ECB Working Paper Series: when less is more – behavioral effects of CBDC holding limits

Holding limits are a central design feature of proposed retail central bank digital currencies (CBDC). While such limits mechanically prevent individuals from exceeding a maximum balance, they may also generate behavioral responses whose directions are a priori unclear, according to a latest ECB Working Paper called “When less in more: behavioral effects of CBDC holding limits”.

Several central banks are exploring the possibility of issuing a central bank digital currency (CBDC) — a digital form of public money for everyday payments. The CBDC design needs to balance ease of use with ensuring that it preserves financial stability. In response, most CBDC projects foresee the introduction of a holding limit, which would cap the amount of CBDC that individuals could hold in their digital wallets. At the same time, automatic funding mechanisms such as the reverse waterfall functionality can allow individuals to make payments even when they do not hold sufficient CBDC, potentially reducing the need to hold large CBDC balances.

While holding limits would mechanically restrict how much CBDC people can hold, they may also have a behavioral impact. For example, some individuals may view the limit as a restriction of their decision rights, decreasing the attractiveness of the CBDC. For others, instead, the limit can act as a reference point, attracting CBDC holdings towards that value. Understanding these possible responses is important to assess how much CBDC people would actually hold and thus anticipate its impact on the financial system if such limits were introduced.

This paper investigates how holding limits influence individuals’ choices about how to allocate their money between different payment instruments. In particular, it studies whether the introduction of a limit changes individuals’ behavior beyond its direct mechanical effect.

The analysis also provides empirical evidence on the reverse waterfall functionality. This mechanism automatically converts funds from a user’s commercial bank account into CBDC whenever the user needs to make a payment but does not currently hold enough CBDC.

To disentangle the direct effect of the limit from its behavioral effects, the paper uses a controlled online experiment with 761 participants from four euro area countries: France, Germany, Italy, and Spain.

In the experiment, participants made decisions about how to allocate tokens between two means of payment, then faced automated sellers, and earned money if they held the means of payment required by the seller. One instrument bears interest but is not always accepted, while the other pays no interest, is always accepted for payments and could be subject to a holding limit.

These differences capture the essence of the differences between bank-card payment and CBDC, where the former can be remunerated via a deposit account and the latter can be used for peer-to-peer payments. Our identification strategy relies on comparing participants’ decisions in the absence and the presence of a limit, and assessing whether the level of the limit affects these behavioral responses by comparing
decisions with relatively lower and higher limits. In addition, we investigate how the presence of a reverse waterfall functionality affects individuals’ responses to these limits.

The results show that holding limits can generate indirect behavioral effects. Participants whose initial holdings are below the limit, and thus would be expected to keep the same allocation in the absence of indirect effects, tend on average to increase their holdings when the limit is introduced.

Moreover, distinguishing between relatively lower and higher limits, the authors of the report find that this increase in holdings emerges only when the limit is higher due to an asymmetric impact of attraction and repulsion. When the limit is lower, the opposing behavioral responses offset each other, leaving average holdings unchanged. By contrast, when the limit is set at a higher level, the anchoring effect becomes stronger while the negative reaction to the restriction becomes weaker. As a result, average holdings increase after the limit is introduced with the higher limit.

“Finally, we find that introducing a reverse waterfall functionality both increases adoption of the limited means of payment and decreases the level of its holdings. This suggests that these kind of automated funding mechanisms can allow individuals to benefit from the payment advantages of CBDC without requiring them to hold large CBDC balances. Overall, we provide the first evidence that combining holding limits with automatic funding mechanisms can support the use of CBDC as a means of payment while addressing concerns about potential
financial stability risks.” – the authors concluded.

More details: ECB Working Paper Series – When less is more: behavioral effects of CBDC holding limits