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Monetary theory and international spillover aspects of digital currencies

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

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)

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).

14 Diamond and Dybvig (1983) 15 White (1999)

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

16 See Chapter 9. 17 Lo (1986), Szalai, Z. (1998)

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;

18 Cœuré (2019)

– 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 Federal Reserve Bank: Carpenter and Demiralp (2010), Bank of England:

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 post-

Keynesian economists working based on Káldor et al. For more on this topic, see also Bánfi (2016).

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)

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

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

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

21 Kregel (2016) 22 Aglietta (2016).

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.

23 BIS (2020c)

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). 25 Kregel shows that modern commercial banks integrated the features of the 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.

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)

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

27 Hockett and Omarova (2017)

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

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

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

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

29 Issing (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.

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.

30 BIS (2020b).

– 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

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. – Macroeconomic 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.

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.

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