The government of China has taken preliminary steps to roll out its new digital currency. This has created tremendous buzz online, and articles from a wide variety of news outlets including NBC News and The Guardian have been produced to try to answer some of the questions many people may have about this new type of money.
It can be hard to explain what digital currency is to a general audience because most people do not know how money works in the first place. So the first thing is to explain how traditional cash and bank deposits work.
How traditional cash, bank deposits, and payments normally work
What we all know as money is created by central banks, because all cash is basically a kind of I.O.U., or liability, of a central bank. This can confuse many people because holders of cash, whether they are individuals, businesses, or commercial banks, are not able to demand anything from a central bank in return for its cash other than a fresh note. This is called fiat money, because the central bank can make as much of it as its directors decide to make.
In the old days, the central bank would use cash to purchase gold or silver bullion, or coins made of valuable metals, and the holders of cash could demand the precious metals in return from the bank as well. For example, until 1914, a holder of a one pound note could go into a commercial branch of the Bank of England and exchange that note for one gold sovereign - which is a type of gold coin. Naturally, this placed a kind of limit on the amount of cash that the bank could produce before it risked running out of reserves. That does not mean the central bank had to back up all of its cash with reserves, because banking operates on a fractional system, where the bank tries to lend out as much cash as possible and holds reserves only sufficient to meet current demand for redemptions. The use of fiat money allows the central bank to avoid this problem altogether.
In the modern system, the central banks buy and sell government bonds from the commercial banks in an open auction that takes place on a regular basis. The central bank puts the money into the accounts of the commercial banks when it purchases securities from them, and subtracts it from their accounts when it sells the securities to the other banks. This allows the central bank to calculate how much cash it wants to produce or how much it feels the economy should have, in order to meet its economic objectives for the overall society. This gives central banks tremendous control over the health and function of the entire economy.
The money that the central banks produce does not begin its life as cash. It starts off as deposits in the bank accounts that the commercial banks keep at the central bank. If the commercial banks need physical cash for their customers to withdraw, they are allowed to withdraw it from their accounts, and if they have an excess supply of cash they can deposit it with the central bank. When the central banks need to transfer money from one bank to another, it is transferred through their accounts at the central bank.
The commercial banks must keep enough money on deposit at the central bank to meet all of their payment obligations to the other banks and to have enough cash available to meet the demands of their customers. If they do not have enough, there is a system of overnight lending inside the central bank system that allows commercial banks with excess funds to briefly loan those funds to other banks, in return for a small interest rate. This allows the banks to maximize their use of the funds available, and protects the system from the kinds of liquidity failures that used to be a normal part of banking.
What is the new digital currency and how does it work?
The new type of digital currency is a kind of digital wallet that the central bank would maintain on behalf of private customers and institutions. In the new system, customers would have less need for the services of commercial banks because their money could be stored directly in their digital wallets as a type of cash. People who do not have a bank account, which includes over 1.5 billion people in the world today, could potentially get a digital wallet directly through the central bank. People and institutions that currently have accounts at commercial banks might also choose to transfer their funds from their commercial bank accounts to their digital wallets, progressively eliminating the need for commercial bank accounts entirely.
In the words of central bankers, the new system would allow for a kind of “managed anonymity” because while the transactions would be conducted in a generally anonymous fashion (similar to cash payments in the current system), the bank would still have a kind of oversight through the back door of the system. This would give police services greater power to track and discover illegal uses of money in the financing of criminal activities.
What are the implications?
The current system allows commercial banks to charge fees for the use of various services. The most obvious example is the fee charged to customers for the use of debit card payment systems. If customers used a digital wallet, they could potentially bypass the entire banking industry and avoid the service fees that are currently a significant cost to the economy and a major source of revenue for the commercial banks and their partners.
In the fullness of time (and perhaps not a very long time), commercial banks could potentially be eliminated altogether and the central bank would be the only kind of bank. It has already been proposed that with such a system the central bank would be able to give subsidies or support to persons or institutions that it understands to be in need, bypassing the need for welfare checks or specific corporate subsidies. The bank would be able to simply pick the winners by fiat, giving a new meaning to the term fiat currency. Of course, theoretically, the bank could also discontinue the accounts of those entities that it believes to be operating outside the rule of law.
Ultimately, the central bank would have total control over society and would serve as a kind of monetary master system, in much the same way that big tech companies serve as corporate masters over the global flow of information. Those who support these sorts of ideas generally see this as a positive development in the quest for a fair, stable, and totally secure global system.
