Does the introduction of a central bank digital currency (CBDC) crowd out bank funding? Does it open the door to runs on the aggregate banking system? In a recent Staff Working Paper we provide insights on these questions. We find that some of the major risks to financial stability posed by CBDC can be addressed by a set of four core design principles for a CBDC system. Implementing these principles, however, is non-trivial and risks would remain.
Francis Breedon, Louisa Chen, Angelo Ranaldo and Nicholas Vause
Most academic studies find that algorithmic trading improves the quality of financial markets in normal times by boosting market liquidity (so larger trades can be executed more quickly at lower cost) and enhancing price efficiency (so market prices better reflect all value-relevant information). But what about in times of market stress? In a recent paper looking at the removal of the Swiss franc cap, we find that algorithmic trading provided less liquidity than usual, at worse prices, and that its contribution to efficient pricing dropped to near zero. Market quality benefits from a diversity of participants pursuing different trading strategies, but it seems this was undermined in this episode by commonalities in the way algorithms responded.
What could falls in sterling mean for UK firms’ ability to sustain foreign currency (FX) debt obligations? The value of sterling began falling around two years ago and dropped further after the EU referendum – remaining around these lower values ever since. There is every possibility that sterling may stay low for the foreseeable future – creating both potential winners and losers. In this piece, I investigate one particular channel for losses related to sterling weakness: whether UK firms could find meeting their FX debt obligations more challenging. By reviewing market intelligence, market prices and derivatives databases, I find limited evidence that sterling weakness has yet produced any significant changes to UK firms’ ability to manage their FX debt obligations.
Despite decades of trade deficits (spending more on foreign products than foreigners spend on UK products), the UK’s net liability with the rest of the world remains negligible. How does it pull off that trick? By earning a higher return on its foreign assets than it pays on its foreign liabilities.
The Law of One Price (LOOP) is an old idea in economics. LOOP states that the same product should cost the same in different places, expressed in the same currency. The intuition is that arbitrage (buying a product where it is cheap and selling it where it is expensive) should bring prices back into line. Can LOOP help us understand UK inflation? Yes. I find EU prices have much higher explanatory power for UK prices than domestic cost pressures, and the effects of exchange rate changes last longer, but build more slowly than commonly assumed.
Economists usually talk about money serving three functions – a medium of exchange, a store of value, and a unit of account. But the ability to make payments using commercial bank deposits, which account for the vast majority of money, has already divorced the physicality of notes from the concept of the medium of exchange. Inflation and non-remuneration renders physical money a poor store of value. And the unit of account does not rely on physical cash. So is there a specific role for physical paper money anymore?