This post is the first in a series called ‘central bank digital currencies 101: what are they and why should I care?’. This first post explores the different kinds of money in the economy today

Let’s start this week with a personal question: how much money do you have? It might sound like a simple question, but it is surprisingly difficult to answer. When you answered, did your mind immediately go to the balance in your bank account? How about the money in your purse or the proverbial – or real, no judgement here – cash under your mattress? While you might think of money in your pocket and money in the bank as the same thing, they are not. In the economy at the moment there are really three different types of money, and they all have different qualities and features.

Cash

The first type of money is cash. Think about the money in your pocket again. If you haven’t already abandoned cash entirely, take it out and look at it. What do you see? On the front of the British ten pound note in front of me I’m met firstly by the face of our hereditary monarch, Her Majesty Queen Elizabeth The Second, Defender of the Faith and Seigneur of the Swans (seriously) and her fetching ‘ERII’ logo. The words ‘Bank of England’ appear seven time across the front. A portcullised arch and the royal crown are embedded in the security holograms, and the emblems of the four nations of Great Britain and Northern Ireland sit squarely in the middle of the note.

You don’t have to be a Dan Brown style symbologist to take in the fact that this is an instrument of the state. It practically screams it at you. On the reverse of the note the fetching portrait of Jane Austen looks like a pastoral scene, but look closer and what looks like etching marks on an engraving behind her is actually the letters ‘BOE’ repeating again and again so many times that I gave up the will to count them all. Far from being a uniquely British phenomenon, the same is true of government bank notes around the world: cash is explicitly, overtly, smack you over the head obviously an instrument of the state.

Cash is also unusual in that it is highly private. Cash comes without memory, and cash is available to everyone. For this reason it is favoured by the tax averse, the privacy conscious, those avoiding transaction fees, and those who struggle to gain access to the banking system. (We’ll explore these features in a later post.)

Bank Deposits

The second type of money is bank deposits. Now that you’ve taken a look at a bank note, open up your online bank account on your phone or your computer. Before you click into it, have a look at the icon they’ve used. What about the name they have given it? Now click inside, what logos and colours greet you? The difference is obvious and stark: while the world of the bank note is the world of the state, the world of your bank account is the world of that bank. The only visual similarity between the two is likely to be the symbol used to denote the currency in your jurisdiction. This is not just a branding difference, but is actually an insight into the differing natures of bank notes and bank deposits.

Cash, as in notes and coins, are state issued money you hold without any intermediary. That is to say you don’t need a bank, or a PayPal or a Facebook, or a Mastercard in order to have, and use, cash (although it is in all of their interests to cajole you into using them as much as they can so they can take their cut of your money). A bank deposit on the other hand is, if viewed from the bank’s perspective, money that you have chosen to lend to the bank and as such sits on their balance sheet as a liability, not an asset.

Most people are familiar with the idea of credit from a credit card; credit is a loan extended by one party to another party. While many people don’t think about it, when you deposit money into a bank account, you are taking on credit risk to the bank. Put simply, if the bank goes bust, you might not get all your money back. That’s because the bank does not put ‘your’ money into a particular vault and keep it safe for you, adding a few pennies of interest every month to your little hoard with all the bitterness of a Gringotts goblin. Instead they use your money; to help them lend money to your neighbour to buy a house, to pay their staff, to hedge their exposures.

Generally we accept that this poses us a minimal risk, and most states operate some kind of deposit guarantee scheme to protect small deposit holders, but the risk exists none the less. The Bank of Cyprus depositors who lost 47.5% of their savings in 2013 in what was described at the time as a ‘haircut’, but probably felt to them more like a trepanning, can attest to the fact that bank deposits are not as safe as they appear to be. This is important because, as the use, acceptance and availability of cash decreases, so does your ability to hold risk-free state money. If all your money exists only as a number in a bank’s computer, your financial fate is totally tied to the behaviour of that bank.

Central Bank Reserves

Banks themselves have access to a third, special, kind of money, namely central bank reserves. This money is electronic state money that a small number of licensed operators hold in a special account with the central bank in their jurisdiction, so Deutsche Bank with the Deutsche Bundesbank, JP Morgan with the Federal Reserve, Barclays with the Bank of England and so on. The central bank creates this money out of nothing – the economy is like a game of Monopoly: if the bank starts without any money then nobody can play the game. The commercial banks swap other assets – like bonds – for this money which is then credited to their accounts. They use the reserves to settle up the balances that result from all of our individual daily transactions, so if I bank with Nationwide in the UK and send £100 to my friend who banks with Barclays, my transaction appears at the central bank as Nationwide and Barclay’s ‘settle’ the aggregate movement of money between them.

Holding an account with the central bank comes with conditions like needing to leave a certain amount of money in the account at any given time to make sure you can pay all your bills. It also gives the central bank insights into the flow of money between the banks, which has become increasingly important to them as many have taken on regulatory and oversight responsibilities for their domestic banking sector. The amount of reserves held by banks has swelled massively since the global financial crisis due to quantitative easing. It’s about to net them a very tasty profit (reportedly upwards of £57bn in the UK) as the bank pays them interest on all that new money.

Central bank digital currencies

The idea behind a central bank digital currency is an alluringly simple one: to create a fourth type of money that takes some of the features of the types we already have. Tune in next week to find out more!

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Postscript:

This is only post two of the blog, and the first of the kind of content I imagine I’ll be posting most weeks, so I’m keen to get your feedback! Enjoyed it? Let me know. Think someone else would enjoy it? Share it with them. Have questions, comments or observations or want to join the conversation – please dive right into the comments.

Further reading:

• If you’re looking for a more technical overview, this Philadelphia Federal Reserve working paper is a good place to start.
• The bank of England provide some helpful overview of how reserves function, and an overview of cash in the time of Covid with some interesting insights.

Briefly noted:

• Minecraft have banned NFTs as they create exclusivity and are against their values
• Financial regulators are looking seriously are regulating big tech across their entire group structures in order to manage the risk they pose in the financial sector (predict this could become a big story)
• The SEC have classified digital assets as ‘securities’ and charged a Coinbase staff member with insider trading
• Irish village sports team loves cash and is angry at their bank for taking it away