The Influence of Central Bank Digital Currencies (CBDCs) on Stock Markets
This newsletter is inspired by this Reuters article titled ‘SWIFT planning launch of new central bank digital currency platform in 12-24 months’. Global bank messaging network SWIFT is planning a new platform in the next one to two years to connect the wave of central bank digital currencies now in development to the existing finance system, it told Reuters.
In our future newsletters, we will highlight the investment opportunities that will be brought by SWIFT after it implements the central bank digital currencies platform, and how it will disrupt the financial markets. However, this newsletter will only be for paid subscribers. Use this link ‘The Baileys and Partners Subscription Plans’, just in case you want to upgrade to paid. In this newsletter, we are going to highlight the influence of central bank digital currencies in the stock markets.
Introduction
Recently, a new invention in central banking has emerged, providing a rapidly evolving technology that can be utilized to produce a digital version of central bank money, the central bank digital currency (CBDC). CBDCs are best thought of as the digital counterpart of cash. It is a risk-free type of central bank money because it may be used in electronic payments just like cash, and unlike bank reserves, a CBDC is the central bank's direct liability.
Central bank cash money has been in circulation for decades, first as metallic coins and later as banknotes. Given this historical trend, it is unsurprising that the vast majority of central banks are either issuing or considering issuing a CBDC. According to a recent poll of central banks, three-quarters are working on CBDC, with half performing trials or proofs of concept and one in ten launching pilots. Despite widespread interest in this topic, academics have been hesitant to investigate the macroeconomic and monetary consequences of CBDCs.
One possible explanation is a general lack of understanding about the effects and operation of existing kinds of central bank-issued money in the economy. CBDCs mainly mirror the function of physical currency or reserves, so understanding how these kinds of money work is critical in assessing the ramifications of implementing a CBDC. The impact of CBDC on financial markets and institutions is one area where there is a particular lack of knowledge, despite the fact that this is a critical aspect to understand given the consequences of post-crisis regulatory changes and the impact of central bank monetary policy during the ultra-low interest rate environment.
Overview of Central Bank Digital Currencies (CBDCs)
A CBDC is the digital equivalent of a country's fiat currency issued by the central bank, and it represents the central bank's liabilities. A CBDC can be implemented utilizing a range of technologies, the design of which will influence the policy aims. The simplest form is a straight adoption of currency in which the CBDC is a direct claim on the central bank, but it might be granted more access, as in a token-based system using distributed ledger technology (DLT) or an account-based system using traditional database technology.
The two-tier system requires the central bank to issue the CBDC exclusively to licensed banks or other regulated financial institutions that can utilize it to provide liquidity to their customers. This is comparable to how banknotes are now issued, while also maintaining financial intermediation; however, the design may allow the general public access to the CBDC. An indirect implementation entails the central bank expanding access to its balance sheet in order to offer support for privately issued assets that can be exchanged.
The latter can entail expanding access to central bank reserves in order to back privately produced digital tokens or providing backing for privately issued stablecoins. Different implementation strategies have ramifications for monetary policy and financial stability, and should be customized to match the specific demands of each country.
A CBDC generally has the same purposes as existing monetary and financial stability policy, allowing the central bank to offer a secure and stable unit of account, a resilient payment and settlement system, and to accomplish macroeconomic targets such as price stability and full use. However, it will present additional financial stability problems as a type of risk-free central bank liabilities available by the general public could have repercussions on the demand for commercial banks deposits and central bank and commercial bank balance sheets will become more interconnected.
Importance of Stock Markets in the Economy
Stock markets, as emergent elements of modern economic systems, play an important role in economic performance. They give direction and corporate valuations, mobilize domestic and international financing, and promote risk sharing. Both theoretical and empirical studies have demonstrated that stock market development is a significant driver of economic growth. In 1996, Jean-Claude Bérthélemy and Aristomène Varoudakis conducted a detailed review of the literature on this subject for the World Bank.
Raising capital through equity issuance has long been seen as a significant financing conduit, as exemplified by the fundamental Modigliani and Miller arguments. High-growth enterprises in particular rely heavily on equity financing. A well-functioning stock market boosts the availability of financing, and consequently the likelihood of success, for these businesses. Stock market valuation can promote effective resource allocation by directing money to initiatives with the highest Net Present Value.
This is a critical component of financial systems that is often overlooked in basic Keynesian macroeconomic models. Debt is increasingly being issued by developing-country governments, and it has been suggested that valuation on global financial markets has at least partially removed earlier Washington Consensus conceptions of conditionality in debt sustainability. Active research is being conducted on global equity valuation and the effects of foreign portfolio investment, with a particular emphasis on the implications for financial stability following a capital flight crisis.
A convincing positive relationship between stock market development and economic growth has been robustly reestablished following the recognition that the ‘stock markets promote growth’ hypothesis of the 1980s was prematurely dismissed in the aftermath of financial liberalization failures in many developing countries. Robert Shiller, an economist and Nobel Prize laureate, discusses this topic in a 2013 World Economic Forum article.
Significance of the Relationship between CBDCs and Stock Markets
A change in the CBDC rate will have a direct impact on financial institutions' funding costs, as the risk-free rate is a significant determinant of opportunity cost when granting credit. In the event where the CBDC is an ideal substitute for government debt, the marginal cost of funds for a government loan will be identical to the rate at which the government can directly finance spending with fresh money.
This would affect the lending decisions of all firms, public and private; therefore changes in CBDC rates are expected to have an economy-wide impact, making it possible to aggregate all enterprises' credit demand. Any shift in credit demand will cause changes in aggregate investment; however, the influence on the stock market is less apparent.
This is because reduced debt financing by enterprises increases the marginal relevance of equity financing; nevertheless, if the money supply is reduced, there will be excess demand for money in the IS-LM general equilibrium, causing interest rates to fall. This will make credit and equity financing substantially cheaper than the initial equilibrium, but it is unclear which will rise. However, any decreases in government or private sector debt will undoubtedly reduce the size of the debt market when compared to an economy at full use.
The second issue involves the link between the central bank's interest rates and those in the interbank market. Under the assumption that financial institutions and the general public can hold CBDC instead of risk-free government debt, changes in the CBDC interest rate will have a direct impact on the entire yield curve for government debt up to the longest maturity, as well as the interest rate on interbank loans.
This is a simplification of reality in which institutional supply and demand factors influence government yields; therefore the model may be used to perform a partial equilibrium examination of the impact of interest-bearing CBDC on the government debt market. High-quality assessments of this topic are available, such as the Federal Reserve Bank of New York staff report on a related question about negative interest rate policy. In any case, if changes in the CBDC rate successfully translate into one-for-one changes in the risk-free rates on government debt, this would be considered fiscal policy rather than monetary policy.
Regardless of the ratio of private sector debt to CBDC, changes in public borrowing rates would have an impact on the government's budget constraints and hence its spending and taxing choices. However, assuming that the government and/or the public sector solely hold the CBDC, this would represent a shift in the debt-to-money supply balance, affecting government expenditure via the money and credit channels. Diagrams to illustrate this study have been excluded for the purpose of brevity, but they will be included after the model given has been extended to a broader Keynesian cross IS-LM framework.
It is critical to investigate the interaction between CBDCs and stock markets. An earlier article examined the impact of implementing a CBDC on the banking industry and concluded that welfare improvements could only be reached if a CBDC competed with bank deposits. If a fully-fledged CBDC were established, it would be the nationalization of the banking sector and might result in a significant reduction in credit as deposit funding fell.
This would diminish the money supply, and consequently aggregate demand. In this scenario, government deficits would have to be funded by printing money, with all of the associated risks. Stock markets are likewise likely to shrink in size relative to GDP as the economy's demand for equity financing declines. So implementing a CBDC is not a free exercise, and the results will be determined by the particulars of the institutional structures.
Effects of CBDCs on Stock Markets
Central Bank Digital Currencies (CBDCs) may have a variety of consequences on stock markets, depending on how they are introduced and used. Here are some potential impacts:
CBDCs have the potential to improve liquidity in financial markets, especially stock markets, by facilitating transaction settlement. This could lead to shorter settlement times and lower transaction costs, which could boost trade volumes and market liquidity.
CBDCs can improve access to finance for investors and enterprises by expediting fund transfers and increasing transaction efficiency. This enhanced access to funds has the potential to increase stock market investing activity.
Market infrastructure: the implementation of CBDCs may require adjustments to clearing and settlement systems. This could lead to improvements in market infrastructure efficiency and resilience, benefiting stock markets by lowering operational risks and increasing market stability.
Impact on traditional banks: CBDCs, depending on their design and adoption rates, may enhance competition for traditional banks by offering other methods of keeping and transferring funds. This could have an influence on loan availability and capital costs, influencing stock market valuations, particularly for financial sector stocks.
CBDCs could impact monetary policy transmission. CBDCs may allow central banks to have greater direct control over the money supply and interest rates, thus influencing investor behavior and stock market dynamics.
CBDCs can improve cross-border transactions by simplifying currency exchange and lowering expenses. This could result in more international investment flows into stock markets, as investors may find it easier to invest in overseas stocks.
Regulatory implications: CBDCs may require revisions to financial market regulations. The regulatory clarity and monitoring around CBDCs may have an impact on investor confidence and behavior in stock markets.
Market volatility: CBDCs may cause short-term market volatility as participants adapt to the new technology and its ramifications. CBDCs, on the other hand, may help to strengthen market stability in the long run by increasing efficiency and transparency.
Conclusion
Central bank digital currencies (CBDCs) may have both good and negative effects on stock markets. On the one hand, CBDCs offer the potential to increase market liquidity and efficiency by streamlining transaction processes and shortening settlement times. This could result in larger trade volumes and better access to funds for investors and businesses, boosting stock market activity. Furthermore, CBDCs may allow cross-border transactions and international investment flows, possibly widening market participation and expanding investment prospects.
However, CBDCs may provide issues, such as greater competition for traditional banks and significant disruptions to current market infrastructure. Furthermore, the implementation of CBDCs may entail changes to regulatory frameworks and generate uncertainty about monetary policy transmission, affecting investor confidence and market stability in the medium run.
In summary, the impact of CBDCs on stock markets is determined by a variety of factors, including implementation, acceptance rates, and regulatory environment. CBDCs promise to promote efficiency and financial inclusion, but they also introduce risks and uncertainties that must be properly managed. Finally, the overall impact of CBDCs on stock markets will be determined by how effectively these problems are solved and the benefits realized in practice.
Overall, the impact of CBDCs on stock markets will be determined by a variety of factors, including their design, adoption rates, regulatory environment, and macroeconomic conditions. CBDCs have the potential to provide major benefits in terms of efficiency and financial inclusion, but they also present obstacles and uncertainties that market participants and governments must overcome.