CBDCs

Introduction

The 2008 financial crisis was a wake-up call for central banks worldwide. In the face of collapsing financial institutions, central banks resorted to unprecedented measures like quantitative easing (QE) to stabilize their economies. These interventions averted immediate catastrophe, but they left central banks in a fragile financial position, with bloated balance sheets that would eventually become a source of concern. As interest rates rose to combat inflation, the value of the assets held by central banks—primarily government and corporate bonds—plummeted, leaving many central banks technically insolvent.

While the public debates about CBDCs have primarily focused on concerns around privacy and centralized power, a much deeper and less-discussed issue is at play: the financial vulnerability of central banks themselves. Just as commercial banks were “too big to fail” during the 2008 crisis, central banks now face their own financial fragility. However, bailing out central banks presents a far more complex and invisible challenge, one that may be quietly solved through the introduction of CBDCs.

Central bank digital currencies have been framed as a technological advancement to modernize payment systems, make transactions faster, and promote financial inclusion. But beneath these surface-level benefits lies a more urgent, hidden motive: CBDCs offer a tool to repair central banks’ balance sheets and restore their financial strength. In essence, while much of the discussion centers on peripheral issues like individual privacy and the potential risks of government overreach, CBDCs could serve as a lifeline to stabilize the very institutions that underpin the global financial system.

In this chapter, we will explore how the financial positions of central banks deteriorated in the years following the 2008 crisis, how quantitative easing played a significant role in weakening their balance sheets, and why the introduction of CBDCs may be an attempt to shore up their financial health. This overlooked dimension of CBDCs—the bailout of central banks—will be examined in detail, revealing a critical but underappreciated motivation for their adoption.

QE’s Unintended Consequences

Quantitative easing (QE) was introduced as an emergency measure during the 2008 financial crisis, intended to inject liquidity into the financial system by allowing central banks to purchase large quantities of financial assets, primarily government and corporate bonds. This strategy was essential to stabilize markets and prevent a deeper economic collapse. However, despite its short-term benefits, QE has produced several unintended and long-lasting consequences, many of which have left central banks in a precarious position.

Inflated Central Bank Balance Sheets

The most immediate consequence of QE was the massive expansion of central bank balance sheets. To implement QE, central banks bought vast amounts of assets from commercial banks and other financial institutions. This process significantly increased the asset side of the central banks’ balance sheets, while the liabilities grew in the form of reserves held by commercial banks.

By 2023, central banks such as the U.S. Federal Reserve, European Central Bank, and Bank of Japan had accumulated trillions of dollars’ worth of government bonds and other assets. These bloated balance sheets have created vulnerability, particularly as interest rates have begun to rise. Higher interest rates decrease the market value of bonds, leaving central banks with assets that are worth significantly less than when they were purchased​.

Negative Equity and Technical Insolvency

As interest rates have risen to combat inflation, the value of the bonds held by central banks has dropped. This decline in bond value has pushed several central banks into a state of technical insolvency. While central banks don’t operate like commercial institutions and can continue to function with negative equity, this situation is financially precarious and could erode public confidence in their ability to manage the economy​.

The challenge is that central banks are now caught between competing goals. On the one hand, they need to raise interest rates to manage inflation, but on the other hand, doing so makes their bond holdings worth less, further weakening their balance sheets.

Disrupted Bond Markets and Financial Imbalances

Another unintended consequence of QE is that it distorted bond markets. By purchasing large amounts of government bonds, central banks suppressed long-term interest rates, creating a low-yield environment. This encouraged investors to seek higher returns in riskier asset classes, fueling asset bubbles in markets such as real estate and equities. The resulting financial imbalances increased systemic risk in the economy.

As central banks now attempt to unwind their QE policies, there is a risk of market disruptions, particularly as bond yields rise, making it more expensive for governments and companies to borrow. This reversal has the potential to unsettle financial markets, which have grown accustomed to the liquidity provided by central bank bond purchases​.

Widened Wealth Inequality

Although QE was designed to stabilize the economy, it inadvertently contributed to widening wealth inequality. By lowering interest rates and increasing asset prices, QE disproportionately benefited asset owners—those with stocks, bonds, and real estate—while doing little to address broader issues of income inequality. The value of financial assets surged, enriching the wealthy, while wage growth stagnated for the middle and lower classes.

This growing wealth gap has been a significant social consequence of QE and has contributed to rising political and economic tensions in various countries​.

The Impact on Commercial Banks

QE also altered the relationship between central banks and commercial banks. While the large influx of reserves helped shore up banks’ balance sheets during the crisis, it also increased their reliance on central bank liquidity. As QE has been unwound, commercial banks face challenges in adjusting to tighter liquidity conditions. This, coupled with the introduction of potential CBDCs, could further undermine their role as key intermediaries in the financial system​.

Conclusion

In conclusion, while QE helped avert a deeper crisis in the immediate aftermath of 2008, it has left a lasting impact on central banks, financial markets, and society. Central banks, now facing technically insolvent balance sheets, are exploring solutions like CBDCs not only to modernize the monetary system but also to address the vulnerabilities created by years of unconventional monetary policy. However, as CBDCs are introduced, it remains to be seen how these new tools will navigate the consequences of QE and whether they will truly stabilize the financial system or create new risks.

Debating the Periphery

The public discourse around central bank digital currencies (CBDCs) has focused largely on issues of privacy, government overreach, and the risks of centralized power. These are undoubtedly critical concerns, as CBDCs offer the potential for central banks to gain unprecedented insight into every transaction made with digital currency. Privacy advocates rightly worry about how easily such a system could be used to track individual spending habits or control access to money. Similarly, critics warn that centralizing so much financial power under one institution could undermine democratic freedoms by giving governments or central banks the ability to freeze accounts or limit financial autonomy​.

However, while these debates have captured public attention, they are ultimately discussions about the periphery of the issue. The true, central reason behind the development of CBDCs often goes unnoticed: CBDCs are being introduced, in part, to bail out central banks themselves.

Central banks have been grappling with the unintended consequences of quantitative easing (QE) since 2008. After years of buying massive amounts of government and corporate bonds, central banks now face balance sheets filled with low-yield or devalued assets. As interest rates rise, the value of these bonds drops, leaving central banks in a position of technical insolvency. The introduction of CBDCs offers a pathway to stabilize their balance sheets without having to sell off these assets at a loss or admit financial weakness​.

Despite the importance of this issue, public discussions tend to focus on more immediate concerns like individual privacy or the fear of government control. These are important issues, but they are peripheral to the core reason for CBDCs: the financial health of the central banks themselves. CBDCs could enable central banks to regain control over monetary policy in ways that commercial banks cannot match. By directly issuing digital currency, central banks can limit their liabilities, create new avenues for seigniorage, and potentially avoid a financial reckoning over their QE legacy​.

In other words, while privacy concerns and centralized power are indeed necessary topics of discussion, they miss the bigger picture. The introduction of CBDCs is not just about modernizing payment systems or offering more efficient financial tools—it is also about ensuring the survival and stability of central banks, which are the bedrock of the global financial system. The central bank bailout is the unspoken motive, and failing to recognize this leaves the public debating only the surface issues while the deeper financial restructuring takes place in the background.

By focusing too much on the periphery, the public risks being blindsided by the more fundamental shifts happening beneath the surface. The true impact of CBDCs extends far beyond the issues of privacy and centralized control. It goes to the heart of global financial stability, the relationship between governments and banks, and how central banks plan to manage their liabilities for decades to come.

Lifeline for Central Banks

In the wake of the 2008 financial crisis and the large-scale implementation of quantitative easing (QE), central banks found themselves facing a new dilemma: how to manage their growing balance sheets filled with low-yield or depreciating assets. As bond prices fell and interest rates rose, central banks became technically insolvent, grappling with liabilities that exceeded their assets. Central Bank Digital Currencies (CBDCs) present an opportunity to stabilize these financial institutions, giving them a much-needed lifeline. But how exactly can CBDCs accomplish this?

Digital Seigniorage and Accounting Challenges

One of the most intriguing possibilities for CBDCs lies in their potential to generate “digital seigniorage” for central banks. Seigniorage refers to the profit that a central bank earns from issuing currency. With physical cash, seigniorage is straightforward: the face value of money minus the cost of producing it. However, in the case of CBDCs, the cost of issuing digital money is minimal, potentially creating a new source of revenue for central banks.

But the question arises: how do CBDCs fit into central banks’ balance sheets? If CBDCs are considered an asset, what are the corresponding liabilities? Traditionally, when central banks issue money, it’s recorded as a liability—whether it’s in the form of physical cash or reserves in the banking system. CBDCs would likely follow the same pattern, where the issued digital currency is logged as a liability, representing the central bank’s obligation to honor that currency. However, the accounting of CBDCs might differ from traditional models because of ongoing discussions around eliminating or minimizing central bank balance sheets​.

The concept of eliminating balance sheets reflects a potential shift in central banking philosophy. As CBDCs are introduced, some discussions suggest moving away from the conventional asset-liability framework, instead focusing on managing the digital currency as a public utility. This would allow central banks to issue CBDCs without needing to match them against corresponding assets, effectively reducing the pressure on their balance sheets. While this shift could provide central banks with much-needed flexibility, it also raises concerns about transparency and accountability, as balance sheets have historically been the primary means of tracking the financial health of these institutions​.

Direct Control Over the Money Supply

Unlike the traditional process where central banks create money by injecting it into bank reserves, CBDCs allow central banks to bypass commercial banks altogether. In the current system, central banks create money by adding reserves to the accounts commercial banks hold with them. The commercial bank, in turn, updates the customer’s balance. This reserve barrier ensures that commercial banks act as intermediaries in the flow of money into the broader economy​.

CBDCs change this dynamic by allowing individuals and businesses to hold accounts directly with the central bank. This gives central banks unprecedented direct access to the economy, enabling them to inject money without relying on the commercial banking sector. This is a fundamental shift in how money is created and circulated, granting central banks more granular control over the money supply​.

By directly issuing digital currency, central banks can manage liquidity with far more precision. Instead of adjusting reserve requirements or manipulating interest rates to influence commercial banks’ lending behavior, CBDCs would allow central banks to distribute or retract money in real-time. This kind of direct control is particularly appealing in a post-QE world, where central banks are trying to unwind their balance sheets without destabilizing financial markets​.

A Path Away from QE’s Long-Term Risks

The appeal of CBDCs also lies in their ability to mitigate the long-term risks posed by QE. With QE, central banks bought large amounts of government bonds to inject liquidity into the financial system. This expanded their balance sheets and left them exposed to interest rate fluctuations, creating a situation where rising rates now threaten their financial stability. Instead of continuing to expand their balance sheets by purchasing assets, central banks can use CBDCs to inject liquidity directly into the economy without adding further liabilities​.

This provides central banks with a pathway out of the QE cycle. They can stop relying on asset purchases to manage monetary policy and instead focus on managing digital currencies that provide liquidity without adding the same risk to their financial health. CBDCs offer a new tool that could help central banks regain control over their balance sheets and reduce their reliance on risky asset purchases.

Bailing out Central Banks

At the heart of the push for central bank digital currencies (CBDCs) lies a critical issue that is often overlooked: central banks themselves are financially vulnerable, and CBDCs offer a potential solution to stabilize them. While the public conversation around CBDCs frequently focuses on concerns about privacy, surveillance, and government control, the core problem CBDCs address is the weakening financial position of central banks in the wake of quantitative easing (QE).

Central Banks in a Precarious Position

After years of QE, central banks’ balance sheets are filled with devalued assets, particularly government and corporate bonds that have lost significant value as interest rates have risen. This has created a situation where many central banks are technically insolvent, with liabilities far exceeding their assets. While central banks can continue to operate with negative equity, this financial fragility puts them in a precarious position, one that is difficult to resolve through traditional means.

The introduction of CBDCs offers central banks a way to address this imbalance. By issuing digital currencies, central banks can regain control over the money supply and reduce their dependence on risky assets like bonds. This is why, while privacy and control are the topics that dominate the headlines, the underlying issue is the financial bailout of central banks themselves.

A Quiet Bailout

CBDCs allow central banks to inject money directly into the economy, bypassing the traditional system of money creation through commercial banks. Unlike physical cash, which has production costs and logistical challenges, CBDCs can be created and distributed digitally at virtually no cost. This makes it easier for central banks to issue money without the same burdens on their balance sheets.

By issuing CBDCs, central banks can stabilize their financial positions without needing to sell off devalued assets or rely on further asset purchases. This is the hidden bailout at the core of CBDC development: central banks are using this new form of currency to quietly shore up their finances. Unlike the overt bailouts of commercial banks in 2008, this one happens behind the scenes, masked by the more visible benefits of CBDCs, such as faster payments and financial inclusion.

Moving Beyond QE

What makes CBDCs particularly appealing to central banks is their potential to replace QE as a tool for managing liquidity. QE worked by expanding central banks’ balance sheets through large-scale asset purchases, but it also created long-term risks by tying central banks to the fluctuating value of those assets. CBDCs, on the other hand, allow central banks to manage liquidity more directly without adding to their already bloated balance sheets.

This is the essence of why CBDCs are being pushed so aggressively: they offer a lifeline to central banks trapped by the consequences of their own past policies. The ability to issue and manage digital currency gives central banks a new tool to regain control over their finances and navigate the challenging post-QE environment.

Conclusion

While privacy, control, and the implications for individual financial autonomy are important aspects of the CBDC debate, the core issue that often gets overlooked is the financial stability of central banks. CBDCs provide a mechanism for these institutions to quietly address their balance sheet problems without drawing attention to the fact that they are, in essence, bailing themselves out. By focusing on the broader benefits of CBDCs, central banks can avoid the uncomfortable discussion of their own financial fragility while moving toward a more stable future.

How CBDCs will Alter the Financial System

The introduction of Central Bank Digital Currencies (CBDCs) is poised to fundamentally change the way the financial system operates, affecting everything from the role of commercial banks to the way monetary policy is implemented. While CBDCs promise many benefits, their adoption will bring significant shifts in the relationships between central banks, commercial banks, and consumers, with both intended and unintended consequences.

Disintermediation of Commercial Banks

One of the most immediate and profound changes CBDCs could introduce is the disintermediation of commercial banks. In the current system, commercial banks act as intermediaries between central banks and consumers. They create money by issuing loans and maintain the flow of money into the economy through deposit-taking and lending. However, with CBDCs, individuals and businesses could hold accounts directly with central banks, bypassing commercial banks altogether.

This shift could weaken the role of commercial banks as the primary creators of money, as central banks would take on a more direct role in issuing digital currency to the public. With fewer deposits, commercial banks might find it more difficult to fund lending, potentially reducing their capacity to offer credit. As a result, banks could be forced to rely on other, more expensive sources of funding, raising the cost of loans for consumers and businesses​,

The Changing Nature of Money Creation

Currently, commercial banks create most of the money in circulation by issuing loans—money is created when a bank credits a borrower’s account, essentially creating money “out of thin air.” With CBDCs, central banks would have the ability to inject money directly into the economy, bypassing the traditional banking system. This could change the dynamics of money creation, with central banks gaining more control over the money supply while reducing the influence of commercial banks.

This alteration could give central banks more flexibility in managing the economy, allowing them to directly influence inflation, liquidity, and overall economic stability without relying as heavily on the commercial banking sector to distribute money through lending​

Increased Central Bank Control Over Monetary Policy

By issuing CBDCs, central banks gain the ability to directly manage the flow of money in the economy. This would make monetary policy more precise, as central banks could inject liquidity directly into the hands of consumers or withdraw it from circulation more effectively. For instance, during times of economic stress, a central bank could distribute CBDCs to citizens quickly, acting as a form of direct stimulus. Conversely, it could impose negative interest rates on CBDC accounts to encourage spending during periods of stagnation.

This level of control could significantly enhance the effectiveness of monetary policy, making it easier to manage inflation and stabilize the economy. However, it also raises concerns about how much control central banks should have over the financial lives of individuals and businesses.

Reduced Risk of Bank Runs

One potential advantage of CBDCs is the reduction of risk in bank runs. In times of crisis, depositors might rush to withdraw their funds from commercial banks, fearing insolvency. However, if consumers have access to accounts directly with the central bank through CBDCs, they might feel more secure, as the central bank cannot “fail” in the same way commercial banks can. This could reduce the likelihood of panicked withdrawals and help stabilize the financial system during times of uncertainty​,

Impact on Commercial Bank Profitability

As CBDCs allow consumers to bypass commercial banks for deposits, the banking sector could experience a significant reduction in profitability. Commercial banks currently earn a large portion of their revenue from the spread between the interest they pay on deposits and the interest they charge on loans. With fewer deposits and more expensive alternatives for funding, banks’ profit margins could shrink, leading to reduced lending activity and higher costs for consumers and businesses.

Moreover, the introduction of CBDCs may prompt central banks to explore new regulatory frameworks to ensure that commercial banks remain solvent and capable of lending, even in a system where they play a diminished role in money creation​.

Increased Financial Inclusion

CBDCs could also play a role in improving financial inclusion, particularly in countries where access to banking services is limited. By allowing individuals to hold digital currency directly with the central bank, CBDCs could provide banking services to unbanked populations, giving them access to digital payments and the ability to save securely without needing to open a traditional bank account. This would expand access to the financial system, especially in underserved or rural areas​.

Conclusion

In summary, CBDCs have the potential to reshape the financial system by altering the roles of commercial banks, changing the dynamics of money creation, and providing central banks with greater control over monetary policy. While CBDCs could offer benefits like reducing the risk of bank runs and increasing financial inclusion, they also pose challenges to the profitability and functioning of commercial banks. As central banks continue to explore and develop CBDCs, the financial landscape could shift in ways that redefine the balance of power between central and commercial banks, with lasting effects on how money flows through the economy.

Implementation

The implementation of Central Bank Digital Currencies (CBDCs) presents significant challenges, and central banks are approaching this task with a variety of models and goals in mind. CBDCs come in two broad forms: retail and wholesale, each with its own implications for the financial system. Within these categories, central banks must also decide whether to adopt token-based or account-based systems, as well as how to balance privacy, control, and the role of commercial banks. The complexity of these decisions means there is no one-size-fits-all approach, and the choices made will shape the future of global finance.

Retail vs. Wholesale CBDCs

Central banks are exploring both retail and wholesale CBDCs. Retail CBDCs are intended for use by the public—individuals, households, and businesses. They function much like digital cash, offering a more secure, centralized alternative to physical currency and existing electronic payment systems. With retail CBDCs, central banks could directly distribute digital money to consumers, either through intermediaries like commercial banks or through direct issuance.

On the other hand, wholesale CBDCs are designed for use by financial institutions and central banks to settle large interbank transfers and manage liquidity. These CBDCs would primarily be used within the banking system, improving the efficiency of transactions between banks, particularly for cross-border payments. Wholesale CBDCs are not meant to be accessible to the public but aim to streamline and secure the infrastructure that underpins large-scale financial transactions​.

Token-Based vs. Account-Based Systems

A critical aspect of CBDC implementation is whether to adopt a token-based or account-based system.  Token-based CBDCs work similarly to cryptocurrencies or digital cash. Ownership is transferred through cryptographic keys, and the system is designed to allow for more anonymous transactions. However, this can also pose risks related to security and illicit activities, as it is more difficult to track the movement of money.

Account-based CBDCs are more traditional, with money held in digital accounts linked to verified identities, much like today’s bank accounts. Each transaction in an account-based system is tied to an individual or institution, providing central banks with greater oversight and control but at the potential expense of privacy​.

Two-Tiered vs. Direct Issuance Models

Another significant decision central banks must make is whether to adopt a two-tiered system or a direct issuance model. In a two-tiered model, the central bank distributes CBDCs through commercial banks or other financial institutions. This maintains the current role of commercial banks as intermediaries, managing customer relationships, lending, and payments, while the central bank focuses on controlling the overall money supply.

The direct issuance model, however, would allow individuals and businesses to hold accounts directly with the central bank. This could lead to a more efficient system by cutting out intermediaries, but it would also disrupt the traditional role of commercial banks. Direct issuance could lead to a loss of deposits for commercial banks, which rely on these deposits to provide loans and other financial services. This model could fundamentally alter the banking landscape by diminishing the role of commercial banks as financial intermediaries​.

Privacy and Surveillance Concerns

The question of privacy is one of the most debated aspects of CBDC implementation. Token-based CBDCs offer a higher degree of privacy, but they also present challenges in tracking financial crimes such as money laundering or terrorism financing. Conversely, account-based CBDCs allow central banks to maintain full oversight of transactions, but this level of transparency raises concerns about government surveillance and the potential for financial control.

In countries like China, privacy concerns have been heightened by the digital yuan, where critics worry about the potential for increased state surveillance over financial transactions. In contrast, European and U.S. central banks have emphasized the need for privacy protections in their CBDC designs. For example, the European Central Bank has committed to ensuring that the digital euro will offer privacy levels comparable to current payment systems​.

Interoperability and Cross-Border Transactions

One of the most promising aspects of CBDCs is their potential to facilitate faster and cheaper cross-border transactions. Currently, international payments are slow and costly due to the involvement of multiple financial intermediaries, currency exchanges, and settlement systems. Central banks are exploring how CBDCs could streamline cross-border payments by allowing instant settlement between different jurisdictions.

However, interoperability between national CBDCs is crucial for this vision to be realized. Central banks, including those participating in initiatives like Project mBridge, are working on systems that ensure CBDCs from different countries can work together seamlessly. This collaboration will be essential in building a global CBDC framework that allows for efficient, real-time cross-border transactions​.

Challenges to Commercial Banks

The implementation of CBDCs, particularly through direct issuance models, poses challenges to the traditional role of commercial banks. If individuals and businesses can hold money directly with the central bank, commercial banks could lose a significant portion of their deposits. This could reduce their ability to lend, raise the cost of credit, and potentially destabilize the banking system.

To mitigate this, central banks considering the two-tiered system may attempt to strike a balance that allows commercial banks to remain relevant, managing customer relationships while benefiting from the efficiency and security of CBDCs. However, finding this balance will be critical to avoid undermining the role of commercial banks in the broader financial system​.

Summary

In conclusion, the implementation of CBDCs will vary significantly depending on the choices central banks make regarding retail vs. wholesale applications, token-based vs. account-based systems, and whether to use two-tiered or direct issuance models. These decisions will shape the future of the financial system, impacting everything from the role of commercial banks to how global transactions are conducted. Central banks must carefully navigate these challenges to ensure that CBDCs achieve their goals of improving financial inclusion, efficiency, and stability, without undermining the existing financial infrastructure.

Conclusion

The development and potential implementation of Central Bank Digital Currencies (CBDCs) marks a critical juncture for central banks and the broader financial system. While much of the public discourse around CBDCs centers on privacy concerns, centralized control, and efficiency improvements, the core issue—one that is rarely highlighted—is the financial vulnerability of central banks themselves. After years of expansive monetary policies like quantitative easing (QE), many central banks find themselves grappling with technically insolvent balance sheets, and CBDCs offer a hidden lifeline to stabilize their financial health.

CBDCs provide central banks with direct control over the money supply, bypassing traditional commercial bank intermediaries and allowing for more granular control of monetary policy. Whether issued in retail or wholesale forms, and whether implemented through token-based or account-based systems, CBDCs could fundamentally reshape how money is created, distributed, and controlled. The ability to directly inject or retract liquidity from the economy grants central banks unprecedented power to manage economic fluctuations with far more precision than traditional tools allow.

However, the transition to CBDCs is not without its challenges. Commercial banks, which have long played a central role in the financial system, may find their positions weakened, particularly if direct issuance models are adopted. These banks, traditionally responsible for creating money through lending, could face reduced deposits and, consequently, a diminished capacity to offer credit, which could disrupt the flow of funds in the broader economy.

Moreover, the global coordination required to make CBDCs interoperable across borders, the balance between privacy and surveillance, and the potential for disintermediating the financial sector all pose critical questions for policymakers and central banks alike. In navigating these complexities, the choices central banks make will shape the future of the global financial system and the role of money itself.

Ultimately, while CBDCs offer a powerful tool for modernizing and stabilizing central banks, they also represent a profound restructuring of the financial landscape. Central banks may be quietly using this technology to address the financial imbalances created by years of QE, but in doing so, they are also laying the groundwork for a new era of money. As the debate continues, it is essential to recognize that CBDCs are not just about improving payment systems—they are about ensuring the survival and relevance of central banks in the face of profound economic challenges.