Digital currency can inhibit bubbles and runs

The unmet demand for safe assets boosts their prices. Digital currency would satisfactorily alleviate the need for safe assets.

In boom times of an economy, the unmet demand for safe assets boost their prices. While the supply is limited, a price bubble becomes unavoidable.

Wealthy savers do not deposit their money in a bank account since the government insurance covers only a limited amount. If they directly parked their money at the Fed, the need for safe assets would satisfactorily decline.

Rising number of central banks prepare to introduce digital currency. This trend can result in the solution of the safe asset problem.

In the years heading to the global financial crisis, countries such as China with trade surpluses and corporate cash pools had been demanding safe and liquid assets. Consequently, asset backed securities (ABS) became attractive for the investors, as they were perceived as liquid and safe (Pozsar 2011).

In the pre-crisis era, the demand for ABSs were so high that government guaranteed instruments could not meet that demand. The unmet demand for safe assets were $1.1, $1.6 and $1.6 trillion in 2005, 2006 and 2007, respectively (Pozsar 2011). The shortage of safe assets pushes risk-averse investors to buy riskier assets. Prices of even riskier types of ABSs spike prior to a financial crisis. The unmet demand boost asset prices, leading to a more optimistic atmosphere among the market participants. This trend is observed both prior to 2008 and 2020. Reducing investment-grade assets in the market, quantitative easing of central banks also contribute to price bubbles. Notwithstanding the COVID-19 shock, stock prices skyrocket as central banks push investors to riskier assets.

Investors consider high rated ABSs as safe due to the collateral backing them in a tranche system (Pozsar 2011). Yet, in the crisis time, collateral prices slump alongside security prices, making lenders anxious about the collateral’s sufficiency (Mayer et al. 2009). Although top rated securities remain resilient, lower graded ones incur losses. First runners in a financial distress are the risk-averse investors who bought risky assets in the shortage of safe options. Once savers with the incentive to store value are excluded from the financial system by means of digital currency, it would be much easier to manage liquidity and credit risks. An investor, who deliberately invests in risky assets for a return, would be prepared for losses. Hence, runs from financial markets become less of a concern.

In boom times of an economy, the unmet demand for safe assets boost their prices. While the supply is limited, a price bubble becomes unavoidable. Digital currency would satisfactorily alleviate the need for safe assets. Today, central banks can be the bank of not only banks but also everyone. Technology allows everybody to open an account at central bank. If investors could directly park their money at the Fed, they would not search for a safer financial instrument. When financial entities with the incentive to store value are excluded from financial markets, the motivation behind price bubbles and runs would fall. Thus, price bubbles in assets such as houses and stocks would be a historical phenemenon.