Coming Battle

In the past decades, privately owned payment systems (e.g., PayPal, M-Pesa, Alipay, and Square) have gained widespread popularity. Recently, various cryptocurrencies further caused a fundamental reorientation of domestic and international monetary and payment technologies, as well as of policies and regulatory frameworks governing payment systems (Brunnermeier, James, and Landau, 2019; Adrian and Mancini-Griffoli, 2019; Cong, Li, and Wang, 2021a). Many countries around the globe react to these trends by actively researching on Central Bank Digital Currencies (CBDCs, see, e.g., Bech and Garratt, 2017; Duffie, 2021; Duffie and Gleeson, 2021), as revealed by the sharp rise in the number of central banks in the process of developing their own digital currencies (Boar, Holden, and Wadsworth, 2020; Boar and Wehrli, 2021).1 Due to their potential to be safer, cheaper more efficient, interoperable, and versatile, digital currencies have the potential to challenge or even replace traditional fiat currency and other online payment systems. How does the emergence of cryptocurrencies shape international currency competition? Will digital currencies challenge the dominance of the dollar? Which countries should develop CBDCs and when? How are various currencies differentially affected? To examine these issues, we develop a dynamic model of currency competition among multiple countries (or regions with a shared currency or a “systemic hegemonic currency,” as in Carney, 2019) allowing the potential co-existence of fiat money, cryptocurrencies, and CBDCs, a crypto sector with endogenous growth, and governments’ endogenous efforts for digitizing money. Our theory helps rationalize international trends in payment and currency digitization, reveals a novel pecking order for CBDC development, and provides insights concerning the implications of the rise of digital currencies for global competition, financial innovation, and the future of money. Specifically, we consider two countries, A and B, each with its fiat currency, and a digital economy featuring one representative cryptocurrency C as the means of payment. In each period, one representative OLG household is endowed with perishable consumption goods, which also serve as the numeraire. Importantly, all three currencies A, B, and C fulfill the standard roles of money as (i) store of value allowing households to store endowments for desired consumption timing, (ii) medium of exchange (generating a convenience yield), and (iii) unit of account (not only domestically but also internationally as a reserve currency). In general, households choose their holdings of currencies A, B, and C to store their consumption goods over time, trading-off the currencies’ convenience yield versus inflation and depreciation relative to other currencies which compromise the store of value function. Importantly, currencies A and B exhibit an endogenous debasement that decreases with the strength of countries’ economic fundamentals captured by the countries’ expenses, such as the fiscal deficit, international trade costs, or the debt service costs countries A and B incur. For example, a country’s high expenses in terms of the consumption good represent weak economic fundamentals, cause a high inflation rate and/or depreciation relative to other currencies, and thus imply a weak national currency. We use A to denote the stronger country and its currency, which is more valuable in terms of the numeraire and can be viewed as the international reserve currency (e.g., the U.S. dollar); then B represents a competitor currency, such as the Yuan. To incorporate that foreign debt is often denominated in the reserve currency, i.e., dollars (Maggiori, Neiman, and Schreger, 2020), or that the U.S. dollar is the global unit of account for invoicing in international trade (Gopinath, Boz, Casas, D´ıez, Gourinchas, and Plagborg-Møller, 2020), we assume that countries’ expenses are partially denominated in currency A. Households’ choice between national currencies induces a feedback and can lead to a vicious circle of inflation and depreciation for weaker currencies. A stronger currency A causes higher inflation and depreciation of currency B. As currency B depreciates, households substitute more towards currency A, aggravating inflation and depreciation of currency B. Country A essentially imposes a pecuniary externality on the relatively weaker country B through a form of dollarization. The mechanism manifests itself clearly in practice in that the strength of the U.S. dollar and the trust the world has in U.S. finance (or submission to its technological and military prowess) are mutually reinforcing. We then consider the crypto sector in which the growth rates of adoption, usage, and convenience yield of cryptocurrencies endogenously increase with adoption. Cryptocurrencies, including stablecoins pegged to fiat currencies, constitute a viable substitute for fiat currencies as a store of 3 Electronic copy available at: https://ssrn.com/abstract=4044170 value and medium of exchange. High inflation rates in fiat currencies spur cryptocurrency usage and growth over time. Intuitively, the absence of strong national fiat currencies implies a vacuum in the currency space, and private cryptocurrencies emerge to fill the demand. Households also hold more cryptocurrencies when the underlying technology is more effective or the crypto sector is more vibrant and creative. Interestingly, the cryptocurrency market acts as a buffer zone amidst the battle between the two fiat currencies and dampens the degree of dollarization and the vicious circle of debasement the weaker currency is exposed to. As the crypto sector grows and the household substitutes toward crytpocurrency, the strong currency faces more competition from cryptocurrency and depreciates. Because the growth of the cryptocurrency market depends on the strength of currencies A and B, a stronger currency B could benefit A by slowing the growth of the crypto-sector which in turn poses less competition to A. Importantly, the weaker currency B might benefit from the rise of cryptocurrencies, depending on whether the reduction in competition from A outweighs the increase in competition from cryptocurrencies. The model therefore rationalizes why countries with dominant currencies are more eager to ban or regulate cryptocurrencies, whereas countries with the weakest currencies, such as El Salvador and Venezuela, do exactly the opposite and even adopt cryptocurrency as a legal means of payment. Our framework also applies to the study of fiat-backed cryptocurrencies, especially stablecoins which are typically pegged to the U.S. dollar and (partially) backed by U.S. dollar assets (e.g., USDC). When a cryptocurrency is backed by reserves consisting of currency A, country A can capture part of the seigniorage generated from cryptocurrency usage, which strengthens currency A but weakens other currencies. These findings suggest that the U.S. and the U.S. dollar may benefit from regulation that requires stablecoin issuers to hold U.S. dollar reserves instead of regulation that restricts or bans stablecoin issuance. Furthermore, as an alternative to developing CBDCs to compete with cryptocurrencies, properly regulated stablecoins could potentially allow countries such as the United States to effectively “delegate” the creation of a digital dollar to the private sector, whilst sharing the seigniorage revenues. We next consider the endogenous development of sovereign digital currencies, notably CBDCs. We model CBDC implementation in a technology-neutral manner that does not rely on any specific design, simply stipulating that it increases the convenience yield of holding the country’s currency. Our framework features monetary neutrality and can accommodate possible interest-bearing or 4 Electronic copy available at: https://ssrn.com/abstract=4044170 tax-charging digital currencies. We also recognize that launching CBDCs entails tremendous technological, legal, economic, and operational obstacles, therefore modeling it as a Poisson arrival process based on the countries’ endogenous (and costly) efforts. Once implemented, CBDCs would immediately alter the endogenous value of other currencies, whether fiat or digital, as well as other countries’ incentives to implement their own digital currencies. Countries’ strategic decisions to implement CBDCs reflect competition from both cryptocurrencies and other fiat currencies. The stronger country’s incentives to launch CBDC mainly derive from the desire to compete with cryptocurrency. These incentives are high when the cryptocurrency market is in its infancy, because then the launch of CBDC has the largest effect in reducing competition from cryptocurrencies. This effect gives rise to a “cryptocurrency kill zone” that allows for a preemptive“killer adoption” of the technology. If countries with strong currencies adopt the technology underlying cryptocurrencies through launching CBDC early enough, they can nip the future growth and dominance of cryptocurrencies in the bud. Otherwise it is only until the cryptocurrency market has gained widespread adoption that the implementation of CBDC becomes unavoidable to avert a takeover by cryptocurrencies. As a result, the stronger country’s strategy for launching CBDC evolves from an offensive, preemptive tactic to a purely defensive measure. Regardless, our model predicts that the digitization of money becomes inevitable in the long run. We find that CBDCs offer the most advantages for countries with non-dominant currencies (country B), as long as their currencies are not too weak. The non-dominant country B’s incentives to launch CBDC is stronger than A’s and are primarily shaped by the desire to obtain a technological first-mover advantage to reduce the degree of dollarization country B is exposed to. Our model explains why the first CBDCs have been implemented by countries such as China, rather than the United States. The implementation of CBDCs by such countries poses considerable challenge for both the cryptocurrency market and stronger fiat currencies, such as the U.S. dollar. We also find that the dominance of the U.S. dollar causes “entrenchment” that reduces the incentives of the U.S. to implement CBDC. The recent spike in U.S. inflation, however, potentially undermines the dominance of the U.S. dollar and improves government incentives to venture into digitizing money. Depending on the circumstances, decisions to launch CBDC can be either strategic substitutes or complements. Our model highlights that through the launch of CBDC, weaker currencies may challenge the dominance of stronger currencies. If it poses a threat on the dominance of the stronger currency, the implementation of CBDC by weaker countries increases the incentives of 5 Electronic copy available at: https://ssrn.com/abstract=4044170 the stronger country to launch CBDC too, giving rise to strategic complementarity in CBDC issuance. Consistent with our model, the issuance of CBDC by China is often perceived as such a threat to the dominance of the U.S. dollar and, accordingly, has led calls to action (Ehrlich, 2020, Forbes) for the U.S. to consider the development of CBDC too. In contrast, CBDC issuance by stronger countries eliminates the possibility for weaker countries to attain a technological firstmover advantage, thereby always reducing weaker countries’ incentives to develop CBDC and giving rise to strategic substitutability in CBDC issuance. We further study the implications of CBDC issuance on the currencies of developing countries with particularly weak currencies (bigger gap between A and B). Consistent with Brunnermeier et al. (2019), we find that such countries are particularly prone to digital dollarization: they tend to suffer the most when a country with strong currency implements CBDC. Yet, these developing countries and their currencies do not benefit much from implementing CBDC themselves, because their currency is weak regardless of its underlying technology. Our analysis suggests that developing countries may benefit from adopting cryptocurrency as a legal means of payment within their own territory instead of implementing CBDCs as a way to escape from (digital) dollarization. Overall, the pecking order of CBDC development entails countries with strong but non-dominant currencies (e.g., China) leading the efforts, followed by countries with the strongest currencies (e.g., the U.S.), and then by nations with the weakest or non-existent sovereign currencies (e.g., El Salvador). Finally, we recognize that fiat currencies and traditional bank-payment-rails are inefficient and fragmented, due to the non-digital nature, the lack of coordination, or the limited competition in the presence of network effects (Rochet and Tirole, 2003). The development of various digital currencies therefore can be viewed as financial innovations that eventually benefit households (and businesses and governments, see, e.g., Duffie, Mathieson, and Pilav, 2021). Our model can be used to understand how currency competition and the strength of national currencies relate to financial innovation. In particular, the weakness of national currencies implies a vacuum in the currency space which favors the emergence of (private) cryptocurrencies and thus financial innovation in the private sector. Moreover, as crytpocurrencies gain widespread adoption, countries’ incentives to innovate through the implementation of CBDC increase too, further stimulating financial innovation. Put differently, the dominance of national currencies curbs incentives for innovation both for governments and the private (financial) sector, which is consistent with the view that competition stimulates innovation. 4 Conclusions We develop a dynamic general equilibrium model of global competition among national fiat currencies, cryptocurrencies (stablecoins included), and Central Bank Digital Currencies (CBDCs). The strength of a country and of its currency are mutually reinforcing, leading to global currency dominance by the strongest countries. The endogenous rise of cryptocurrencies hurts the stronger country, but may benefit weaker currencies by reducing fiat competition and dollarization. Reserve requirements on stablecoins mitigate the impact of cryptocurrencies on the fiat currencies they are pegged to. Because countries’ strategic decisions to implement CBDCs reflect the competition from both emergent cryptocurrencies and other fiat currencies, a pecking order for digital currency development emerges: Countries with non-dominant currencies tend to have the highestpowered incentives to launch CBDC first so as to attain a technological and cumulative first-mover advantage; countries with dominant currencies are motivated to launch CBDC early on both to nip cryptocurrency growth in the bud and to counteract a competitor’s CBDC; nations with the weakest or without a sovereign currency may opt for cryptocurrencies or stablecoins pegged to a basket of currencies to avoid (digital) dollarization. In general, weaker national currencies favor the emergence of cryptocurrencies as competitor and boost countries’ incentives to implement CBDC, both spurring valuable financial innovations. Our findings help rationalize recent developments in the digitization of money and provide insights into the future of money and the global battle of currencies.