Without Cash, Can There be Safe Payments?

A recent Bank of Canada Staff Working Paper on ‘Safe Payments’ (2020-53) posed the question whether private payment systems based on bank deposits provide the optimal level of safety?

As cash declines, is a payment system dominated by privately issued money safe? This is an important topic because the credit risk of these deposits is greater than cash. The paper is written in the context of a future time when cash ceases to exist and CBDCs replace it.

The broad conclusions of the paper were that although there are theoretical safeguards to ensure safe payments, there will need to be additional incentives put in place to ensure sufficient adoption of safe measures.

The sort of inducements considered were the establishment of narrow banks to invest funds in highly liquid and safe government assets and to allow payments in their liabilities. Such narrow banks, also referred to as safe banks, are expensive to set up and represent an opportunity cost since their investments will earn low levels of return. In addition, deposit insurance can also make bank deposits safer.

Depositors should, of course, perform ex-ante monitoring to reduce the likelihood of their banks defaulting, ie. they should actively ensure their banks are investing properly.

They should also perform ex-post monitoring to detect signs that their banks are failing to perform early liquidation of their investments to reduce losses.

Both activities are expensive and early liquidation implies investors lose liquid balances as a means of payment.

The research suggests the safe accounts are sub-optimal because people don’t fully think through the implications of their adoption decisions. Safe accounts will be under adopted as people don’t properly understand the risks. It also found that private incentives to adopt safe accounts are distorted by public safety nets. As a result, ex-ante public interventions such as corrective taxes or subsidies on safe payment adoption can restore the optimal adoption of safe accounts.

For CBDCs, the paper concludes that they can provide a safe payment system in the absence of cash by setting up a safe bank, together with appropriate taxes or subsidies, to ensure sufficient adoption of the safe means of payment.