Central bank digital currency remuneration in a world with low or negative nominal interest rates
The possible introduction of central bank digital currencies (CBDCs) has developed into one of the most debated topics amongst central bankers, monetary policy researchers, and members of the payments industry. While so far, the general public and non-bank firms have only been able to access central bank money in the form of banknotes, CBDC is electronic central bank money that is available to all. Changing payment habits of consumers and the rapid progress in payments technology may induce central banks to offer digital means of payments to allow citizens to combine the convenience of modern electronic payments with the advantages of central bank money. The ECB has just published a report on a digital euro (ECB 2020).
In this column, we discuss issues relating to the remuneration of CBDC, in particular in a negative interest rate environment such as that prevailing in the euro area, as well as in countries including Japan and Switzerland.
It is often assumed that CBDC would be designed to have cash-like properties, including zero remuneration. Central bankers and holders of central bank money got used to banknotes representing a risk-free, short-term financial asset with a zero nominal yield, regardless of the level of nominal interest rates. While some consider this feature of banknotes to be an anomaly that could be solved with CBDC (and the discontinuation of banknotes), others argue instead that it is important to preserve this cash-like feature when issuing CBDC. This debate neglects the fact that zero remuneration of CBDC would have different implications depending on the interest rate environment (i.e. depending on whether short-term nominal rates are at 10%, 3%, 0%, or -0.5%).
We propose the adoption of a two-tier remuneration approach to CBDC in order to relieve the tension between two fundamental objectives; (i) to offer CBDC to citizens (in quantities sufficient for it to be used as means of payment) at interest rates that are never lower than those on banknotes (i.e. never below zero); and (ii) to protect financial stability and the effectiveness of monetary policy. The two-tier approach would also allow central banks to offer CBDC in an elastic and unconstrained way to other holders, such as corporates or foreigners. In doing so, it would also make it possible to overcome the perceived dichotomy between ‘retail’ and ‘wholesale’ CBDC.
Structural bank disintermediation through CBDC
CBDC has both found support as well as raised strong concerns with regard to its impact on the structure and scale of bank intermediation. Advocates of sovereign money see bank disintermediation as the specific goal of CBDC. Others have raised concerns about the prospect of CBDC inflating the central bank balance sheet at the expense of the deposit funding of banks. Carstens (2019) and CMPI-MC (2018) emphasise such concerns. CBDC replacing banknotes appears uncontroversial, as this would merely imply the transformation of one form of central bank money into another with no effect on the rest of the financial system. By contrast, CBDC replacing bank deposits would reduce the availability of a cheap and relatively stable source of funding for banks. Moreover, it would require an increase in the dependence of banks either on central bank credit or on bank bond issuance, in the latter case combined with an increase of the central bank’s outright holdings of securities (or both). A larger recourse to central bank credit could lead to collateral scarcity issues and make the availability of central bank collateral a crucial issue, to the point that an effective centralisation of the credit provision process could occur. Banks could react to the reduced demand for deposits by increasing their recourse to capital markets, but this would be costly and might exacerbate vulnerabilities.
Bank runs and CBDC
While runs from deposits into banknotes are limited by the risks and costs of storing large amounts of banknotes at home or at other places, there would be no such limitations if households and institutional investors were able to hold unlimited amounts of CBDC (a riskless asset with no storage costs). A crisis-related run from bank deposits into low-risk financial assets (such as gold-related assets and highly rated government debt) can already happen in ‘electronic’ form and therefore does not pose the same security issues (except for physical gold). However, this type of run (i) is dis-incentivised through the price mechanism (as the safe assets will become very expensive in a crisis); and (ii) on aggregate, does not reduce deposits with banks as such; for the investor it, would reduce exposure to default risk, but increase market and liquidity risk. Therefore, it is plausible that CBDC could make bank runs worse, as it would neither create physical security issues nor be subject to scarcity-related price disincentives if it were to be supplied in unlimited quantities and without other control tools, like banknotes.
Negative interest rate policy and CBDC
A number of central banks have implemented a negative interest rate policy (NIRP), notably in the euro area, Denmark, Sweden, Japan, and Switzerland. Moreover, long-term nominal interest rates suggest that markets believe that NIRP could re-emerge in the future, including possibly in monetary areas where it is not currently applied. Issuing zero-remunerated CBDC without limits on access or quantities would, however, imply the end of NIRP. It would also imply that NIRP would no longer be possible in the future, because issuance would likely lift long-term nominal yields – even those in positive territory – as NIRP scenarios would no longer be factored into expectations. Indeed, if the least risky assets in the economy – i.e. a liquid central bank liability in domestic currency, such as a CBDC – offer a return of zero, no other financial instrument can yield a negative rate, as its holders would then substitute it with CBDC. Therefore, effective access and/or quantitative constraints on CBDC holdings would be necessary to preserve the ability to conduct NIRP following a future issuance of a zero-remunerated CBDC.
However, these constraints would reduce the scale and scope of use of CBDC and, consequently, its effectiveness and usefulness as a means of payment. Moreover, they would raise a number of technical issues – for example, a ceiling on individual holdings of CBDC could limit the number or size of payments, as the recipients’ holdings of CBDC would have to be known in order to complete the payment.
A two-tier remuneration system for CBDC
Some have noted that the potential structural and cyclical bank disintermediation caused by CBDC could be addressed by applying unattractive and/or negative interest rates on such currencies. However, they are sceptical that the tool of negative interest rates will always be effective enough in times of crisis, also because of political acceptance problems. What’s more, central banks will prefer to promise citizens that CBDC will be at least as attractive as banknotes in all relevant areas, meaning that a household’s holdings of CBDC that are equal in size to normal holdings of banknotes would not be subject to negative remuneration, even during a crisis.
In this section, we propose a solution based on tiered remuneration of CBDC. This would solve the potential problems set out above while still granting non-negative CBDC remuneration to citizens. Panetta (2018) was first to hint at the idea of a tiering system for CBDC to address the bank run problem, while Bindseil (2020) has carried out in-depth analysis on the application of a tiered CBDC remuneration system.
Central banks are already applying reserve tiering systems to the remuneration of deposits for the specific purpose of controlling the total amount of deposits. Under such a system, a relatively attractive (or non-penalising) remuneration is applied up to a quantitative ceiling, while a lower interest rate is applied to larger amounts. The Eurosystem applies this type of tiering system for deposit accounts of public sector institutions, such as domestic governments and foreign central banks or sovereign wealth funds. For example, Article 4 of the Eurosystem’s DALM guidelines1 specifies that a two-tier remuneration system applies to government deposits. Similarly, Eurosystem reserve management services, which grant deposits to foreign central banks and public sector funds, foresee a more attractive rate up to a certain limit and a less attractive one above this limit.
Applying tiered remuneration to CBDC would have a number of key advantages. First, it would allow the retail payment function of money to be assigned to CBDC holdings below the threshold (tier one CBDC), while the store of value function would be assigned to tier two CBDC, which would essentially be dis-incentivised through a less attractive remuneration rate. Indeed, central bank money should not become a large-scale store of value (i.e. a major form of investment), as in that case the central bank would effectively become an intermediary for private savings (a development that would have no particular justification). Second, it would make CBDC attractive to all households, as reliance on tier one CBDC would never need to be disincentivised by negative remuneration. Third, it would help prevent excessive structural and cyclical bank disintermediation. Finally, it would preserve the ability to apply NIRP, as tier two remuneration could always be applied in such a way that it does not undermine the monetary policy stance.
The central bank can make a commitment regarding the quantity of tier one CBDC. For example, it could promise to always provide a per capita tier one amount of €3,000, implying an amount of total tier one CBDC for households of around €1 trillion (assuming an eligible euro area population of 340 million). Recall that the amount of banknotes in circulation in the euro area is slightly above €3,000 per capita (currently totalling around €1.2 trillion), securities holdings of the Eurosystem (including investment and policy portfolios) are currently above €3 trillion, and the banking system has excess reserves above €2 trillion. A per capita amount of €3,000 for tier one CBDC could be interpreted as covering the average monthly net income of euro area households, such that the normal payment function of money would be covered.
For corporates (financial non-banks and non-financials) the tier one allowance could be set to zero, or it might be calculated to be proportional to a measure of their size and, thus, presumed payment needs. Foreigners could be allowed to hold CBDC, but should not have any tier one allowance.
To solve the problems described above, the tier one remuneration rate, r1, should never fall below zero, while the tier two remuneration rate, r2, should be set such that tier two deposits are rather unattractive as a store of value (i.e. less attractive than bank deposits or other short-term financial assets, even when taking into account risk premia). The two rates could co-move in parallel with policy interest rates, with an additional special provision when zero lower bound territory is approached. The rates on CBDC would not be regarded as policy rates. Moving the rates would simply serve to keep a similar spread over time to other central bank rates and thus, in principle, to other market rates. Initially the ECB could, for example, consider the following remuneration for a tier one CBDC: r1 = max(0, iDFR-2%), where iDFR is the remuneration of overnight deposits held by banks at the ECB. For a tier two CBDC, the remuneration formula could be: r2 = min(0, iDFR – 0.5%). Therefore, currently in the euro area r1 = 0 and r2 = -1%. The central bank would explicitly reserve its right to worsen the tier two remuneration rate in a financial crisis, while it would commit to never worsening the formula for tier one remuneration, especially as regards the zero lower bound.
Tiered remuneration would simultaneously achieve four key objectives related to CBDC:
1. Offering CBDC as a means of payment to households at conditions at least as attractive as banknotes, including non-negative remuneration, for an amount that generously covers the payment needs of the average household.
2. Offering CBDC in a quantitatively unconstrained manner to any holder, not just citizens – i.e. to corporates, foreigners and institutional investors, among others – in such a way as to ensure that CBDC can achieve maximum scale, scope and effectiveness as a means of payment, including internationally, and serve as both a retail and a wholesale currency.
3. Controlling the risks of structural or cyclical bank disintermediation through CBDC, in particular in a low interest rate environment or in crisis periods.
4. Preserving the ability to conduct NIRP and thereby preserving the current accommodative monetary policy stance prevailing in a number of advanced economies.
The solution relies on a tiered remuneration of CBDC, in line with a long-tested central bank practice. Tiered remuneration is probably not needed when nominal short-term risk-free interest rates are far above zero, as they were in G7 countries in the early 1980s, for example. In such circumstances, zero remuneration of CBDC would be sufficient to deter the extensive use of CBDC as a store of value (i.e. as a large-scale investment), probably even in most financial crisis situations. For economies with moderately positive nominal interest rates, the technical ability to introduce tiered remuneration may also be desirable, in particular to address the risk of crisis-related bank disintermediation.
Offering zero-remunerated CBDC to households can achieve objectives 1 and 2 but not objectives 3 and 4, or, if there are quantity and access constraints, objectives 1, 3 and 4, but not objective 2. Offering CBDC with a single remuneration rate can achieve objectives 2, 3, and 4, if it sacrifices objective 1. Tiering appears to be the only solution to achieve all four objectives.
Authors’ note: The opinions expressed in this column are our own and not necessarily those of the ECB. We would like to thank Katrin Assenmacher, Andrej Bachmann, Elizabeth Hulmes, and Andrea Pinna for their helpful comments.
Bindseil, U (2020), “Tiered CBDC and the financial system”, Working Paper Series, No 2351, ECB, Frankfurt am Main, January.
Carstens, A (2019), “The future of money and payments”, Speech at the Central Bank of Ireland, 2019 Whitaker Lecture, Dublin, 22 March.
Committee on Payments and Market Infrastructures and Markets Committee – CPMI-MC (2018), Central bank digital currencies, BIS, Basel, March.
ECB (2020), Report on a digital euro, 2 October.
Panetta, F (2018), “21st century cash: central banking, technological innovation and digital currency”, in Gnan, E. and Masciandaro, D. (eds.), Do We Need Central Bank Digital Currency? Economics, Technology and Institutions, SUERF Conference Proceedings 2018/2, pp. 23-32.
1 Guideline, EU, 2019/671 of the European Central Bank of 9 April 2019 on domestic asset and liability management operations by the national central banks, recast, ECB/2019/7.