Money is on the verge of undergoing its most radical transformation in centuries. Consumers are going cashless as a result of modern technology and even the coronavirus pandemic, and with alternative concepts like Bitcoin gaining traction, central banks are acting quickly to ensure they don’t fall behind. Their promise is to provide a payment system that is more secure, resilient, and cost-effective than private alternatives. The central banks of the Bahamas, the Eastern Caribbean Currency Union, and Nigeria have already established themselves as forerunners in the field of central bank digital currency, or CBDC, while China, the eurozone, and others are experimenting. Meanwhile, the Federal Reserve of the United States and the Bank of England are acting much more cautiously.
What would digital money from a central bank look like?
On the surface, it’s not that different from keeping electronic money in a bank account and using cards, smartphones, or apps to send that money out into the world. The key distinction is that central bank-issued money, like cash, is a risk-free asset. A physical dollar bill, for example, is always worth one dollar. While a dollar in a commercial bank account is theoretically convertible into paper cash on demand, it is subject to the bank’s solvency and liquidity risks, which means consumers may not always be able to access it, and may even lose it on rare occasions. CBDCs, like banknotes and coins, would be the central bank’s direct liability.
How will this affect payments?
CBDCs could take several forms, but all of them would have the same goal: to make payments happen faster. Commercial banks settle their net payments with one another using central bank money in the current system, but this process is typically not instantaneous for technological and operational reasons, opening up a credit risk during the settlement period.
How does this relate to cryptocurrencies?
Aside from the potential technological design, there isn’t much else. CBDCs are conceptually distinct from cryptocurrencies such as Bitcoin, which are too volatile to be used as a store of value and are not widely accepted enough to be useful for payments. Bitcoin is classified as a speculative asset. The decentralization of Bitcoin, which means there is no central party controlling it and transactions are recorded on a publicly distributed ledger, is a key appeal among its supporters. CBDCs are regulated by a central bank. While some countries are experimenting with full or partial use of distributed ledger technology, also known as blockchain, for their CBDCs, it is far from certain that they will do so in the long run. The European Central Bank, for example, has expressed concerns about the environmental impact of running a parallel blockchain infrastructure, and it already has another system, launched in 2018, that may be more appropriate.
What are the various types of CBDCs?
There are two major paths to take: wholesale and retail. CBDCs would be issued in retail projects through what would effectively be accounts at a central bank for the general public – or accounts at commercial banks working with the central bank. A CBDC-based system has no credit risk because funds are not held on an intermediary’s balance sheet, and transactions are settled directly and instantly on the central bank’s balance sheet. A retail approach may be especially beneficial for customers who do not have access to traditional banking services. However, some countries, such as Denmark, have ruled it out because it could leave banks vulnerable to depositors fleeing to central bank accounts. Other central banks have stated that in order to avoid such financial stability risks, they will impose upper limits on holdings. Access to digital currency in wholesale projects would be limited to banks and other institutions in order to make payment flows within the existing financial system faster and cheaper while causing less disruption to the sector’s overall structure.
Who is attempting this?
According to the IMF, more than a hundred countries are at various stages of CBDC exploration. India surprised the payments world by announcing that its central bank will issue a digital rupee as early as the next fiscal year, while China tested its digital yuan with athletes and spectators ahead of the 2022 Beijing Winter Olympics to see how popular it would be with foreigners. Some Eastern Caribbean islands that share a central bank have already launched their own digital currency, DCash. After a volcano eruption forced thousands of people to flee their homes last year, the program was expanded to St. Vincent and the Grenadines, and the roll-out was seen as an important part of rebuilding efforts.
The Fed, for example, has been slow to embrace the concept of digital currency, but it recently took a significant step forward by publishing a 35-page discussion paper outlining a number of potential benefits. Nonetheless, it made no firm decisions on whether issuing such a currency was prudent, and it stated that it would not proceed without the support of the White House and Congress. The Bank of Canada has not yet identified a pressing need for a digital currency, but it is continuing to build the technical capacity to issue a CBDC and monitor developments that may heighten its urgency.
What are the advantages?
If central banks can overcome the technical challenges, digital currencies could allow for faster and cheaper money transfers within and across economies. They may also improve access to legal tender in countries where cash reserves are running low. According to an IMF paper, the new currencies could increase financial inclusion in areas where private financial institutions find it unprofitable to operate, as well as generate more resilience in disaster-prone areas. ECB President Christine Lagarde has argued that a digital euro could become especially important if protectionist policies disrupt Europe’s primarily foreign payment services. A digital currency may provide a means for China to keep up with and control a rapidly digitizing economy. On the other hand, it could provide the government with an additional tool for surveillance.
What are the other drawbacks?
The risks of getting it wrong are significant, which is why most central bankers have erred on the side of caution thus far. Depending on the CBDC model, central banks risk either eliminating commercial banks, a vital source of funding for the real economy, or taking on the direct risks and complications of banking for the masses. Problems in managing a new business could erode the public trust that they rely on to allow them to take sometimes unpopular actions, such as raising interest rates. Furthermore, some researchers have expressed doubts about the current blockchain technology’s ability to support a large volume of concurrent transactions. According to a People’s Bank of China official, research shows that Bitcoin’s blockchain capacity fell far short of peak demand on China’s 2018 Singles’ Day shopping gala, which was 92,771 transactions per second. According to other studies, Ethereum handles an average of 15 transactions per second, while Visa Inc.’s network can handle 24,000.
Disclaimer: These are the writer’s opinions and should not be considered investment advice. Readers should do their own research.