Federal Reserve examines stablecoin, CBDC impact on monetary policy – Ledger Insights

Earlier this month, the Federal Reserve published a thought-provoking article examining the impact on monetary policy of a central bank digital currency (CBDC), stablecoins and narrow banks.

The latter are banks that compete directly with commercial banks for deposits, but do not provide loans. As a result, they are not subject to the same run risk as conventional banks.

On the face of it, all three seem highly disruptive to the current system. However, the paper begins with a reminder that the Federal Reserve has fundamentally changed how it conducts monetary policy in the recent past.

Changes in Monetary Policy: 2007 to Date

Until the Great Financial Crisis, the Fed did not pay interest on reserves deposited by banks. As a result, banks were not incentivized to keep money at the central bank and kept a minimal level of reserves, averaging about $10 billion during 2007. In September 2023, the figure was $3.1 trillion, an increase of 30,900%.

Until 2008, the central bank controlled the interest rate through open market operations – by buying and selling Treasuries. Today it influences the interest rate through the rate it offers on central bank reserves and the reverse repo (repurchase) rate.

The latter has a similar effect on non-banks, such as money market funds and primary dealers with access to reverse repos. The central bank sells treasuries to these non-banks in exchange for their cash. It agrees to buy back the Treasuries at a future date at a slightly higher price, with the difference representing interest.

This significant change is important because of the potential for CBDCs, stablecoins and other changes to disrupt how interest rates are set. It can also affect the size of the Fed’s balance sheet. In 2007, it was less than $1 trillion. It peaked at nearly $9 trillion in 2022 and is now around $7.6 trillion.

While the situation looks stable right now, the paper doesn’t mention that a few people are concerned about the current Fed balance sheet size and composition.

Difference between a retail CBDC and stablecoin

While a retail CBDC (rCBDC) and stablecoin may be very different instruments, the impact of the two is similar from a monetary policy perspective. However, much depends on assumptions. For example, the author started by assuming that a retail CBDC is a substitute for cash rather than bank deposits and does not pay interest. In that scenario, the impact is minimal.

However, if you drop these two assumptions and assume that households convert some deposits into an interest-bearing CBDC, then there is a much larger impact. The result is that banks increase their lending rates and reduce the volume of new loans. However, the higher lending rates encourage non-banks to cover most of the lending shortfalls.

Since the central bank does not want lending to fall, it can lower the policy rate in response. However, this would lower the equilibrium interest rate closer to zero, giving the central bank less room to maneuver in a crisis.

An interesting takeaway is the analysis that stablecoins are very similar to a retail CBDC. The higher the interest rate offered, the greater the attraction of the stablecoins, which lures away depositors and affects lending volumes. Again, the central bank may lower rates in response.

Narrow benches have the greatest impact

Another scenario was the case of now banks. A key assumption here is that consumers view niche banks as direct competitors to commercial banks, which is not the case for stablecoins.

So if banks now offer better rates, consumers are happy to switch to them. Since narrow banks are simpler with less overhead, they are likely to offer more competitive deposit rates. We saw last year, with rising interest rates, how commercial banks failed to pass on the increase.

The shift of deposits from commercial banks to close banks lowers the ability of commercial banks to lend. And lending volumes become quite sensitive to changes in interest rates. While non-banks are expanding their lending, there is a notable overall decline in total lending.

The central bank’s balance sheet expands in all three of these scenarios.

However, the author emphasized that assumptions greatly influence the conclusions. So, if stablecoins are considered more of a perfect substitute for bank deposits, the impact could be more extreme and closer to the narrow banking scenario.