Digital currency can inhibit bubbles and runs

CBDC transforms safe asset provision from private securitization to public digital money, making bubbles and runs far less frequent.

The global financial system repeatedly faces bubbles and runs due to safe asset shortages and liquidity panics:

Individuals and institutions can hold CBDC instead of chasing risky “safe” securities.

CBDC can be issued and later removed from the central bank’s balance sheet, increasing the supply of safe assets without asset purchases.

1. Safe Asset Shortages and Bubble Dynamics

The early 2000s saw an unprecedented safe asset shortage, which intensified the search for yield:

• Pozsar (2011) estimates that the unmet global demand for safe assets reached$1.1 trillion in 2005,$1.6 trillion in 2006, and$1.6 trillion in 2007.IMF WP 11/19

• Risk-averse investors, unable to find enough Treasuries or agency debt, turned to high-rated ABSs.

• This pushed up the prices of riskier tranches, creating pre-crisis bubbles in housing and structured credit markets.

This mechanism repeated in 2020:

• Quantitative Easing (QE) by central banks reduced the supply of safe assets in the market by absorbing Treasuries and agency securities.

• As a result, investors moved into equities and corporate bonds, contributing to rapid price recoveries and bubble-like valuations despite the COVID‑19 shock (Gourinchas et al., 2021).

2. Runs in Structured Markets

Structured finance promised safety via collateralized tranches:

• Senior tranches of mortgage-backed securities (MBS) and ABS were considered near risk-free, supported by junior tranches absorbing first losses.

• In practice, collateral prices collapsed alongside security values in crises, undermining the perceived safety (Mayer, Pence & Sherlund, 2009).FRB Paper

• Lower-rated tranches incurred severe losses, triggering runs by institutional investors such as money market funds and securities lenders—exactly the “first movers” most sensitive to risk.

This dynamic explains why shadow banking runs magnify systemic stress: risk-averse investors exit en masse, forcing fire sales that depress prices further (Gorton & Metrick, 2012).

3. CBDC and the Central Bank Balance Sheet: A Game Changer

At present, central banks can only issue reserves against an asset:

• When the Federal Reserve or the ECB injects liquidity, it must buy an existing asset (Treasuries, MBS, or other eligible securities).

• This means monetary expansion merely swaps one asset for another, without increasing the net supply of safe assets in the economy.

Digital currency changes the game:

1. If Central Bank Digital Currency (CBDC) is recorded as a central bank asset at issuance, the bank canspend it directly into the economy and then remove it from its balance sheet.

2. The CBDC continues to exist outside the central bank balance sheet,in an electronic platform administered by the central bank.

3. This structure allows the central bank to create a safe asset directly for the publicwithout needing to purchase existing securities.

This is fundamentally different from QE, which only swaps deposits for securities and cannot expand net safe assets. CBDC can provide a new safe asset class that satisfies value storage demand without inflating financial bubbles.

4. How Digital Currency Breaks the Bubble-Run Cycle

Central Bank Digital Currency (CBDC) could satisfy the global demand for safe assets directly, eliminating the root cause of many bubbles and runs:

1. Direct safe-asset access for everyone

   • Technology now allows individuals and institutions to hold digital accounts at the central bank.

   • A Fed digital account would serve as the ultimate risk-free store of value, removing the need to chase complex “safe” securities like high-rated ABSs.

2. Preventing Safe Asset Shortages

   • By bypassing the private securitization process, CBDC reduces demand for synthetic safe assets, mitigating bubble formation in Treasuries, housing, or equities.

3. Containing Runs and Liquidity Spirals

   • Value-storing investors can sit in CBDC safely outside the banking system.

   • Risk-taking investors remain in markets, and accept losses without triggering mass withdrawals.

   • Liquidity spirals and fire sales become less likely.

5. Conclusion

Digital currency can inhibit bubbles and runs by:

• Eliminating artificial safe asset shortages that drive credit and asset price booms,

• Allowing central banks to expand net safe assets directly via CBDC, and

• Separating risk-free value storage from risky investment, which reduces systemic run incentives.

In this architecture, asset price bubbles and shadow banking runs could become far less frequent, as the public can hold ultimate safe assets without destabilizing financial markets.

References

Pozsar, Z. (2011). Institutional Cash Pools and the Triffin Dilemma of the U.S. Banking System. IMF Working Paper 11/19. https://www.imf.org/en/Publications/WP/Issues/2016/12/31/Institutional-Cash-Pools-and-the-Triffin-Dilemma-of-the-U-S-Banking-System-24640

Mayer, C., Pence, K., & Sherlund, S. (2009). The rise in mortgage defaults. Federal Reserve Board Finance and Economics Discussion Series.https://www.federalreserve.gov/pubs/feds/2008/200859/200859pap.pdf

Gorton, G., & Metrick, A. (2012). Securitized banking and the run on repo. Journal of Financial Economics, 104(3), 425–451.

Gourinchas, P. O., Kalemli-Özcan, Ş., Penciakova, V., & Sander, N. (2021). COVID-19 and small- and medium-sized enterprises: A 2021 update. Brookings Papers on Economic Activity. https://www.brookings.edu/bpea-articles/covid-19-and-small-and-medium-sized-enterprises-a-2021-update/