With recent furore regarding cryptocurrencies and their potential adoption by central banks, Chang Wei Goh and Gurinayat Brar investigate the potential implications of their introduction into our everyday lives.
With the Bank of England issuing a discussion paper on Central Bank Digital Currencies (CBDCs) last year, much hubbub has been generated around their potential introduction. However, there is still confusion regarding their nature and implications. In this article, we seek to explain what CBDCs are, how they differ from contemporary cryptocurrencies and digital banking systems, and the potential pros and cons of their introduction.
What exactly is a CBDC and how is it different from contemporary cryptocurrencies like Bitcoin? A CBDC is a digital currency issued by a state (or central bank), much like the issuance of cash, rather than private individuals or corporations. As a corollary, a potential CBDC will likely have its value tied to the currency of its respective country. For example, if the Bank of England decides to issue a CBDC, it will likely be pegged to the Pound. The value of this CBDC will likely be similar, if not identical, to the value of the Pound. Thus, the value of the CBDC will potentially be less volatile than traditional cryptocurrencies like Bitcoin or ADA, making the former a less speculative asset and arguably better suited for our daily transactions. Therefore, a more accurate way to think of CBDCs is that they are the state currencies that we are already familiar with, but in a different format. Analogous to how a $5 pound note is equivalent to five one-pound coins - the same intrinsic value just in different physical forms.
This leads us to the next question - If a CBDC is issued by the state (or central bank), how does it differ from current digital banking platforms? The main implication is for end-consumers. A transaction or payment made through a CBDC might not need to go through intermediaries (i.e. banks or payment-processors like Visa and Mastercard). In this manner, a CBDC can be likened to digital cash since a bank is not involved between a buyer and seller when payment is made through cash. From a technical standpoint, this is possible because the electronic settlement process (think chargebacks or overdrafts) is done by the central bank rather than the intermediary, cutting them out of the process.
What is the need for Central Banks to enter this space? Simply because people aren't using cash anymore. Owing greatly to the Covid-19 pandemic and the convenience of digital payment options by private incumbents, there has been a significant decline in cash usage. Over the last 10 years, cash usage in the UK has declined by approx. 65% from 37% in 2010 to 13% in 2020, with one in four people using cash only once a month or less. With the expectation of countries such as Japan, which are still quite cash reliant, the overall global trend is towards a cashless economy. Such excessive reliance on private players for financial transactions could have grave consequences on the economy in case of a payment system failure. Therefore, it is becoming imperative for governments to adapt to the changing financial services ecosystem. A more centralised state-backed crypto could be better than a crypto made by a private company (e.g. Facebook’s Libra) or existing decentralised ones like Bitcoin. There are also additional benefits of using CBDCs over cash such as efficient cross border payments, smart contract programmability, etc.
It is key to note that the fundamental design of the CBDC would have a significantly different impact on the economy. For instance, if the CBDC of a particular country is interest bearing, it would prove to be a versatile instrument for the Central Bank to implement monetary policy. An expansionary monetary policy such as reducing interest rates would not only impact bank deposits, but a larger pool of funds held by households and businesses. Moreover, having accurate data on spending patterns will help develop better monetary policies at the microeconomic level. Central Banks of emerging economies are especially focussing on the retail operations of CBDCs with the objective of fostering financial inclusion in the countries. It can particularly be beneficial for countries with a high number of unbanked population which otherwise have high digital usage such as India and Indonesia. As CBDCs deposits will come with almost negligible fee and risk attached to them, they will potentially encourage people to use financial services. At present, the central banks of The Bahamas and Cambodia have officially launched CBDCs for retail operations by their citizens. The Bank of England has also been actively examining its benefits and risks since March 2020.
The proposition to replace the age-old legal tender undoubtedly comes with its concerns and uncertainties. The primary concern is that a significant shift from cash to CBDCs would lead to a heavy outflow of deposits from commercial banks. This would potentially affect their ability to function and extend loans at low interest rates. There will also be a loss of anonymity that is brought about by paper cash. Though CBDCs are a potential tool to foster financial inclusion in a country, ensuring its accessibility and encouraging usage amongst all demographics will pose a challenge for central banks.
To summarise, the devil is in the details and the specifics of any country’s CBDC are not fully known. Therefore, it is difficult to give a definitive opinion on CBDCs. However, the key takeaway is that they are very different from current cryptocurrencies and unlikely to become a speculative asset. Rather, they might be an evolution of the digital banking methods currently used. The potential introduction of CBDCs might bring a paradigm shift in the way we interact with national currencies. It can bring about a sizable impact on the economy, from improved access to financial services for under-banked groups to smarter payments to compromised privacy. Whether CBDCs potentiate a boon or a bane, only time will tell.