparent and understandable communication, may be construed as attacks leading to a loss of confidence in the information system. The CBDC system and the related infrastructures, whether operated by banks or other service providers, may also be subject to various cyberattacks, which may significantly damage masses of customers and operators, disrupt operations and force them to shut down, and cause a permanent loss of confidence among users. For a hypothetical evaluation of cyber incidents to assist preparations, the European Systemic Risk Board (ESRB) has developed an analytical framework67 that provides an overview of the diverse causes and systemic risk consequences of cyber incidents, despite the fact that incidents observed in the past are still rare or that there are no observations at all for certain types. The limited availability of experience also suggests that incidents are likely to materialise only rarely as systemic disruptions to the financial system. In order to assess whether a systemic impact is expected with the occurrence of a cyber incident, the ESRB recommends examining the following stages of the process leading up to it:

ee, for example, the summary by the ESRB (2020a, 2020b) on systemic aspects S of cyber risks.

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i. Environment, context: among the preconditions for the systemic spread of the incident, the following aspects must be examined: – whether operations are disrupted due to a planned cyberattack or unintended error, how and what damage the technical and IT characteristics of the incident may cause; – whether one or more financial institutions or institutions operating the IT infrastructure have been affected, and whether the functioning of those institutions is affected similarly or to a different extent and in a different manner; – the extent to which the institutions concerned are prepared to eliminate the disruption or prevent the attack, the incident management tools at their disposal; – what financial or IT assets (including software, hardware and intellectual property) are at risk. ii. Cybershock: various incidents that can be interpreted as shocks can affect the financial institutions and related IT infrastructures in different scopes and to different degrees, causing technical disruptions and business damage. Shocks can compromise basic information security criteria such as the confidentiality, integrity, accessibility (the characteristics defining the “CIA triad”), authenticity, accountability of those accessing the data and non-repudiation of access, and the reliability of data processing and security techniques. Furthermore, shocks may affect the business results of financial corporations, their compliance with regulatory requirements, the confidence of customers and investors, the perception of the financial markets about them and their ability to raise funds, their corporate reputation, press coverage and brand, but may also directly cause disruptions to the performance of critical financial functions. iii. Systemic amplification: the shock caused by a cyber incident may occur directly to a systemically significant financial

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institution or to a system-critical entity or service company of the IT infrastructure, so that the incident itself may be considered systemically relevant. However, with second-round effects of the incident potentially emerging, other participants, nodes or functions of the financial or IT system may also be affected by the shock. Cyber incident contagions can spread through operational, reputational and financial connections. The likelihood and extent of contagion can be influenced by a number of characteristics of the financial network: the density of relations between financial institutions, the degree of timecriticality of the problematic activity, the time of detection at different network nodes, the preparedness of the institutions for intervention, the homogeneity of the IT tools they use, the possibility of coordinated crisis management in the system, the possibility to reconstruct the situation before the occurrence of an attack or error, and the degree of complexity of the system, which may also make problem detection difficult. iv. Systemic impact and its management: Where the impact of the incident reaches the system-critical level, in order to determine the actual consequences, it should be taken into account whether the resilience of the system is strengthened by tools of preventive surveillance and crisis management mechanisms. Possible tools to support the mitigation of this risk include:68 – modelling the systemic effects of the cyber incident – cyber stress testing, ethical hacking exercises – monitoring system to facilitate risk monitoring – sharing information among the members of the system about the identified possible points of attack and vulnerabilities, coordinated development of industry-wide crisis management practices and scenarios

DTCC and Oliver Wyman (2018), BCBS (2018).

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– involvement of an expert third party in the risk assessment – agreements on taking over critical activities between market participants – use of secure data repository services – control of the introduction of circuit breakers69 to limit contagion – support for the introduction of techniques to strengthen the cyber resilience of financial institutions, such as zero trust architectures70 – the introduction of macro-prudential instruments to strengthen financial resilience, which would mitigate the adverse effects of ancillary financial losses; – development of an effective market and supervisory crisis management communication strategy.

inancial circuit breakers (named by analogy of the security arrangements in F electricity networks) allow time, by halting the trading of a company, a type of financial instrument or overall trading systems, to ensure that market imperfections (e.g. traders overloaded with operational tasks due to active trading) cause less distortions in efficient market pricing. Similarly, certain cyberattacks can compromise the efficient functioning of financial markets, such as the dissemination of false information, unauthorised access or cyber insider trading committed through data theft. It should be examined whether halting trade in the compromised asset or in the market segment can contribute to avoiding negative consequences.

I n the zero trust cybersecurity paradigm (i.e. a system of principles governing the organisation of IT workflows, system designs and procedures), users belonging to an IT network and their devices are not exempted from security procedures, either on the basis of the users’ network positions, or on the physical position of IT assets, or on the owner of a device, such as verifying their identity when accessing the IT system’s processes and other tools. The zero trust architecture may cover certain critical network segments, such as the data centre, but also the connection with external service providers (such as cloud, web and other IT service providers). See NIST (2020) for more details.

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Central banks must also defend themselves against cyber incidents, as highlighted by cyberattacks on the financial systems of Bangladesh, Mexico or those launched by Anonymous against targets including the US Fed, and the central banks of Greece and Cyprus. With the introduction of CBDC, for certain designs the centralised information generated on customer transactions may be the target of attacks. By hacking the databases, and in the event of unauthorised access, customer data can be accessed on a massive scale. In order to maintain trust, the design should also enable customers to easily and effectively preserve the security of customer identification, and ensure they feel their CBDC assets are protected. Finally, the system should be designed in such a way that, despite a possible successful attack, it is possible to restore it within a short period of time in the largest possible number of cases. This requires not only IT preparation, but also the renewal of regulatory and supervisory expectations that strengthen cybersecurity on an increasing scale.

4. Rethinking the regulatory framework in the event of introducing CBDC The introduction of CBDC also requires a rethink of the current institutional and prudential legal framework. On the one hand, the widespread uptake and use of central bank digital currency also necessitates the renewal of the current legal framework based on traditional financial services provided by banks (deposit taking, account servicing, lending, etc.), taking into account the need to maintain their international harmonisation. According to ITC (2019), these include, inter alia, central bank’s mandate to create money, the legal and financial definition and management of digital assets, and data protection and banking secrecy requirements. On the other hand, it is necessary to rethink

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the specific regulatory and supervisory frameworks that set expectations for the safe functioning of the banking system and significantly affect the possibilities for introducing CBDC. Further complexity and challenges result from the fact that the design of CBDC can vary considerably across countries. This may justify the expansion or even the transformation of the rules on the basic functioning and tasks of the banking system and central banks, and in the absence of cooperation between countries, the very implementation of an effective CBDC may become questionable. Of the above, we will focus on the prudential requirements that were strengthened after the 2008 economic crisis in order to mitigate the risks in the banking sector. These may require a rethink in order to take full advantage of CBDC due to the transformation of banking system operations alongside the introduction of CBDC. 4.1. Principles for transforming prudential regulation Based on the collection of Kiff et al. (2020), the regulatory framework should be established along the following lines: – What central bank objectives will CBDC serve? – In what technical and infrastructural framework will the central bank digital currency operate? – What is the current legal and regulatory environment and what obstacles can be identified within it? – What internal organisational structure will be in place for the introduction of CBDC and the subsequent operation of the system? In order to properly assess risks, central banks can test the effects of introducing central bank digital currency through pilot projects, thus identifying potential operational and systemic risks. This can be supported by “sandboxes”, which are being adopted by central banks on an increasing scale, and where central banks and — 230 —

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market participants can test new technologies and the regulatory environment in a secure manner, under specific conditions, with real customers. Accordingly, national digital central bank currencies have to date been introduced on a pilot basis and subject to restrictions in several countries (such as China and Sweden). 4.2. Challenges for prudential regulation In order to ensure financial stability, the MNB, following its macro- and micro-prudential mandate, mitigates the risks arising from the operation of the banking system, systemically important institutions and financial infrastructures through regulation and supervisory tools, and ensures the stable functioning of the financial system.71 Depending on its design and technological specificities, the possible introduction of CBDC may affect most elements of the prudential instruments. Whether regulations are affected and need to be rethought largely depends on the fundamental issues outlined previously in connection with the introduction of CBDC. In particular, the objective of introducing central bank digital currency determines the impact on the banking sector and thus on the prudential and supervisory regulations and instruments. 4.2.1. Cash-substitute CBDC designs Due to its relatively moderate impact on systemic risk, CBDC introduced as a cash substitute would presumably lead to less drastic changes in the functioning of the banking sector. Cash and cash transactions account for only a small part of the balance sheet and services of the banking sector (in many cases this is only a necessary complementary service, which may not even be profitable due to the costs of cash transit and ATM network maintenance). There are nevertheless new aspects that need to 71

he theoretical basis of the macroprudential regulatory framework and the T domestic practice are summarised in the MNB’s Macroprudential Strategy: https://www.mnb.hu/letoltes/stabilita-s-ma-stabilita-s-holnap-hun.pdf.

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be taken into account from a regulatory and supervisory point of view: – Possible emergence of new system-critical activities and institutions: With the entry of CBDC in the market, the structure of payment systems may change as outlined earlier, new players and payment solutions may emerge, potentially playing an important role at the system level. While systemically important institutions are given special attention in the banking sector, it may be justified to revise and extend the previous set of rules for new non-bank players. – Possible increase in the risk of cyberattacks: In connection with the greater uptake of digital solutions, the expected emergence of new providers specialising in digital services, and central bank functions related to CBDC, cyber risks and the resulting abuse and fraud attempts are also expected to increase. Preparing for cyberattacks is a challenge not only for the central bank, but also for service providers in the financial system. Accordingly, consideration should be given to the renewal of the cyber-protection standards and supervisory solutions currently in place, which are internationally fragmented, and lack harmonisation. Based on the recommendations of Crisanto–Prenio (2017), this should include the development of banks’ internal rules and cyber risk management systems, the improvement of the qualifications of bank employees and the strengthening of international cooperation. –P ossible contribution to the risk of deposit flights: As described above, central bank digital currency, which is an easier and more convenient alternative to cash, can, on the one hand, also increase risks of a bank run at the sectoral level. On the other hand, when introducing CBDC, measures are needed to ensure that retail customers only replace their cash holdings and that savings in deposits do not flow into CBDC on a massive scale. The increase in withdrawals in this case is not caused by a bank run due to external shock, but in general the withdrawal of — 232 —

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deposits can be accelerated by the simplification and efficiency gains in the process. In the case of cash-substitute CBDC, the risk to the financial system is moderate. However, it can also be discouraged by design solutions such as limited convertibility, limited volume or differentiated pricing, primarily in normal times and not under stress. – Possible changes in risks related to money laundering and terrorist financing: The emergence and subsequent uptake of CBDC could reduce the volume of cash transactions and, with the implementation of specific CBDC designs, contribute to ensuring that the system of anti-money laundering and counterterrorist financing (AML/CFT) institutions can effectively prevent the offences targeted by it. For example, it could also be easier to detect indications in due course and to monitor suspicious monetary movements. At the same time, CBDC can also be implemented with designs that present novel challenges for anti-money laundering and counter-terrorist financing activities (CPMI, 2018); for example, a high degree of anonymity in the choice of implementation may need to be balanced with a design that also enables the effective control of money laundering. Such a trade-off may include, for example, the design outlined by the ECB (2019, 2020), under which the identity of users and the history of transactions in small transactions are not accessible to either central banks or credit institutions, although both types of institution are involved in the operation of the system, but large transactions may be audited by the authority performing the AML functions. 4.2.2. CBDC designs implementing the concepts of the deposittaking and creditor central bank Profitability and capital The possible consequences of the potential deterioration in the profitability and capital position of credit institutions are an incentive to take risks and a change in regulation. The introduction of CBDC may reduce banks’ profitability due to more

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expensive means of raising funds and a possible decline in banks’ role in the credit market. As income generation is an important way of generating capital, compliance with capital requirements may be jeopardised. Moreover, the profitability of the banking sector is not only challenged by central bank digital currency, but is also subject to constant pressure from other factors. Some of these include direct competition within the banking sector, external competitive pressure, and the popularity of shadow banks, FinTech financial intermediaries, digital currencies, payment service providers and other alternative forms of savings and investment in a persistently low interest environment. As a result, the already observed bank response strategies and trends may further strengthen after the introduction of CBDC. This and the changing landscape of risks may require a rethinking of the framework for capital requirements, and preparing supervisory work. The implications of decreasing profitability for risk taking by banks, market structure, and regulations are summarised as follows: – Higher risk appetite in the banking sector: The banking sector may be unable or, due to profitability considerations, unwilling to adjust to the decline in deposits and capital accumulation. Investor expectations, increasing leverage and decreasing profitability can all be incentives for increased risk-taking. As a result, it can maintain its previous (lending) activity within regulatory limits, or even increase its risk taking, while its capital and liquidity buffers decrease. The supervisory authority must be prepared to monitor banks more closely, and for dealing with both minor breaches and major stress events. – Regulatory arbitrage: The increase in risk appetite may reach a point where the bottleneck for the bank’s liquidity and capital buffers will be represented by regulatory requirements rather than internal risk assessment. Pressure will then increase for the development and sale of products that do not involve higher requirements in legal terms, but provide the expected

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profitability through greater risk-taking. Since legislators focused on existing products when defining the rules, consideration must be given to the possibility that regulatory arbitrage develops through new products. This risk will require regular review of the regulation at macro level and verification of the banking classification of individual products at micro level. – Less regulated institutions: The service provider may try to conduct its activities through less strictly regulated financial intermediaries (shadow banking phenomenon). An increasing proportion of the current commercial banking may shift to other financial institutions, where not only does the supervisory authority have more limited powers today, but because of the simpler reporting, it will not have the same insight into the processes. However, the emergence of a competitive CBDC may even reduce the market penetration of new players specialising in payment traffic, such as FinTech companies. – Possible divergence of commercial banking functions: Maintaining payment accounts, deposit taking and lending may become services offered by separate institutions in the future, should CBDC become widespread. Current supervisory work in Hungary is helped by the fact that the vast majority of banks are commercial banks, i.e. all three activities are often provided by institutions which are subject to the same regulations (NDIF coverage, capital and liquidity requirements, etc.) If these functionalities become separated72 and each specialised institution is obliged to comply with the relevant legislation with distinct adjustment strategies, the individual financial products

ffective spin-offs or the returns of business licenses is unlikely, but it is E possible that some banks will be crowded out of certain market segments and retain specific products only for the full service of their own premium customers. Rather, divergence at the sectoral level can be a result of new players achieving significant shares in specific market segments with their focused services.

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and business models have to be assessed separately. This is also challenging from the supervisory side, but the investor or the customer may also face new risks, which also raises investor and consumer protection issues. – Increasingly limited scope for bank modelling: Based on the above, the range of available data may become narrower, which makes bank modelling difficult in the areas of risk management and capital adequacy, as well as other compliance areas. This may adversely affect credit approvals, but also the accuracy of impairment provisions and capital requirements. The use of regulatory instruments preventing excessive risk taking related to credit growth could strengthen capital positions. If the adverse income effects materialise and the banks concerned respond by increasing the risk of their lending activities, an adjustment may be made to the instruments aimed at mitigating credit risks, including capital buffers that strengthen the capital position and are likely to mitigate risk-taking incentives. In the case of direct lending models of CBDC, the central bank has more direct control over credit outflows. These designs may reduce the risks arising from excessive lending if appropriate risk assessment and management mechanisms are put in place. At the same time, the capital rules may need to be reconsidered because of central bank loans intermediated by commercial banks, while the borrower-based measures (requirements limiting the amount of loans available on the basis of income or collateral) may need to be reconsidered, for example, with regard to risk management systems applied by central banks, or to non-mortgage lending that is likely to be preferred in central bank lending. Financing structure Changes in the funding risks in the structure of bank liabilities can be significantly influenced by the funds replacing deposits. With regard to the financing opportunities of commercial banks, it is primarily sight deposits that will receive a new competitor

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with the introduction of CBDC, to complement cash, securities, investment units, digital currencies and other cash substitutes. If an attractive CBDC instrument is designed successfully, the banking sector will have to respond to the resulting restricted supply of stable, inexpensive, unsecured funds. The replacement of funding may result in new risks, and the new investors may require collateral or a premium. Depending on the technical solution chosen by the bank or emerging on the market, a funding risk may arise, which may increase the importance of the corresponding rules. In theory, the central bank could redistribute the savings flowing into CBDC to the commercial banks. However, the use of refinancing and the transformation of the financing structure largely depend on the maturity, pricing, collateral requirements and purpose limitation at which the central bank provides funds to the banks, and on the extent to which these conditions prove to be time invariant. In other words, banks may also run regulatory or business model risks with regard to central bank credit conditions. In addition to balance sheet considerations, taking customer deposits brings other informational and business benefits to banks, the availability of which may also become restricted. Customers also use a number of payment services, which involves significant revenues from fee and commissions. They also provide opportunities for targeted outreach to sell other products: savings, for example, first appear in current accounts. In addition, they provide an information base e.g. for assessing the periodicity of income for credit approval purposes, and for monitoring the customer’s income (real estate insurance premium) in the case of an existing credit relationship. Possible problematic consequences of the reduction in deposit taking, requiring regulatory and supervisory attention, may include: – Miss-selling: If the banking sector seeks to compete with the central bank’s deposit taking, then one approach to attempt this could be through the provision of complementary services. This

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may be a preferred choice for banks also because if the central bank only provides limited services, the banks’ competitive advantage in other areas will remain. This may include credit cards, but it is also possible to offer foreign currency accounts and provide investment services even if the conceptual design of the creditor central bank is implemented. Product development and better serving customer needs can fundamentally be a positive contribution from the introduction of CBDC, but the pressure may increase on banks to force customers to use services that they do not need. – Agency sales: If banks lose their customers along with the relationship of maintaining their account, it will be more difficult to sell other products. For this reason, banks may be forced to look for new customers, with the potential result of more widespread agency engagements, which requires more attention from the supervisor. – Potential increase in bond issues and securitisations: In the Hungarian market, the issuance of securities itself is currently a rather underutilised option to raise funds. Securitisation also realizes the transfer of credit risk, that is, it also reduces the capital requirement from a banking point of view, thus it also releases this constraint on lending. Currently, the issuance of securities is considered an expensive way to raise funds in terms of interest rates and fixed costs, but if banks are forced to offer higher deposit rates due to the shortage of funds resulting from central bank deposit accounts, the cost disadvantage may decrease. After the first issues, this form of funding can spread relatively rapidly, as it is easier to compile the issuance documentation for the second time, investors become familiar with and price in the securities, and a wider range of investors can also have a beneficial effect on the secondary circulation (liquidity) of the paper. Smaller series and issuers may also appear as the market develops. The process also requires greater supervisory control due to the additional risks of securitisation.

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Regulations on the management of liquidity and financing risks may need to be adjusted to address potentially changing financing structures. Current regulations (LCR, NSFR, etc.) require banks to maintain sufficient liquidity and stable financing even under market stress. Although these are effective and necessary risk mitigation steps in banks’ current operating model, which relies heavily on deposit financing and bank lending, they may significantly restrict the possibilities for introducing CBDC, as explained previously. Therefore, if central bank digital currency is implemented on a wide scale then these regulations also require rethinking these regulations. For example, consideration needs to be given to a reassessment of the stable classification of specific items and their weights, or even to the replacement of the indicators used so far with solutions tailored to the new banking model. Bank stress tests and related regulation (e.g. LCR) should also be considered from the point of view that whether the transactional motives of a cash substitute or the motives for deposit holding dominate, due to the small impact on the normal course of business, historical time series provide relatively limited information to model the behaviour in stress situations. Other regulatory areas – Instruments to limit excessive exposure concentrations: The uptake of CBDC on a wide scale and the substantial replacement of customer bank deposits, as well as the takeover of lending functions by the central bank, may reduce diversification in financial services and may also cause risks currently distributed among institutions to be concentrated at the central bank. In the case of indirect central bank lending expanding through the banking system, a large exposure with a significant credit risk, depending on the level of concentration in the banking system, may appear among central bank assets. Simultaneous implementation of direct and indirect lending may reduce the former concentration, but commercial banks may get crowded out of certain market segments financed by the central bank or capital markets. In the case of direct central bank lending, while — 239 —

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maintaining the quality of the service, this may pose challenges to the central banks on the operational side, which requires considerable preparations and a major enhancement in central bank apparatus and technological background. With the entry of direct central bank lending, transparent regulation of the central bank’s own operations must be established and ensured as well. From the point of view of operations and regulation, it is necessary to develop a well-defined and distinct solution for the overseeing of the activity by the central bank. – Instruments to mitigate the risks of systemically important service providers: As explained earlier, CBDC can divide the operational tasks and the related roles of service provider and developer between the central bank and the market participants according to new structures, whereby new critical participants may also emerge. Regarding systemically important players and critical functions, the prudential system already applies a variety of instruments in the banking sector (e.g. through macroprudential capital buffers, tighter supervision and the resolution framework). Extension of this system may be necessary for new entrants, with the possibility of a shift in the focus of frameworks from institutions to activities. – Consumer protection challenges: Consumer protection tasks are also heavily influenced by the central bank’s role in the introduction and operation of CBDC. For example, in the case of a CBDC model involving direct central bank account servicing, the central bank itself may be required to comply with the relevant financial consumer protection and complaint management provisions. In the case of an indirect CBDC design or a hybrid model, the issue of liability for individual consumer losses and the protection of consumer-owned CBDC assets could arise. From a consumer protection point of view, it is also necessary to consider the social policy aspect that certain categories of consumers who could find it challenging

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or impossible to handle their transactions with CBDC should not be excluded from the use of the financial intermediary system and the services provided by other market participants. Thus, the possibility of using CBDC in offline mode may arise due to possible problems with internet coverage. Operational risks related to cybersecurity, fraud and abuse can also create consumer protection risks – such as loss of consumer confidence, material damage to consumers, theft of consumer personal data – and therefore, from a consumer protection perspective, safe and reliable operation of the CBDC system is of paramount importance. – Other considerations: The need to develop the legal framework may also arise in relation to other expectations that are not prudential but have an impact on banking operations. For example, one of the key issues in the introduction of CBDC is data protection, especially where related tasks are also performed by actors other than the central bank, and outside the banking sector. Maintaining confidence in the banking system is a key financial stability objective, which calls for the establishment of a strict set of requirements for data processing, to be defined according to the new digital solutions. Hayashi et al. (2019) and Nabilou (2019) also point out that due to the specificities listed previously and their implications, it is appropriate to examine in detail the need to amend the legislation and the supervisory activity in the event of the introduction of a wider CBDC framework. If the central bank wishes to operate the CBDC solely or mainly within its own institution, this may lead to conflicts of interest regarding regulatory compliance. A rethink of the prudential framework entails significant costs that should be taken into account in a possible introduction of the CBDC (Wierts and Boven, 2020). In addition, it is important to note that a significant part of the emerging issues and potential changes brought about by the CBDC also affect international regulatory

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expectations, given that in recent years regulatory harmonisation has been key concern both globally (e.g. through BIS) and in the EU. For that reason, and in order to address potential cross-border impacts, it is important to review the regulatory approaches in international cooperation and to lay the foundations for a new harmonised regulatory framework jointly.

5. Conclusion In our analysis, we reviewed the financial stability aspects of the possible introduction of CBDC through changes in the balance sheet of the central bank and the banking system in a general approach in which no significant restrictions were made on the technical operation and design of CBDC. In addition, we examined other operational and systemic risks that could pose a threat to financial stability, then examined the main principles and areas of revision of the regulatory framework in relation to CBDC. In the case of cash substitute CBDC, we found that its introduction would not give rise to classical financial stability risks in terms of either financing or profitability. The effect of the central bank crowding out cash in its function of deposit-taker and/or creditor can be considered neutral for financial stability purposes. A number of financial stability risks have already been identified for the deposit-taking central bank. Some of these include the risk associated with the financing of deposit outflows, such as the renewal risk of wholesale funds (from financial corporations), the wider maturity and currency mismatch associated with raising such funds, and the increase in short-term external debt. The other significant risk relates to a decrease in profitability, which may stem in part from an increase in funding costs and in part from the loss of fee income from payment services. As a result of all these factors, therefore, the profitability of the banking

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system decreases, which may direct its lending activities towards more risky transactions with higher returns. At the same time, decreasing margins and the fight for deposits can also lead to increased competition between banks, which can be seen as a positive development in a less competitive banking system. However, as demand for CBDC grows, deposit withdrawals from the banking system already lead to a reduction in banking system liquidity, which reduces the shock resilience of the banking system. At this point, the transformation of central bank instruments becomes necessary, because the central bank must arrange for long-term financing of the banking system. However, if the popularity of CBDC continues to increase, the continued outflow of deposits will lead to a contraction of the balance sheet of the banking system, resulting in a fall in lending and ultimately a slowdown in economic growth. In the case of the creditor central bank, financial stability risks arise primarily in terms of decreasing profitability, which, as in the case of the deposit-taking central bank, may arise in a riskier lending activity of the banking system. In our view, introducing CBDC for lending purposes could be a reasonable and feasible alternative for a narrower credit segment, with the aim of addressing some well-defined market failure. However, the introduction of CBDC may also entail other risks arising from the emergence of new services, infrastructures and institutional systems associated with central bank digital currency. In addition to the increasing possibility of bank runs, the emergence of new systemically important institutions and infrastructures and the increase in cyber risks are challenging for central banks. The new framework also calls for a renewal of regulations and the supervisory instruments. This also means reviewing the mandates of the central bank and the laws governing the functioning of the financial system (e.g. the management of digital money, remote administration, money laundering and data protection — 243 —

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regulations) and rethinking the prudential requirements and the supervisory monitoring and expectations system. In addition to adapting existing rules and expectations in the fields of lending, liquidity and capital adequacy to new conditions, it is also necessary to establish a framework to support the management of new risks, such as cyber risks. In order for the potential introduction of CBDC to be successful, efforts are needed to specify design aspects ensuring that the resulting stability risks remain manageable and do not outweigh the benefits of CBDC use. In the framework of the above analysis, we see headroom from both the deposit-taker and the creditor central bank roles.

References Bank of England (2020): Central Bank Digital Currency Opportunities, Challenges and Design, Discussion Paper, 2020 March Barrdear, John and Michael Kumhof (2016): The macroeconomics of central bank issued digital currencies, Bank of England Working Paper No. 605 BCBS (2018): Cyber-resilience: Range of practices, Bank for International Settlements, 2018.Bindseil, Ulrich (2020), Tiered CBDC and the financial system, ECB Working Paper No. 2351, January 2020 Boar, Codruta, Henry Holden and Amber Wadsworth (2020): Impending arrival – a sequel to the survey on central bank digital currency, BIS Papers, No.107, January 2020 CPMI (2018), Central bank digital currencies, Committee on Payments and Market Infrastructures Markets Committee, March 2018. Brown, Martin, Benjamin Guin and Stefan Morkoetter (2013): Deposit Withdrawals from Distressed Commercial Banks: The Importance of Switching Costs, Working Papers on Finance Vol. 1319, University of St. Gallen, School of Finance, revised Dec 2017 Brown, Martin, Benjamin Guin and Stefan Morkoetter (2020): Deposit withdrawals from distressed banks: Client relationships matter, Journal of Financial Stability Vol. 46 100707, 2020 Brunnermeier, Markus Konrad and Dirk Niepelt (2019): On the Equivalence of Private and Public Money, CES ifo Working Paper No. 7741, October 2019 Calomiris, Charles and Gary Gorton (1991): The Origins of Banking Panics: Models, Facts, and Bank Regulation, National Bureau of Economic Research, Inc, pp 109-174

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VII. Financial stability aspects of the introduction of a central bank digital currency Cœuré, Benoít (2018): The future of central bank money. Speech at the International Center for Monetary and Banking Studies, Geneva, 14 May 2018 Crisanto, Juan Carlos and Jermy Prenio (2017): Regulatory approaches to enhance banks’ cyber-security frameworks, FSI Insights, No. 2, August 2017 DTCC and Oliver Wyman (2018): Large-Scale Cyber Attacks on the Financial System: A case for better coordinated response and recovery strategies. A White Paper to the Industry. Downloaded: https://www.oliverwyman.com/content/dam/oliver-wyman/ v2/publications/2018/march/Large-Scale-Cyber-Attacks-DTCC-2018.pdf ECB (2019): Exploring anonymity in central bank digital currencies, ECB In Focus, Issue no. 4, December 2019. ECB (2020): Report on a digital euro, ECB, October 2020.ESRB (2020a), Systemic cyber risk, European Systemic Risk Board, February 2020 ESRB (2020b): The making of a cyber crash: a conceptual model for systemic risk in the financial sector, European Systemic Risk Board Occasional Paper Series, No. 16, May 2020 Fernández-Villaverde, Jesus, Daniel Sanches, Linda Schilling and Harald Uhlig (2020): Central Bank Digital Currency: Central Banking For All?, NBER Working Paper No. 26753, June 2020 FSB (2020): Cyber Lexicon, Financial Stability, Board, 12 November 2018.,https:// www.fsb.org/wp-content/uploads/P121118-1.pdf Hayashi, Kenji, Hiroyuki Takano, Makoto Chiba and Yasuhiro Takamoto (2019): Summary of the Report of the Study Group on Legal Issues regarding Central Bank Digital Currency, Bank of Japan Research LAB No.19-E-3, December 24, 2019. Juks, Reimo (2018): When a central bank digital currency meets private money: effects of an e-kronaonbanks, Sveriges Riks Bank, Economic Review 2018:3 Kiff, John, Jihad Alwazir, Sonja Davidovic, Aquiles Farias, Ashraf Khan, Tanai Khiaonarong, Majid Malaika, Hunter K Monroe, Nobu Sugimoto, Hervé Tourpe, Peter Zhou (2020): A Survey of Research on Retail Central Bank Digital Currency, IMF Working Paper WP/20/104, June 2020 Levine, Ross (1997): Financial development and economic growth: Views and agenda, Journal of Economic Literature,35(2), 688−726 Mancini-Griffoli, Tommaso, Maria Soledad Martinez, Peria, ItaiAgur, Anil Ari, John Kiff, Adina Popescu and Celine Rochon (2018): Casting Light on Central Bank Digital Currency, IMF Discussion Note, SDN/18/08, November 2018 Nabiliou, Hossein (2019): How to regulate bitcoin? Decentralized regulation for a decentralized cryptocurrency, International Journal of Law and Information Technology, Volume 27, Issue 3, Autumn 2019, Pages 266–291, September 2019 NIST (2020): Zero Trust Architecture. National Institute of Standards and Technology, NIST Special Publication 800-207. Downloaded: https://doi.org/10.6028/NIST.SP.800207

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VII. Financial stability aspects of the introduction of a central bank digital currency Ousméne, Jacques Mandeng (2020): Foreign exchange trading with instant settlement in central bank money, Technology and Financial Seminar, Swiss National Bank, June 2020 Panetta, Fabio (2018): 21st century cash: Central banking, technological innovation and digital currencies. SUERF Policy Note Issue No 40, August 2018 Schoors, Koen, Maria Semenova and Andrey Zubanov, (2019): Deposit or discipline during crisis: Flight to familiarity or trust in local authorities? Journal of Financial Stability, Elsevier, vol. 43(C), pages 25-39 Wierts, Peter and Harro Boven (2020): Central Bank Digital Currency Objectives, Preconditions and Design Choices. Netherlands Central Bank Occasional Studies Vol. 20-01, Draft April 2020

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VIII. Effects of central bank digital currency on payments László Kajdi–Lóránt Varga In our study we first examine the objectives and future development scenarios for which the introduction of central bank digital currency (CBDC) may be theoretically justified from a payments perspective; second, given the current situation of Hungarian retail and corporate payments, we review which of these objectives may also be relevant to these actors; and third, we explain the effects that the various possible operating models would have on the payments market if CBDC were to be introduced. With almost all international CBDC research and projects currently underway, payment objectives of some sort have been formulated, but these are very diverse: they can be linked to reducing the use of cash or to preserving the role of generally available central bank money in payments, enhancing financial inclusion, increasing the development and security of electronic payments, reducing payment service charges, or, as the case may be, addressing the challenges posed by FinTech and BigTech operators. Although, theoretically, several of the above objectives could be relevant in Hungary based on the characteristics of domestic payments, they can apparently be achieved more quickly or more efficiently by other means, such as the development of already available electronic payment solutions and payment services in the market. However, that situation may change at any time in the future. For example, if the increase in the proportion of electronic payments stalled, or BigTech operators carved out a more significant share of domestic payments in an uncontrollable manner, or the package-based, transaction fee-free pricing of retail electronic payment services failed to be taken up at an adequate rate, consideration should be given, inter alia, to the possibility of introducing CBDC as a means to address the situation at hand. — 247 —

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Regardless of the reason for the introduction of CBDC, the chosen operating model would definitely have major implications for the payments market. In this context, primary consideration should be given to what payment services the central bank seeks to take over from market participants and to what extent, as well as to the impact this is expected to have on the costs of introduction, the stability of the domestic financial intermediary system, or the future innovation of payment solutions.

1. Introduction Ensuring the efficient and reliable functioning of payment systems and the payments market is one of the core tasks of any central bank. There are already various types of money circulating in the economy, in the form of cash, money held in commercial banks’ accounts, electronic money, or other digital currencies73. Payment transactions carried out in these assets are all part of the payments market, the rapid, cost-effective and reliable operation of which is of paramount importance for the performance and competitiveness of the economy. Therefore, in addition to the operation, oversight and supervision of critical financial infrastructures, such as central bank and clearing house systems, central banks are actively involved in initiating, coordinating and regulating payment flows and developments in almost all countries of the world. While supporting more efficient monetary transmission and maintaining financial stability, this also carries additional benefits: it can strengthen competition and innovation in the market, and due to more transparent processes, the increasing share of electronic payments can also lead to a reduced level of tax avoidance. Another important aspect is that, as demonstrated by a number of studies (Danish Payment Council 2018, Schmiedel et al. 2012, Turján et al. 2011), the widespread use of electronic payment methods entails lower social costs compared to cash.

For example, different types of cryptocurrencies or virtual currencies.

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The 2008 global economic crisis also brought about a number of new phenomena in payments, such as the emergence of digital currencies like Bitcoin, which, however, had only a moderate impact on the payments market precisely because of their limited performance of the functions of money. Of much greater significance, however, has been the emergence of FinTech and BigTech companies74, whose main area of market entry was precisely in payment solutions. This could be traced back to several reasons, such as to the increasing consumer demand for innovative payment solutions, to the data-driven business model of BigTech companies, whereby – preferably increasingly frequent – payment transactions can not only be monetised on their own, but also allow for an even more accurate understanding of customers, and to the failures and specificities of the payments market such as network effects and economies of scale, which constitute obstacles to market entry, and, therefore, to competition. In recent years, central banks and regulatory authorities have responded actively to all these changes. On the regulatory side, regulations on interchange fees introduced in Europe75 (and one year earlier in Hungary), the SEPA End Date Regulation76 and the new European Payment Services Directive (PSD2)77 all aimed at stronger competition. Of these, PSD2 is expected to have the greatest impact going forward, providing regulated conditions 74

I n literature, global technology companies with a very large number of customer relationships, such as Facebook, Amazon, Apple, Google or Alibaba, are typically referred to as BigTech or Tech Giants.

egulation (EU) 2015/751 of the European Parliament and of the Council (29 R April 2015) on interchange fees for card-based payment transactions.

egulation (EU) No 260/2012 of the European Parliament and of the Council R (14 March 2012) establishing technical and business requirements for credit transfers and direct debits in euro and amending Regulation (EC) No 924/2009.

irective (EU) 2015/2366 of the European Parliament and of the Council D (25 November 2015) on payment services in the internal market, amending Directives 2002/65/EC, 2009/110/EC and 2013/36/EU and Regulation (EU) No 1093/2010, and repealing Directive 2007/64/EC.

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to support the market entry of new non-bank FinTech payment service providers. In an another important step forward, major infrastructure developments have been carried out to complement regulations, especially in the field of instant payments: in addition to the European TIPS system already in operation,78 the new infrastructure planned in the United States,79, and instant payment systems already in place or underway in many countries around the world, the Hungarian instant payment model should be highlighted as the first one to require payment service providers mandated by regulation to offer instant payments as a basic service. Figure 1: Instant payment systems operating and under implementation or planning in the world in 2020

Instant payment systems in operation Instant payment systems under introduction or planning

Source: FIS 2021, MNB collection

https://www.ecb.europa.eu/paym/target/tips/html/index.en.html

https://fasterpaymentstaskforce.org/

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The major changes listed in the foregoing therefore show that the development of payments is a high priority for central banks worldwide. Recently, this process has been given another boost by two additional factors. Launched by Facebook, the Diem (formerly known as Libra) project seeks to provide payment services at a global level, which, taking into account the company’s outstanding customer base of several billion users, poses a significant challenge both to participants in the traditional payments market and to central banks. On the other hand, the coronavirus emerging in 2020 and the restrictive measures taken in response have prioritised cashless, preferably remote, payment solutions that do not require personal presence. As a result, central bank projects and research exploring the possibilities of using central bank digital currency (CBDC) have begun, or respectively have already reached an advanced stage in several countries. Furthermore, as highlighted by BIS (2020a), at their current stage, these explorations tend to be motivated by payment objectives. Indeed, technological development has enabled central banks to keep a dedicated account for every citizen or company. That is, while the physical form of cash was primarily determined by the technological level available, with the removal of such barriers, it is a fair question to ask whether there is an advantage for society as a whole from the claim on the central bank also becoming available in digital form to a wide range of users. While central bank digital currency has long been available to participants in the financial system, especially to commercial banks, the rollout of CBDC to a wider scope of stakeholders would be equivalent to the emergence of a new form of money for the public and for companies. This would automatically extend the payments mandate of central banks, bringing about new challenges in this area, given that, going forward, payment transactions carried out in CBDC would also become part of payment flows, requiring central banks to ensure their efficiency and reliability as well.

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Arguably, on the side of central banks too, current CBDC research also tends to be motivated by payment objectives. That said, other objectives such as those related to monetary policy may gain prominence over the medium term, as CBDC could have a direct impact not only on the financial sector, but also on other economic agents such as consumers and non-financial enterprises. At the same time, it should be pointed out that even if introduced in pursuit of objectives other than payments, CBDC may have major effects on the functioning of the payments market and on financial infrastructures, which calls for an examination of these aspects for any underlying objective. In our study, therefore, we present the effects on payments, focusing primarily on the Hungarian situation. We seek to determine whether there is a payment objective justifying the introduction of CBDC in the present situation and, were it to be introduced with any objective in mind, what the optimal way to do so would be from a payments perspective. Our discussion is strictly limited to “retail” CBDC, i.e. the case of central bank money becoming available to companies and/or consumers. Accordingly, “wholesale” CBDC, being the form of central bank money available to actors in the financial system, is not addressed here as it is already widely accessible by these actors, which makes CBDC an issue concerning the development of technology and financial infrastructure, rather than one of public policy. The study is structured as follows: in the second chapter we review the payment objectives that may justify the introduction of CBDC, and in the next we evaluate these objectives in the light of the present situation in Hungary. Chapter four presents the possible effects of the introduction of CBDC on the payment services market, while the last chapter summarises the main conclusions.

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2. Possible scenarios where the need to introduce CBDC may arise in order to achieve payment objectives The introduction of CBDC allows for direct central bank intervention in the functioning of the financial sector and of the economy, which naturally has diverse effects. For this reason, the application of CBDC may be justified by a number of objectives, a common element in virtually all of them being the presence of a payment dimension: either the aim to address a problem or market failure already identified in the payments market, or the pursuit of another objective, nevertheless subject to the requirement to ensure a payment function. Below we have gathered how CBDC can support the achievement of certain payments-driven public policy objectives. For that purpose, we defined scenarios for the future development of the payments market, and examined how CBDC can be used to address the problems that may arise if the corresponding conditions are satisfied. 1. The use of cash does not decrease, causing the related social costs to remain high. Previously, a number of central bank studies (Danish Payment Council 2018, Schmiedel et al. 2012, Turján et al. 2011) concluded that the increased use of electronic payment methods would enable significant cost savings at the level of society at large. Indeed, the production, transit and safekeeping of cash, as well as cash transactions involving personal presence have a much higher time requirement compared to electronic payment methods, which tend to rely only on IT infrastructure in most cases. It is therefore appropriate to redirect payment flows towards the latter, one possible means of which being the introduction of CBDC as a new cashless alternative to existing electronic payment methods.

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2. Cash-dominated payments lead to significant levels of tax avoidance and money laundering risks. One of the advantages of electronic payment methods over cash is that they make transactions much easier to track, which in turn makes it easier for public authorities to enforce the legislation in place. One consequence is that re-channelling current cash flows, at least in part, to electronic CBDC, makes it possible to counter the grey economy and thereby increase budget revenues. Compared to physical cash, CBDC also has benefits in terms of antiterrorist financing and anti-money laundering. Obviously, all these benefits can only be exploited if users are not granted anonymous access to CBDC. 3. Acceptance of cash loses prominence, with most locations offering only the electronic payment solutions of payment service providers in the market. This scenario assumes trends contrary to the processes described in the previous points, but in the case of the Swedish model, one of the most advanced, the specific situation of payments in the country justified an examination of the possible introduction of CBDC. In recent years – in no small part due to the uptake of instant payments on a large scale – the use of cash has been reduced enormously, accounting for about 15 per cent of all transactions in 2018 (Sveriges Riksbank, 2019). This has several important consequences. On the one hand, an increasing number of merchants are refusing to offer the option of cash payment, primarily because of the significant resource requirements associated with it, which makes consumers dependent on electronic payment methods. However, the latter are provided only by market participants, at the rates fixed by them. Consequently, if someone is unable to pay the fees of the market service providers, or if the market service providers refuse to serve them for some reason, they will be virtually excluded from the economy and their daily life may become impossible to conduct. It should be noted that while merchants

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in Sweden and in some other European countries have the legal means to refuse cash payments, in many countries they do not, because in many places the law or even the Constitution provides for the mandatory acceptance of cash. Even if cash is accepted in a person’s environment, it can typically only be withdrawn from teller machines and at branches operated by market service providers, in decreasing numbers due to economic considerations. As a combined result of these factors, the Swedish central bank considered it important to start exploring ways to continue providing payment opportunities for everyone, including persons who do not want to or cannot contract with market service providers. 4. A significant number of consumers still do not have bank accounts (low level of financial inclusion), which prevents them from using electronic payment methods. Due to the considerations already mentioned above, in almost every country priority is given to increasing the use of electronic payment methods, which requires that the greatest possible number of consumers have payment accounts to initiate or receive transactions. This amounts to strengthening financial inclusion or, as often termed, to an increase in the number of bank relationships. Although there are countries (for example, the United Kingdom) where basic payment services, such as account keeping or the initiation of credit transfers, are typically available free of charge, in many places, including Hungary, such services carry substantial fees (Kajdi et al., 2019). Obviously, not everyone can afford to pay these, which is addressed, along with a range of similar problems, through the concept of basic payment accounts, set out in the European Payment Accounts Directive (PAD). Typically in less developed countries, financial inclusion can also be impeded by the absence of a sufficiently extensive market-based system of financial institutions, for example where many people do not have access to a nearby bank branch where they can open

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a bank account to establish a banking relationship. In theory, CBDC offers the possibility for the central bank to intervene directly by leaving out market participants, rather than the regulator expecting or requiring payment service providers to provide basic payment services on a large scale for moderate fees, or free of charge. 5. Market participants do not develop electronic payment solutions that can be used widely, or they do not provide them at favourable prices that are affordable for all. As explained above, cashless payment solutions have several advantages at the level of society at large. At the same time, payment service providers may not develop such solutions on their own due to the lack of infrastructure (possible factors include internet coverage in addition to infrastructure elements linked to finances, such as terminals allowing electronic payments to be made with merchants), or lack of solvent demand, or market failures (such as high market entry barriers). Among others, this is a possibility in developing countries or in small countries where, for payments otherwise based on economies of scale, market participants do not see sufficient business potential in a small number of customers. For example, the e-Peso project in Uruguay also aimed primarily to ensure a more efficient payment system and wider access to electronic payment services (Barontini-Holden, 2019). However, in Denmark, which has advanced electronic payment solutions, the central bank does not see a way forward in CBDC on the payments side (Danmarks Nationalbank, 2017). It is also possible that electronic payment services are also available from market participants, but are offered for fees that make their use impossible or unreasonable for a significant proportion of users. In this case, the basic payment services offered with CBDC can support stronger competition and the availability of an electronic payment method for a wide range of users.

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6. The security of payments decreases, with a major increase in the number of fraud cases, and in the operational risks of critical financial infrastructures. While this aspect was considered the most important by a majority of the responding central banks according to a BIS survey (Barontini-Holden, 2019), the pursuit of this objective may have multiple motivations. On the one hand, there may be types of fraud and trends for market services that justify the central bank providing a safer alternative than market solutions, thus strengthening confidence in electronic payment methods. On the other hand, the introduction of CBDC could also pursue the objective to strengthen the resilience of critical systems in the country concerned, i.e. to reduce operational or cyber risks, by building a new infrastructure that is independent of current financial infrastructures. Indeed, this would allow electronic payments to continue to be ensured through CBDC, and thus the functioning of the economy to be maintained in the event of the outage of traditional banking systems and payment solutions for any reason. This can be complemented by the fact that CBDC also makes it possible to carry out transactions offline, at least up to a certain value limit, which, in addition to supporting electronic payments in remote areas with poorer internet coverage, enables the continued operation of payments even if the electricity network and internet service become inoperable. 7. BigTech operators and their payment solutions (such as stablecoins) take over a significant share of the payments market. BigTech operators are increasingly entering the payments market as well, since the ability to monitor customer transactions can be integrated well into their data-driven business models. – One example could be the Chinese market, where Alipay and Tencent/WeChat, the two most important non-bank service providers, have effectively taken over the retail payment

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business from Chinese commercial banks (Kajdi, 2017). In addition to monetary policy and financial stability risks caused by re-channelling some of the bank liquidity provided by the population, this also carries operational risks. Indeed, the high level of market concentration also implies that a major part of the retail electronic payments would become unavailable in the event of the outage of any market service provider. In addition, there are also competition drawbacks from the duopolistic market situation and the use of selfcontained, non-interoperable market solutions, which do not allow other service providers to enter the market with new innovative payment solutions. In addition to the main goal of reducing the use of cash and spreading electronic payment methods, this may also have been one of the drivers for the Chinese central bank’s establishment of its dedicated digital currency research institute in 2014 (China Banking News, 2018). As a result of the developments carried out here, a pilot program was launched in China in 2020, as part of which testing will cover four districts (Shenzhen, Suzhou, Xiong’an, Chengdu) and foreign companies (e.g. McDonald’s, Starbucks) will participate as merchant acquirers, while the intermediation of CBDC to customers will involve the four largest state-owned commercial banks (Central Banking, 2020; Finextra, 2020; Payments Cards and Mobile, 2020). – Another important development in this area is the launch of Facebook’s Diem (formerly known as Libra) project. Published in 2019 (Libra, 2019) the first “whitepaper” was followed by a second, revised version a year later (Libra, 2020). Regulators and central bankers in a number of countries have called for a thorough examination of the parameters foreseen, as they could have major implications for the effectiveness of monetary policy, and also for financial stability. At the same time, it should be pointed out that the basic objective of the Diem project, at least nominally, is to provide electronic

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payment services to those for whom this is not currently available. Importantly, therefore, Facebook – following the strategy of Chinese BigTech companies – seeks to acquire additional users through payments and to extend the range of data it has about existing ones. In several countries, the resulting conclusion has been that the threat posed by Diem to the financial sector can be addressed, inter alia, by the introduction of a CBDC that would ensure that those who do not have access to or prefer not to use banks’ payment services should opt for the central bank solution.80 8. Modern and convenient electronic payment solutions are limited to the field of public sector collections and disbursements. One possible situation is where CBDC is introduced for a somewhat more limited purpose, and offers an alternative to cash only in terms of public sector collections and disbursements. This provides for a means to handle the collection of taxes, fees, commissions and fines on a new infrastructure, for example in cases where market participants do not develop in this field. Conversely, CBDC may be limited to public sector disbursements, i.e. to direct payments of aid or subsidies, for instance. Since aid primarily affects people in poorer financial situations who do not necessarily represent a business opportunity for market service providers, this objective can be linked to strengthening financial inclusion. 9. Cross-border electronic payments are dampened by expensive and slow solutions. Cross-border credit transfers still tend to be highly complex and are carried out through a chain of correspondent banks, which makes them slow and costly in most cases. Interconnecting individual countries’ CBDC systems could provide support for making these processes significantly simpler, faster and cheaper. The European Central

ee ECB President Christine Lagarde’s speech https://www.ecb.europa.eu/ S press/key/date/2020/html/ecb.sp200910~31e6ae9835.en.html

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Bank (ECB) has already taken a number of infrastructural and regulatory steps in the area of traditional payment methods based on commercial bank money, with the aim of eliminating or at least reducing the disparities between domestic and crossborder payments. For its part, the CPMI (2020) identified 19 development points for the improvement of cross-border payments, one of which is CBDC. An initiative of an even wider scope involving the English, Japanese, Canadian, Swiss and Swedish central banks, the ECB and the Bank for International Settlements (BIS) was announced in 2020 (BIS, 2020b). However, the ECB also points out that access by nationals of countries outside the euro area should be restricted when adopting a possible digital euro, as the risk of exchange rate fluctuations may otherwise increase (ECB, 2020b). It should also be noted that even if CBDC is not primarily intended to serve payment objectives, its introduction is almost certain to have a considerable payments dimension. For example, any central bank lending (to consumers or corporates) requires developments in the financial infrastructure, and even possibly in the market for payment services if the utilisation of the loans in CBDC is also to be ensured. Similarly, even for CBDC of a “helicopter money” nature, serving mainly monetary policy objectives, the utilisation of the funds disbursed should be ensured, and the effects on the payments market examined.

3. Overview of the Hungarian situation in light of the possible objectives of introducing the central bank digital currency This section reviews the extent to which the possible future scenarios presented in Chapter 2, and the payment objectives that may be put forward for the introduction of CBDC for each — 260 —

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scenario, could be relevant in Hungary. In this regard, on the one hand, it should be examined which of the problems presented in each scenario could reasonably occur in our country in the future. On the other hand, it should also be taken into account that a number of individual factors will influence which of the theoretical solutions that can be given to a payments market problem will actually work in practice. 1. Encourage greater uptake of electronic payments. Electronic payment methods are associated with predominantly fixed costs, i.e. those related to infrastructure deployment, which may be “evaporated”, that is, unit cost may be reduced, by increasing the number of transactions. Accordingly, CBDC could drive a major reduction in social cost if the transactions were re-channelled from cash flows rather than from already electronic payments, and if a sufficiently large number of transactions were carried out on the CBDC infrastructure. This may, of course, also depend on the CBDC operating model (see Chapter 4), as it is not absolutely necessary to build a completely new infrastructure. An assessment of this objective thus needs to examine whether CBDC has any feature or function that cannot be provided by existing electronic payment methods. In Hungary, market-based electronic payment solutions can now be used in basically every conceivable payment situation thanks to the widespread use of contactless card payments and to the instant payment system launched under the leadership of the MNB on 2 March 2020 (MNB, 2020). If those payment solutions continue to develop at the pace seen so far, the introduction of CBDC would probably not be sufficient to drive a meaningful improvement in the quality of electronic payment services; therefore, in this regard the introduction of CBDC alone would not significantly increase the uptake of electronic payments. Consideration may be given to the question of whether an anonymous CBDC, specifically defined as an alternative to cash, could nevertheless be successful in terms of this objective. Indeed, it cannot be ruled out that some people’s aversion to — 261 —

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using the existing electronic payment methods is primarily explained by the lack of anonymity, whereas an anonymous CBDC could already be a real cash alternative for them, too. However, this effect is weakened by the fact that consumer attitudes towards payment methods are typically the result of complex effects, and apart from the lack of anonymity, the rejection of electronic payments is very often due to other factors such as lack of digital skills and awareness, and mistrust of digital solutions. These barriers will not be addressed by CBDC either. 2. Support reduction of tax avoidance and money laundering risks. As in the previous point, with this objective the benefits to be derived from introducing CBDC will be substantial only if a significant proportion of cash flows can be re-channelled. While this may be possible through additional regulatory steps restricting the use of cash, it should be noted in this regard, too, that the functions that can only be achieved with CBDC and not with existing electronic payment solutions are currently not apparent. Moreover, contrary to the previous point, this objective would require the introduction of a non-anonymous CBDC. 3. Preserve the role of generally available central bank money in retail payments. As explained above, this objective forms the basis of the Swedish central bank’s project, as cash use has fallen to about 15 per cent of transactions in the country. By contrast, Hungarian data show the rates in reverse: according to the highly granular online cash register (OPG) database of the National Tax and Customs Administration (NAV), which contains more than 4 billion records, in 2019 nearly 82 per cent of transactions were in cash (MNB 2020), and similar rates were shown in the MNB’s previous survey of retail payment habits (Ilyés−Varga, 2015). Although, according to OPG data, recent years have seen a steady decrease in cash use and the rate of that decrease has accelerated due to the lockdowns imposed and to

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consumer habits changing due to the coronavirus outbreak in the first half of 2020, the likelihood of a similar cash flow rate emerging in the next decade to that in Sweden is low, even by reference to the current path. 4. Increase financial inclusion. According to the MNB’s previous representative retail survey (Ilyés−Varga, 2015), no general problem is apparent with the coverage of the population in terms of accounts and payment cards, which was already around 80 per cent at the time of the last survey. While this does not yet reach the average of the most advanced economies, which is above 90 per cent according to the World Bank’s 2017 analysis, it is a high rate in global comparison (World Bank Group, 2017). At the same time, groups such as aid recipients, the unemployed and pensioners can be identified as having significantly lower rates of bank relationships. These are also groups where, due to their poorer financial situation, members generally do not represent significant business opportunities for market participants, rendering a market-based change unlikely in this regard. Therefore, addressing this problem should involve an assessment of whether CBDC is the most suitable and most effective tool, or other means (for example, requiring payment service providers to provide a free social payment account by regulation) would be more appropriate. This is also highlighted among other points in the IMF’s study (Mancini–Griffoli et al., 2018). 5. Increase the security of electronic payments. The operation of payments and financial infrastructures in Hungary is extremely secure (MNB, 2020). This is also true by international standards: in 2018, Hungary was one of the countries of the European Union with the lowest fraud rate as a percentage of total turnover for card payments, which is currently the most widespread retail electronic payment method (ECB, 2020a). On those grounds, no problem is apparent in this area which would require immediate intervention and could only be solved

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through the introduction of CBDC. The introduction of offline transactions may carry additional advantages in terms of the Hungarian financial infrastructure’s resilience, but this may have the opposite effect when it comes to fraud. 6. Ensure the availability of cheap and innovative electronic payment solutions. In recent years, card payments in Hungary have shown an annual growth rate of 20 to 25 per cent, and within that, contactless transactions account for the vast majority of the turnover. In addition, the instant payment system was launched on 2 March 2020, and market participants started to develop various innovative payment solutions (online and physical acceptance, QR code handling, mobile applications, etc.). Accordingly, no substantive problem appears to exist in terms of the intensity of market developments. However, the transaction pricing of credit transfers is a problem that has been communicated by the MNB for a long time, and may hinder the spread of instant payments. Indeed, our previous analysis found that the monthly fee burden from the use of retail electronic payment services in Hungary is one of the highest among European countries (Kajdi, et al., 2019). Accordingly, the introduction of CBDC may be conceived of either as implemented through the instant payments infrastructure, or as a solution offering a customer experience similar to instant payments, enabling users to use basic payment services on more favourable terms than current market-based transaction pricing. In this context, however, it should be examined whether there are other ways to achieve this objective more effectively. This is particularly important from the point of view that if a CBDC service were to be launched solely on the basis of pricing considerations, market participants, in theory, could respond flexibly through pricing adjustments. Although this would help achieve the desired objective, it is expected to do so at substantial cost, since the deployment and launch of a CBDC system is very resource-intensive. Moreover, if price adjustments by market participants ultimately resulted in — 264 —

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a low uptake of CBDC, it would in fact be difficult to maintain a favourable pricing for the CBDC service itself in the longer term, due to economies of scale. However, it is definitely to be noted that according to our analyses, the pricing of retail credit transfers in Hungary, which is very expensive even by international standards, indicates a failure in the Hungarian market that must be addressed, and that the introduction of CBDC must be taken into account as one of the possible means of doing so. 7. Address the challenges of BigTech operators. While BigTech operators (e.g. Apple Pay, Google Pay, Alipay) are already present in the Hungarian payments market, a truly significant impact could be made through the implementation of projects such as Diem, providing, in a short timeframe, a significant proportion of customers with access to the payment function of a service they already use frequently, which would rechannel the retail and corporate payment flows and liquidity of the Hungarian banking system to the systems of other nonbank service providers. In that regard, further examination is needed, on the one hand, of the probability of Diem (or other BigTech payment solutions) actually entering the market, and of the boundary conditions and timeframe within which this may occur. In addition, further examination is also needed of the reasons for which users may opt for a new solution, and whether this can be addressed by the introduction of CBDC. Namely, it should be taken into account that creating CBDC as an alternative to the new BigTech payment solutions is not necessarily sufficient in itself; it should also be understood why users might choose these new solutions instead of the existing market services, and how CBDC can be more competitive in this regard. As market participants already have much more experience than central banks in product development and in customer experience and relationships, the conditions under which CBDC can successfully compete with BigTech solutions pose a question yet to be answered. — 265 —

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8. Support the electronic transformation and modernisation of public sector payments. In practice, re-channelling to CBDC the payments made to the State would mean that the MNB would take over the central role of the Hungarian State Treasury (MÁK) in public sector payments, and it would service accounts for the MÁK (as is already the case for handling the foreign exchange flows of MÁK), treasury institutions, local authorities, NAV and other public bodies. In that regard, it is important to see that on the recipient side MÁK has already joined the Hungarian instant payment system, and that the development of the new treasury account servicing system is ongoing, as a result of which no efficiency or service level gains from such re-channelling are readily apparent. Public sector disbursements, such as those in aid and subsidies, could also be made directly on CBDC foundations. As already explained in the assessment of financial inclusion, this is an option to be considered, but can also be achieved by other means, for example by providing support to payment service providers for all accounts provided to those in need. It should also be noted that in the case of CBDC services provided to socially more disadvantaged groups, intensive communication and education efforts must also be reckoned with in order to ensure that for less digitally skilled people, electronic transformation does not have the opposite effect of financial exclusion. 9. Ensure cheap and fast cross-border electronic payments. In 2019, cross-border credit transfers accounted for a mere 1 per cent of all credit transfers (MNB, 2020b). Additionally, complementing euro-based payments, in theory cross-border payments in other European currencies (including HUF) could also be possible through the ECB TIPS system, which would help to eliminate the slow and expensive correspondent bank model for cross-border payments within Europe. A number of non-bank FinTech payment service providers, such as PayPal, Revolut and TransferWise, are already offering solutions that can be used to send money to other countries in seconds, for — 266 —

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a fraction of the bank transfer fees. Accordingly, for Hungary, the problems encountered in conducting cross-border transactions do not appear to warrant the introduction of CBDC. Importantly, however, if CBDC were to be introduced in Hungary in pursuit of any other objective, it should also be examined whether interconnection with international financial infrastructures may become necessary in the foreseeable future, and whether there may be international standards that would be appropriate to apply, for example in the context of the BIS (2020a, 2020b) cooperation referred to earlier. The above considerations suggest that at first glance, on the basis of the characteristics of electronic payments in Hungary, several theoretical payment objectives of introducing CBDC could be relevant in Hungary, such as encouraging the uptake of electronic payments (given the still relatively high rate of cash use in retail payments), ensuring the availability of cheap and innovative payment services (since the fees of retail payment services in Hungary are high by international standards), or increasing financial inclusion (as Hungary has yet to reach the average bank account coverage rate of the most developed economies). However, these objectives can apparently be achieved more quickly or more efficiently by other means, such as the development of already available electronic payment solutions and payment services in the market. This is also highlighted among other points in studies by the central bank of New Zealand (Wadsworth, 2018) and Spain (Nuno, 2018). For this reason, the introduction of a broad retail and corporate CBDC does not seem urgent from a payments perspective. It should be added, though, that the situation may change in the future. For example, if the increase in the proportion of electronic payments stalled for any reason, or BigTech operators carved out a more significant share of domestic payments in an uncontrollable manner, or the package-based, transaction fee-free pricing of retail electronic payment services failed to be taken up at an adequate rate,

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careful consideration should be given, inter alia, to the possibility of introducing CBDC as a means to address the situation at hand.

4. Effects of central bank digital currency on the payments market Whether carried out with payment considerations in mind or in order to achieve other objectives, such as those of monetary policy, the introduction of CBDC will certainly have a large and complex impact on the system, market and actors of payment services as we know them today. In this respect, the precise extent of the impact depends on the role that the CBDC to be introduced would play in the execution of payment transactions related to economic transactions. The extent of the uptake of CBDC in payments will be influenced by a number of factors, which can be considered as input parameters that can be “adjusted” by the central bank to influence the effect on payments and other effects (marked green in Figure 2): – range of access – whether CBDC is accessible to the whole population or only to a specific group (e.g. recipients of aid); – range of auxiliary services offered, e.g. whether an easy-to-use mobile payment application is available; – the price at which CBDC is offered, i.e. whether an account servicing fee or transaction fees apply, for example; – any limits to the value or number of transactions or the amount that may be held in each account; – whether transactions are anonymous and, consequently, the extent to which CBDC can support transparency, such as the prevention of tax avoidance or of money laundering. The range of CBDC access (which is fundamentally influenced by the objective for which it is introduced) also affects the infrastructure to be deployed; consequently, the extent of the — 268 —

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development required will be largely determined by factors such as the number of customers the central bank will need to service accounts for. In turn, infrastructure influences the range of services provided: it determines whether anonymous transactions are possible, while it also has a direct impact on service development opportunities. The characteristics of the infrastructure to be deployed determine the development costs incurred by the central bank and by market participants, as the case may be. The implementation (and operating) costs for market participants and the extent to which CBDC is used give an indication of the market effects; in practical terms, of the share of the payments market that CBDC can acquire. Finally, the development costs, possible central bank revenues from CBDC fees, and the use of CBDC (such as the payment methods the turnover of which is re-channelled to CBDC) collectively make up the effects of introducing CBDC on payments, i.e. the amount of social cost savings that can be achieved through the introduction of CBDC. Accordingly, in this theoretical framework, from a central bank perspective pricing, any restrictions applied, anonymity, range of access, CBDC infrastructure and the range of services provided are the initial parameters to be decided depending on the objective, which then determine the actual use of CBDC, which in turn will primarily determine market impacts and the amount of cost savings that can be achieved at the level of society. This model therefore includes the achievement of the CBDC objectives and the resulting (social) benefits only partially, at the level of the social costs of payment methods. This is because when introducing CBDC, the first aspects to be reviewed should also include the decision points from a central bank point of view, and how they will affect CBDC uptake and, consequently, the payments market.

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Figure 2: Effects of introducing CBDC from a payments perspective Goal of CBDC Central banks’ decision points Anonimity

CBDC architecture

Reachability

Development costs

Changes in social costs

Use of CBDC

Market effects

CBDC service levels

Transaction limits Pricing

Central bank revenues

Increasing transparency

Source: Authors’ compilation.

Continuing this line of thought, a review is appropriate of the options available in terms of infrastructure and operations. The introduction of CBDC can be envisaged in a variety of ways depending on what portion of the tasks is to be performed by the central bank, in other words, what part of the market services the central bank seeks to take over. In the literature (Auer–Böhme, 2020) three basic models are outlined in this regard; accordingly, we will examine the market effects along those lines, as this greatly affects how much of the payment services the central bank is to take over from market participants. Direct CBDC In this case, the central bank issuing the CBDC is also in direct contact with the consumers, whereby the central bank provides the payment services and the consumers have claims on the central bank. This also requires the central bank to build new capacities for the additional processes that are currently managed — 270 —

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by market participants and are closely related to payments, such as customer identification (Know-Your-Customer i.e. KYC) and authentication, the provision of customer service and branch administration, fraud and anti money laundering monitoring, development of the acceptance network, development of customer interfaces (e.g. internet bank, mobile application), etc. Depending on the extent of the uptake and use of CBDC, this may in practice steer this segment towards the operating model of the one-tier banking system, where market participants do not have, or have a much more limited opportunity to participate in the provision of payment services than at present. Figure 3: Schematic diagram of the direct CBDC operating model Consumer A

Central bank

Assets 600

CBDC A: 200 B: 100 C: 300

Consumer B

Consumer C

Source: Authors’ compilation based on Auer–Böhme 2020, p. 89.

In this case the central bank provides a full service covering not only account servicing but also other services (such as mobile payment), accordingly the greatest market impact can also be expected here. As explained earlier, the actual impact will obviously depend on a number of factors, such as who can access the CBDC, or at what fees. The most extreme case would be for the central bank to take over the entire payment services market. In 2019, the revenues of Hungarian financial institutions from payment services amounted to HUF 587 billion (MNB, 2020b),

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which is already comparable to the HUF 698 billion profit generated by the Hungarian banking sector in the same year. This is obviously a scenario that is not viable in practice, but can provide a reference point by way of an upper limit. If CBDC was only used to re-channel the credit transfer service from the banks (whereby the banks would continue to provide card services and service the corresponding accounts), the revenues of the banking sector could decrease by HUF 146 billion in total. It should be noted that the takeover of the payments business by the central bank, and the resulting very significant decrease in the revenues of the banking sector would not necessarily entail comparable cost reductions, as the branch network, customer service and the vast majority of banking systems would still have to be maintained due to other business lines (lending, savings, etc.). Overall, therefore, the full takeover of the payment business would also pose significant financial stability risks in the banking sector, the quality of market services would deteriorate due to the decreasing operating and development costs, and the costs of other financial services would also increase for customers. However, the direct model would not necessarily cover the whole range of retail and corporate customers, so it is possible, for example, to limit its scope to the launch of services for people who are socially more disadvantaged, in poorer financial situations. Given the business aspect that members of this group tend not to use banking services anyway, the profitability of the Hungarian banking sector would probably be significantly less affected by the introduction of this type of CBDC. The challenge in this area would rather be posed by development costs, i.e. in a business otherwise strongly reliant on economies of scale, it would be necessary to build a stand-alone infrastructure covering all elements of the payment chain for a limited customer base where transactions are also presumably less frequent. This includes the need to ensure the acceptance of CBDC by online and physical merchants, as well as by public bodies, for example. If this were to happen on a completely new infrastructure, that is, on — 272 —

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a network developed from scratch rather than on the systems and communication networks currently used by market participants, it would entail extremely high development and operating costs. At the same time, no recovery of such costs is apparent – whether considering the lower social costs of switching from cash to CBDC or the increased tax revenues due to a more transparent payment method compared to cash. In terms of competition and innovation in the market, other negative effects may result from the fact that while credit institutions have additional services other than payments, which may partly compensate for the loss of revenues, the operations of market service providers engaged only in payments would become largely impossible. This would reduce the very competition that e.g. the PSD2 is supposed to strengthen by helping the market entry of new service providers. In the long term, therefore, payments innovation and the emergence of new services would depend solely on the intentions and capabilities of the central bank. The significant market risks described above are also indicated by an ECB study (ECB, 2020b) explicitly underlining that noncore activities should be provided by market institutions, but supervised by the central bank. Indirect (synthetic/two-tier) CBDC In this model, CBDC is issued by the central bank, and is intermediated to consumers by market participants (e.g. commercial banks). Rather than on the central bank, consumers have claims on commercial banks, which are also responsible for “onboarding” (e.g. KYC tasks), and for the additional tasks mentioned in the direct model, i.e. customer relations would remain with market participants. Based on its description (Sveriges Riksbank, 2020), the Swedish pilot programme examines such a model and the Uruguayan e-peso programme also includes such an element. At the same time, the model differs from the current solutions based on commercial bank money in that commercial — 273 —

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banks have to keep CBDC (any central bank money) funds at 100 per cent to secure each consumer claim, which means that the novelty of this model does not primarily lie in the field of services, but in the fact that it can provide a new central bank guarantee on each CBDC in addition to the state deposit insurance, regardless of any value limit. Obviously, this would also have an impact on banks’ liquidity management, with several available options, of course, for example, depending on whether the MNB pays interest on the liquidity set aside as collateral, and if so, at what rate, or whether that liquidity counts in the reserve requirement. It should also be noted that the literature is unclear as to whether this solution may be regarded as CBDC at all; for example, it is not classified as such by BIS (2020a), inter alia because claims are not on the central bank. Figure 4: Schematic diagram of the indirect CBDC operating model Central bank Assets 600

CBDC A: 200 B: 100 C: 300

Bank X CBDC 300

Consumer A

Liabilities A: 200 B: 100

Consumer B

Bank Y CBDC 300

Liabilities C: 300

Consumer C

Source: Authors’ compilation based on Auer–Böhme 2020, p. 89. For the sake of simplicity, the figure uses the name bank, which can denote any type of account servicing payment service provider.

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Accordingly, the expected market effects are also moderate for this modality of implementation, as it would not fundamentally deviate from the ways in which payments currently function. This also means that, for example, there would be no improvement in the cyber-resilience of infrastructure. In another possible arrangement, the central bank would provide payment initiation services in relation to accounts held with market participants. This could provide benefits if market service providers, for example, were not to develop easy-to-use payment solutions that could also be used by less digitally skilled target groups. However, the current situation in Hungary implies that market participants have started intensive developments in the field of solutions based on instant payments, which are expected to be capable of serving a wide range of customers. Hybrid CBDC In operating terms, it is similar to the indirect model, with payment service providers in direct contact with consumers, although central bank onboarding is also possible, when only the development of submission channels is outsourced to market participants (in which case they practically act as payment initiation service providers). One difference with the indirect model is, however, that here consumers have claims on the central bank. Market participants provide only services (e.g. mobile wallets), but CBDC is neither included in their balance sheets nor is part of the liquidation assets, and the central bank has the right to re-channel the customers of a failing financial institution to a properly functioning market participant.

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Figure 5: Schematic diagram of the hybrid CBDC operating model Central bank Assets 600

Payment service provider

CBDC A: 200 B: 100 C: 300

Consumer A

Consumer B Payment service provider Consumer C

Source: Authors’ compilation based on Auer–Böhme 2020, p. 89.

In the hybrid model, therefore, CBDC accounts are serviced by the central bank, but the business opportunity for market participants in developing related services is questionable. In one possible arrangement, the end-user or a group of end-users would pay a fee to market participants for the transactions. In this case, however, the role of CBDC in facilitating financial inclusion may be undermined, because presumably people in more socially disadvantaged situations will continue to be prevented from using electronic payment services. Alternatively, CBDC services, such as the mobile payment application, could be offered free of charge for end-users, with the central bank paying reimbursement to service providers for the development and operation of those services. In that arrangement, compared to the direct model, the central bank outsources certain functions to market participants, which can determine the operating costs for a long time ahead. In this case too, it may be more cost-effective to facilitate financial inclusion by making accounts serviced in commercial bank money available to disadvantaged groups, i.e. the objective itself cannot be seen as explicitly requiring the application of CBDC.

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From a market effects perspective, it can therefore be argued that payment service providers would only develop solutions for the use of CBDC if they were able to retrieve development and operating costs, any revenues that may be lost due to their turnover being re-channelled from commercial bank money, and gain a certain profit margin. In terms of specific submission channels, the optimal way to achieve this would be to incorporate a CBDC module into existing market mobile applications so that users can manage both their commercial bank and CBDC accounts within one application.

5. Conclusions Essentially, our study served a triple purpose: (1) to examine the objectives and future development scenarios in connection with which the use of CBDC may appear reasonable from a payments perspective; (2) to review the objectives that may be relevant in the light of the current situation in Hungary; (3) to explain the effects that the various operating models would have on the payments market if CBDC were to be introduced for any reason. For the interpretation of the conclusions, two important facts should therefore be highlighted. First, our analysis was restricted to payments only, i.e. in connection with specific CBDC scenarios or implementation models we did not address other aspects such as those related to monetary policy and financial stability. Second, our examination of market effects was based on the assumption that the central bank would provide payment services with CBDC, so we did not examine, for example, the market effects of possible central bank lending activities. A review of the international literature shows that for the most part, current projects and research efforts tend to be motivated by payment considerations. However, these can be extremely diverse and largely depend on the characteristics of the given

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country. Swedish research, for example, is mostly motivated by the fact that with cash use reduced, people will only have access to (electronic) payment methods provided by market participants. Consequently, the extent to which a particular person is enabled to participate in everyday life and economic processes will depend mostly on whether market participants are willing to provide payment services to everyone, and at what price. In the case of the other advanced project, the Chinese “digital yuan”, the fact that a significant part of electronic payments has come to be controlled by two non-bank service providers (Alipay and Tencent/WeChat) is an important underlying motivation, which makes it necessary to provide a central bank alternative in order to strengthen competition, and to ensure the wide availability and reliable operation of electronic payment solutions. A mention is also warranted of central bank cooperation, primarily coordinated by BIS, which primarily explores ways to make cross-border payments more efficient through CBDC. A closer examination of the Hungarian situation reveals that the current main directions for payments development in Hungary are primary set by problems other than these. Despite a steady decline in the use of cash in recent years, cash clearly remains the dominant payment method in terms of the number of transactions (especially in the retail segment). At the same time, the use of payment cards has increased dynamically in recent years, and the instant payment service launched in Hungary on 2 March 2020 also offers a wide range of options for the electronic transformation of payments. Recognising this, market service providers have also embarked on their developments based on instant payment. All this indicates that electronic payments in Hungary continue to evolve and are moving in the right direction; accordingly, over the short term, the introduction of CBDC does not appear warranted from a payments perspective. Neither are any general problems apparent in terms account coverage of the domestic population; in this area, it is particularly the socially disadvantaged and the elderly that are seen as lagging — 278 —

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behind. However, there are a number of effective tools available to improve that, regardless of CBDC. It nevertheless deserves to be noted that the continuous monitoring of the situation is also necessary, as events such as an emergency like the coronavirus pandemic, the emergence of solutions like Facebook’s planned Diem (formerly known as Libra) project on the Hungarian market, or the disruption of efforts to reduce charges for retail payment services, may occur in the near future, which may justify the introduction of a widely available Hungarian CBDC under certain circumstances. This leads us to our third main theme, the operating model to be applied in the event of CBDC getting introduced for whatever reason. In our study, we sought to demonstrate that the introduction of CBDC should be preceded by very thorough analyses – for several reasons. First, for certain models (for our purposes, particularly the direct model), the central bank may incur extremely high costs from the introduction of CBDC. This is also partly due to the possibility that the central bank may be required to provide services in lieu of market participants (e.g. customer service and branch network, fraud monitoring, customer identification and authentication, development of mobile applications) for which it has no previous experience or existing infrastructure at its disposal. Another important aspect is that if a significant proportion of electronic payments were to become re-channelled into CBDC, this would also seriously affect the revenues and profitability of market participants, already pointing to financial stability issues. It should also be examined how the central bank would influence the innovation of payment solutions if it handled a significant part of electronic payments, what the motivation would be for market participants to carry out new developments, and whether innovation based on CBDC would be more efficient than primarily market-driven processes.

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References Agur, I. – Ari, A. – Dell’Ariccia, G. (2019): Designing Central Bank Digital Currencies, IMF WorkingPaperWP/19/252 Auer, R. – Böhme, R. (2020): The technology of retail central bank digital currency, BIS Quarterly Review, March 2020 Bank for International Settlements (BIS) (2020a): Central bank digital currencies: foundational principles and core features, Report No. 1. in a series of collaborations from a group of central banks Bank for International Settlements (BIS) (2020b): Central bank group to assess potential cases for central bank digital currencies, BIS Press release. https://www. bis.org/press/p200121.htm Barontini, Ch. – Holden, H. (2019): Proceeding with caution – a survey on central bank digital currency, Bank for In-ternational Settlements, BIS Papers No. 101 Central Banking (2020): PBoC confirms digital currency pilot,https://www. centralbanking.com/fintech/cbdc/7529621/pboc-confirms-digital-currency-pilot Christine Lagarde (2020): Payments in a digitalworld,https://www.ecb.europa.eu/ press/key/date/2020/html/ecb.sp200910~31e6ae9835.en.html China Banking News (2018): Digital Currency Research Institute of the People’s Bank of China,http://www.chinabankingnews.com/wiki/digital-currency-research-institutepeoples-bank-china/ Committee on Payments and Market Infrastructures (CPMI) (2020): Enhancing crossborder payments: building blocks of a global roadmap, Stage 2 report to the G20. Bank for International Settlements Danish Payment Council (2018): The aggregate costs of payments in Denmark were kr. 15.6 billion in 2016. Analysis from the Danish Payment Council,https://www. nationalbanken.dk/en/bankingandpayments/danish_payments_council/Documents/ The%20aggregate%20costs%20of%20payments%20in%20Denmark%20were%20 kr.%2015.6%20billion%20in%202016.pdf Danmarks Nationalbank (2017): Central bank digitalcurrency in Denmark? Analysis, 15 December 2017, No. 28 European Central Bank (ECB) (2020a): Sixthreportoncardfraud,https://www.ecb. europa.eu/pub/cardfraud/html/ecb.cardfraudreport202008~521edb602b.en.html European Central Bank (ECB) (2020b): Reporton a digital euro,October 2020. https://www.ecb.europa.eu/pub/pdf/other/Report_on_a_digital_euro~4d7268b458. en.pdf?0b17405a54c7c6ad4e137e257dd02672 Finextra (2020): How National Digital Currencies Will ChangeOurLives, https://www. finextra.com/blogposting/18765/how-national-digital-currencies-will-change-our-lives FIS Global (2021): Flavours of fast 2020, https://www.fisglobal.com/flavors-of-fast

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VIII. Effects of central bank digital currency on payments Ilyés, T. – Varga, L. (2015): Mutasd, mivel fizetsz, megmondom, ki vagy – A pénzforgalmi szokásokat befolyásoló szociodemográfiai tényezők (Show me how you pay and I will tell you who you are – Socio-demographic determinants of payment habits), Financial and Economic Review, Vol. 14 Issue 2, June 2015, pp. 26–61. Kajdi L. (2017): Nyugati menü kínai fűszerekkel – a kínai pénzforgalom sajátosságai (A Western Diet with Chinese Spices – The Specificities of Payments in China), 140–169. o. Financial and Economic Review, Vol. 16, Special Issue, January 2017, pp 140-169. Kajdi, L. – Sin, G. – Varga, L. (2019): A hazai lakossági pénzforgalmi szolgáltatások árazása nemzetközi összehasonlításban (Pricing of Hungarian retail payment services in an international comparison), Magyar Nemzeti Bank. https://www.mnb.hu/letoltes/ mnb-penzforgalmi-arazas-nemzetkozi-osszehasonlitasban-002.pdf LibraAssociationMembers (2019): An introduction to Libra, White paper. https:// libra.org/en-US/wp-content/uploads/sites/23/2019/06/LibraWhitePaper_en_US.pdf Libra Association Members (2020): White paper v2.0,https://libra.org/en-US/whitepaper/#cover-letter Magyar Nemzeti Bank (2020): Dimenzióváltás a pénzforgalomban: Az azonnali fizetés bevezetésének története (Dimensional change in cash flow: The history of the introduction of instant payment). Book series of the Magyar Nemzeti Bank on economics and monetary policy, Budapest, 2020. Available: https://www.mnb.hu/kiadvanyok/ mnb-szakkonyvsorozat/dimenziovaltas-a-penzforgalomban-az-azonnali-fizetesbevezetesenek-tortenete Magyar Nemzeti Bank (MNB) (2020): Payment systems report 2020, https://www. mnb.hu/letoltes/fizetesi-rendszer-jelentes-2020.pdf Magyar Nemzeti Bank (MNB) (2020b): Payment table set, https://www.mnb.hu/ statisztika/statisztikai-adatok-informaciok/adatok-idosorok/xiv-penzforgalmi-adatok/ penzforgalmi-tablakeszlet Mancini-Griffoli, T. – Peria, M.S.M. – Agur, I. -Ari, A. – Kiff, J. – Popescu, A. – Rochon, C. (2018): Casting Lighton Central Bank Digital Currency, International Monetary Fund, IMF Staff Discussion Note, November 2018 Nuno, G. (2018): Monetary policy implications of central bank-issued digital currency, Banco de Espana, Economic Bulletin 3/2018 Payments Cards and Mobile (2020): China starts trial of Central Bank Digital Currency,https://www.paymentscardsandmobile.com/china-starts-trial-of-centralbank-digital-currency/ Schmiedel, H. – Kostova, G. – Ruttenberg, W. (2012): The social and private costs of retail payment instruments, A European perspective. European Central Bank, Occasional Paper Series No. 137, September 2012 SverigesRiksbank (2019): Payments in Sweden 2019,https://www.riksbank.se/ globalassets/media/rapporter/sa-betalar-svenskarna/2019/engelska/payments-insweden-2019.pdf SverigesRiksbank (2020): The Riksbank’s e-krona pilot

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VIII. Effects of central bank digital currency on payments Dr. Turján, A. – Divéki, É. – Keszy-Harmath, Z. – Kóczán, G. – Takács, K. (2011): Semmi sincs ingyen: A főbb magyar fizetési módok társadalmi költségének felmérése (Nothing is free: A survey of the social cost of the main payment instruments in Hungary), MNB Occasional Papers No 93. Wadsworth, A. (2018): The pros and cons of issuing a central bank digital currency, Reserve Bank of New Zealand Bulletin, Vol. 81, No. 7 June 2018World Bank Group (2017): The Global Findex Database 2017. https://globalfindex.worldbank.org/

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IX. Key implementation issues of central bank digital currency in the light of infrastructure and operation István Ádor – Péter Eigen – Zoltán Huszár – Zsolt Láda-Hartyáni – Szilvia Szécsiné Kardos – Róbert Taczmann The possible introduction of central bank digital currency will result in significant changes both in technological and business terms, which must be preceded by complex and detailed analyses. Traditional infrastructures and future IT solutions are examined against the key criteria of reliability, transaction speed and cost-effectiveness. When choosing the business model, the needs of prospective users must be considered, and the cooperation between the central bank and participants in payments must also be planned, with the needs and options of all market participants taken into account. Following the selection of the operating model and the technological solution serving it, arrangements can start for the provision of the infrastructural conditions and staffing required for the central bank to perform its new tasks, each providing a pillar of the operations, ensuring that the new service is efficient and innovative.

1. Introduction The main promise of central bank digital currency (CBDC) is that it offers security similar to that of scriptural money, except that claims are made directly on the central bank rather than on a commercial bank or other payment service provider, which provides for an outstandingly high level of reliability, given that a situation where a beneficiary is unable to enforce such a claim

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against the central bank is essentially unthinkable. (Auer & Böhme, 2020). Although in the literature terminology the indirect model is also classified under CBDC, this model carries the important difference that claims are not made on the central bank, whereby its operational risk is also higher. CBDC can be implemented in a variety of ways. In this study we only address issues related to the implementation of “retail” CBDC, which is widely available to households and corporates and can serve as a payment instrument in similar payment situations as scriptural money or payment cards. Ideally, CBDC is also a good approximation to available cash payment options. From a methodological point of view, the following main cases of CBDC implementation can be distinguished: • Account-based approach: – Central bank as account provider: The central bank provides all customers with accounts – both consumers and companies – which could amount to servicing millions of accounts in a central bank account management system. – Model based on distributed ledger technology (DLT)81 operations: The central bank can also service accounts in a socalled distributed ledger model (equally in a closed or an open network), the participants and rules of which are determined by the central bank. The availability of individual items of customer and transaction data from several actors gives this solution enhanced protection in terms of data redundancy82 and counterfeiting; however, with critical infrastructures

Distributed Ledger Technology; DLT

I n IT, the term redundancy refers to the multiplication of data, information, or, in a broader sense, system components and systems. For the latter, from an operational point of view, it is advantageous for critical components of a system to be configured on a redundant basis, and many fault tolerant systems use redundancy to achieve that objective.

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this technology is not yet used live production situations anywhere, on the grounds of which some central banks (e.g. In Israel) rejected this solution, while the pilot project of the Swedish central bank is based on DLT (Sveriges Riksbank, 2020). • Value-based approach: Similarly to current prepaid card solutions, a solution is possible where CBDC would be stored on a device (e.g. on a card or in a mobile application). It should be examined whether in this case, it is absolutely necessary to keep a central record of the amounts stored on each device, or the anonymous solution provided by the technology can also be used (Mancini Griffoli, et al., 2018). • It is also possible to combine the two solutions, so that accountbased records can be complemented by value-based solutions, primarily to provide offline, low-value, possibly anonymous payment options. When introducing complex systems and services, including the case of a potential CBDC implementation, it is necessary to examine several factors in detail so that the design process can consider all relevant circumstances and potential impacts, and thus eliminates the most significant possible errors. Accordingly, this study seeks to take stock of the main issues and aspects that must definitely be examined for the introduction of CBDC. As the examination should cover the important environmental parameters listed below, the subject is presented in the same structure in each sub-chapter: • examination of the possibilities offered by the technological environment • review of existing and planned resources • cataloguing processes relevant to their impact on operations.

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2. The technological environment One of the first steps in the design of the CBDC to be implemented is the examination of the available technologies, as they are prerequisites of an implementation. Today, there are several information and communication technologies that support rapid transactions, of which the most appropriate one must be selected to achieve the objectives at hand, which enables the desired operations to be achieved without compromise. Basically, there are two main directions; accordingly, we will present the options of technological implementation along those lines. On the one hand, it is possible to use new, innovative technologies, of which DLT is perhaps the best known. Another obvious possibility is that existing financial infrastructures will be further developed for the introduction of CBDC. 2.1. Benefits and risks of distributed ledger technology For the technical implementation of central bank digital currency, it is necessary to examine both established and mature, and new technologies. The advantage of the former is their low level of hidden risks, while the latter can offer innovative, modern and mostly rapid solutions in some cases. One of the latest technologies, gaining ground for the past few years, comprises solutions based on distributed ledger technology. In order to judge whether DLT is appropriate for a given CBDC project, it is necessary to determine the following: – the objectives pursued by the introduction of CBDC that can be supported by the specific features of DLT; – the system requirements that can be met using DLT to a higher standard or in a simpler way compared to traditional technology, and the requirements that are more challenging to meet; – t he type of DLT required for each model and the model-specific questions arising; – the risks in using DLT and how to manage them. — 286 —

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2.1.1. CBDC objectives supported by DLT Improve acceptance of innovative technologies and test innovative technologies

As a new form of money, CBDC offers a good opportunity to involve innovative technologies in operations, and can adequately support their improved acceptance, with DLT being a possible practical application. Improve access to financial services The logical structure of DLT solutions enables easier, and sometimes faster, access to financial services. Research by the Swedish central bank has found that if the objective is to make digital financial services available to those who do not have bank accounts and, as a consequence, asset-based currency needs to be managed through anonymous transactions, DLT is able to support this adequately and more maturely than traditional technologies (Sveriges Riskbank, 2018.). In this case, the central bank issues tokens83 of specified value, which are transferred directly or indirectly (through commercial banks or other financial service providers) to digital wallets whose owners are not personalised, and payment transactions are made between these digital wallets. If, however, anonymity is to be ensured on a substantially limited scale, only between portable devices, or even for offline CBDC transactions, and consequently CBDC itself can be account-based, then traditional technology can be applied in the same way, according to a report by the European Central Bank (European Central Bank, 2020). Increase the security of payments and ensure their operation in crisis situations Increasing the security of payments, and the combined availability and improved operation of individual infrastructure elements can

CBDC token is a digital entity that has a monetary value guaranteed and A fixed by the central bank, is passive, and a given token can only belong to one digital wallet at a time – e.g. it can be accessed with a secret (private) cryptographic key –, and is transferable.

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be achieved by creating a separate CBDC infrastructure operating in parallel to existing infrastructure, while at the level of society the cost of operating parallel systems can be much higher. The continuous operation of an infrastructure deployed on those foundations can be ensured through both traditional redundant IT infrastructure and a DLT solution. The assessment of the risks inherent in DLT is complex; the technology provides adequate support for increased protection against fraud, but precisely due to its distributed nature, it is more exposed to cyberattacks and therefore requires a very high level of consistently robust protection compared to traditional technology. In addition, the novelty of the technology also carries risks, given the lack of a history of experience with it, gained through multiple implementations. Achieve greater transparency in payments and reduce the black economy In terms of achieving greater payments transparency and reducing the black economy, the DLT is essentially equivalent to traditional technologies, but as this objective limits the objective of transaction anonymity, the applicability of DLT should be assessed with that in mind. Make payments more efficient While DLT solutions can play a role in making payments more efficient, this goal can also be achieved through traditional technologies. Spreading over the past decades, instant payments systems have significantly increased the efficiency of payments, but have apparently opted for traditional technology. This may be explained by the fact that although DLT itself is a suitable tool to drive efficiency gains, the use of new technologies in payments started with a lag, on the one hand because the need to avoid compromising trust in payment systems adds much more to the balance, and on the other hand because DLT’s transaction processing speed is currently not sufficient to provide the settlement time expected in instant payments systems, and

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building a system with sufficient speed is not possible within the confines of economic viability. Other possible CBDC objectives Additional objectives pursued by the introduction of CBDC may be to develop the market for financial services, to stimulate competition, to improve financial awareness, to increase the efficiency of monetary transmission and thereby to increase economic performance, and to reduce cash holdings and cash logistics costs. These objectives can be achieved with both traditional and DLT-based systems, and the more appropriate of the two technology groups can be selected in light of the specific implementation and the objectives at hand. 2.1.2. Comparison of expectations and the possibilities offered by the technologies One of the most important expectations is that the technology applied should be safe and resilient to environmental impacts. The resilience of DLT systems to malicious interference is a result of (1) transactions being arranged into chains using cryptographic processes so that their sequence and data content cannot subsequently be altered, (2) storing multiple, perfectly identical copies of the chains across the nodes of the network, and (3) transactions that make up the chains being typically controlled by multiple nodes. This represents a clear advantage over traditional technology, but also higher costs at the level of society due to the multiplication of individual system components and data. DLT systems vary significantly in terms of vulnerability depending on the technological functionality of the chosen DLT platform and the way it is implemented; consequently, if significantly higher cybersecurity84 than what is offered by traditional technology is also a priority objective pursued through the introduction of CBDC, then great emphasis must be placed on this in platform

ybersecurity is a collective concept comprising the secure operation and use C of the cyberspace created by IT solutions, and protection of its data.

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selection and implementation. Among other aspects, the following aspects must be examined: – The number of nodes validating transactions in the given solution – increasing their number will increase reliability exponentially, along with cybersecurity risk and costs resulting from a possible failure to provide for consistently robust protection, accompanied by reduced transaction processing speeds. – The type of consensus algorithm85 applied in the solution. – Whether completely identical chains are stored at each node, or possibly a single node can store several different chains that are identical only at the nodes involved in the given transaction. – How authentication and encryption certificates are managed. However, greater resilience does not mean that DLT systems are unbreakable, and therefore they must be protected in the same way as systems based on traditional technology, with information security technologies and methods. Importantly, all nodes should have the same level of protection, because out of all accessible nodes, cyberattacks will target the one with the weakest protection. Where a new feature of protection is introduced, it should be applied uniformly at all nodes, otherwise the measure will not work its effect. Proper design of intrusion protection is crucial for the application of any technological solution, because the highest level of reliability is primarily achieved through the prevention of unauthorised access. After a successful intrusion attempt, it is essentially “merely” a matter of computing power to crack any encryption algorithm used today. In the post-intrusion phase, DLT is offers a higher level of protection compared to traditional technologies due to its distributed structure, because data to which unauthorised changes are made would have to be 85 A mechanism of the network through which agreements are reached as to which transaction can be considered valid and stored in the system.

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transmitted to and changed in all data storage nodes, which may increase security. However, if sufficient time is available – i.e. the intrusion is not detected within a short time – encrypted data can be decrypted. A requirement closely related to the expectation of security is that users of the system should trust the data on the system. In the case of systems based on traditional technology, apart from physical and technological protection solutions, trust is also strengthened by the legal environment regulating the system operator, and by the activities of the third party supervising its enforcement. In the case of DLT systems, compliance with the rules is guaranteed by the procedures stored in the system and running automatically. However, the significance of that may be smaller with CBDC, because even in the case of infrastructures operating on current traditional systems, no concerns are likely to arise about the manipulation of data or transactions from the central bank side. Although anonymous transaction processing can also be implemented using traditional technology, in the case of CBDC anonymity involves the handling of asset-based currency rather than account-based currency, except where anonymous transactions are carried out between portable assets in an accountbased CBDC arrangement. In the case of asset-based currency, it should be ensured that a given token cannot be spent more than once, and it should also be possible to subdivide a token within certain limits. DLT systems provide solutions to address these needs. In addition to the above, transaction processing speed is one of the most important aspects in the design of systems. Due to the large number of cryptographic operations to be performed and the distributed system logic, the processing speed of DLT systems is lower than that of systems using traditional technology, which makes this one of the biggest challenges in DLT deployment. In general, DLT’s performance may be sufficient for clearing in payment cycles of several hours, but it is not sufficient to provide — 291 —

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the settlement times required for instant payments systems, of typically only a few seconds. The infrastructure of the Hungarian instant payments system has been scaled to a throughput of 500 transactions/second, and although the demand on the system has never exceeded 155 transactions per second to date, this is already a much higher value than what has ever been achieved using CBDC test applications implemented with a DLT system (South African Reserve Bank, 2018). The performance of DLT systems may vary greatly depending on their deployment platform, the method of implementation, the number of validating nodes, and the size of the blocks. However, if higher performance is achieved by using a single dedicated validation node or by recording only the transactions of the nodes concerned in a given chain and only storing them on these nodes, this will come at the price of higher system vulnerability (South African Reserve Bank, 2018). Apparently, the most important advantage of DLT systems – a particularly high level of authenticity in terms of transaction data – amounts to more of a disadvantage in terms of speed, as speed needs to be improved at all nodes simultaneously. This does not arise as a major problem in the design phase, but when the system is subsequently further developed.

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Figure 1: Conceptual decision points in CBDC implemented on a DLT basis

CBDC type?

Account-based

Asset-based

Anonymised

Non-anonymised

Source: MNB

Compliance with the legislative environment is another major challenge facing DLT systems. Compliance with the requirements of the GDPR86, in particular the right to erasure and the right to be forgotten, is complicated due to the specific nature of DLT, as the basic principle of the system is precisely the inability to alter transactions subsequently. Solutions to the problem already exist, including the storage of only imprints87 of personal data in the chain and the storage and deletion of personal data outside of the chain, or the encrypted storage of personal data in the chain and

U general data protection regulation 2016/679 (GDPR); the Regulation of E the European Union on the processing of personal data, which entered into force on 25 May 2018.

Cryptographic hash

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the disposal of the encryption key, but their use will reduce the resilience of the DLT system. In addition to the processing of personal data, compliance with the rules on the processing and confidentiality of non-personal data also causes problems due to data sharing. The legislation defines precisely which institutions may process data on financial transactions, for what purpose, and how. According to the current interpretation of the law, the storage of data qualifies as data processing even if the data is encrypted and the storing organisation does not have the key required for decrypting it; accordingly, even the storage of data subject to bank secrecy in a distributed network in encrypted form raises a question of legal compliance. Issues arising from the specificities of the legislative environment and DLT technology are still to be resolved, and the inherent legal risk cannot be eliminated until that is done; therefore, a thorough analysis of the relevant legislation is required when designing DLT solutions. It should be examined whether each item of data stored in the system can be lawfully processed by the institutions operating each node, and if not, what legally compliant technological solution is available to enable processing. The operational arrangements mentioned earlier under performance improvement, in which fewer institutions function as nodes in the system or only the transactions of the nodes concerned are recorded in a given chain and only stored on these nodes, provide an answer to this problem, but that comes at the price of reduced system redundancy.

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Figure 2: Effect of validation and form of redundancy on security and processing speed

Redundancy?

Performance

Security

Several different chains are on the nodes

Security

Performance

Identical chains are on each node

Performance

Multiple nodes perform

Security

One node performs

Performance

Validation?

Source: MNB

In an alternative arrangement, all data may be stored in encrypted form on each node, and the key to decrypt specific data is only held by the authorised nodes. In this arrangement, if these nodes are also involved in the validation of transactions, it should also be ensured that the node concerned performs the validation so that the institution operating the node cannot decrypt the data of transactions in which it is not involved, in order to avoid bank secrecy from being compromised. This, however, will significantly increase the complexity of the administration and functionality of key management, which will in turn increase the vulnerability of the system. Storing encrypted data in chains will pose an additional challenge for the system in the long run. Namely, the keys used currently can become breakable over time as computing capacities evolve, which calls for the development of a method whereby the data stored in the system will be re‑encrypted with the new key providing the required security,

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and the data encrypted with the old key will be deleted. Due to the immutability of the chain, this amounts to either rebuilding the chain or starting to build a new chain and permanently deleting all copies of the old chain, which raises new technological issues. A payment system must provide the means to determine the finality of settlements. In DLT systems, this can be provided by transaction validation and the system’s consensus algorithm, but that requires the development of an appropriate operating model, and the choice of a platform in which this can be achieved (Monetary Authority of Singapore, 2018.), (Burgos, Filho, Suares, & De Almeida, 2017). The cost-effectiveness of operations is largely dependent on the answers given to the questions referred to earlier; accordingly, those answers also influence the complexity of the DLT system to be implemented, and consequently the cost of its implementation and operation. Whether a CBDC system is more cost-effective with traditional technology or a DLT solution cannot be determined in general, it can only be established once the solution to be implemented is precisely known, after a detailed analysis. In the case of DLT systems, the modification of the scope of processed data and stored procedures is more complex than with traditional technology; consequently, when designing the system more care and foresight needs to be taken in this regard to ensure that the scalability of the system is appropriate. Since DLT systems are architecturally different from existing technologies, there is no difference between the two groups in terms of user interface, transparency, easy accessibility and uptime, and both types of technology are fully capable of performing these functions. 2.1.3. Operating models and types of DLT In all three models that may be conceived of according to the possible roles of the central bank and market participants, entry into the network as a new node – and depending on the model, — 296 —

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participation in the consensus – must be made subject to central bank authorisation, but the system must be accessible and open to anyone through the nodes. For the three basic implementation models, i.e. direct, indirect and hybrid (described in chapters 4.1.1.1 − 4.1.1.3), the most important question is which institutions should be the operators of the nodes, that is also influenced by the issues mentioned previously in connection with performance and the legal environment of data processing. In the hybrid and indirect models, besides the central bank, it is appropriate that commercial banks and other payment service providers should participate in the network as nodes, whereas in the direct model these institutions are excluded, in which case a relevant question is how many and what type of institutions should operate nodes apart from the central bank in order for the benefits of the distributed network to be felt. In the latter case, because of the centralised nature of the model, the expediency of applying DLT is questionable, as the transactions could only be stored and validated by the central bank’s node and possibly by a node operated by a clearing house that acts as an independent institution even in the current infrastructure. 2.1.4. Risks and their management Regarding the operation of the financial infrastructure, the biggest risk of DLT systems is that no solution based on this technology is currently operating on any critical financial infrastructure, which means there is no compliance experience even at international level, and as a result, there are unknown technological risks that cannot be mitigated in advance. Additional risk results from the above-mentioned challenges, to which it is currently uncertain whether an appropriate response can be given in a live production environment, as typically the response to one challenge either increases the vulnerability of the system, or makes it more difficult to develop a solution to another challenge (South African Reserve Bank, 2018).

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Consequently, it is appropriate to create experimental, testtype DLT systems with gradually increasing functionality, whereby risks can be better explored, appropriate solutions can be developed to the individual challenges at the current level of maturity of the technology, and thus an informed answer can be obtained as to whether a potential CBDC infrastructure would be optimally operated with DLT or traditional technology. 2.2. Aspects of upgrading central bank RTGS systems The design of Real Time Gross Settlement (RTGS) systems dates back to the mid-‘80s, and since then many countries have introduced (Bech & Hobijn, 2007) such a system, primarily used for high-value transfers88. With their emergence, processing lead times then measurable in days and weeks decreased significantly, to a few minutes. The system design aspects that were considered modern at the time when RTGS systems became widely adopted, may also pose significant limitations in terms of today’s expectations for upgradability. Gross settlement in central bank money (Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries, 1997) is characteristic of both RTGS systems and a potential CBDC implementation, in this sense the upgrade of RTGS provides a good basis for the development of a new CBDC if the processing speed of RTGS is an acceptable compromise. If it proves to be slow, the possibilities and costs of increasing speed should also be examined. One characteristic of RTGS systems is the small number of participants and accounts, as well as the high amount of individual transactions in addition to the low number of transactions. Significant increases in the number of participants and accounts and of daily transactions warrant a system redesign in terms of 88

hese systems are commonly classified in the Large Value Payments System T (LVPS) group because they primarily serve large-value transactions.

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capacity and performance, where the extent of performance gains and enhancement costs are in direct proportion to each other, but not necessarily in a linear manner. The main advantage of multi-currency operations is that it is sufficient to build a single system, but in terms of operations it can also be pointed out that serious operational problems will have the same effect on all currencies, that is, either the system is fully operational or none of its segments are functioning. In addition to functional enhancement, this is a special case of scalability, since a single system member will have multiple accounts serviced, and the number of transactions will also increase significantly. The majority of RTGS systems implement account servicing by central banks for commercial banks and possibly other key partners, with access granted through a secure communication channel (RTGS Monitoring). RTGS systems are basically self-contained systems, where participant account holders hold in central bank money their mandatory central bank reserves and coverage for other settlement systems, among other assets. CBDC enhancement requires opening up to other systems that is not justified prior to CBDC. 2.2.1. U pgrade limitations Although RTGS systems have made a major breakthrough by providing processing times of around 1 minute, they have been far outpaced by the instant payments systems that have since been widely adopted. If processing times similar to those of instant payments systems are required for the development of the RTGS system CBDC, this can only be achieved by replacing the entire communication infrastructure of the RTGS system and the account management system. Depending on the expectations, a blended solution is also possible, where the RTGS system is retained, and CBDC functionality is implemented with a front-end system.

Regarding opening hours, RTGS systems typically fall short of instant payments systems – they do not operate 24/7 – and they are — 299 —

IX. Key implementation issues of central bank digital currency

also characterised by the mandatory execution of daily opening and closing activities and the daily routine activities associated with them. It is possible to open system maintenance windows outside the operating hours, which enable scheduled installations, backups, archiving and other tasks to be performed in a wellplanned manner. The opening hours of RTGS systems can be extended up to a reasonable limit, but continuous availability cannot be achieved without redesigning the system and the scope of services. The continuous availability on a 24/789 basis can only be achieved by replacing the RTGS account management system in a new infrastructure environment. Very high availability (24/7 operations) requires full application of the principle of redundancy in all aspects of system operation, thus avoiding single-point-offailure90 risks, which may call for the deployment of additional site(s). The number of sites required for normal operations can be supplemented by at least one backup site to ensure that the service is provided even in the event of planned shutdowns at any site (e.g. replacement of computer room extinguishers). 2.3. Setup of sites and their communications For the development of the CBDC system, regardless of its operating model, two main problem areas need to be examined and planned for in terms of core IT infrastructure: the location of the server-side infrastructures of the central or distributed ledger model, and the data transmission network technologies between components. Aspects of infrastructure location are fundamentally influenced by the choice of the technology to be implemented, i.e. a distributed ledger technology or a principal central bank technology. For

The term refers to continuous operations 24 hours a day, 7 days a week.

sed in systems analysis and technological design, the concept refers to U a system component whose failure causes the entire system to shut down. Also known as critical error point.

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design purposes, the same parameters should be examined from the point of view of availability, because the business need will not change due to the method of implementation. The fundamental difference is that in the case of a distributed ledger system, the high-availability infrastructure elements are not necessarily located with the owner or operator, because the individual server DLT nodes can operate autonomously, allowing for the separation of their ownership and, consequently, the responsibility for their operation. In the case of principal central bank technology, the basic principle of the implementation of high-availability functionality operating on a 24/7 basis is to ensure adequate redundancy for all components of the entire infrastructure to cover singular errors, even in the case of planned operation and maintenance works. Computer centres and the energy, engineering, fire protection, air conditioning technology and physical security systems supporting their operations must comply with the requirement of high availability as defined by the international standard91, which is a condition for critical operations on a 24/7 basis. The distributed and the centralised solutions, do not involve any significant difference in terms of data centre infrastructure, except the possibility to recognise investment and operating costs in a decentralised or centralised way, respectively. Conversely, the direct, hybrid and indirect models, are substantially different according to whether CBDC accounts are serviced directly at the central bank. If so, i.e. in the case of direct and hybrid models, the number of accounts to be serviced is only a matter of scaling the appropriate resource, but from the point of view of the basic infrastructure, it is irrelevant whether arrangements need to be made for servicing a few tens of thousands or a few million accounts, as this only affects computing and data storage capacity. In this case, for operational 91

ANSI/TIA-942 Tier 3

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security it is essential to have the three independent data centres with at least high operational security provided in each. In the case of the third computer room, it should be considered whether in addition to two owner-occupied computer rooms with adequate operational security (or one less than the required site number), a third (or of a higher serial number, but no more than one) virtual data centre based on Platform as a Service92 (Violino, 2019) technology should also be incorporated as a cloud service. While there is nothing in the Hungarian legal environment93 or in Recommendation No. 4/2019. (IV.1.) of the Magyar Nemzeti Bank to prevent the implementation of this arrangement, its deployment may pose technological, application security and data security risks, given that the cost is lower per server, but that may in turn carry higher data security risk. If a model is developed in which the account holders are commercial banks, the central bank will not be required to deploy a system that provides a higher level of operational security than what is currently in place. Another important design aspect involves the design of individual telecommunication channels. A fundamental distinction should be made between the data link between the end-user, i.e. the account holder and the account provider, and the data links between the elements of the account provider(s) infrastructure. Based on market practice, there can be no doubt that the transmission medium for the data link between the account holder and the account provider can only be the Internet. This provides the possibility for the use of either terminal networks or mobile devices, but it obviously also enables transactions to be carried out directly from CBDC customers’ computers, from corporate governance systems, or cash registers.

aaS: a cloud service where the service provider provides the infrastructure, P resources and operating systems, but the applications and databases continue to be owned and operated by the customer.

ct L of 2013 on the state- and local government-owned organisations’ A electronic information security

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In the indirect model, the existing data transmission media can be used to ensure a data link between the account provider and the central bank, and the only changes that may need to be made concern some of their parameters, such as bandwidth, compression and encryption. If the account servicing function is partially or fully assigned to the central bank, whether a distributed ledger system or a central bank system is to be served makes a difference in terms of the communication medium to be used. In the case of a distributed ledger system, if the DLT nodes are not owned by a single operator, the speed and reliability of the data transmission channels between each server node will significantly influence the operability of the whole system, i.e. in this respect the stability of the DLT system is exposed to a much greater extent, which is inversely proportional to the number of nodes. Transmission channels are a critical element in all communication networks, as their failure may cause the entire service may to shut down, and therefore this element carries one of the highest operational security risks. The higher the number of these elements, the greater the risk to business continuity, which rise exponentially as the number of nodes increases. Where distributed ledger system elements are not owned by a single operator, it should be examined whether an independent, self-contained communication network should be deployed, or whether an existing self-contained communication network (such as SWIFT, GIROHáló) may be used to serve these systems, and under what conditions. In addition, the use of channels based on an open network and protected by appropriate encryption may be considered, but their exposure to cyberattacks is constantly higher, and consequently they require more attention and a larger pool of assets for their protection. From the viewpoint of data links between central elements, it is irrelevant whether transmission technology should be implemented between the data centres of a central bank system or whether there are nodes of a multinode DLT technology in several data centres of the central bank.

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As an additional design task for communication modes, the most appropriate means must be found to provide technical interoperability between CBDC and traditional payment systems.

3. Providing the required human resources For CBDC design purposes, in addition to these other components – system enhancements and replacements, introduction of new services and technologies, 24/7 operations – account must be taken of the development of operating personnel, which will differ significantly in size for the direct model and for the indirect model. Staff is affected by the decisions made on all other issues, since the organisation of 24/7 operations is a complex task in itself, but the setup of a nationwide customer service or of an access network similar to a classic branch network is a similar challenge, not to mention the development of a completely new account management system. In addition to determining the required headcount, the scope of training should also be defined, with the most effective organisational structure and its operating expenses specified, and other parameters factored in. In addition, the office, IT and labour law issues of the working environment must also be reviewed and organised. Arrangements should be made for the further training of existing staff in order to enable new colleagues to be trained in a mentoring system, and training materials should also be prepared.

4. O perational processes Naturally, in addition to the technological and legal environment, operational aspects will also need to be examined, as these typically form the basis for defining the principles and rules of future operations. This environment is the most complex, because it is requires a review of not only the systems, needs and opportunities of the central bank, but also other participants. — 304 —

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4.1. Interconnection of central bank and commercial bank infrastructures Depending on the operational model deployed, monetary movements between the commercial bank account and the CBDC account can be ensured in several ways. A fundamental question is whether the CBDC at hand is anonymous or not. Another aspect to address with non-anonymous CBDC is the distribution of tasks between the central bank and payment service providers. Some possible solutions for operational implementation are explained below (Auer & Böhme, 2020). 4.1.1. Non-anonymous CBDC Non-anonymous CBDC differs from current central bank money, i.e. cash, in that while the central bank has no information about the amount of cash held by each consumer, it knows precisely, or at least approximately, the amount of CBDC each consumer has. Whether accurate or approximate information is available depends on whether the direct, hybrid or indirect model is implemented during deployment. The model implemented also determines what improvements are needed for customers to initiate a transaction between their commercial bank account and their CBDC account. 4.1.1.1. D irect model Key features of the direct model:

– Consumers have claims on the central bank. – The central bank is also in direct contact with consumers. – The central bank provides payment services along with its performance of customer identification, onboarding and other customer-related operations. Of all models, this is the most challenging from a central bank point of view, because many tasks need to be solved and new functions need to be deployed with which the central bank has only limited or no experience to date. — 305 —

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As central banks tend to provide account services to a limited number of customers, unrestricted retail account servicing is a major challenge due to the amount of accounts to be serviced, because instead of a few tens or a few hundred invoices, accounts will have to be serviced in the order of several hundred thousand, or millions. In this case, at least the capacity of the central account management system needs to be significantly increased, which is a complex task in itself, since the capacity of RTGS systems is typically not scaled to such a high number of accounts. In addition, the scope of services will also differ, as very similar services will be needed for accounts serviced by commercial banks, in which central banks generally have limited direct experience. In addition to the above, applications should be developed at the central bank that provide consumers with the options commonly offered by market participants, such as access to internet banking, mobile banking and payment card transactions. Consumers have the same expectations for the system elements deployed by the central bank as they experience on the market: fast and reliable operations, with user-friendly interfaces. With the first two, central banks have considerable experience, but since they are not usually in contact with massive numbers of users, the experience in that regard, along with the operation of services such as a customer service, can also be new territory. Figure 3: Schematic diagram of the direct CBDC operating model Consumer A

Central bank

Assets 600

CBDC A: 200 B: 100 C: 300

Consumer B

Consumer C

Source: MNB

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For the execution of credit transfers to and from the CBDC accounts held with the central bank, the central bank’s account management system must be linked to the settlement systems handling CBDC transactions. The proportion of the functions offered by the settlement systems to be implemented in the account management system depends primarily on the scope of services related to the CBDC account servicing. Below we present the available options for implementation through the example of the Hungarian payments system. In the direct model, a customer can initiate a top-up of their CBDC account against the debit of their payment account with their account provider financial institution through the usual channels such as internet bank, mobile bank, or mobile application. In accordance with the dedicated Hungarian business process, the payment service provider may execute the order through VIBER94 or through the BKR’s95 instant settlement service. Through VIBER, the commercial bank transmits the customer’s order to the central bank, which is executed within one minute of its receipt in the system, so that the amount of the order can be credited to the customer’s CBDC account held with the central bank within a few minutes, depending on the method of submitting the order. Debits may be made in a similar way, with orders charged to the balance of the account to be sent to the central bank, to be executed by the central bank through VIBER. For the central bank – the operator of VIBER – the expected increase in the volume of VIBER messages may represent a task to be solved in the VIBER account management system. The capacity requirements of the communication channels and the processing

eal-time gross settlement system, a domestic payment system operated by R the MNB.

I nterbank Clearing System is a payment system operated by GIRO Zrt., in charge of interbank clearing for domestic HUF credit transfers and direct debits.

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speed of the ancillary systems, which may also affect the rate of transaction processing on the side of the central bank, need to be examined. As far as account servicing payment service providers are concerned, it should also be examined whether the increase in VIBER transaction volumes requires a capacity increase in their systems. BKR’s Instant Payments Platform can also serve as a settlement channel, where payment orders are executed in a shorter time compared to the solution outlined above, within 5 seconds. Where access is made to the instant payments service, the central bank must appear in the system on both the sending and receiving sides. The capacity of the systems should also be examined in this case, and payment participants should ensure that CBDC transactions are processed quickly and accurately within the limits required by the instant payments service. In Hungary, this solution may involve the lowest development need from a central bank point of view, as system membership is mandatory; however, as the regulation of membership in the instant payments system varies by country (it is voluntary in several places), this positive effect will not necessarily be made consistently. The increase in order numbers may be decelerated by the periodic net settlement of CBDC transactions. In this case, commercial banks and customers send their CBDC transfer orders to the central bank, the central bank aggregates them at specified times and then initiates the net amounts allocated to each payment service provider in a settlement system. In parallel with the monetary movements, through a dedicated communication channel the central bank also submits analytics containing the information on the basis of which the transactions can be booked in customers’ accounts. Out of the possible solutions presented above, implementation through instant settlement may represent the least amount of IT development for participants. Net settlement would require the introduction of new elements into current payment processes, — 308 —

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due to the operating principle of the model, the clearing would not be completed immediately, which would be a step backwards compared to the instant payments system, and the user experience would be significantly impaired relative to the speed of the instant payments system. If the central bank’s CBDC account servicing is complemented by additional services such as lending, a major enhancement to the central bank’s account management system or even the introduction of a new account management system will be necessary. In addition to the credit registration system, applications for credit approval, collateral valuation and registration and customer relations can also play an important role. Another issue to be decided is whether customer service tasks should be performed on digital, traditional or mixed channels. The use of digital channels may narrow the potential customer base – older age groups follow new technologies to a lesser extent – but it requires less input from the central bank, and thus from taxpayers, as traditional face-to-face customer service may even require the establishment of a nationwide branch network, the cost of which may be very high. The increasing penetration of digital channels can also be observed in the market for financial institutions; however, despite their declining share, traditional orders and administration, mostly carried out through the branch network, have not disappeared. The need to ensure a high level of consumer service may require the central bank to adopt 24/7 operations, which would also require a significant effort in organisational terms, since central banks typically do not provide such operations, or only to a limited extent. 4.1.1.2. H ybrid model Key features of the hybrid model:

– Consumers have claims on the central bank.

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–T hey are in direct contact with consumers and payment service providers, mainly commercial banks. – Services are provided to consumers by market participants. Figure 4: Schematic diagram of the hybrid CBDC operating model Central bank Assets 600

Payment service provider

CBDC A: 200 B: 100 C: 300

Consumer A

Consumer B Payment service provider Consumer C

Source: MNB

The hybrid model combines the characteristics of the direct and indirect models and requires close cooperation between the central bank and commercial banks, since while the consumer’s claim is on the central bank, all payments and customer service activities are carried out by commercial banks. The risks arising from this duality should be assessed in detail and the model should be designed in such a way that no additional risks can arise within the system as a result of the operation of commercial banks, or if they do, their management should be ensured. The central bank should have up-to-date information from commercial banks in all respects to ensure that the CBDC balance records of individual consumers are accurate.

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The model is conceivable both with direct central bank account servicing and with the registration of payment service provider balances. For both solutions, the execution of the transactions initiated by the consumer is accompanied by the exchange of information between the central bank and the payment service provider. In the case of direct central bank account management, the central bank has up-to-date information on the consumer’s account balance; accordingly, the payment service provider requests statements of funds from the central bank, and carries out the transactions only in the event of a positive response. If consumers’ balances are recorded by payment service providers, the central bank records the data in its own register periodically, even several times a day, but at least once a day. The setup and operation of the conditions for information flow between the central bank and commercial banks are important tasks for all participants. If not within the central bank, the increase and decrease of the balance of the CBDC account against the commercial bank account may take place through payment infrastructures. Similarly to the direct model, provided that it services accounts directly, the central bank is also required to connect to settlement systems in this case. 4.1.1.3. I ndirect model Key features of the indirect model:

– Consumers have claims on market participants. – Consumers are in direct contact with commercial banks. – Services are provided to consumers by market participants. –M arket participants must keep CBDC (any central bank money) at 100 per cent to secure each consumer claim. Similarly to cash in circulation, the central bank is responsible for recording the amount of CBDC. Due to the nature of the

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model, market participants have the latest information about the distribution and movement of CBDC in circulation. Central bank records cannot be provided without the cooperation of market participants and the central bank, as part of which the account servicing payment service providers send their data to the central bank on a regular basis. That reporting would also enable the verification of whether market participants have provided CBDC coverage in any form of central bank money corresponding to the balance of the CBDC accounts they manage. The reporting of data requires IT developments at the banks, and its reception and processing at the central bank, while the recording of coverage requires the renewal of the central bank collateral valuation system. As with the design of instant payments, the question arises also when designing a CBDC solution whether the coverage provided by account servicing payment service providers should be included in their minimum reserve to the same extent as the total value of the CBDC held by the customers. Determining that is a complex monetary policy task, and the answer to that question requires prior in-depth analysis. Assuming that, as a result of an analysis, the answer is that CBDC deposit coverage can be included in the fulfilment of the reserve requirement, then, after comparing the reporting with the actual coverage provided, the central bank records the amount recognised as a fulfilment of reserve requirements equivalent to the portion set aside for that purpose from the midnight balance of the settlement accounts of instant settlement. The criteria for the accrual of interest on the amount recorded as reserve should also be decided in the light of monetary policy objectives. In the indirect model, market participants service both traditional and CBDC accounts for consumers, and the monetary movements between the two intra-bank accounts, whether between their own commercial bank account and the CBDC account or between

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two customers, can be handled within the system of the financial institution in question, similarly to other payment systems. However, one of the solutions to support CBDC transactions between banks may need to be the establishment of a system, separated from traditional scriptural money, that meets the conditions for CBDC account servicing at the central bank as well as at the rest of payment participants. It is necessary to ensure the conditions for the monetary movements between CBDC accounts across payment service providers, and therefore both the RTGS system for high value payments and the settlement systems for low value transactions should be prepared for the task. In addition, in the case of a CBDC settlement system for a given financial infrastructure, it is obvious that its main service parameters should be adapted to the most advanced system, thus having parameters similar to those of a single express payment system: – 24-hour operations every day of the year – Fast processing and execution of the entire payment process, typically within 1 minute – Transaction costs not exceeding those of traditional payment systems, possibly zero – At least 99.9% availability – Interoperability with other payment systems. A new settlement system does not necessarily have to be established to execute interbank transactions, CBDC flows can be handled using the current infrastructure if the expectations of the central bank are met, for example, if CBDC accounts are secured by coverage equivalent to the amount of their balance. While such a solution does not represent a major development task for payment participants, neither would it bring about an improvement in the quality of service. If one of the main objectives of introducing CBDC is to increase the resilience of the system, — 313 —

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this is not the right solution because the objective cannot be achieved. Figure 5 Schematic diagram of the indirect CBDC operating model Central bank Assets 600

CBDC X: 300

Bank X CBDC 300

Liabilities A: 200 B: 100

Y: 300

Consumer A

Consumer B

Bank Y CBDC 300

Liabilities C: 300

Consumer C

Source: MNB

4.1.1.4. Transmission of transactions between participants Whichever model a central bank implements, the monetary movements between the CBDC account and the commercial bank account should be ensured in payment systems. To resolve this, payment service providers and the operators of the domestic payment systems would have a register of direct and indirect participants in the domestic payment systems, ensuring that each participant can be identified and addressed by all other participants. In Hungary this function is carried out by the authentication table, which is operated and issued by the MNB to payment participants on the basis of the data reported by the system members. Since the introduction of CBDC will no longer allow payment orders to be executed only in traditional scriptural money, it may also be necessary to indicate the addressability of CBDC accounts in the authentication table by enhancing the data content of the register. Changes in registration standards would

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require IT development at the payment service providers, the operators of the domestic payment systems and the central bank. 4.1.2. Anonymous CBDC Anonymous CBDC is not held by its owner in an account, but, for example, by means of a plastic card or a mobile application in such a way that the balance can be used without the identification of the holder’s person. In this sense, CBDC is very similar to banknotes, where the central bank only has information about the amount circulating in the economy, but is no information about who has what amount. In its physical realisation, it can behave in the same way as a top-up gift card that can be purchased from a merchant or a digital gift voucher that can be used in instalments. The balance is updated by overwriting the chip on the card or the application registry, when we pay or when we are paid.

CBDC top-ups charged to commercial bank accounts can be made using an ATM96 or by using a dedicated terminal network, internet or mobile connection. When using ATMs, as with the current cash withdrawal, a funds coverage query is sent to the account provider bank and, in case of a positive answer, the CBDC account can be topped up by selecting the appropriate function of the ATM and entering the number of the CBDC account held with the central bank. CBDC balances may be reduced through the opposite process. The great advantage of the solution is that the CBDC held can be used to make offline and anonymous payments with a card or application, just like with cash payments, it does not require a connection with payment infrastructures, and if properly designed, not even electricity is strictly necessary, but it carries a significant risk in the sense that since the total of the balances is not known at any moment, it may be the target of fraud.

Automated Teller Machine.

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5. Conclusions The possibilities of introducing central bank digital currency have been addressed by the central banks of an increasing number of countries in recent years, and as a result of the investigations pilot projects already exist, such as the e-crown in Sweden, whereas China also already has its own production CBDC system in place. Central banks tend to share the position that a more in-depth analysis of the subject is necessary; accordingly, the Magyar Nemzeti Bank is also examining the possibilities of introducing this form of money, its effects, risks and preconditions. In our study, we reviewed the tasks arising in connection with infrastructure and operations, examined new technologies such as DLT, addressed the differences and problems of sites and the intermediary channels in different designs, as well as the reuse of the basic infrastructure elements of the financial intermediary system and the issue of the integration of an independent system with these in the event introducing the new form of money. We reviewed the effects on the central bank’s operating organisation and presented in detail the transformation of certain operating processes for each CBDC model. We have found that for CBDC implemented under the direct, indirect or hybrid models, each variant represents a significant amount of tasks to be solved for the banking system as a whole, although for each variant the load is placed at a different level of the banking system and in a different way. On the one hand, due to the limited knowledge and limited operational examples available, the deployment of such a system requires a significant analytical and planning capacity within the central bank organisation and, on the other hand, the existing systems should also be adapted to the solution at the second level of the banking system.

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References Auer, R., & Böhme, R. (2020). BIS Quarterly Review. Bank for International Settlements. Bech, M., & Hobijn, B. (2007). Technology Diffusion within Central Banking: The Case of Real-Time Gross Settlement (Working Paper. kötet). Federal Reserve Bank of New York. Burgos, A., Filho, J., Suares, M., & De Almeida, R. (2017. augusztus 31). Distributed ledger technical research in Central Bank of Brazil. Source: Central Bank of Brazil Web site: https://www.bcb.gov.br/content/publicacoes/outras_pub_alfa/Distributed_ ledger_technical_research_in_Central_Bank_of_Brazil.pdf Committee on Payment and Settlement Systems of the central banks of the Group of Ten countries, B. f. (1997). Real-Time Gross Settlement Systems. European Central Bank. (2020. október). European Central Bank. Source: European Central Bank web site: https://www.ecb.europa.eu/pub/pdf/other/Report_on_a_ digital_euro~4d7268b458.en.pdf?0b17405a54c7c6ad4e137e257dd02672 Mancini Griffoli, T., Soledad Martinez Peria, M., Agur, I., Ari, A., Kiff, J., Popescu, A., & Rochon, C. (2018). Casting Light on Central Bank Digital Currencies. International Monetary Fund. Monetary Authority of Singapore. (2018.. november 12.). Monetary Authority of Singapore. Source: Monetary Authority of Singapore Web site: https://www.mas. gov.sg/news/media-releases/2018/mas-and-sgx-successfully-leverage-blockchaintechnology-for-settlement-of-tokenised-assets South African Reserve Bank. (2018). South African Reserve Bank. Source: South African Reserve Bank web site: https://www.resbank.co.za/Lists/News%20and%20 Publications/Attachments/8491/SARB_ProjectKhokha%2020180605.pdf Sveriges Riksbank. (2020). The Riksbank’s e-krona pilot. Stockholm: Sveriges Riksbank. Source: https://www.riksbank.se/globalassets/media/rapporter/ekrona/2019/the-riksbanks-e-krona-pilot.pdf Sveriges Riskbank. (2018.). Sveriges Riskbank. Source: Sveriges Riskbank web site: https://www.riksbank.se/globalassets/media/rapporter/e-krona/2018/the-riksbankse-krona-project-report-2.pdf Violino, B. (2019. 07 19). What is PaaS? Platform-as-a-service explained. Source: InfoWorld: https://www.infoworld.com/article/3223434/what-is-paas-softwaredevelopment-in-the-cloud.html

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X. Strengthening the financial inclusion of the retail segment through the use of central bank digital currency – Retail account servicing and opportunities beyond András Szabolcs Csonka – Bálint Danóczy – Péter Sajtos Globally, several types of friction can be identified in the market for retail financial services, to address which digital development may provide new opportunities. One radically new and innovative approach could be the introduction of central bank digital currency (CBDC) for the retail segment, which is being prepared or examined in an increasing number of international projects, while some central banks have already reached the test phase. This study describes in detail the possible social objectives of the introduction of retail CBDC at international level, as well as the main international examples where consideration has been given to the introduction of such a framework along the lines of specific public policy objectives. It then presents the design aspects of a retail CBDC framework geared towards financial inclusion, drawing on the findings and design structure presented in the chapter outlining the conceptual framework. Finally, in addition to the theoretical possibilities of an introduction in Hungary, we present a pilot project that is already underway in Hungary, which can provide important lessons and insights for the implementation of any larger scale concepts in the future.

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1. Frictions in the retail financial services market 1.1. Bank account access and coverage issues The number of people without a bank relationship remains high globally. Despite the increase in bank account access in recent years and the emergence of various mobile money services, primarily in African countries, nearly 1.7 billion people worldwide (around 30 per cent of the adult population) do not have access to banking services (Global Findex, 2017). Therefore, universal access to banking services is not ensured, as opposed to cash. The absence of bank relationships in the retail segment is due to a number of reasons, including income situations considered insufficient for the purposes of opening a bank account, unfavourably priced related services, and the unavailability of banking channels (for example, there are areas where there are no banks and physical branches at all). It should also be pointed out that among residents who do not have accounts, a high proportion have reported lack of trust as a reason to avoid opening an account with a financial institution (Global Findex, 2017). Bank access is restricted by the fact that cash remains the only universally available means of payment. Cash offers consumers several advantages that make specific user groups unmotivated for replacing it. Functions preferred by both service providers and users include anonymity and general acceptance. Protected from cyber risks by completely offline operations, while its use does not require any special tools or software solutions. Although the cheaper and more accessible financial services provided by the FinTech sector had appeared to relieve the problem of the lack of digitally accessible payment solutions, the poorer financing situation caused by the COVID-19 pandemic made these very companies more vulnerable and thus the long-term sustainability

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of the previously followed competitive model became uncertain (Sahay et al., 2020). There are several consumer groups that are adversely affected regarding the availability of financial services. Among the adult working-age population, banking services are typically not used by segments with lower levels of education and lower incomes. In their case, the effects of the limiting factors listed above are compounded in relation to the establishment of banking relationships, and neither are financial service providers interested in providing a full range of services to these segments, as these consumer groups would typically be given more disadvantageous risk ratings and would be less compatible with banks’ business models that are based on high profit expectations. Providing a full range of services to people above retirement age is also less attractive for financial institutions, which raises the possibility that supplying banking services to this social group proves to be expensive relative to their income situation (MNB, 2019). Similar sub-optimal operations in terms of the supply of financial services may also occur with younger age groups, especially students, who have no earnings of their own, or are low earners; however, it should be noted in that regard that the legal environment may also restrict independent disposal of bank accounts for underage customers, despite which schemes specifically developed for students could nevertheless be implemented. This recognition has produced an increasing number of initiatives with such a focus, but the penetration of these service types remains low. 1.2. Need for the sovereign management of payment systems Technological development contributes to the increasing use of electronic payment systems. Thanks to the advances in information technology in the 21st century, internet coverage has increased significantly, and the advent of smartphones has brought about the uptake and increasing use of online services, which are typically available through applications. These trends — 320 —

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fundamentally change consumer expectations: fast and convenient services, accessible from anywhere, or real-time messaging have become essential. These digital needs are also relevant in the market for financial services, and from a consumer perspective they mainly concern the area of payments, whereby a significant number of digital developments have already been implemented (e.g. real-time and interactive expense tracking, cross-border money transfers, online retail currency exchange, etc.). The digitalisation of the payments market and the development of electronic data transmission systems are increasingly driving consumers towards convenient, favourably priced electronic payment methods (Vennli, 2016). Furthermore, in the context of this development, it should be noted that restrictions to curb the spread of the Coronavirus have contributed globally to achieving a higher level of technological maturity in all age groups, i.e. it is no longer only younger generations that have a definitive digital and online presence. At the same time, in electronic payment systems, which are used on an increasingly wide scale and are essentially operated by the private sector, a sovereign mandate serving public interests cannot prevail. With the steadily increasing uptake of digital financial services, consumers tend to focus on commercial bank money, or on some form of digital instrument (e.g. e-money) (OMFIF, 2019). There has been a significant increase in the influence of enterprises that are typically involved in electronic payment flows, and, in the provision of services, primarily have business interests in mind (e.g. the execution of payment card transactions). Thus, in the digital space, which is increasingly preferred by consumers, operational shortcomings may occur at any time, which, given the decline in cash-based transactions, cannot be remedied by direct intervention by the central banks. In this way, the possibility of ensuring smooth payment flows may be restricted in the absence of direct central bank access.

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Active, comprehensive sovereign involvement is also needed in the electronic space. With the potential decline of cash and the connected payment systems, it may therefore be necessary to maintain an alternative supplementary system that takes into account the public good and consumer interests in the provision of payment services, and can also function as an efficient backup payment system in the digital space in the event of potential malfunctions of electronic payment systems, or in other crisis situations. In addition, a sovereign payment system can contribute to a high level of trust in digital payment services. 1.3. Efficiency problems with the operation of the cash payment system As far as retail participants are concerned, the use of cash entails costs that are not perceived directly. Obtaining the cash required for the execution of transactions tends to be a time-consuming and costly process for individuals. Converting commercial bank money to cash typically requires personal attendance, which potentially results in higher indirect opportunity costs, while access to cash sometimes entails significant direct costs such as ATM and withdrawal fees (N26, 2016). However, due to its physical nature, cash is exposed to a number of risks, which are often more difficult to mitigate compared to electronic payment methods: it can be lost without trace, stolen by unauthorised persons, damaged or destroyed; while the risks of these events are difficult or impossible to quantify, they are essentially present thanks to the physical form of cash. In addition, the costs of the activities of merchants accepting cash related to the operation of the cash-based payment system (e.g. acceptance, storage, provision of change) are typically also paid by consumers, incorporated into the prices of the individual products and services. Although those who do not have a bank relationship typically do not open an account on the basis of high costs, the costs

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of using cash may be higher for these segments. Notably, for example, where various allowances (e.g. pensions, state aid) are available to consumers without bank accounts, the distribution costs typically have to be paid by consumers in connection with their delivery, and the time required for these distribution tasks may also be significant, and possibly disadvantageous to consumers (Weisbaum, 2013). The execution of cash transactions also raises efficiency issues in the operation of businesses. By holding cash for transaction purposes businesses will also need to provide for cash payment facilities and the smooth execution of these types of transaction. In addition, regarding all physical facilities (e.g. chain store units, branches and ATMs for banks) businesses require significant resources to estimate cash demand as accurately as possible and to optimise the tasks of cash storage and transit between units (Denecker et al., 2018). In enterprises creating added value, holding an excessively high level of cash may carry a high opportunity cost (e.g. by preventing investments), while holding an excessively low level of cash may hinder the completion of transactions. The production, storage and transportation of cash not only entail costs, but also raise sustainability issues. The production of physically available banknotes and coins requires a significant amount of raw materials, and in a variety of forms (e.g. banknotes can be paper or polymer based, whereas coins tend to have varying components of non-ferrous and precious metals). This diversity involves a significant environmental burden, while in the production of bank notes and coins, paper mills, banknote printing companies and mints are constantly seeking to renew their technology in order to reduce environmental harms. The logistics tasks involved in the use of cash, mainly for merchants and banks, also have a significant ecological impact. Surprisingly, the energy demand of ATM networks is also high, as installed ATMs tend to have a variety of typically different functions,

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must provide continuous availability (e.g. even at night, which requires lighting), and must maintain constant synchronisation with central systems. Although the increasing use of modern technologies and digitalisation, possibly also through CBDC, can increase energy consumption and environmental burden, especially if a CBDC runs in parallel with the cash payment system, the development of a digital alternative to cash offers the opportunity for efficiency gains and to mitigate adverse ecological impacts in many processes (IFoA, 2018). At the level of national economy, the excessively high level of cash usage for transaction purposes is not optimal either. Cash transactions cannot be monitored or controlled directly by any sovereign actor, and it is also difficult to ensure the monitoring of cash movements. The wide coverage of ATMs has significantly simplified access to cash. Furthermore, if the oversight of highvalue cash movements is limited, their overall economic relevance cannot be measured effectively either, leading to anomalies in tax planning and tax revenues (OECD, 2017). In addition, although direct monitoring is constantly improving due to the increasing use of online cash registers, the full coverage of this monitoring activity is not yet resolved, which also limits the enforcement of consumer protection interests, and may also cause losses to the retail customers if people are not sufficiently conscious and careful when purchasing a product or service.

2. Possible social objectives of retail CBDC The introduction of central bank digital currency can be instrumental in the achievement of several social objectives, some of which can be considered quite timely, while others may serve to proactively solve the challenges that arise in the medium and long term. The possible social objectives of a CBDC accessible to the retail segment may, include (i) to significantly reduce the

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social costs typically associated with high cash usage; (ii) to provide a solution, as a more effective financial stimulus tool in unprecedented and sudden periods of stress such as the pandemic situation in 2020; (iii) to provide an excellent opportunity to develop a new platform to increase the efficiency of all economic participants in relation to everyday payments, thereby giving significant competitive advantage to both the private sector and the state; (iv) not least, instead of a reactive regulatory response, that only hits the target partially, CBDC could represent a highly proactive step forward, even over a horizon of several decades, ahead of the increasingly drastic expansion of alternative payment methods. The motivating factors to be listed below may give rise to the consideration of introducing CBDC, while the social objectives (excluding central banks’ monetary policy objectives) discussed later provide guidance on the choice of the specific method of implementation. 2.1. Fixing issues with bank account access and coverage Of the many positive outcomes of central bank digital currency, one of the most welcome benefits is the improvement of opportunities for unbanked and under-banked social segments (FDIC, 2017). The former term denotes a group of consumers who do not have access to basic financial services. In principle, members of the latter group could have access to such services, but do not use them for some reason, either because they find the services expensive, or they have no adequate income, or they are unaware of the associated benefits. For this reason, they either continue to make all of their payments relatively expensively in cash, or use alternative financial services, which are not subject to direct supervision in Hungary. Although the latter can theoretically contribute to the development of their financial awareness, this is not the case for cash-only payment habits. Furthermore, while using alternative solutions, the existing

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financial vulnerability of these groups, which is significantly higher than the average, constitutes an additional risk factor (for example, if they do not have a bank account and thus fall outside the scope of domestic consumer protection), which could also be remedied by the establishment of a wide network of payment service providers linked to central bank digital currency. With the introduction of central bank digital currency, account servicing and payments can essentially be transformed into public goods (Szabó–Kollarik, 2017). Central banks could provide the necessary infrastructure to all households (and even companies) with more favourable conditions and easier access than at present. Key target groups include retail participants who do not have a payment account and do not use electronic payment services. In Hungary, the relative banking burdens are the highest for consumers who already appear in the banking system, but represent the lowest-income group therein (Kajdi et al., 2019). This group could therefore derive major benefits from central bank digital currency, or even its initial use for basic payment services. 2.2. Reducing the fragmentation of payments and the possibility for the design of a robust system The introduction of central bank digital currency available to the retail segment may allow a more targeted and effective implementation of a possible financial stimulus, either for immediate assistance or to address prolonged market failures. In the event of a possible stress situation, it can provide a rapid and effective means for the immediate delivery of aid granted as temporary compensation for lost incomes, and thus for the maintenance of household consumption. In view of the fact that, at present, electronic transactions either in the digital space or at physical merchants cannot effectively fulfil the role of a means of payment that is viable in all circumstances, even in the event of natural disasters or possible cyberattacks, with the steadily increasing uptake of digital payment solutions, there is greater

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need for a reliable central infrastructure that is capable of ensuring that electronic payment transactions are carried out at all times, even under extreme conditions, without any profit considerations. If specific social groups or even all individuals had a central bank digital currency account, the fiscal authority would have direct (and cost-effective) access to the retail segment through this channel. In principle, direct access could also pave the way for account servicing, or credit lines that can be drawn quickly and easily, for retail participants. This could possibly enable crisis management measures to be executed even more effectively. However, it should be noted in connection with this suggestion that the aim is not for economic agents to maximise their deposit holdings with the central bank, and thereby to compromise the stability of the banking system. Furthermore, it should be pointed out that the implementation of this concept requires further indepth research on the effects on the banking system. Decision on this typically goes beyond the mandates of the central bank and may require legislative changes. 2.3. Remedying efficiency problems resulting from the operation of the cash-based payment system The use of cash generates social cost, the extent of which is difficult to predict for the long term. In the early stages of crises, as a result of a kind of instinctive reaction the amount of cash held by the population tends to surge, as it happened in the case of the coronavirus pandemic. In March 2020, cash in circulation in Hungary increased by HUF 250 billion (about 4 per cent) over 8 working days, which historically reflects approximately six months’ increase (Végső–Bódi-Schubert, 2020). In the medium term, however, the pandemic situation also accelerated the trend observed over the past decade: in 2020 the rate of decline in transactional cash usage increased by approximately five

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times globally (McKinsey, 2020). At the same time, it is part of the realistic assessment of the situation that demand for cash increased strongly in almost all countries following the outbreak of the coronavirus crisis. An increase in cash holdings was observed even in countries where demand for cash had stagnated or declined for years, such as the United Kingdom or Norway. Although for the first time in the second quarter of 2020 the value of card payment spending in the retail segment exceeded the amount of cash withdrawn (Végső–Bódi-Schubert, 2020), even in the period of the most stringent lockdowns, three-quarters of the transactions recorded by online cash registers were still made in cash. The majority of the society do not perceive the social cost of using cash. Consumers frequently assume that cash transactions are effectively free of charge, as opposed to electronic payments which they consider expensive. This perception stems from the fact that the related costs in this latter case are charged directly on the individual, even on a per-transaction basis, although cash withdrawal is not necessarily free of charge either. Probably also partly because of this, the value of cash in circulation in Hungary was close to HUF 7,000 billion at the end of the third quarter of 2020, of which more than three-quarters may be held by the retail segment (MNB, 2020a). Although cash demand in Hungary is indeed high, it is not outstanding by international standards, in addition, the main driver for the use of cash is savings and not transaction purposes; moreover, the share of the latter has been decreasing for years (Végső, 2020). Since 2010, the volume of cash in circulation has tripled, despite the improving trend in the share of card transactions. This costs the society about HUF 400 to 450 billion annually (Government of Hungary, 2019). On the one hand, this is an enabler for the activities of the shadow economy, while the production, holding and handling of cash and related indirect activities entail high national economy and social costs.

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According to the 2019 calculations of the Hungarian Banking Association, on a social level a significant reduction in cash in itself would help achieve savings of up to 0.4 per cent of GDP. In practice, this would essentially go hand in hand with the shrinking of the shadow economy, which – according to the example presented –, could increase the revenues of the budget by an additional 1.3 per cent of GDP in the case of a black economy falling to 10 per cent in the total economy (Hungarian Banking Association, 2019). By reference to the social cost quantified previously, assuming that all economic agents use cash to a similar extent, the social cost of this may exceed HUF 40,000 per year for every individual. At the same time, it is important to see that the preferences of the population for payment methods are determined primarily by long-term and only slowly changing sociodemographic factors (education level, economic activity, etc.). For this reason, the continuous but gradual introduction of CBDC may be the most appropriate, while ensuring continuous cash supply. The successful introduction of central bank digital currency could lead to a stable future growth in cashless payment methods. This could help to achieve significant cost savings on social level and, with the uptake of electronic payment and savings solutions and the strengthening of social confidence in them, even a part of the cash held for savings in the retail segment (if only in the form of commercial bank deposits) could return to the economy (Hungarian Banking Association, 2019). Importantly, however, introducing central bank digital currency could, in the first place, be expected to have a desirable effect on transactional demand for money, and is not aimed at replacing cash. Consumers would thereby still have a choice to decide whether to use cash or electronic methods in specific payment situations. Reducing the ecological footprint associated with cash logistics can also be an important social objective (ECB, 2020). Although a sufficiently detailed analysis of the Hungarian forint is not available, the 2018 study of the Dutch central bank shows that cash has a significantly greater impact on the environment and — 329 —

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climate change than bank card payments. According to the results of the transactions examined by De Nederlandsche Bank, the ecological footprint of cash payments was 36 per cent higher than that of card payments, while their impact on climate change (average carbon emissions per payment) was 21 per cent higher (Hanegraaf et al., 2018). Based on the available Hungarian data, it can be concluded that besides cash logistics, the entire cycle from banknote production through destruction to pressing and transformation into brick-shaped briquettes, representing the end of the cycle, does not only have significant annual costs, but also a significant environmental effect. The MNB has been continuously striving to reduce this for years as part of its environmental strategy, and as a result of the significant reduction so far, the Hungarian Banknote Printing Company and the MNB have obtained their EMAS97 certificates. 2.4. Developing and expanding the financial services market and driving competition As a percentage of their incomes, Hungarian retail customers’ cost of payments is outstanding by European standards, even when controlled for transaction fees, which greatly hinders the uptake of electronic payment methods in Hungary (Kajdi et al., 2019). Overall, a “clean-up” and simplification of the entire ecosystem may be justified if the cost to individuals and society can be substantially and simultaneously reduced. Moreover, the current situation is particularly disadvantageous for consumers who are already banked but have lower incomes. The introduction of central bank digital currency available to the retail segment as a public good could create an electronic payment system that would provide free or low-cost payment transactions similar to cash (BoE, 2020). Optimally, merchants could also be incentivised

his certificate may be awarded to companies complying with an T environmental management system certified under the Eco-Management and Audit Scheme (EMAS) Regulation issued by the European Union.

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through a scheme that is more favourable than the fees currently applied to help redirect consumers from cash payments to digital ones. One of the advantages of central bank digital currency, if not the greatest, could be in the future that it can be incorporated into everyday life on a widening platform, essentially functioning as an enhanced and integrated customer portal, providing a kind of starting point for smart contract schemes (Chamber of Digital Commerce, 2016). This would significantly reduce the amount of resources spent on administration, while it would also increase efficiency and transparency. The implementation of smart contracts could bring progress in many areas. For example (i) in a car purchase, all information would be transferred to the competent bodies and authorities immediately upon completion. Neither the seller nor the buyer would have to go from authority to authority with stacks of paper, because everything from the transfer of ownership through the subject of the vehicle tax, optionally including even thirdparty liability insurance, could be automatically administered in a very short time. Another example (ii) is a home purchase where the transaction would allow the registration process of the property; moreover, in the case of a related mortgage loan, even the entry of the bank’s lien. May also be a related use case the repayment of the last instalment could automatically notify the competent authority that the mortgage could be cancelled, and the contract could be closed. It may also be more common (iii) to issue and send invoices electronically attached to physical transactions, or, in the case of a given product range, for example, to provide warranty certificates. The potential of such a platform and the resulting synergies go far beyond the digitalisation of the processes currently in place. The number of administrative steps could be drastically reduced, while the time requirement of these processes and the possibility of errors could also be minimised. Ultimately, the creation of such a platform – one of the pillars of

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which could be the central bank digital currency –, could lead to extraordinary improvements in competitiveness for the entire national economy.

3. International examples of retail CBDC driven by specific public policy objectives – similarities and differences Central bank digital currency is increasingly appearing in international literature and among leading central banks as a potential direction for future development. Digital money issued by a central bank would be a major innovation both in the form of money made available to the public and in the operation of payment infrastructure. The possibility of central bank digital currency is therefore being examined by an increasing number of central banks. In addition, some central banks and international organisations have also outlined conceptual, and representative operating models to fully assess the potential impacts in order to evaluate how CBDC fits into the wider payment environment and how it works with other initiatives on improved payments, or with ongoing or already implemented digital developments. Although CBDC research is already being actively conducted in several countries, no major central bank has committed itself to extensive live operation. Several major central banks have already started testing a CBDC-based business concept (Figure 1), but they stand at different levels, and no launch decision has been made or official launch date has been set for any CBDC (Auer–Böhme, 2020). Some central banks have only started the corresponding dialogues, and they are currently conducting research, without any specific commitments. Most retail initiatives essentially seek local implementation within a given country. Exceptions are the ECB’s and the Caribbean’s digital money initiatives.

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Central banks see significant potential in the business model based on the use of Distributed Ledger Technology (DLT). In the longer term, this would probably add more value to the introduction of a digital currency, but its role in short-term planning remains modest (for example, not even the Chinese pilot that has already started relies primarily on the use of DLT). Figure 1: Retail focused international CBDC research and pilots

Live retail Retail research Ongoing retail pilot Completed retail pilot

Source: BIS; central bank websites. Status as of 30 April 2021.

3.1. Representative operating models In international central bank discourse, there is a lively theoretical debate on the need to introduce CBDC on a wide scale, while the development of conceptual operational models has also started. Most CBDC research addresses the advantages and risks of CBDC in addition to mapping possible objectives for introduction, delivering the actual standpoint of its central bank as well. In contrast, some central banks have already gone

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as far as outlining possible operational frameworks as the next step on the road to implementation. In the vast majority of cases, these theoretical frameworks are geared towards the development of systems for retail payment transactions to be operated in collaboration with external partners. They all agree that a number of open questions still need to be answered before CBDC is introduced extensively. With the aim of creating a coherent framework, the Bank of International Settlements, in cooperation with representatives of seven central banks,98 published its first joint report on 9 October 2020 focusing on the principles and basic features of the functioning of central bank digital currency (BIS, 2020). The Bank of England has long been addressing the options for introducing central bank digital currency. The analytical framework defines the central bank needs, user considerations and market expectations that a CBDC scheme must meet. The BoE is actively examining a platform-based indirect solution in which intermediaries would play a prominent role in the operation of CBDC. In the platform model, the BoE would provide a fast, secure and flexible technology infrastructure that operates in parallel with the central bank’s RTGS service and provides the minimum functionality required for CBDC payments. In the envisaged layered, two-tier model, the supervised Payment Interface Providers (PIP) operating on a market basis are in contact with the customers. In this concept, although the BoE seeks to establish an appropriate level of transaction anonymity, it does not consider its task to provide completely anonymous payment option. In their view, the use of the distributed ledger system (DLT) is not necessary either, and the same result can be achieved with a conventional, centralised technology within a secure, tried and tested framework. They give consideration to the application

he group consisted of the Bank of Canada, the European Central Bank, the T Bank of Japan, the Swedish Riksbank, the Swiss National Bank, the Bank of England, the Federal Reserve System and BIS, which published the report.

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of DLT only in the interest of the flexibility and programmability of CBDC. The digital euro of the European Central Bank would contribute to the standardisation of payment systems in euro area countries and reduce the dominance of foreign payment systems (ECB, 2020a). According to a study published by the ECB, the main objective of the digital euro would be an even stronger integration of European economies. One of the principles associated with the design of the digital euro is that it would be fully convertible into other forms of the euro. This means full convertibility with cash and commercial bank money. Second, the digital euro would be risk-free euro area money as a liability of the central bank. Third, it would have to be widely and equally accessible throughout the euro area. Fourth, it must be market-neutral, i.e. it must not crowd out market-based solutions in the private sector. Finally, it must be a robust payment system that operates reliably and strengthens social confidence in digital payment options. A decision is expected to be taken in mid-2021 on whether to launch a project to explore the possibilities for introducing the digital euro. 3.2. Relevant international projects already being in test phase In addition to theoretical research, several central banks around the world are also conducting practical tests. In terms of central bank pilots, several approaches can be observed in Europe: in France, opportunities for the development of interbank settlements are being examined as part of the CBDC project; in Lithuania, the possibilities of DLT are being tested through the issuance of commemorative coins; and in Sweden, a digital cash substitute was tested in a restricted fashion. The launch of pilot programmes is also receiving increasing focus on the American continent (Ecuador, Uruguay, Bahamas) and Asia (China, Japan). In Sweden, the fact that the amount of cash in circulation accounted for only 1 per cent of the country’s GDP in 2018 — 335 —

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is a significant motivator in the context of CBDC research. This indicator averaged at 11 per cent in European countries, 8 per cent in the USA, and 4 per cent in the United Kingdom (Fulton, 2020). In parallel with the increasing uptake of electronic payment solutions, the central bank seeks to provide a digital but generally accessible central payment system for the elderly, the disadvantaged, or those excluded from traditional digital solutions. Based on distributed ledger technology, the testing of e-Krone was launched in February 2020 and was completed in February 2021. According to Riksbank, the Swedish central bank, this step can also reduce the threat posed by competitive, private alternative forms of money and can be a digital alternative to cash (Riksbank, 2020). Research has shown that the e-Krone can be implemented both as a value-based payment instrument similar to electronic money and as an account-based payment instrument similar in character to a commercial bank deposit. Although with respect to both concepts the practical insights are to be gained from a pilot, the former version is clearly feasible legally (the central bank has the appropriate powers for its issuance), whereas in the case of the latter, the possibilities of the central bank under law are not clear, which may call for legislative changes. For this reason, consultations have already started with the Swedish Parliament (Riksbank, 2018). Globally, one of the most advanced projects is China’s e-Yuan project. That said, the People’s Bank of China (PBoC) has not yet adopted an official position on the schedule foreseen for nationwide introduction. In a test launched in 2020, DC/EP99 was used in more than 3 million transactions worth a total of RMB 1.1 billion (approximately HUF 49.5 billion) in large cities such as Shenzhen and Xiong’an (Bray–Tudor-Ackroyd, 2020). During the test, the digital money balance can be topped up regularly and purchases and transfers can be made with digital money. Some government officials already received reimbursements for their 99

Digital Currency Electronic Payment

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trips in the form of digital renminbi, while McDonald’s fast-food restaurants in Xiong’an are already known as locations accepting e-Yuan. Similarly to mobile payment, the scheme uses digital wallets that can be downloaded to phones, and users can register in the account-based system by verifying their identities. Digital money is valued at 1:1 against physical renminbi, and during the test period PBoC transfers the central bank digital currency to real economic operators in a two-tier system through dedicated partners. To be tested in a self-limited arrangement, central bank digital currency is an alternative to cash in all possible dimensions: in terms of anonymity, a concept called controllable anonymity is applied, which means that the use of digital wallets during the test period is linked to different identification levels, and certain customer identification steps will enable users to increase the amount of the budget that can be kept in their wallets, along with transaction volumes (Bloomberg, 2020). The most advanced stage of CBDC has been reached by Sand Dollar in the Bahamas, which has already been formally launched. In contrast to other countries, the motivation for launching the project was not the declining use of cash, but rather the promotion of financial inclusion. The Bahamas is a country of 690 islands, from which several large international banks withdrew after the global economic crisis, and the remaining banks have not been able to implement digital developments quickly and effectively enough. The national bank seeks to provide all residents with access to online payments and basic financial services. Mobile phone usage is high, around 90 per cent, enabling identities to be verified quickly on service platforms that comply with KYC and AML requirements (Haig, 2020). For the time being, six financial institutions have been licensed to operate digital wallets, but the central bank has plans to expand the distribution network over time. There are three types of wallets, in which different user limits are available, with the corresponding different KYC controls. The aim of the differentiated solution is to prevent a reduction of the banks’ intermediary role. The Sand — 337 —

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Dollar is a direct claim on the Central Bank of The Bahamas and its value, like that of the Bahamian dollar, is pegged to the US dollar. Currently, Sand Dollars can only be used within country borders, but the central bank also has plans to develop a crossborder payment system that would allow conversion into other digital currencies. According to a statement from the central bank, Sand Dollar’s gradual national issuance was launched on 20 October 2020, making it the first CBDC in circulation in the world (Larsen, 2020).

4. Technology and design aspects of CBDC aimed at financial inclusion of the retail segment 4.1. Fundamental goals, accessibility criteria and monetary policy-related features The main objective of a CBDC with a retail focus can be to improve access to basic financial services. The provision of better access to bank accounts and payment services may justify central bank participation, and may also be a key motivator for the development of CBDC. Furthermore, from a central bank perspective, the general improvement of financial awareness may play an increasingly prominent role. The introduction of CBDC and targeted awareness-raising via a dedicated central bank channel may be justified in the context of this stronger participation. The introduction of a retail CBDC could help create a central bank electronic cash substitute payment system. Another key motivating factor for improving access to financial services is the digitalisation of cash functions and the creation of a new digital cash substitute payment system. In addition, CBDC-based retail account servicing and the related framework, whether in

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a direct or indirect model, can also be an effective channel for the direct delivery of government transfers to residents. CBDC can be universal in terms of access, accessible to all, or specifically targeted at certain groups of consumers (for example, those in lower income categories, pensioners and young people), while the possibility of broadening its scope gradually is provided. Monetary policy implications may be more pronounced if deposit-taking or lending functions are also assigned to retail CBDC. While the impact on monetary policy in the case of account servicing is moderate and mostly addresses frictions in access issues, in the case of retail account keeping combined with other functions that have to date been available at commercial banks, such as deposit taking or lending, this can also have a significant impact on monetary transmission. With these functions, retail CBDC can both increase the central bank’s room for manoeuvre in monetary policy and have a positive impact on the intensification of market competition. Notwithstanding that, with the long-term persistence of cash holdings, the viability of these effects can only be considered clear on tightening paths. The potential monetary policy and financial stability impacts of retail CBDC should also be addressed as a priority. The disintermediation effect of active central bank participation may lead to the exclusion of certain actors from the retail banking and savings markets. The banking system may see its profitability and liquidity levels undermined as a result, which also increases stability risks due to a shift towards a less prudent business policy. Furthermore, a number of risks may be transferred to the central bank that commercial banks are likely to have more advanced mechanisms and expertise to deal with effectively. Taking these aspects into account during the design process is of key importance, and matters concerning stability must be factored in with regard to both objectives and to specific design aspects.

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4.2. Possible restrictions related to the use and convertibility of CBDC Ensuring interoperability between different forms of money is essential for use in the retail segment. In retail payment transactions, convertibility between individual forms of money (commercial bank money, e-money, cash, etc.) is an important design aspect due to heterogeneous user needs. Since the role of cash remains decisive in many payment situations, it is of paramount importance for the substitutability of cash functions to ensure that users are able to perform conversions between CBDC and cash. However, this aspect also entails important tasks for central banks (such as the deployment of an ATM network), but the specific development needs are issues to be examined only after the operating model (direct, indirect, hybrid) has been determined. The involvement of commercial banks for creating interoperability with commercial bank money may also arise as an option. Offline operations and the possibility to handle international currencies may also be relevant in order to adapt for retail needs and for alignment with the fundamental goal. For CBDC to be an effective cash substitute and an alternative that is resilient to a variety of operational disruptions, it must also be available to users offline. Uninterrupted internet access is not necessarily available to all consumers or in all walks of life, which is why CBDC must be designed to be accessible in any situation with the right tools at hand. In addition, in the case of retail CBDC, for the longer term central banks should also consider tasks related to handling foreign currencies (for example, accounting for the transaction of products with prices determined in foreign currencies, or receiving and converting foreign currencies). The incorporation of a certain level of qualitative and quantitative restrictions may be justified when introducing retail CBDC. Quantitative restrictions may be justified as regards the reliability of offline operations, the identification — 340 —

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of potential risks and the mitigation of the impact on monetary policy and on the stability of the financial intermediary system. In addition, a properly targeted retail CBDC focusing on a narrower social group can effectively support the fundamental goals set for the introduction and be better justified in terms of addressing the identified frictions. A focused business model targeting a narrower range of users may also be useful in the light of the fact that a highly heterogeneous consumer base, such as the entire population of a country, may have different needs and capabilities, allowing for the creation of a business model best suited to the groups through targeted and restricted implementation. In this case, retail CBDC can be sufficiently flexible and go beyond the current functionality of cash, while allowing for the implementation of a variety of aspects on access holders of different characteristics, and ensuring an adequate level of interoperability. 4.3. Options for the establishment of the operational framework and the involvement of market participants, functions related to CBDC issuance and distribution While CBDC issuance is a task of the central bank, several operating models may arise in connection with allocation and the operation of the payment system. In the case of retail use, alignment is needed with a number of specific needs, and in the case of retail financial services, the need for convenient, fast and personalised services is becoming increasingly dominant. On account of the development options for retail payments and of the development trends in the provision of digital services, it is recommended to develop platform-based business models that allow the involvement of multiple market participants (Figure 2). The retail customer base of market participants is significant, while central banks are likely to encounter capacity problems in the short term as far as full direct access is concerned; however, direct access cannot be excluded for specific narrowed consumer groups. — 341 —

X. Strengthening the financial inclusion of the retail segment

Cooperation between market participants and the central bank supports the identification of standardised development directions. In terms of retail payments, the application of uniform standards is of paramount importance in order to ensure the highest possible quality of customer experience and to minimise market fragmentation. Setting system-level development directions will support the integration of future innovations as well as efforts to increase efficiency in general. Figure 2: Possible residential CBDC implementation models

Central Bank retail account management

Central bank nostro account

1.5: Hybrid access (via PSP)

Central bank application

PSP application

2.0: Indirect access

1.0: Direct access

100% collateral

Banking application

Source: Authors’ compilation.

4.4. Issue of anonymity and the management of money laundering and terrorist financing risks In the retail segment, it is recommended that a customer identification and due diligence system is in place that is — 342 —

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differentiated according to several criteria. In the case of regular or low-value ad hoc transactions, speed and instant settlement are essential for consumers, which in such situations calls for the development of features similar to cash also from a due diligence perspective. At the same time, in cases of emphasis in terms of national economy and tax planning (in the case of major transactions or above a certain monthly limit), and in order to comply with anti-money laundering and counter-terrorist financing rules, it is also necessary to implement traceability and to control and approve the movement of transactions. Separate identification procedures based on transaction size, regularity and customer type (e.g. adult or student, consumer or merchant) should therefore also be considered. Specific identification steps and the degree of anonymity are also partially determined by functionality. For credit functions, full customer due diligence and identification is required, which may have an impact on the business model around implementation (determining which actor should perform these tasks, whether a significant capacity upgrade is required for the central bank). In the case of the provision of account keeping, the differentiated, gradual principle outlined above can be effective, where the interests of both consumers and the national economy can be upheld. 4.5. The technology applied, expectations for the operational framework, options for the use of distributed ledger technology In the context of the technological development required, the relevant decision-making criteria are the possibility to exploit innovation opportunities and interoperability with existing systems. Speed, transparency, and ease of access and usage are of paramount importance on account of the retail target group. In this respect, the CBDC framework should be based on a technology that supports the servicing of modern user needs on the one hand,

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and on a sufficiently flexible and innovative approach on the other, so that further innovation opportunities can be exploited in the future. At the same time, in the case of retail focus particular attention should be paid to various interoperability issues (cash conversion, commercial bank money conversion, interoperability with certain payment and e-money systems). Taking these issues into account may require the deployment of a new system, either on traditional or innovative basis (e.g. distributed ledger, DLT). The intended user base and its characteristics are decisive for the choice of technology. In the context of widespread retail use, the significant heterogeneity of the potential user base should be taken into account along a variety of characteristics. Furthermore, in terms of the social perception of a payment system and the achievement of the fundamental goal foreseen, it is particularly important that a high level of trust towards the system and the currency develops on the consumer side. Social perception and the expected substantial increase in complaint handling resulting from innovation are likely to support the development of a “new traditional” system. This line of direction is also supported by the fact that the existing systems of central banks were designed for a considerably smaller number of customers, so that their expansion may prove to be limited, or would significantly increase the complexity of the system. At the same time, innovative technological foundations should be considered in the selection process by narrowing the user base and designating special target groups. Through the involvement of more restricted groups, the potential benefits of innovative technologies could be tested effectively, and, in the case of certain innovations, advanced technology could be of paramount importance in view of the fact that retail payments are an important innovation area for market participants worldwide.

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Testing DLT-based technology in a narrower target group can improve the acceptance of technology and help to understand its possibilities. In addition, in the case of groups open to innovation, more additive functions resulting from the novelty of the technology could be tested. After a successful test phase, social perception can be improved step by step, and consideration should be given to implementation on a wider scale. This continuous introduction may also be supported by global processes: if DLTbased technologies and related business models enter a more mature phase, their acceptance improves, and their specific areas of use become more accurately definable, then, incorporating these in addition to the experience of the central bank concerned, implementation may become possible on a wider scale. 4.6. Additional opportunities for innovation – options for artificial intelligence and smart contracts for CBDC with a retail focus Innovation opportunities can be decisive in the retail segment, which should be taken into account for CBDC design. In addition to fast and convenient usage, the possibility of personalised services is a priority aspect in relation to retail solutions. As part of a CBDC project, a new approach to the provision of services can be developed in the financial system, which may justify active central bank participation. One reason to consider the use of DLT-based technology for the longer term is that the feasibility of the platform-based operations projected in connection with the future of financial services should also be tested in this system. Technology solutions built around DLTbased, distributed systems can significantly shorten the protracted processes arising from the different data and information usage needs of market participants, while value and supply chains can also be shortened and reconstructed. These innovative approaches

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typically operate on an ecosystem basis, and once an item of data is included in the system, it can be used uniformly and quickly by other actors (BIS, 2017). This is a remarkable and forwardlooking aspect also in terms of financial services (for example, in the case of real estate sales, reading the title deed or notarial deed directly, etc.). Thus, while a new centralised system based on traditional foundations and a DLT-based but partially centralised technology (e.g. CLT) can deliver similarly high performance and rapid execution at transaction level, maximising the exploitation of the potential for innovation may also warrant steps in the latter direction. Innovative technologies also offer a number of other possibilities to renew service provision (e.g. micro transactions in the case of media consumption, automated transactions, automated decisions that can be implemented through smart contracts), which proves to be particularly relevant in the retail segment.

5. Options in Hungary for central bank account keeping and credit facilities targeting the retail segment In Hungary, access to financial services should be developed in certain consumer groups, while it is also necessary to encourage the conscious and active usage of these services among users in general, with special attention to the opportunities available digitally. According to data based on international research, the proportion of people with bank accounts in Hungary is fair by global standards, although it ranks in the lower third in the EU (World Bank Group, 2017). At the same time, despite a good international ranking at the overall economy level, several types of consumer groups can be identified in Hungary whose account and card coverage is significantly below the average (e.g. lowincome, young people, retirement age) (MNB, 2019), in which

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case improving access is justified. In addition, the utilisation and use of (digital) financial services should be generally improved along with the development of financial awareness, so that users can choose the appropriate service packages, possibly in digital form, by exploring their possibilities, knowing their regularly incurring costs and their financial situation, having the necessary basic financial knowledge, and applying it in practice (OECD, 2020). In this respect, the pricing practice of payment services is also not ideal for several customer groups and incentives for digital use tend not to be universally present (MNB, 2020b), which is also reflected in high transactional cash use. In Hungary, a solution based on account keeping and payment services may be a relevant direction of development within the framework of a CBDC project, aiming to improve access to financial services and fostering the development of conscious financial thinking. Focusing on a number of clearly identifiable target groups and product types, a specific retail CBDC could be introduced in a targeted manner. Several target groups can be identified in Hungary (e.g. secondary school students, university students), whose access problems could be solved by active central bank participation and the digitalisation of many cash functions. Introducing younger age groups to financial services can fundamentally support financial awareness efforts, and novel and innovative approaches and design aspects can also be effectively tested on such groups. The design of a lending based CBDC solution could also be envisaged in principle. By European standards, the level of retail indebtedness as a percentage of GDP is seen as particularly low (Figure 3). Furthermore, given the pro-cyclical functioning of the financial intermediary system and the low supply of credit to certain social groups according to traditional lending criteria, direct retail lending by the central bank may also arise as an option in the event of a clear market failure. In addition, it may be useful to develop the scheme also in concert with a national

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economy objective (for example, family policy or the promotion of sustainable, modern developments) in order to ensure that the social objectives of CBDC are well defined and forward-looking and that the need for legislative changes related to this form of implementation can be initiated on sufficiently concrete grounds. Figure 3: Stock of household loans as share of GDP in European countries (2020 Q2) 0-25% 25-50% 50-75% 75-100% 100%+

79%

68% 110% 92%

39% 21%

110%

36%

88%

103% 65% 69% 66%

24%

35%

56% 33%

129% 44%

52% 27%

121%

46% 20% 16%

36%

24% 66%

61%

56% 52%

Source: ECB, BIS, central bank websites

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92%

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In the case of a potential retail CBDC in Hungary, several factors may justify the implementation along with the indirect or hybrid operating model. In general, in alignment with the heterogeneous needs of retail participants, the development of a multi-stakeholder model may prove forward-looking. In order to exploit innovative capabilities and reduce capacity constraints, it is worth involving domestic market participants in the operation of the payment system. In this respect, the Hungarian market has significant comparative advantages, on the one hand through the joint ownership and experience surrounding the establishment of the Instant Payment System, while on the other hand, developed and well-functioning advocacy bodies operate in Hungary, which not only support the cooperation and joint initiatives of incumbents (Hungarian Banking Association, Association of Hungarian Insurance Companies), but also of innovative enterprises (Hungarian FinTech Association, IT Association of Hungary). 5.1. Potential effects on the financial intermediary system The implementation of a CBDC with a domestic retail focus can significantly affect the operations of the financial intermediary system. The launch of CBDC affects both consumers and all actors of the financial intermediary system. It is important to take into account the impact on the central bank’s core mandate, i.e. ensuring price stability and financial stability, the additional functions involved, the new types of risk, and their impact on the current functioning of the market. When designing CBDC, it is necessary to carefully identify which market friction the central bank seeks to respond to, and to devise a solution so as not to compromise the functioning and stability of the financial system in areas where its institutions operate properly. This approach may also be supported by carefully targeted introduction, the active involvement of market participants and the incorporation of restrictions appropriate to the desired functionality.

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6. The first Hungarian central bank digital currency pilot project: The Digital Student Safe 6.1. Supporting financial inclusion and education as relevant public policy objectives for a specific target group The Digital Student Safe can serve as an experimental field for the introduction of CBDC. On the one hand, it provides an opportunity for restricted and controlled testing, but in realistic circumstances. On the other hand, it facilitates the gamified inclusion of young people mainly between the ages of 8 and 14 who are not included in the formal financial system (Figure 4). The application seeks to achieve several relevant public policy objectives already in the pilot phase, while as a restricted retail account keeping system it can also be considered as the first domestic manifestation of the CBDC framework. These include (i) the development of a novel digital savings product for young people, which is of particular importance: certain forms of financial behaviour, financial planning and regular savings activity, budgetary plan creation can already be established in childhood. It also (ii) facilitates the development of digital competences and skills that participating students can exploit in many places in everyday life during the accelerated digitalisation caused by the pandemic. Finally (iii) the establishment of an ecosystem that is viable in the long term, and preparing the younger generation for financial independence are also among the primary objectives.

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Figure 4: Development of banking relationships and financial behaviour by age group MNB Digital Student Safe

First bank card payment

Occasional contact with money

First savings account („baby bonds”)

Children under 8 years

Savings, first payment faced on their own Regular allowance, First smart phone

Pre-teens (8-14 old)

First salary

First mobile banking app

Regular cashflow (rent etc)

Personal loan First apartment purchase, mortgage

First bank card and payment account

Teenagers (14-18 old)

Dependent on the family

Investment account and small investments

Bigger investments

Young adults (19-24 old)

Adulthood (24 old and above)

Shared responsibility

Financial independence

Source: Authors’ compilation.

6.2. Importance of pilot projects in preparing for CBDC introduction The MNB Digital Student Safe provides a gamified opportunity to transact in virtual assets (medals) using mobile phones. The complexity of a CBDC project requires low-coverage and continuous testing prior to the wider introduction of such a system, and also that as many potential obstacles should be identified as possible. It is also necessary to explore potential consumers’ attitudes towards the technology in the production — 351 —

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phase, and to examine whether it will be possible to incorporate into consumers’ daily lives sufficiently. The service provider manages virtual accounts for participating children, who can set savings targets, earn and collect digital medals denominated in Student Taler (e.g. by successfully answering quizzes). Students can transact and exchange their medals with each other, and finally redeem for real gifts in the dedicated webshop (Figure 5). Figure 5: Demonstration of the CBDC characteristic of the Digital Student Safe

Ordering the service, providing statistical data

Central bank

Money creation

Data flow (balance of coins) Transaction service provider

Money Compass Foundation

Financing

Webshop

e-Wallet service Students

Gifts (physical)

Source: Authors’ compilation.

The medals available in the Digital Student Safe can also be interpreted as central bank digital currency available on a limited scale. In addition to supporting financial education, the programme is suitable for testing the concept of central bank digital currency in pilot form, since (i) in economic terms, through the support provided to the Money Compass Foundation, the MNB is the ultimate financier of the medals that can be awarded to students, and (ii) it is able to fully control the supply of

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Student Taler, and, furthermore, (iii) the central bank finances the operation of the user interface. At the same time, it is important that further planning will be based on real experiences rather than on assumptions. The current solution is closer to the so-called account-based solutions: accounts are managed in a central system and the other party participating in the transaction is identified through parental registration. At the current stage, the project operates in limited manner, involving mostly schools participating in the pilot programme. Later on, the mobile application can be extended and upgraded as required. The modular structure of the application enables the enhancement of functionality and upgrades in several ways, thus the achievement of the public policy objectives can be improved by incorporating new functions if needed. The lessons learned from the first period of implementation and user feedback both support the MNB’s subsequent decisions concerning developments and the extension of the application.

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X. Strengthening the financial inclusion of the retail segment Bloomberg (2020): How China Is Closing In On Its Own Digital Currency QuickTake. Bloomberg Quint, https://www.bloombergquint.com/quicktakes/how-china-isclosing-in-on-its-own-digital-currency-quicktake BoE (2020): Discussion Paper – Central Bank Digital Currency, Opportunities, challenges and design. Bank of England, https://www.bankofengland.co.uk/-/media/ boe/files/paper/2020/central-bank-digital-currency-opportunities-challenges-anddesign.pdf Botta, A.–Bruno, P.–Chaudhuri, R.–Nadeau, M. (2020): The 2020 McKinsey Global Payments Report. McKinsey, https://www.mckinsey.com/~/media/McKinsey/ Industries/Financial%20Services/Our%20Insights/Accelerating%20winds%20of%20 change%20in%20global%20payments/2020-McKinsey-Global-Payments-Report-vF. pdf Bray, C.–Tudor-Ackroyd, A. (2020): People’s Bank of China’s digital currency already used for pilot transactions worth 1.1 billion yuan. SCMP, https://www.scmp.com/ business/banking-finance/article/3104281/peoples-bank-chinas-digital-currencyalready-used-pilot Brugge, J.–Denecker, O.–Jawaid, H.–Kovacs, A.–Shami, I. (2018): Attacking the cost of cash. McKinsey, https://www.mckinsey.com/industries/financial-services/ourinsights/attacking-the-cost-of-cash Citi (2020): Citi GPS: Global Perspectives & Solutions. https://ir.citi.com/pN%2BOlBahjzmphVliXxcaHdn%2BlkONN7NB7l3YKzlQvpsbYl%2Bril0LJyscLIG8hM%2FoOLl0CKhz8l0%3D Chamber of Digital Commerce (2016): Smart Contracts: 12 Use Cases for Business & Beyond. http://digitalchamber.org/assets/smart-contracts-12-use-cases-for-businessand-beyond.pdf ECB (2020): Report on a digital euro. https://www.ecb.europa.eu/pub/pdf/other/ Report_on_a_digital_euro~4d7268b458.en.pdf ECB (2020): Tiered CBDC and the financial system. European Central Bank, https:// www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2351~c8c18bbd60.en.pdf FDIC (2017): National Survey of Unbanked and Underbanked Households. Federal Deposit Insurance Corporation https://www.fdic.gov/ householdsurvey/2017/2017report.pdf Fulton, C. (2020): Sweden starts testing world’s first central bank digital currency. Reuters, https://www.reuters.com/article/us-cenbank-digital-swedenidUSKBN20E26G Global Findex (2017): Spotlight: Access to mobile phones and the Internet around the world. https://globalfindex.worldbank.org/sites/globalfindex/files/chapters/2017%20 Findex%20full%20report_spotlight.pdf Global Findex (2017): Chapter 2: The Unbanked. https://globalfindex.worldbank. org/sites/globalfindex/files/chapters/2017%20Findex%20full%20report_chapter2.pdf Haig, S. (2020): The Bahamas will launch a digital central bank ‘Sand Dollar’ in October, Cointelegraph, https://cointelegraph.com/news/the-bahamas-will-launchits-central-bank-sand-dollars-in-october

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X. Strengthening the financial inclusion of the retail segment Hanegraaf, R.–Jonker, N.–Mandley, S.–Miedema, J. (2018): Life cycle assessment of cash payments. De Nederlandsche Bank, https://www.dnb.nl/binaries/Working%20 paper%20No.%20610_tcm46-379441.pdf Herb Weisbaum (2013): Cash costs Americans $200 billion a year. CNBC, https:// www.cnbc.com/2013/10/10/cash-costs-americans-20-billion-a-year.html IFoA (2018): A Cashless Society- Benefits, Risks and Issues. https://www.actuaries.org. uk/system/files/field/document/Issue%2021-%20Environmental%20Sustainability%20 of%20a%20Cashless%20Society%20-%20disc.pdf Kajdi, László–Sin, Gábor–Varga, Lóránt (2019): A hazai lakossági pénzforgalmi szolgáltatások árazása nemzetközi összehasonlításban (Pricing of Hungarian retail payment services in an international comparison). Magyar Nemzeti Bank, https://www. mnb.hu/letoltes/mnb-penzforgalmi-arazas-nemzetkozi-osszehasonlitasban-002.pdf King, R. (2020): The world’s first retail CBDC tiptoes into existence, Central Banking, https://www.centralbanking.com/fintech/cbdc/7713961/the-worlds-first-retail-cbdctiptoes-into-existence Larsen, A. (2020): Bahamas confirm Launch Date for the world’s first Retail Central Bank Digital Currency. The Daily Chain, https://thedailychain.com/bahamas-confirmlaunch-date-for-the-worlds-first-retail-central-bank-digital-currency/ Government of Hungary (2019): A készpénzhasználat 400-450 milliárd forintba kerül évente az országnak. (Cash usage costs the country HUF 400 to 450 billion annually.) https://www.kormany.hu/hu/nemzetgazdasagi-miniszterium/penzugyekert-felelosallamtitkarsag/hirek/a-keszpenzhasznalat-400-450-milliard-forintba-kerul-evente-azorszagnak MNB (2019): Versenyképességi Program 330 pontban (Competitiveness Programme in 330 points). Magyar Nemzeti Bank, https://www.mnb.hu/letoltes/versenykepessegiprogram.pdf MNB (2020a): Értékeljük reálisan a hazai készpénzállományt! (Let’s evaluate domestic cash holdings realistically.) https://www.mnb.hu/sajtoszoba/sajtokozlemenyek/2020evi-sajtokozlemenyek/ertekeljuk-realisan-a-hazai-keszpenzallomanyt MNB (2020b): FinTech és Digitalizációs jelentés (FinTech and Digitalisation Report), https://www.mnb.hu/letoltes/fintech-es-digitalizacios-jelente-s-final.pdfN26 OECD (2017): Shining Light on the Shadow Economy: Opportunities and Threats. Organisation for Economic Co-operation and Development, https://www.oecd.org/ tax/crime/shining-light-on-the-shadow-economy-opportunities-and-threats.pdf OECD (2020): OECD/INFE International Survey of Adult Financial Literacy Competencies. Organisation for Economic Co-operation and Development, http:// www.oecd.org/daf/fin/financial-education/OECD-INFE-International-Survey-ofAdult-Financial-Literacy-Competencies.pdf OMFIF (2019): Retail CBDCs The next payments frontier. https://www.omfif.org/ wp-content/uploads/2019/11/Retail-CBDCs-The-next-payments-frontier.pdf Riksbank (2020): The Riksbank’s e-krona pilot. https://www.riksbank.se/globalassets/ media/rapporter/e-krona/2019/the-riksbanks-e-krona-pilot.pdf

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X. Strengthening the financial inclusion of the retail segment Sahay, R.–von Allmen, U.–Lahreche, A. (2020): The Promise of Fintech: Financial Inclusion in the Post COVID-19 Era. IMF, https://www.imf.org/en/Publications/ Departmental-Papers-Policy-Papers/Issues/2020/06/29/The-Promise-of-FintechFinancial-Inclusion-in-the-Post-COVID-19-Era-48623 Szabó, Gergely–Kollarik, András (2017): Mi is az a digitális jegybankpénz? (What is a central bank digital currency?) Magyar Nemzeti Bank, https://mnb.hu/letoltes/szabogergely-kollarik-andras-mi-is-az-a-digitalis-jegybankpenz-mnb-honlapra.pdf Végső, Tamás (2020): A magyarországi készpénzkereslet változásának összehasonlító elemzése (Comparative analysis of the changes in cash demand in Hungary). Financial and Economic Review, Vol. 19(1), pp. 90-118, https://www.mnb.hu/letoltes/hsz-191-t4-vegso-1.pdf Végső, Tamás–Bódi-Schubert, Anikó (2020): A koronavírus-járvány hatása a hazai fizetési szokásokra – 1. rész (Impact of the coronavirus epidemic on domestic payment habits – Part 1). Magyar Nemzeti Bank, https://www.mnb.hu/letoltes/a-koronavirusjarvany-hatasa-a-keszpenzallomany-valtozasara-2020-januar-augusztus-folyaman.pdf Vennli (2016): 8 Challenges for Retail Banking and What to Do Next, https://www. vennli.com/blog/8-challenges-for-retail-banking-and-what-to-do-next World Bank Group (2017): The Global Findex Database 2017. https://openknowledge. worldbank.org/bitstream/handle/10986/29510/9781464812590.pdf

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XI. Options to extend SME financing through central bank digital currency Laura Komlóssy – Blanka Kovács – Soma Sándor While a strong sector of small and medium-sized enterprises (SMEs) is the foundation for sustainable economic growth, these companies often face obstacles in accessing credit. In recent years, the Magyar Nemzeti Bank (MNB) has deployed several targeted instruments to support domestic SMEs’ financing with favourable conditions, and thus economic growth. This paper presents the prospective design and operational aspects of a possible form of SME-focused central bank digital currency. A low-cost and secure alternative lending channel in the form of central bank digital currency can help the SME sector, which is important for economic growth, to realise its development potential across financial cycles.

1. Relationship between the SME sector and the financial intermediary system 1.1. Smooth financing for the SME sector is fundamental economic interest As the SME sector is one of the fundamental pillars of an economy based on inclusive growth, SMEs’ access to an adequate form and volume of financing is important in all countries. The SME sector plays an important role in Hungary, both economically and socially. Currently, more than 750,000 SMEs operate in Hungary, which account for more than 99% of

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all domestic enterprises. According to data from the Hungarian Central Statistical Office (HCSO), the gross value added by the sector increased steadily from HUF 6,800 billion in 2013 to HUF 11,100 billion in 2018. In 2018, the SME sector’s share of the gross value added by the entire business community was 45.7%. SMEs are the largest employers, employing nearly two-thirds of the workforce (HCSO, 2018). The number of SMEs in Hungary is the highest in the services, agriculture and construction industries (HCSO, 2019), the last two also being the most capital-intensive. Maintaining the supply of funds to these businesses is therefore a priority not only from the perspective of their own growth and operation, but also that of the whole economy. If these firms do not access an adequate amount of funds in the appropriate structure, this may entail a drop in investments, rising unemployment and less innovation. SMEs have limited financing opportunities; typically they can only raise funds through banks, whereas equity-type financing, even though showing an increasing trend, is not significant. Unlike large companies, which can borrow directly from abroad or issue bonds in addition to having access to domestic bank loans, the financing of domestic SMEs is bound to be linked to domestic credit institutions. In terms of their financing opportunities, SMEs are also generally more likely to experience difficulties in effectively obtaining funds. 1.2. Market frictions and dysfunctions in financial services to SMEs, particularly in SME lending In many cases, credit markets create barriers for companies seeking access to funds. In classical economic models, pricing plays the most important role in the relationship between lenders and prospective borrowers. In the credit market, realtime and reliable information about the financial position of companies is difficult to obtain, which creates a high degree of — 358 —

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information asymmetry in this market. Lenders are prompted to be more cautious about financing, in particular smaller and undercapitalised companies that have possibly been established only recently and are exposed to specific sectoral impacts—that is, SMEs. Additionally, at the turn of each economic or credit cycle, lenders’ appetite to take risks will change due to their more pessimistic assessment of the economic outlook ahead. In response, not only do they raise their interest rates, but also reduce the amount of credit granted, demand additional collateral, or refuse to lend completely. As a result, the average risk rating of companies deteriorates, and banks only find it worthwhile to finance more risky investments. Above a certain interest rate, they would lose more on a loan than they would receive in surplus interest, which leads them to suspend or reduce their lending in what is referred to in literature as “credit rationing”. Three types of credit rationing The three distinct types of credit rationing are redlining, intensive margin and extensive margin. Redlining occurs when a particular group of companies, defined by certain characteristics, are denied access to credit. This phenomenon is typical to the SME sector, mainly because of the size of such enterprises. Some of the problems associated with SME growth stem from the fact that the relative transaction cost of financing is high because of economies of scale. Zott and Amit (2007) find that large companies have more resources to implement new products and projects, which, if successful, will become more profitable by accessing larger markets. Ceteris paribus SMEs are less likely to succeed on average than large companies, and even if they do, their average return is lower than that of their large and medium-sized counterparts. As a result, banks may expect higher profits on loans to large and medium-sized enterprises than on loans to SMEs. The second type of credit rationing is referred to as intensive margin, where credit institutions lend less than — 359 —

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the companies require. An important part of a commercial bank’s business policy is to carry out a preliminary risk assessment, determine the exposures that are acceptable on the basis of those risks, and to make a specific decision based on those risks. Accordingly, in a number of cases, available loan amounts are maximised in relation to a potential debtor in alignment with the given risk profile. The typically high risk ratings for SMEs, especially start-ups and scale-ups, are accompanied by high capital needs, which a bank’s business policy is not always ready to satisfy in full. The third and extreme type of credit rationing is extensive margin, where the loan requested is completely rejected. Another financing barrier is that some SMEs find it difficult or are completely unable to provide the collateral or other guarantees required by banks to prove creditworthiness. Difficulties may also often arise where, as part of the credit approval process, banks require at least 2 to 3 closed business years in order to reduce the risks they undertake, while they also limit the amount of credit available depending on the revenue that applicants generated in previous years. In addition, banks have less room for flexibility in terms of deviating from the assessment of the indicators integrated into their usual approval and monitoring processes, and the means to evaluate alternative criteria are also yet to be provided. All these factors point to lower expected profits for banks, which, in turn, will be more likely to refuse to lend (Jin and Zhang, 2019). Higher risks may affect the time required to approve a loan, resulting in long approval times. As a result of the limited information base, the credit approval process is longer as banks need to assess the competitiveness of the industry in which the SME operates, the profitability of the SME’s operations, and the maturity stage of the SME.

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Compared to other sectors, SMEs are more exposed to the procyclical behaviour of the financial system. During a cyclical upturn, stronger lending activity supports growth, but carries significant risks to the stability of the financial system. The improved growth outlook will further strengthen lending activity, driving the banking system to relax its terms of borrowing and increasingly lend to the SME sector as well, which is expected to derive a greater benefit from the overall upturn despite the risks, thereby also improving the profitability of banks. However, beyond a certain point, amid the general euphoria banks will become unrealistically optimistic in their risk assessment and see an increase in the number of their new loans carrying excessive risk, which will indeed soon fail due to their unsustainability. In Hungary, one example of such an overshoot in lending was the general uptake of foreign currency lending, and a similarly unhealthy expansion had also occurred in project financing before the crisis of 2008. Conversely, in a recession the banking system will seek to lend as cautiously as possible and provide less credit than optimal, only to contribute to the prolongation of the recession. Indeed, in many cases even truly creditworthy companies will be denied access to funds, which will in turn deepen the problem of the real economy and drive banks into stronger risk aversion. In times of recession, banks themselves may also incur significant losses, and with information asymmetry becoming more prominent in their risk analysis processes, they will reduce their lending to segments they consider more risky, leaving the SME sector even harder hit by cuts in bank lending (Balog et al., 2014). The 2008 financial crisis was an extreme form of credit rationing, when credit supply dropped drastically. In the years of the financial crisis, Hungary saw a prolonged decline in both retail and corporate lending. In the corporate segment, however, in addition to demand factors, supply also became a bottleneck, due in part to the banking sector’s ability to adapt quicker in corporate loans, where average maturity is shorter. Although parent banks — 361 —

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carried out capital increases, they did so mainly to cover their losses. As Hungarian banks found it more difficult to increase their capital, they cut back on their lending. From 2009 to 2013, the Hungarian financial system experienced a sustained credit crunch (Balog et al., 2014).

2. International examples for addressing identified market frictions 2.1. Lending incentive programmes introduced after the 2008 crisis, and the lessons learned Following the onset of the financial crisis, a number of central banks eased their monetary conditions. When the interest rates hit the zero-lower bound, several central banks announced asset purchase programmes (e.g. government securities purchases), and, in addition to these, some also introduced negative policy rates, which had previously been deemed impracticable. Moreover, a wide range of central banks used liquidity-providing instruments to stabilise financial markets and reduce uncertainty about liquidity processes. In addition to interest rate cuts and asset purchase programmes, several central banks sought to address the friction in lending in a targeted manner: as a result of the banking system’s balance sheet deleveraging process, bank lending had dropped significantly, prompting the ECB, the Bank of England, the Hungarian central bank and others to introduce various instruments to support lending in order to stimulate the lending activity, and in particular to ensure the supply of funds to the SME sector. Nevertheless, these instruments always sought to achieve their intended financing effect by involving the banking sector, providing specific, dedicated funds, and continuing to build on banks’ risk-taking. Therefore, in any case, the success of the programmes also required banks’ participation and activity.

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In December 2011, the European Central Bank decided to introduce a refinancing facility with a maturity of more than one year (Longer-Term Refinancing Operation, LTRO) to support bank lending and provide the necessary liquidity. The loans were granted by the ECB with a maturity of three years, with the interest rate set at the average of the key interest rate (MRO100) over the period concerned. In June 2014, the ECB announced the launch of a Targeted Longer-Term Refinancing Operation (TLTRO I), available in proportion to the volume of lending to non-financial corporates and households. Under the 4-year instrument, banks were eligible for a loan amount corresponding to 7% of their respective credit stock. Each bank was required to make a commitment with regard to the development of its total loan portfolio and repay the loans before maturity if it failed on its commitment. In June 2016, the central bank launched a new Targeted Longer-Term Operation (TLTRO II). Unlike the TLTRO I, at this stage the ECB tried to encourage credit institutions to lend to the real economy at a lower interest rate; depending on the volume of lending, the cost of funds could fall to the level of the central bank’s overnight deposit rate. Under the TLTRO II, each credit institution could draw funds up to 30% of its loans outstanding to the private sector. According to the ECB’s analyses, TLTRO tenders contributed to the easing of lending conditions, and significantly reduced the marginal cost of funding for banks participating in the operations. In 2012, the Bank of England introduced a scheme which, in addition to base rate cuts and high volume of asset purchases, sought to increase corporate lending, with greater focus on SME lending over time, in more a targeted way. Launched in July 2012, the Funding for Lending Scheme (FLS) was novel in the sense that it tied the quantity and price of available funds to lending performance. The scheme was extended in April 2013, once an increase had been achieved in the portfolio of loans to SMEs, with 100

Main Refinancing Operations (MRO) rate

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central bank funds available at a higher (ten times) multiplier. The scheme, launched in mid-2012 contributed to a sharp drop in banks’ cost of funds, which in turn led to a reduction in lending costs and better access to credit for both corporations and households. To address the situation that emerged in the aftermath of the Brexit decision, in August 2016 the Bank of England introduced a new programme called Term Funding Scheme (TFS) in order to foster the interest rate cut of August 2016 to spill over to corporate and household loans. The scheme enabled credit institutions to draw funds from the central bank at rates close to the base rate, over a period of 4 years. In both schemes, the amount of available funds was effectively set at 5% of the amount of the initial loan portfolio plus the amount of portfolio increment achieved over the reference period. In the central bank’s assessment, the TFS successfully contributed to a decrease in corporate and household interest rates, without causing any major reduction either in creditors’ net interest rate margin or in the credit supply to the economy. In addition to significant base rate cuts, in recent years the Magyar Nemzeti Bank (MNB) has also supported domestic SMEs’ favourable access to finance, and thus economic growth, with a number of targeted instruments. Under the Funding for Growth Scheme (FGS) launched in 2013, the MNB provided refinancing loans to credit institutions at an interest rate of 0%, which they used for lending to domestic SMEs for specific purposes at a maximum interest rate of 2.5%. The phases of FGS had different characteristics, and in the later phases of the programme the focus increasingly shifted to investment loans due to the opportunities of gradual restrictions on loan purposes and longer availability periods. In the phases already completed in the seven years since the start of the scheme, approximately HUF 3,400 billion worth of funds have been allocated under favourable terms to nearly 50,000 enterprises. Given its important role in turning SME lending into a rising trend following the crisis, FGS had a major impact on both economic growth and employment. — 364 —

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The MNB estimates the impact of the scheme on economic growth to have been around 4.5% in 2013–2020. In another targeted MNB instrument, the Market-Based Lending Scheme (MLS), the central bank provided banks with favourably-priced assets to support risk and liquidity management in order to stimulate lending, available on the condition that recipient banks would increase the volume of their SME loan portfolios. 2.2. Central bank responses to the coronavirus crisis to stimulate lending Several central banks have announced extraordinary measures in the recent year to counteract the adverse economic effects of the coronavirus outbreak. In addition to interest rate cuts, asset purchases and liquidity-providing measures, some central banks also introduced other comprehensive economic recovery measures to complement monetary easing. While targeted instruments were not widely used after the previous crisis, this time a wide range of central banks have opted to introduce measures focused on addressing market friction in specific areas of the economy. To maintain the lending activity in the banking system, a number of central banks have recently introduced lending incentive schemes, in several cases including additional incentives by design to improve the supply of funds to the SME sector. The Bank of England’s (BoE) Term Funding Scheme with additional incentives for Small and Medium-sized Enterprises (TFSME) provides four-year101 refinancing funds to credit institutions until the end of April 2021, at or very close to the central bank base rate. Initially, each credit institution has access to refinancing funds corresponding to at least 10% of its outstanding loan portfolio. Additional funds may also be drawn 101

o support the government’s Bounce Back Loan Scheme (BBLS) program, T the maturity of the central bank funding can be up to six years, which can be extended for another 4 years to 10 years.

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in amounts determined by the BoE as a weighted average of bank lending to various sectors, with factor of five applied to SME lending. The central bank estimates that based on experience from the previous TFS scheme, the amount drawn under TFSME may exceed GBP 100 billion. The drawdown period for central bank funds was extended by the BoE in December 2020 by 6 months until the end of October 2021. In March, the ECB decided to modify the terms of TLTRO III and to reopen LTRO tenders temporarily. The more favourable terms of TLTRO III apply from June 2020 until June 2021. Due to the adverse economic effects of the coronavirus pandemic, the ECB extended the favorable terms of TLTRO III by 12 months in December 2020, until June 2022, and also announced three additional tenders for 2021 (June, September and December 2021). As part of the scheme, banks are granted ECB loans over 3-year terms and are encouraged to ramp up their lending to euro area companies and households, excluding property purchases in the latter segment. Refinancing funds are provided by the ECB at 50 basis points below the MRO interest rate (currently 0%), with banks that maintain their lending activity at its current level possibly eligible for lower rates. The maximum available refinancing was set by the ECB at 55% of the credit institutions’ loan portfolios outstanding as of 28 February 2019. In addition to TLTRO III tenders, the ECB is also providing funds to support lending to the real economy under a new Pandemic Emergency Longer-term Refinancing Operations (PETLRO) programme, introduced temporarily in connection with the coronavirus. Under PELTRO, credit institutions can apply for central bank refinancing at 25 basis points below the MRO rate, with decreasing tenors (16 months in the first tender, down to 8 months by the last tender). In contrast with TLTRO, the funds may be drawn in unlimited amounts against sufficient collateral, and can be used for any purpose (ECB, 2020). In December 2020

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the Governing Council of the ECB announced an additional 4 PELTRO tenders for 2021 to provide the necessary liquidity. In March, policy makers at the Swedish central bank decided to introduce a new corporate lending instrument with an overall amount of SEK 500 billion. As part of the programme, Riksbank provides variable interest-rate refinancing to commercial banks, against collateral, at the key rate (currently 0%), with a maturity of 2 years. Participating banks accept to use at least 20% of the amount borrowed from the central bank for lending to the corporate sector, otherwise they will have to pay a penalty interest of 0.2% on the funds drawn. In March 2021, the program was stopped, and the Riksbank launched a new lending incentive program (Funding to Banks to support corporate lending, UBF). The new program continues to aim to support corporate lending, but the conditions attached to it are simpler, more generic and less time-dependent. The central bank’s funds are still provided by the Riksbank at the prevailing interest rate; in the event of non-compliance with the lending conditions, credit institutions will continue to have to pay penalty interest on the funds drawn. Unlike the previous program, banks’ lending activity to nonfinancial corporations is assessed on a 12-month frequency. Credit institutions must meet a 1 percent increase in loan portfolios. In the new program, banks can choose from 3 different maturities (April 2022, April 2023 and April 2024) during the tenders, instead of the previous weekly frequency, the tenders will be held monthly. The Riksbank will provide funding in the new program until the drawn funds reach 500 billion crowns (including the drawdowns of the old program) or until the Riksbank no longer considers central bank refinancing necessary. Under the Term Funding Facility (TFF), the Australian central bank provides loans to credit institutions with a maturity of 3 years, at a fixed interest rate of 0.25%. The initial facility provided by the central bank is capped at 3% of credit institutions’ loans to the private sector outstanding as of 31 January 2020, but at

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least USD 90 billion. Additional allowance may also be drawn in amounts depending on the increase in lending to large companies and SMEs. The initial facility may be drawn until September 2020, with additional allowance available until March 2021 at the latest (RBA, 2020). The call period for initial and additional funding was extended by central bank decision-makers in September 2020 until the end of June 2021. From November 2020, the interest rate on the newly drawn refinancing funds fell to 0.1 percent. As part of its lending incentive scheme with an allocated overall amount of RMB 400 billion, the Chinese central bank purchases SME loans from banks on a quarterly basis. The maturity of the loans is at least 6 months, and the scheme covers loans granted between 1 March and 31 December 2020. However, the banks participating in the scheme are required to repurchase these loans after one year, and the central bank will not assume the credit risk either. The central bank expects that the scheme, which helps smaller banks, could increase lending to small companies by some RMB 1,000 billion (USD 140 billion) (Reuters, 2020). On 20 April 2020, the MNB launched its new FGS phase called FSG Go!, with an allocated overall amount of HUF 1,500 billion. In terms of its key parameters and the method of implementation, the new phase is identical with earlier phases of the FGS. As earlier, the MNB’s refinancing loans are granted to credit institutions at an interest rate of 0%, with interest charged to SMEs remaining capped at 2.5%. The FGS Go! addresses companies’ changing financing needs and provides funding to SMEs on more favourable conditions than before. In addition to investment loans and leasing transactions, the new phase provides access to working capital loans to cover operating expenses, while it also allows the pre-financing of EU and domestic grants, and the redemption of existing loans accessed earlier at market rates. With a minimum loan amount reduced to HUF 1 million, the programme continues to play an important role in providing access to finance for micro-enterprises. Its increased maximum

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loan amount of HUF 20 billion helps to preserve the stability of major participants in the SME sector, and to implement large investments. Due to the significant demand for financing from enterprises, the MNB increased the budget of the facility by HUF 1,000 billion to HUF 2,500 billion in November 2020, and by another HUF 500 billion to HUF 3,000 billion in April this year.

3. Technology and design aspects of central bank digital currency focused on SMEs 3.1. Central bank objectives and general considerations in CBDC design The fundamental objective of central bank digital currency (CBDC) focused on SMEs may be to support economic growth. The development of a new SME financing channel directly provided by the central bank can mitigate the market problems (pro-cyclical lending, limited commercial bank financing under strict terms, longer approval times) referred to earlier. With FGStype programmes currently running, risks continue to be taken by the banking system, whereby if the risk appetite in this area is reduced, the problem could be addressed at the next level by transferring risk-taking to the central bank. A low-cost and secure alternative lending channel in the form of central bank digital currency can help the SME sector, which is important for economic growth, to realise its development potential across financial cycles in two ways: (1) CBDC funds can support the sector’s investment activity, and (2) a CBDC framework enables targeted support to be provided to the SME sector also in crisis situations, and maintains the sector’s value creation potential by ensuring its operational conditions.

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In addition to the central bank objectives, the proper design of a CBDC project focusing specifically on the SME sector requires that consideration should be given to basic aspects such as other economic policy objectives underlying the blueprint design, the scope of access, and the monetary policy nature of the project. In the next step, the operational framework and the design of the technology underlying the system must be defined, which are partly dependent on previous decisions focusing on business and economic aspects (Figure 1).

Is it feasible on traditional infrastructure? Is the use of blockchain/DLT justified?

VI. ANONYMITY

Are anonymous transactions enabled? Account-based or token-based operation?

V. FRAMEWORK IV. FORM III. MONETARY POLICY NATURE

II. ACCESSIBILITY

What is the basic purpose?

I. FUNDAMENTAL GOAL

Independent decision

VII. TECHNOLOGY

Partially determined

Figure 1: Decision steps in designing a CBDC

Source: own edit

From an economic policy perspective, the most important requirement is to strike the right balance between supporting the SME sector and maintaining financial stability in the banking sector, with targeted temporary intervention by the central bank. The ability to strike that balance can largely depend on the depth of financing opportunities provided by the central bank (see Chapter 4), and on the extent and frequency with which such finance is made available to the SME sector. The objective is to ensure that without classic lending channels being damaged,

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XI. Options to extend SME financing through central bank digital currency

alternative, complementary financing opportunities can provide supply for the high demand, and the SME borrowing market is sufficiently deepened and widened. For a CBDC-based SME financing project, it is also important to define the specifications and technological background required for the newly established channel to operate as efficiently and securely as possible. The method of implementation largely depends on the intended accessibility of the service, and the functionality expected. To select the specific project and elaborate its details, the decision steps shown in Figure 1 should be considered and used to identify the relevant aspects. 3.2. Accessibility and form While the primary target group is the SME sector at large, consideration should also be given to more restricted access within that sector. In the present case, the CBDC project would be targeted at the SME sector, yet it is to be noted that although a universal CBDC project accessible to all SMEs can be considered ideal, for the short and medium term it may be useful to design a targeted pilot project providing restricted access to test it in an easily controlled environment. Targeting will also allow for a more precise identification of groups and industries that are of primary importance for the development of the economy and competitiveness, but for which market frictions are more pronounced. In order to arrive at a design that can be considered optimal for the market, it is necessary to specify whether companies’ use of central bank digital currency can be applied across borders, or only domestically. In a CBDC project whose sole purpose is to help finance the SME sector and support domestic economic recovery, it may be useful to provide the option to convert CBDC into commercial bank money, which can then be converted into foreign currency if necessary and to the extent required by the investment and procurement activities of the enterprises. — 371 —

XI. Options to extend SME financing through central bank digital currency

3.3. Operational framework Market needs must be assessed first, and the central bank must determine the appropriate operational framework accordingly. The establishment of a reliable channel for payments and alternative financing in all conditions remains a priority as far as the SME sector is concerned. To achieve this, the central bank must consider whether it should provide companies with access to central bank digital currency directly, or indirectly through financial market participants (Figure 2). The principal task for the central bank is then to determine the structure of liabilities, and the responsibilities of the central bank itself. On those grounds, two architectures may be conceived (more details on feasibility are provided below): – Within the CBDC structure established with financial service providers as intermediaries, companies would continue to hold their accounts with the financial intermediaries (predominantly commercial banks) already servicing those accounts, only the loan would be provided by the central bank, which would also assume the risk along with the responsibilities related to creditworthiness assessment. The setup of a new central bank payment system is not required in this case. – The second option is for the central bank to open its balance sheet directly to the companies, whereby the companies would owe their debts directly to the central bank, which in turn would significantly increase the responsibilities of the central bank, with the amount of allocated central bank money accounted for separately for each company. Within this option, certain services could be outsourced to financial intermediaries to reduce the burden on the central bank resulting from additional services.

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XI. Options to extend SME financing through central bank digital currency

Figure 2: Possible forms of implementation of SME financing in the form of CBDC

Account management Loan disbursement

ct re s Di es B) acc

m A) a C cr nag ent ed es ra it on l b ac e an co sin k un g t le

Credit register

Mobilebank, netbank and other services

Commercial banks keep in touch Mobilebank, netbank and other services

Source: own edit

3.4. Anonymity and technology Given that central bank money would be allocated as a loan, account-based access needs to be ensured, and anonymous access should not be made an option. Once the concept best adapted to market demand has been established, the technology underlying the entire system needs to be specified. To determine this, it is necessary to define the most efficient system that best fits the operational framework previously established. In an SME financing model where a lending structure is to emerge, consideration may need to be given to relying on currently used infrastructure with appropriate improvements. On the one hand, this implementation would be less costly and resource-intensive, with market participants — 373 —

XI. Options to extend SME financing through central bank digital currency

allowed to continue using a system they already know. If the CBDC scheme involves a relatively small number of companies, or if funds are allocated indirectly through existing banking actors, enhancements to the old system could be less affected by capacity problems. While it may also be worth exploring the possibility of developing a new, innovative technology, such as distributed ledger infrastructure, the deployment and maintenance of completely new infrastructure would entail significantly increased costs and risks. From a security point of view, it is difficult to determine which one is more beneficial, since both systems are associated with different risks: attacks on the central system are a potential threat in the current structure, while in a distributed ledger system the consensus mechanism may be attacked (DDoS attacks102), but centralised variants (e.g. CLT103) can also be implemented in that regard. Overall, the use of new and innovative technology can only be justified if its efficiency, ease of use and reliability outweigh the operation of the system previously in place and, other than achieving the basic objective, additional aspects also arise in terms of upgrading other functions and registers related to SME finance (Auer and Böhme, 2020).

102

istributed Denial of Service (DDoS) – Distributed denial of service attacks D are electronic attacks originating from a group of systems that is capable of placing systems, services or networks under such a load that the system, service or network concerned may become unavailable. This can be achieved both by paralysing systems and by increasing network traffic, which will prevent legitimate data traffic from reaching the destination system.

103

Centralised Ledger Technology (CLT)

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4. Possibilities for central bank SME account servicing and credit facilities in Hungary Opening up the central bank’s balance sheet to the domestic SME sector may improve financing opportunities for companies, while reducing the market frictions explained earlier. An examination of the options suggests that two levels of depth can be provided, which should be reviewed in terms of economic policy and feasibility: (1) by opening up the liabilities side of its balance sheet, the central bank keeps accounts for the SME sector, providing a platform for possible targeted fiscal interventions; and (2) by opening up the assets side as well, the central bank also provides credit facilities for companies. 4.1. Account keeping for SMEs Opening up the liabilities side of the MNB’s balance sheet to the SME sector may contribute to companies’ more cost-effective operations and easier access to State support. Accounts held with the central bank would enable the State to provide targeted economic stimulus directly from fiscal sources where necessary in an economic recession. However, while offering benefits to the SME sector, given the presence of more than 750,000 small and medium-sized enterprises in Hungary (KSH, 2018), this concept can place a huge burden on the central bank’s operations and systems, which may warrant considering the possibility of initially opening up to a restricted segment. As micro and small enterprises are the most affected by the financing disadvantages arising from size, they may be specifically assisted through a targeted pilot programme. Since financial education and the use of digital tools may also be more moderate among these smaller enterprises, a pilot CBDC can support both their digital maturity and closer integration into the financial intermediary system.

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4.2. Providing credit facilities for the SME sector Compared to account servicing, the central bank’s provision of access to credit would be a project of greater volume. The fundamental objective being to support economic growth and to provide alternative financing to the SME sector, possible options include both investment loans granted and the maintenance of a liquidity facility, which can be drawn in specific cases determined in advance. Compared to account servicing, a central bank lending structure may be more instrumental in reducing market frictions across cycles, but it also significantly increases the central bank’s responsibilities, credit risk exposure and the burden of potential infrastructure development, depending on which of the two allocation options is taken. 4.2.1. Lending by intermediaries Although on the recipient side the first type of architecture is largely identical in terms of structure to the operation of the SME lending incentive scheme established by the MNB and currently running as FGS Go!, its fundamental difference lies in the fact that the central bank assumes the full credit risk instead of merely offering lending incentives by providing liquidity. Accordingly, companies will continue to hold their accounts with their financial service providers so that they can also access ancillary services from those providers, while the central bank will set up a technical credit account for SME lending and take over the full credit risk from the financial service providers, whereby the responsibilities it will be required to perform will increase significantly. To mitigate newly emerging risks, cooperation with financial service providers experienced in corporate lending may be warranted in order to enable the central bank to set up its own credit approval and collateral valuation processes and credit portfolio registration platform to the required minimum standard. At this point, the setup of appropriate incentive mechanisms (e.g.

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“Skin-in-the-game”104) could enable the expertise and networks of the commercial banking sector to be channelled into the central bank programme. SME lending by intermediaries requires the least amount of changes compared to the system in place. Using the infrastructure and lending channel previously established, the cost implications and time requirements of a possible new form of lending may be kept within limits. However, the conceptual design of the operational framework of the specific programme supporting SME financing, ensuring compliance with legal requirements, and technological implementation remain rather a complex task. 4.2.2. Direct central bank lending The second option of implementation is for the MNB to provide direct financing to the enterprises without the intermediation of commercial banks. In contrast to lending by intermediaries, direct lending by the central bank would be required both to set up technical loan accounts, and to perform the complete range of lending functions. Taking that option would pose a greater challenge to the central bank, given the need for a complete takeover of the activities involved in commercial banking services, from credit approval to the setup of additional functions (netbank, mobile banking application), for which the provision of the appropriate duties is also key. Since the process would involve the setup of a completely new and independent functionality, it may be worth considering the development of a system based on a more innovative technology that would provide an alternative to the current systems and technologies in a new approach. That said, both the implementation of such a system and determining its efficiency pose a major challenge to the central bank.

The central bank has the possibility to outsource several services to other market participants. The central bank can reduce the

104

I .e., to some extent, credit risk will be shared by the participant performing the credit approval and collateral valuation.

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burden of new functions (such as, communication channels) by outsourcing them to other providers, such as FinTechs. However, regardless of the nature of services outsourced, the conceptual and technical aspects of the system ensuring consistent operations must be designed in compliance with the legal regulations. In that regard, ensuring interoperability between systems is a key enabler of technological innovations and continuous improvements. Overall, the greatest challenge may lie in building a direct lending structure with a focus on the SME sector, which could bring fundamental changes to the credit market structure and affect the income generation and profitability of the financial sector, which calls for a careful examination of this option to ensure that its potential benefits exceed the challenges and risks emerging at the level of both the central bank and the financial intermediary system.

5. Conclusion Ensuring the smooth financing of the SME sector remains a top priority for the national economy. Whenever a major economic shock occurs, including most recently during the pandemic, the vulnerability of financing the SME sector has been demonstrated. Therefore, central banks in several countries, including the MNB, have launched several programmes to support the provision of financing for small and medium-sized enterprises in a more difficult macroeconomic situation. Consequently, even theoretical considerations concerning the implementation of a CBDC framework raise the question whether it is worth exploring the feasibility of a financing channel deploying central bank digital currency. A project based on central bank digital currency and designed to reduce market frictions involves several aspects that the central bank must take into account. Finance provided

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directly by the central bank may complement commercial bank financing by offering an alternative that is fast, cheap, secure, and ensures transparency regarding its operational criteria. In addition, a number of obstacles need to be overcome during implementation, ranging from the legal environment, through the acquisition of adequate knowledge and technical capacity, to the assessment of the effects of possibly irreversible interventions affecting the functionality of the financial intermediary system. The need for central bank intervention may also be influenced by the possibility of alternative forms of financing, such as crowdfunding. Overall, in international professional work related to the introduction of central bank digital currency, the scope of using CBDC for lending has so far been very limited due to its direct, presumably crowding-out effect on the financial intermediary system. Accordingly, for the foreseeable future, no such solution is expected even in countries leading practical implementation. Nevertheless, a volume of studies addressing the potential social benefits of CBDC should also include a more detailed theoretical overview of this option.

References Auer, Raphael–Böhme, Rainer (2020): The technology of retail central bank digital currency Balog, Ádám–Matolcsy, György–Nagy, Márton–Vonnák, Balázs (2014): Credit crunch Magyarországon 2009–2013 között: egy hiteltelen korszak vége? (Credit crunch in Hungary between 2009 and 2013: is the creditless period over?) Financial and Economic Review, Vol. 13. Issue 4. Bank of England (2020): Term Funding Scheme with additional incentives for SMEs (TFSME) – Market Notice https://www.bankofengland.co.uk/markets/marketnotices/2020/term-funding-scheme-market-notice-mar-2020 EKB (2020): The monetary policy response to the pandemic emergency https://www. ecb.europa.eu/press/blog/date/2020/html/ecb.blog200501~a2d8f514a0.en.html Jin, Yuhuan–Zhang, Sheng (2019): Credit Rationing in Small and Micro Enterprises: A Theoretical Analysis. Sustainability 2019, 11, 1330.

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XI. Options to extend SME financing through central bank digital currency KSH (Hungarian Central Statistical Office): A kis és középvállalkozások jellemzői, 2018 (Characteristics of small and medium-sized enterprises, 2018). https://www.ksh.hu/ docs/hun/xftp/idoszaki/pdf/kkv18.pdf Reserve Bank of Australia (2020): Term Funding Facility Increase and Extension to Further Support the Australian Economy https://www.rba.gov.au/mkt-operations/ announcements/increase-and-extension-to-further-support-the-australian-economy. html Reuters (2020): China central bank to buy bank loans to spur lending to small firms worth 1 trillion yuan https://www.reuters.com/article/us-china-economy-pbocidUSKBN23828I Riskbank (2020): Loans to the banks for onward lending to companies https://www. riksbank.se/en-gb/monetary-policy/monetary-policy-instruments/loans-to-the-banksfor-onward-lending-to-companies/ Zott, C.-Amit, R. (2007): Business Model Design and the Performance of Entrepreneurial Firms. Organization Science, 18 (2), 181-199. http://dx.doi.org/10.1287/ orsc.1060.0232

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Acknowledgements The past decade has seen a significant acceleration in the digitalisation of financial services, the entry of non‑bank players to the market of financial services and consequently central banks’ thinking related to central bank digital currencies. Regarding the future, there seems to be a consensus that technological progress opens up new opportunities for central banks, however, actual implementation needs to be preceded by detailed analysis and the careful assessment of risks. The studies in the MNB’s book provide a guide to this by summarising the theoretical considerations, the most important practical issues and the international experiences gained so far related to central bank digital currencies. The studies in this volume greatly rely upon the analyses and workshops of the Magyar Nemzeti Bank as well as the discussions at its various professional fora. The editors would like to thank Governor Mr. György Matolcsy, Deputy Governors Mr. Csaba Kandrács, Mr. Mihály Patai and Mr. Barnabás Virág for their encouraging support as well as all the members of the Monetary Council for their professional comments on the analyses prepared on this subject before. Special thanks to the authors and contributors of the studies in the volume, namely to: István Ádor, Anna Boldizsár, Eszter Boros, András Szabolcs Csonka, Bálint Danóczy, Péter Eigen, Péter Fáykiss, Dániel Felcser, Zénó Fülöp, Balázs István Horváth, Gábor Horváth, Marcell Horváth, Zoltán Huszár, László Kajdi, Laura Komlóssy, Blanka Kovács, Zsolt Kuti, Zsolt Láda-Hartyáni, Kálmán Árpád Marincsák, Péter Sajtos, Soma Sándor, Balázs Sisak, János Szakács, Zoltán Szalai, Szilvia Szécsiné-Kardos, Anikó Szombati, Péter Szomorjai, Róbert Taczmann, Daniella Tóth, Gergő Török, Balázs Varga, Lóránt Varga and Márton Zsigó.

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XI. Acknowledgements

Thanks go to László Csaba Körtvélyesi and Dávid Hódi for their work on the graphic design in this book. The authors owe thanks to Péter Bencsik, István Csonka, Péter Szűcs and all the contributing colleagues for the thorough work, which was indispensable for releasing this publication.

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ISBN 978-615-5318-48-1

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MNB | AT THE DAWN OF A NEW AGE – MONEY IN THE 21ST CENTURY

AT THE DAWN OF A NEW AGE – MONEY IN THE 21ST CENTURY

2021

At the dawn of a new age

Articles inside

Options to extend SME financing through central bank digital currency

Key implementation issues of central bank digital currency in the light of infrastructure and operation

Effects of central bank digital currency on payments

Strengthening the financial inclusion of the retail segment through the use of central bank digital currency – Retail account servicing and opportunities beyond

Acknowledgements

Financial stability aspects of the introduction of a central bank digital currency

The conceptual framework of central bank digital currencies

Digital turnaround in monetary policy? – The monetary policy aspects of central bank digital currencies

Monetary theory and international spillover aspects of digital currencies

Global cash alternatives and their impact on the implementation of monetary policy

Digital renminbi – Taking the US–China geopolitical rivalry to a new level?

Foreword

Introduction