There is little doubt that Central Bank Digital Currency (CBDC) will have far-reaching effects on the global financial system. With dwindling use of cash, digital banking on the rise, and privately held digital assets growing, CBDCs could be set to usher in a new global financial era.
Although CBDCs are still in the pilot phase, this new form of digital currency is now being explored by the federal reserve in 130 countries. That’s 98% of the world’s economy, according to the U.S.-based Atlantic Council think tank.
As we prepare for wide-scale adoption, this article explores the implications for the global monetary and financial system as a whole.
What are CBDCs and how do they work?
Because they are issued and operated by central banks, and pegged to the official sovereign currency of the issuing country, CBDCs are not the same as cryptocurrency. They are an official government-backed currency, and not virtual, decentralized tokens.
A key aspect of CBDCs is that they are held on secure, private, regulated blockchains and transacted through a Central Bank ledger. Digital currencies can be used both for retail and wholesale purposes, and, with a digital wallet, can be held, transferred and used to pay for goods and services.
What’s in it for governments and central banks?
The ultimate aim of CBDCs is to help deliver a modern global payment system that offers greater financial stability. Central to this is the role of a digital currency in combatting financial crime, terrorist funding, and money laundering.
In the few instances where jurisdictions operate CBDCs, and in many pilots, the central bank issues digital tokens on a distributed ledger.
These tokens are held in a separate account with the central bank, and are redeemed against the federal reserve. Interbank transfers are then validated and settled on the ledger by agents within the system using CBDCs.
By replacing physical cash and creating an advanced digital payment system for financial transactions, CBDCs can be increase financial inclusion. It could offer significant benefits for those who are un-banked, or have limited access to traditional banking infrastructure.
Control and transparency
It’s this level of control and transparency they offer, as well as the promise of greater financial stability, that make digital currencies such an attractive prospect for the authorities.
CBDCs are viewed by central banks as a means to address the challenges of:
- Financial inclusion.
- Payment efficiency.
- Payment system operational and cyber resilience.
The permissionless private sector blockchains used in Bitcoin and Ethereum allow transactions to be viewed. Whereas the permissioned CBDC version can add privacy features to mask transaction details. However, it’s a double-edged sword, because digital currencies would also give governments unrivalled access to bank accounts and private consumer data.
CBDCs and global financial stability
Evidence that the use of cash is declining isn’t hard to find. In fact, around 27% Americans only use an online-bank, while EU cash use declined by a third in the seven years leading up to 2021. All of this is asking central banks to re-examine their relevance in the monetary system.
By removing physical cash and creating the conditions for faster, more efficient digital transactions, digital currencies give central banks the chance to regain a foothold in the financial system. As well as the fragmented nature of current global payment systems, the twin threats of crypto and the power of Big Tech, are also important factors.
Central banks as CBDC architects
In essence, Central Bank Digital Currency puts government and central banks back in the strategic driving seat. It gives them greater governance powers, and the ability to exert control of monetary policy and local digital payment systems.
It is precisely the centralized nature of digital currencies that has prompted some experts to conclude it poses too many privacy and cybersecurity risks.
While some among us may be cautious, or even fearful of this level of control, others view the move to CBDCs as a catalyst for positive global financial growth.
So, who should be believed?
Monetary and financial implications
The wide-scale use of CBDCs challenges the existing role of the commercial banks intermediaries that stand between savers and borrowers.
Currently, consumers and businesses place deposits, withdraw money, and receive interest payments from banks. That money is then used to make loans to borrowers who repay them with interest.
With CBDCs, individuals and businesses would make a direct deposit with the central bank federal reserve, and not, as is customary now, with a commercial bank.
Benefits and drawbacks of CBDC
There are both positives and negatives from this – depending on your perspective. On one hand, CBDCs could fundamentally change the way banks are operated and funded, by removing funds from the system.
On the other hand the change could challenge the monopoly of banks, thus increasing competition, and create a situation where a commercial and central bank would vie for customers. This may bring benefits for the consumer; better interest rates, lower fees & charges, more efficient processing of international payments, and so on.
One concern, however, is that the disruption could reduce current deposit and lending structures. This could make credit harder, or more expensive, to obtain for businesses and consumers alike. This is particularly concerning for community banks that put money into various initiatives.
To date, credit to the general public is not part of any CBDC proposals. To illustrate this point, research in 2022 by Piazzesi and Schneider of Stanford University examined what the impact would be if central banks offered CBDCs but not credit lines.
Will CBDCs be compatible with current systems?
They surmised that it could interfere with the compatibility between credit lines and deposits built into modern payment systems. So, even if Central Bank Digital Currencies do offer a technological advantage in offering deposits, and more efficient financial transactions, the impact on credit lines could be detrimental.
It has even been suggested that when consumers and businesses go to fund their CBDC wallets, they will take cash and deposits from their bank. The resulting bank-run could increase the volatility of central bank commercial reserves.
Only time will tell, but it’s clear that the disruption to traditional financial systems could be significant.
Other practical concerns around CBDCs include:
- The time, effort, and cost it could mean for central banks to develop the payment system infrastructure.
- Many developed countries already have instant payments built on legacy technology, not distributed ledger technology.
- It would take time and experimentation for the federal reserve to develop the legislative frameworks.
- That a Central Bank Digital Currency would require unprecedented levels of cooperation between commercial and central banks.
- That the interplay between physical currency, existing digital money, digital assets, and CBDCs would dilute the benefits.
- Creating a unique and identifiable CBDC ‘look and feel’ will be difficult.
- The current system of cross border payments has been hugely improved by digital innovation, the introduction of CBDCs could stall this progress.
As consumers desire to have all digital currencies in a single wallet or card, would interoperability with commercial digital central bank money be possible?
A key role for commercial banks?
As the world’s central banks and legislators enter uncharted waters, it will be interesting to see if they can achieve the required technological stability.
It could require a whole new level of public-private partnership to provide a new digital money infrastructure. This applies both nationally and internationally. For CBDC credit transfers, cross border payments, and the disbursement of assets, it’s certain that new digital currency standards and procedures will have to be developed.
We don’t know what we don’t know
U.S. Secretary of Defense Donald Rumsfeld famously said, ‘We also know there are known unknowns; that is to say we know there are some things we do not know. But there are also unknown unknowns – the ones we don’t know we don’t know.’’
When it comes to the impact of CBDCs on the global financial landscape, the concept is certainly applicable. Yes, we know that infrastructure, regulation, interoperability, and cross border payments will need to catch up. But there are a whole series of unintended consequences that we can only speculate on.
In terms of the adoption of Central Bank Digital Currencies, CBDCs still provoke the kind of uncertainty that is causing policy makers to tread carefully. For one, there are various approaches or types of CBDC systems that are being piloted. And even though eleven countries already operate a CBDC, a selection of which includes The Bahamas, Anguila, and Jamaica, no major developed economy is yet ready.
Models currently used or being developed include:
- An account-based model where deposits are directly held by consumers with the central bank.
- Models where digital currency accounts are maintained by commercial banks.
- Examples such as the pilot European Central Bank digital euro, where licensed financial operators have permission to act as distribution conduits on the federal reserve blockchain network.
So, it’s clear that we are still in the experimental phase, where trust has yet to be established in a single identifiable system. One thing is undeniable – with major economies like the US, Eurozone, and China all developing their own version of a central bank digital currency, the race is well and truly on.
What all this will mean for consumers is not yet known.
Big questions remain, like:
- Will the promise of cheaper, faster, and more secure digital transactions be enough to create consumer demand?
- Is the business case for adoption strong enough to entice notoriously cautious central banks?
- And finally, will any potential benefits be obvious enough to outweigh growing privacy concerns?
Changing relationship with private banks
The global take-up of CBDCs is currently small, but the numbers of jurisdictions piloting it indicate that things are about to change. When and if adoption follows, the way we bank, and how we transact, hold and spend digital currency will undergo profound change.
As consumers, travelers, and business owners, our relationship with traditional banks could also change decisively.
As the rise of digital banking ushers in the final decline of traditional high-street banking, so too could Central Bank Digital Currencies herald the beginning of the end for commercial banks and financial systems as we know them.
Orchestrating payment services innovation
What comes out of this may well be a new dawn of public-private financial cooperation. It could equally see a division of financial roles where central banks control our deposits and private sector commercial banks are forced to innovate with new products and services.
For central banks, the incentive is to be more relevant, to dictate monetary and fiscal policy more effectively in this digital age. By using the technology that has given us the financial diversification of crypto, and coupling it with greater security and privacy, central banks and indeed governments are selling us their version of the financial future.
It’s one where physical money will not change hands, where frictionless banking and consumption, backed up by control and transparency, will bring positive financial growth.
And yet, there is still a lot of caution and uncertainty about what the future of Central Bank Digital Currency will really mean. Critics assert that by accumulating unparalleled amounts of sensitive payment and user data, in the wrong hands, Central Bank Digital Currencies are more vulnerable to financial crime, money laundering, theft, privacy breaches, and spying.
Others feel that legitimate actors like governments and the tax authorities will exert even more control, and use CBDCs as a means to further limit financial freedoms.
Wherever the case, the conflict between transparency and privacy is set to rumble on. For some, the benefits outweigh the disadvantages. For others, CBDCs represent the next step in our all-consuming digital lives, where convenience is paramount, but with it, individualism is eroded even more.
If governments and central banks forge ahead with their digital currency project, we may not have a choice.
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