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Central Banks and money: an everchanging interplay
Colloquium AEDBF Europe, 30 November 2018
Keynote address by M. Jan Smets, Governor of the National Bank of Belgium
Ladies and gentlemen
It is my great pleasure to welcome you today in the premises of the National Bank of Belgium and to
have the opportunity to address this interesting colloquium on the vast topic of money and currencies.
Money is subject to a constant evolution and central banks must carefully take these evolutions into
account when conducting the tasks they are entrusted with. The issuance of euro banknotes is one
of the best known and most visible activities of the Eurosystem central banks1 but, as will become
clear hereafter, it is by no means the most important of their tasks. Instead, central banks will take a
broad interest in the many different appearances and functions of money. Evolutions like the rise of
local currencies or the emergence of digital money such as privately issued cryptocurrencies will
certainly not go unnoticed.
First, I will briefly touch upon the concept of money, before shedding some light on the difference
between commercial bank money and central bank money. I will then clarify the process through
which central banks create central bank money, and position central bank money against alternative
forms of money such as local currencies and cryptocurrencies. In this process we will examine the
impact alternative forms of money have on the central banks' basic tasks to formulate and implement
monetary policy and to contribute to financial stability. Finally, I will talk a little about the promises
that the technology underpinning the rise of cryptocurrencies may hold for central banks, especially
in view of the possible issuance of a central bank digital currency.
1 WHAT IS MONEY?
What is money? It is not easy to give a clear definition. Doctor David Mann, in his standard work on
the legal aspect of money, spends no less than fifty pages to clarify the concept of money2. Not only
does money exist in the form of banknotes and coins, it can also take many other forms such as a
cheque, a scriptural form (i.e. units in an account) or nowadays even some lines of computer code.
Furthermore, money traditionally serves three main functions. First, as a means of exchange, it
prevents that we would have to exchange goods and services directly for other goods and services.
Secondly, as a unit of account, money enables us to compare the value of different goods and
services. It is the standard used to express their prices. In this function, money may be equated with
currency, which in the common language is defined as the money or a system of money that is used
in a particular country at a particular time. And finally, money acts as a store of value, it is used to
accumulate savings which can be quickly and easily converted into any type of good or service.
The law, too, does not hail a single and uniform definition of 'money'. To just give an example, found
in EU law: both the Payment Services Directive and the Payment Accounts Directive explicitly define
'funds' as banknotes and coins, scriptural money, and electronic money in the sense of the electronic
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money directive3. The Settlement Finality Directive, on the other hand,4 does not define the notions
of 'funds' and 'money', but from the objectives of this Directive it is clear that only money and funds
by means of a book entry are envisaged and not banknotes and coins. So, from a legal perspective,
'money' is usually defined with reference to the context in and the objectives for which the concept
is being used.
2 CENTRAL BANK MONEY VERSUS COMMERCIAL BANK MONEY
Let us now turn to the instances that issue money, and to the money creation process. In modern
day society, the most familiar issuers of money are on the one hand central banks which provide
central bank money in the form of both banknotes and deposit liabilities, and on the other hand
commercial banks, which generally issue private or commercial bank money in the form of deposit
liabilities5.
Economic activity can in principle take place without the coexistence of central and commercial bank
money. Both solutions - on the one hand, narrow or mono-banking where there was only central
bank money and, on the other hand, free banking where there was only commercial bank money -
have existed in the past. But neither has proved sufficiently stable or efficient to survive on its own.
There has been an evolution towards intermediate solutions in which both types of money play an
important part in facilitating economic activity. Up till today, it is believed that the most effective and
efficient financial system is one in which commercial bank money and central bank money coexist.
2.1 MONEY CREATION BY CENTRAL BANKS
How then do central banks create money and influence the quantity of money in the market? In the
first place, central banks provide central bank money in the form of banknotes. The issuance of
banknotes entails a reduction in the liquidity of credit institutions, since credit institutions must deposit
liquid means with the central bank against the withdrawal of the banknotes. Banknotes and coins in
euro are the only ones to have legal tender status in the euro area.
Secondly, central banks provide central bank money in the form of deposit liabilities. Deposit liabilities
are created through the monetary policy that central banks conduct, which aims at maintaining price
stability. Central banks maintain price stability through influencing the availability and growth of
money in the economy which is operationally implemented through the transmission mechanism of
the monetary policy instruments. The quantity of money in euro depends on the liquidity needs of
commercial banks and eventually of the market participants like households, companies and the
government. The Eurosystem can influence the quantity of money in the economy in three ways.
First, the Eurosystem central banks conduct open market operations on the basis of Article 18.1, first
indent of the Statute of the ESCB6. The most important tools are the main refinancing operations,
which are regular liquidity-providing reverse transactions conducted with a frequency and maturity of
normally one week7. Since 16 March 2016, the interest rate on main refinancing operations has been
pegged at 0.00 percent.
3
Article 4, (25) of Directive (EU) 2015/2366 of the European Parliament and of the Council of 25 November
2015 on payment services in the internal market, and Article 2, (22) of Directive 2014/92/EU of the European
Parliament and of the Council of 23 July 2014 on the comparability of fees related to payment accounts,
payment account switching and access to payment accounts with basic features.
4
Directive 98/26/EC of the European Parliament and of the Council of 19 May 1998 on settlement finality in
payment and securities settlement systems.
5
COMMITTEE ON PAYMENT AND SETTLEMENT SYSTEMS, The role of central bank money in payment
systems, Bank for International Settlements, August 2003, 7.
6
Protocol (No 4) on the Statute of the European System of Central Banks and of the European Central Bank.
7
Other types of open market operations are longer term refinancing operations, fine-tuning operations and
structural operations. For more information, see EUROPEAN CENTRAL BANK, The Monetary Policy of the
ECB, 2011, 104-108.
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Secondly, the Eurosystem implements monetary policy by setting the interest rates on its standing
facilities on the basis of Article 18.1, second indent of the Statute of the ESCB. Standing facilities
provide or absorb liquidity with an overnight maturity on the initiative of counterparties. Two standing
facilities are available to commercial banks: the marginal lending facility (to obtain intraday credit to
cover shortages in liquidity) and the deposit facility (to make overnight deposits of excess liquidity).
Thirdly, according to Article 19.1 of the Statute of the ESCB, the ECB may require commercial banks
to hold minimum reserves (or compulsory deposits) on accounts with the Eurosystem central banks.
The intent of the minimum reserve system is to create (or enlarge) a structural liquidity shortage: an
increase of minimum reserves entails a reduction of liquidity in the market and vice versa. The
reserve requirement of each institution is determined in relation to elements of its balance sheet.
2.2 MONEY CREATION AND FRACTIONAL RESERVE BANKING
So how, then, is money created in practice? Let me clarify this process through the monetary policy
instrument of the minimum reserves. Commercial banks are limited in the total amount they can loan
to customers by, among others, their required minimum reserve ratios which oblige a commercial
bank to keep a minimum, predetermined percentage of its deposits in an account with the central
bank. This is called the system of fractional reserve banking because commercial banks are required
to only hold a fraction of their total deposits in a central bank account. In practice, if the central bank
imposes a required minimum reserve ratio of, say, 0.10, then each commercial bank is obliged to
keep at least 10% of its total deposits as reserves, i.e. in the account it has with the central bank.
The process of money creation can be illustrated with the following simplified example: when a
person deposits 100 EUR in a commercial bank, this bank will keep 10 EUR as reserves in the central
bank. To make a profit, the commercial bank loans the remaining 90 EUR to another customer. This
customer spends the 90 EUR by buying something from a merchant. The merchant deposits the 90
EUR with his bank. The merchant's bank keeps 9 EUR as reserves in the central bank, and then
lends the remaining 81 EUR to another customer. If this chain continues indefinitely then, in the end,
an amount close to 1000 EUR has gone into circulation and has therefore become part of the total
money supply8.
The system of fractional reserve banking is being criticised by certain scholars since bank deposits
are only partially backed by central bank deposits, the difference being used to finance investments
in the economy. Short-term deposits fund long-term loans, which renders the banking system
inherently vulnerable to bank runs even if prudential regulation and the deposit guarantee system
are making banks less prone to such risks9. It is also deemed to contribute to an enormous build-up
of debt, which forms the Achilles' heel of the financial system. Some therefore propose to move from
fractional banking to a so-called "sovereign money system" or to "narrow banking", where every
commercial bank deposit would be fully backed by central bank money. Proponents of a sovereign
money system argue that commercial banks would lose their capacity to create money in the form of
demand deposits, becoming simple intermediaries between savers and borrowers. Private money
creation would be eliminated and replaced exclusively by money creation through the central bank,
on behalf of the public interest. Instead of encouraging or discouraging the accumulation of private
sector debt by manipulating interest rates, the central bank would moderate the pace of economic
activity by directly controlling the rate at which additional money would be created, or, in rare cases,
destroyed10.
No matter how tempting a sovereign money system sounds, many issues remain to be examined
before considering a move towards narrow banking. For example, such a move could greatly impact
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the funding structure of commercial banks, something they are not indifferent to. Some opponents
also point to the need to maintain a sufficient degree of credit growth in order to stimulate economic
growth11. Earlier this year Switzerland organised a referendum on the introduction of a sovereign
money system called Vollgeld, which requires that every credit granted by a commercial bank is
entirely covered by deposits. The proposal was eventually rejected. This does not mean that central
banks are entirely indifferent to sovereign money systems, as will become clear in a little while when
I talk about central bank digital currencies.
3 ALTERNATIVES TO MONEY IN THE FORM OF EURO BANKNOTES AND DEPOSIT
LIABILITIES AT CENTRAL BANKS AND COMMERCIAL BANKS
So far, I have been talking about central bank money which is being provided in the form of banknotes
and deposit liabilities in euro. But any type of money can potentially be created and issued by for
example private entities, as long as it allows in one way or another to fulfil the main functions of
money. Let us call these types of money alternative money (in the sense that they are an alternative
for both central bank money and for deposits in euro at commercial banks' accounts).
Central banks also take an interest in alternative types of money, even though they would at first
sight fall outside the ambit of the central bank's usual competences. Central banks may have more
than one reason for this. For starters, a considerable increase in the quantity and use of alternative
money may undermine the efficacy of the central bank's monetary policy. If the market players were
to massively move away from the use of banknotes and deposits in euro, a central bank could find it
more difficult to attain its objective of price stability. Indeed, by substitution for regular money such
as banknotes and deposits in euro, widely adopted types of alternative money could significantly
reduce a central bank's control over monetary conditions, such as its ability to steer interest rates12.
Furthermore, many central banks, among which the Eurosystem central banks, are entrusted with
the task of contributing to the stability of the financial system13. Financial stability may be impacted
by sudden or considerable changes in the quantity and use of alternative types of money14.
3.1 LOCAL CURRENCIES
A local or complementary currency is a currency that can be spent in a particular and usually limited
geographical locality, which differs from an official currency (like the euro) and about which a group
of private persons, companies or government instances have agreed to accept it as a means of
exchange. A local currency therefore acts as a complementary currency to an official currency, rather
than replacing it, and aims to encourage spending within a local community or to support the local or
social economy.
European law does not directly deal with the issue of local or complementary currencies but Article
178bis of the Belgian Penal Code stipulates that whosoever issues a monetary sign which is meant
to circulate in public without being authorised by the competent authority, is subject to imprisonment
or the payment of a fine. This Article does not clarify which is the competent authority to authorise
the issuance of a local or complementary currency, but without a doubt the National Bank of Belgium
will have its say, and its opinion is in practice regularly sought by prospective issuers. Article 178bis
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does not apply if a monetary sign is exclusively issued to serve a particular and well-defined purpose
or to circulate locally only15.
It should be noted that the prohibition of Article 178bis only applies to the issuance of monetary signs
in a material and tangible form, meaning that purely digital representations of an alternative currency
are not prohibited by this Article. This does not mean that a local or complementary currency in digital
form can be issued without observing any law. If the issuer of a local or complementary currency
offers payment services in the sense of the Payment Services Directive16, for example, the issuer
should examine beforehand if he or she must obtain a licence as a payment institution. But even
under the Payment Services Directive, the issuer of a local currency that can only be used within a
limited network may be exempt from many of its provisions17.
In Belgium the National Bank of Belgium is designated as the competent authority for grating licenses
to payment institutions and to assess the compliance with the grounds of exclusion for limited
networks. This is a part of the Bank's tasks of prudential supervision. In case of doubt, prospective
issuers of local or complementary currencies in digital form would do well to consult the National
Bank on this matter.
3.2 CRYPTOCURRENCIES
Let us turn then to this other infamous type of alternative money, known as virtual or cryptocurrencies
such as Bitcoin, Litecoin, Ether and many others. The main characteristic of cryptocurrencies is that
they are issued, kept and exchanged in a decentralized way (usually based on Distributed Ledger
Technology or DLT), removing the need for intermediate players and systems like commercial banks,
payment institutions and clearing and settlement systems. Cryptocurrencies can be used only as
contractual money, when there is an agreement between buyer and seller in order to accept a given
cryptocurrency as a means of payment. In the EU, cryptocurrency is at present not regulated and
cannot be regarded as being subject to the Payment Services Directive or the E-money Directive18.
From an economic perspective, most of the cryptocurrencies currently known do not fully meet all
the three functions of money that I mentioned before. Cryptocurrencies have a limited function as a
medium of exchange because they have a very low level of acceptance among the general public.
In addition, the high volatility of their exchange rates to official currencies renders cryptocurrency
useless as a store of value even for short-time purposes, let alone for the purpose of being a
longerterm savings instrument. Finally, both the low level of acceptance and the high volatility of their
exchange rates and thus purchasing power make them unsuitable as a unit of account. Therefore,
cryptocurrencies cannot be regarded as full forms of money at the moment19.
Cryptocurrencies are actually fraught with many issues. From a central bank perspective,
cryptocurrencies pose a risk for the conduct of monetary policy or for the stability of the financial
system. Studies show that cryptocurrencies should not pose a significant threat if they are merely
15
Preparatory works to Article 4 of the Law of 23 December 1988, Senate, 499-1, 1988-89.
16
Transposed in Belgium by the Law of 11 March 2018 on the statute and supervision of payment institutions
and institutions for electronic money.
17
See Article 3, (k) of the Payment Services Directive. This Article excludes services based on specific
payment instruments that can be used only in a limited way when (i) the payment instruments allow the
holder to acquire goods or services only in the premises of the issuer or within a limited network of service
providers, or (ii) when these instruments can be used only to acquire a very limited range of goods or
services. A third exclusion ground exists when the payment instruments are only valid in a single Member
State and are provided at the request of an undertaking or a public-sector entity and regulated by a national
or regional public authority for specific social or tax purposes to acquire specific goods or services from
suppliers having a commercial agreement with the issuer.
18
Virtual Currency Schemes - A Further
EUROPEAN CENTRAL BANK, Analysis, February 2015, 24.
19
Idem, 24. The crypto-community is, however, looking for solutions to this problem, e.g. through the creation
of stablecoins. See
https://medium.com/fintech-weekly-magazine/stablecoins-what-are-they-actually-fora1bc0732e472.
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used as a medium of exchange, since in this case cryptocurrencies would usually be converted back
to regular money as soon as the transaction is settled20. Financial stability risks may, on the other
hand, appear if cryptocurrencies were to be widely perceived as a proper store of value, which they
are not. This is because unlike commodities such as oil and gold, cryptocurrencies have no intrinsic
value. They are nothing more than lines of computer code. Neither do they carry any legal value, in
that they are not backed by a sovereign entity as is the case for regular money. The value of
cryptocurrencies therefore depends on self-fulfilling expectations, which renders them conducive to
speculation and to bubbles21. Finally, cryptocurrencies could pose a considerable risk for monetary
policy and financial stability if they were to be generally accepted and used as units of account. In
this case cryptocurrencies would substitute for the bulk of regular money, including central bank
money. There is doubt, however, that cryptocurrencies would ever become trusted units of account,
among others given their lack of either legal tender or regulatory status22. In any case, it is not
surprising that many national and international authorities have issued warnings against the
investment in and use of cryptocurrencies.
3.3 WILL THE PROMISES OF DLT LEAD TO THE ISSUANCE OF CENTRAL BANK DIGITAL
CURRENCIES?
So, let me wrap up my thoughts. I have thus far briefly explained the process through which central
banks create central bank money, as a result of the implementation of the monetary policy. The
creation of alternative types of money by private players, such as cryptocurrencies, carries the risk
of impairing monetary policy transmission or affecting financial stability. But the advent and rise of
cryptocurrencies and its underlying technology also offer opportunities to central banks23.
First, DLT has the potential to improve efficiency and security of existing payment systems. These
benefits suggest that DLT could help to further underpin trust in the monetary system. Central banks
may, for example, choose to permit interbank payment systems to run on a DLT network24.
Secondly, some central banks have taken interest in DLT to serve as a platform for the issuance of
a so-called "central bank digital currency" or "CBDC"25. A CBDC can be defined as a central bank
liability, denominated in an existing unit of account, which serves both as a medium of exchange and
a store of value. This would be an innovation for the public at large and for use in retail payments,
but not for certain wholesale entities. Indeed, as we have seen, central banks already provide digital
money to commercial banks in the form of deposit liabilities26. Some central banks have completed
proofs of concept, for example to simulate if central bank-operated wholesale payment systems could
run on DLT-based applications27. These projects usually show that DLT is not yet mature enough
for current adoption, and that the legacy systems are outperforming DLT-based applications.
Unlike commercial banks, the public at large is only provided central bank money in the form of
banknotes and coins. A general purpose CBDC, open to the public at large, would be a substitute or
20
A. STEVENS, o.c., 81.
21
Idem, 82.
22
Idem, 82.
23
For some other recent documents that take either positive or negative views on the crypto-revolution, see
among others: FINANCIAL STABILITY BOARD, Crypto-asset markets. Potential channels for future
financial stability implications, 10 October 2018; EUROPEAN PARLIAMENT, Resolution on distributed
ledger technologies and blockchains: building trust with disintermediation, 2017/2772(RSP), 3 October 2018.
24
A. STEVENS, o.c. 83.
25
The best-known example today is the Swedish Riksbank's e-krona project. See https://www.riksbank.se/en-
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a complement to cash. Whether the introduction of a CBDC is desirable depends on many different
considerations. More research should therefore be devoted to the benefits, drawbacks and
implications of the issue of a CBDC. Many questions remain, also of a legal nature. Central banks
must, for example, take into account legal considerations when contemplating the issuance of
general purpose or retail CBDCs. Issuance may require legislative changes which might not be
feasible in the short term. One question is whether CBDCs would have legal tender status just like
euro banknotes and coins. It may be necessary to extend the ECB's monopoly to issue legal tender
banknotes to CBDCs. Central banks would also have to take account of Anti Money Laundering
(AML) concerns and requirements. Issuing a CBDC that does not adequately comply with these and
other supervisory and tax regimes would not be advisable28. It is currently not clear how AML
requirements can be implemented practically for anonymous forms of CBDC.
4 CONCLUSION
To conclude, it is no understatement to say that there is an everchanging interplay between money
and the central banks' mandate to implement monetary policy and to safeguard financial stability.
The future of money is currently being shaped at an unprecedented pace, thanks to the digital
revolution. One of the many emerging trends is the rise of so-called asset-backed cryptocurrencies.
This is a cryptocurrency that represents an underlying traditionally valuable, real-world asset to which
it is pegged. This trend, called tokenisation, shows similarities with the old gold standard where
banknotes issued by central banks were exchangeable for the corresponding value in gold.
Tokenisation shows a lot of promise for traditional assets such as gold and diamonds, but is it
conceivable that other assets are tokenised and find their way to the financial system and maybe
into new forms of money? Many questions to which presently few answers can be offered... So, let
me assure you that a lot of challenging work remains to be done in this area, also with respect to the
legal issues surrounding them. I wish you all an insightful day!
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