Stefan W' Schmitz

1
Will central banking survive electronic money?

• Stefan W. Schmitz
• The future of payments
• Bank of England, 19-20 May 2005, London

1
2
Sources

• Most of the presentation builds on the papers
  published in
• M. Latzer and S. W Schmitz (eds) (2002) Carl
  Menger and the Evolution of Payments Systems
  From Barter to Electronic Money, Cheltenham
  Edward Elgar.
• S. W. Schmitz and G. E. Wood (eds) (forthcoming)
  Institutional Change in the Payments System and
  Monetary Policy, London Routledge.

3
Structure

• Essential elements of central banking and
  effective monetary policy
• Models of the effects of eMoney on Monetary
  Policy
• Conceptual approach to institutional change in
  the payments system
• Institutional change in payments system and
  monetary policy
• The likely institutional structure of eMoney
  schemes
• Summary and conclusion

4
1. Essential elements of central banking and
effective monetary policy

• Implementation of monetary policy
• Manipulation of relative price (i.e. opportunity
  costs) of medium of final settlement
• Spread of rate of interest on medium of final
  settlement and optimal alternative investment
  (i.e. money market)
• Unique position of CB in monetary policy
  implementation?
• CB money is the generally accepted medium of
  exchange (GAME)
• Incidental functions
• Uniform unit of account
• Medium of final settlement
• CB can manipulate supply and relative price of
  GAME at zero marginal cost

5
1. Essential elements of central banking and
effective monetary policy (contd)

• Aggregate supply and demand for CB money?
• Structural liquidity deficit important SCB(rpol)
  lt DCB(rpol)
• Ensures demand for CB money at refinancing
  operations
• Covered only temporarily (repurchasing
  operations)
• Target volume of repos set in accordance with
  estimated structural liquidity deficit at
  intended overnight rate
• Volume of OMOs partly endogenised by tender
• Relative, but not absolute volume of demand for
  CB money relevant
• CB can ensure that SCB(rpol) lt DCB(rpol) holds

6

• Essential elements of central banking and
  effective monetary policy
• Models of the effects of eMoney on Monetary
  Policy
• Conceptual approach to institutional change in
  the payments system
• Institutional change in payments system and
  monetary policy
• The likely institutional structure of eMoney
  schemes
• Summary and conclusion

7
2. Models of the effects of eMoney on Monetary
Policy

• CB money will be replaced by other media of
  exchange -- (Friedman 1999, 2000 Cohen 2001,
  Crede 1995, England 1996, Kobrin 1997, Matonis
  1995)
• Residual demand for CB money positive --
  (Berentsen 1998, Capie/Wood 2001, Freedman 2000,
  Goodhart 2000, Krueger 1999, Woodford 2000)
• Publicly sanctioned unit of account
• (a) Settlement by privately issued fiat-type
  eMonies -- (Costa- Storti/De Grauwe 2003)
• (b) Settlement by transfer of wealth --
  (Browne/Cronin 1995, King 1999, Kroszner 2001)
• IV. Monetary policy w/o CB money -- (Goodhart
  2000, Freedman 2000, Henckel/Ize/Kovanen 1999,
  Lahdenperä 2001)

8
2. Models of the effects of eMoney on Monetary
Policy (contd)

• I. Objectives of assessment
• Critical assessment of the literature
• Focus on the institutional structure of the
  monetary system wrt the money market, the GAME
  and the unit of account
• Litmus-test
• Do papers address the effect of eMoney on
  essentials of effective monetary policy?

9
2. Models of the effects of eMoney on Monetary
Policy - Conclusions

• I. Neglect of transition process from GAME
  uniform unit of account
• II. Neither GAME nor unit of account
• III. Neglect of literature on time inconsistency
  privately issued fiat-type currencies
• IV. Confusion over medium of exchange and
  means of payment

10
2. Models of the effects of eMoney on Monetary
Policy - Conclusions

• V. Neglect of mechanisms of price formation
• VI. No link between unit of account and means of
  payment
• VII. Liquid funds traded in money market not
  well defined
• On closer inspection collapse to current
  set-up/commodity standards/Walrasian economy

11

• Essential elements of central banking and
  effective monetary policy
• Models of the effects of eMoney on Monetary
  Policy
• Conceptual approach to institutional change in
  the payments system
• Institutional change in payments system and
  monetary policy
• The likely institutional structure of eMoney
  schemes
• Summary and conclusion

12
3. Conceptual approach to institutional change in
the payments system

• Literature focuses on impact of new technologies
• Implicit assumption technology main driver of
  institutional change
• Parallel to eCommerce and new economy hype?
• Rather than politico-economic interaction
  between opposing interests, different power
  resources changing incentives and costs of
  particular institutional structures
• Literature assumes structural continuity once
  limit is reached
• Monetary economy w very low demand for CB money
  and zero demand
• Same institutional structure or fundamental
  institutional change?

13
3. Conceptual approach to institutional change in
the payments system (contd)

• Fundamental institutional change
• eMoney instance of institutional change
• Appropriate method of analysis institutional
  analysis
• Institutional characteristics of payments system
• Main drivers of institutional change
• Impact of eMoney
• Path dependent
• Based on current institutional structure
• Conditions for transition to new institutional
  structure

Section 4
Section 5
14

• Essential elements of central banking and
  effective monetary policy
• Models of the effects of eMoney on Monetary
  Policy
• Conceptual approach to institutional change in
  the payments system
• Institutional change in payments system and
  monetary policy
• The likely institutional structure of eMoney
  schemes
• Summary and conclusion

15
4. Institutional change in payments system and
monetary policy

• Institutional characteristics of the payments
  system
• Existence and interrelation of
• Generally accepted medium of exchange
• Unit of account
• Medium of final settlement
• Characteristics of the clearing and settlement
  institution (i.e. the nature of its clearing and
  settlement process)
• Regulatory framework
• Surrounding institutional environment (i.e.
  interbank money market, monetary policy
  implementation)

Relationship to CB money?
16
4. Institutional change in payments system and
monetary policy (contd)

• What are the relevant forces shaping
  institutional change in wholesale as well as
  retail and small-value interbank payment systems?
• What are the implications of institutional change
  in the payments system for the demand for central
  bank money and the conduct and implementation of
  monetary policy?
• Which instruments are available to central banks
  to react to institutional change in the payments
  system?

17
4. Institutional change in payments system and
monetary policy (contd)

• Recent institutional change in the payments
  system
• Wholesale payments
• Emergence of DNS due to lower liquidity costs
• Replaced by RTGS due to policy intervention
  (1990s)
• Evolution of hybrids to lower liquidity costs
  again
• High levels of tiering and of concentration of
  payment flows
• Often central banks operate RTGS (TARGET,
  Fedwire, BOJ-NET)
• Retail payments
• Electronification, product innovation, new
  market entrants
• Subject to regulation in the EU and to some
  extent also in the US
• Organisational structure and market structure
  differ across countries despite similar
  technology available
• SEPA and NLF drive institutional change in
  European cross-border and domestic retail
  payments markets

18
4. Institutional change in payments system and
monetary policy (contd)

• Long term evolution of payments system
• Foundation of central banks (Sveriges Riksbank
  1668 to ECB 1998)
• and establishment of common currencies (US
  notes 1914 to Euro notes 2001)
• politico-economic considerations

19
4. Institutional change in payments system and
monetary policy (contd)

• Humphrey, Sato, Tsurumi, Vesala (1996)
• Differences in institutional structure of payment
  systems due to politico-economic considerations
  and demand factors
• Europe early emergence of credit transfer due to
  postal giro system
• US long reliance on checks due to branching
  restrictions, low concentration, and Fed
  involvement in checks clearing and settlement
  (FedACH)
• Japan BoJ initiated centralised SVPS (NCDE) in
  1943 coordinated banking initiative the ZENGIN
  system in 1973

20
4. Institutional change in payments system and
monetary policy (contd)

• Large differences in institutional structure of
  the payments system
• across countries despite similar technology
  available
• Main drivers of institutional change in payment
  systems
• Policy initiatives and demand factors
• Institutional change results from the interaction
  of opposing interests between
• Central banks require commercial banks to hold
  reserves
• Commercial banks economise on reserves
• Different optimal trade-offs
• between settlement risk and liquidity costs
• due to difference between private and social
  costs of disruptions
• New technology indirect influence changes
  costs underlying a particular institutional
  structure

21
4. Institutional change in payments system and
monetary policy (contd)

• Institutional structure of the payments system
  influences monetary policy by influencing its
• Essentials role of CB money as GAME and its
  role as well as the CBs role in the payment
  system
• Demand for central bank money (interest
  elasticity, volatility)
• Spill-over of intraday credit into overnight
  market
• Implementation operational efficiency of the
  payment system ? prerequisite for deep and liquid
  interbank markets ? prerequisite for OMOs
• Accuracy predictability of autonomous factors
  and the information content of money market rates
  ? predictability of structural liquidity deficit

22
4. Institutional change in payments system and
monetary policy (contd)

• Central banks actively shape institutional change
  in the payments system and have a number of
  instruments at their discretion to react to it
• Substantial influence in political process on
  legal framework
• Regulation of new payment products (e.g.
  redeemability requirement)
• Soft law CPSS Reports, Core Principles and
  Recommendations
• Substantial authority and discretion within legal
  framework
• I.e. minimum reserve requirements influence
  demand for own liabilities
• Oversight over payment systems
• Encourage systemically important payment systems
  to settle in central bank money (settlement
  policy)
• Payment system policy
• Central banks operate many LVPS and SVPS
  settlement and access policy to CB accounts and
  credit

23
4. Institutional change in payments system and
monetary policy (contd)

• Empirical evidence
• Despite large differences in institutional and
  organisational structure in payment systems
• central bank is the GAME, unit of account and
  medium of final settlement
• White (forthcoming)
• Diffusion of credit cards in the US
• Migration of payments to CHIPS
• New payment instruments (PayPal, BitPass etc)
• ? no impact on essentials of monetary policy
• Bradford, Davies, Weiner (2003) and Allen (2003)
• Non-banks engage in payment activities
• but not in settlement activities ? no impact on
  essentials of monetary policy

24
4. Institutional change in payments system and
monetary policy (contd)

• In recent history central banks have demonstrated
  
• their determination
• and their political ability to maintain control
  of the monetary system in the face of
  institutional change
• and to actively shape it.

25

• Essential elements of central banking and
  effective monetary policy
• Models of the effects of eMoney on Monetary
  Policy
• Conceptual approach to institutional change in
  the payments system
• Institutional change in payments system and
  monetary policy
• The likely institutional structure of eMoney
  schemes
• Summary and conclusion

26
5. Likely institutional structure of eMoney
schemes

• Indirect impact of new technologies on
  institutional structure
• Impact on incentives and costs concerning core
  characteristics of payments system
• Will eMoney influence the choice of generally
  accepted medium of exchange and unit of account
  in an environment of a dominant unit of account?
• Parallel use of multiple units of account not
  desirable and in the case of fiat-type currencies
  not feasible

27
5. Likely institutional structure of eMoney
schemes (contd)

• Issuers and users face strong strategic
  incentives not to opt for alternative generally
  accepted medium of exchange and unit of account
• Network effects, sunk costs, information costs
  and switching costs
• Mechanism of price formation

28
5. Likely institutional structure of eMoney
schemes (contd)

• Price formation
• Price matching in eMoney scheme
• Prices in generally accepted medium of exchange
  are multiplied by eMoney exchange rate
• Preconditions for the existence of prices in the
  eMoney unit of account
• Liquid markets for all goods in dominant
  generally accepted medium of exchange and unit of
  account -gt nominal prices in generally accepted
  medium of exchange
• Liquid market for eMoney units -gt exchange rate
  of eMoney unit
• Real prices in eMoney units higher due to spread
  between eMoney and dominant generally accepted
  medium of exchange

29
5. Likely institutional structure of eMoney
schemes (contd)

• Price formation (contd)
• Price discovery in eMoney scheme
• Nominal prices are determined on markets for all
  available goods denominated in eMoney unit of
  account
• Not all goods available
• Real prices in eMoney units higher
• due to lower intensity of competition,
• Higher prices under price matching and price
  discovery ? disincentive for adoption of
  alternative GAME and alternative unit of account

30
5. Likely institutional structure of eMoney
schemes (contd)

• Likely institutional structure of eMoney schemes
• Denomination in the dominant unit of account
• In order to endure parity ? redeemability in the
  dominant generally accepted medium of exchange
• Qualification under moderate levels of inflation
• Implication CB money remains generally accepted
  medium of exchange and medium of final settlement
• CBs can manipulate supply and relative price of
  the generally accepted medium of exchange at zero
  marginal costs

31
5. Likely institutional structure of eMoney
schemes (contd)

• Potential impact
• Decreasing demand for CB money
• CBs maintain structural liquidity deficit by
  reduction of supply
• Similar experience with other innovations in
  payments system (i.e. netting and tiering in
  LVPS, credit and debit cards)
• No negative impact on efficacy of monetary
  policy, in principle
• No impact at all in the Austrian case (Quick
  system)

32

• Essential elements of central banking and
  effective monetary policy
• Models of the effects of eMoney on Monetary
  Policy
• Conceptual approach to institutional change in
  the payments system
• Institutional change in payments system and
  monetary policy
• The likely institutional structure of eMoney
  schemes
• Summary and conclusion

33
6. Summery and Conclusions

• Institutional change results from the interaction
  of opposing interests between
• Central banks require commercial banks to hold
  reserves
• Commercial banks economise on reserves
• Different optimal trade-offs
• between settlement risk and liquidity costs
• due to difference between private and social
  costs of disruptions

34
6. Summery and Conclusions (contd)

• Likely institutional structure of eMoney schemes
• Denomination
• Redeemability
• CB money remain generally accepted medium of
  exchange and medium of final settlement
• CBs can manipulate supply and relative price of
  the generally accepted medium of exchange at zero
  marginal costs

Under moderate levels of inflation
35
6. Summery and Conclusions (contd)

• Given the political will, central banking will
  survive electronic money,
• due to the expected institutional structure of
  electronic money schemes
• and the large number of instruments at the
  discretion of central banks to cope with
  institutional change in the payments system and
  to shape it

36
Sources

• Most of the presentation builds on the papers
  published in
• M. Latzer and S. W Schmitz (eds) (2002) Carl
  Menger and the Evolution of Payments Systems
  From Barter to Electronic Money, Cheltenham
  Edward Elgar.
• S. W. Schmitz and G. E. Wood (eds) (forthcoming)
  Institutional Change in the Payments System and
  Monetary Policy, London Routledge.