According to a report by the Bank for International Settlements, as of 2020, over 80% of the surveyed central banks were looking into adopting the CBDC model. So, why have Central Banking Digital Currencies (CBDCs) become the hot topic of 2020?
… governments seemingly felt that Libra could pose a huge threat to the supremacy of sovereign currencies.
The trend is clear, as we’re starting to see many countries, including China, Sweden, and even private US companies like MasterCard beginning to experiment with the endless possibilities of digital money.
This interest was further piqued after Facebook made a formal announcement of Libra in July 2019. The event represented a massive sentiment shift, and governments seemingly felt that Libra could pose a huge threat to the supremacy of sovereign currencies. If you consider the fact that Facebook already has over 2.5 billion users worldwide (1/3rd of the world’s total population), it pointed to a heavy disruption of the global financial system, if even a fraction of those people were to use it. Central Banks were quick to realize that their purpose is not only to protect the financial system from the seemingly enigmatic crypto world but to avoid the monetary disorder that it could create a regulatory vacuum and to deliver its citizens an alternative way that makes transactions more efficient and hence, the foray into CBDC research.
The pandemic has also propelled small and big businesses alike to shift their offerings online and/or improve existing ones, thus ultimately making digital transactions the only viable solution for payments. This shift provided even more impetus to Governments and Central Banks to dive into research, development, and deployment of CBDCs to sustain domestic as well as global businesses.
Why would governments consider the usage of central bank digital currencies?
Implementing CBDC comes with a myriad of benefits. In countries with sparse geographies, the cost of maintaining cash is very high, and in big economies with high populations, the cost of printing money is substantial. For instance, in the USA, paper banknote printing and operation cost which in the US, this represents a cost of $877.2 million USD. With the threat of economies shrinking, banks are desperate to cut down their own cash handling and fraud-related costs on every level possible. CBDCs help to achieve all of that.
... paper banknote printing and operation cost which in the US, this represents a cost of $877.2 million USD.
The other advantage is increased monetary regulation. Through monetary policies, central banks control the money supply to ensure sustainable economic growth. An interest-bearing CBDC can accelerate an economy’s response to a change in policy rates. Also, in times of crisis, CBDC will facilitate charging negative interest rates (breaking zero lower bound restraint) and avoid a liquidity trap, ensuring the good health of the economy.
CBDC can also be considered as a healthy, direct, and necessary competition to privately owned digital currency. Private currencies, especially the ones denoted in a foreign currency could lead to currency debasement when converted back to a sovereign currency. This could be dangerous for the health of the economy. By launching CBDCs, governments will not only have digital currencies backed by sovereign currency but will also potentially reduce the adoption of foreign, private digital currencies.
Furthermore, the digital payment market (merchants) can be safely assumed to be oligopolistic with only a few big players that have substantial penetration and trust of customers. The huge and deep reach of these merchants, who might start to substitute the national currency for a digital alternative (e.g. Paypal-coin instead of USD), is worrisome for central governments. CBDCs would help central banks take back the control of payment processes, thus aiding in increased and more efficient regulation.
But while central bank digital currency can offer many benefits, it faces its own fair share of issues as well.
What are the issues of CBDC that could hinder its implementation?
In times of crisis, people might perceive cash to be safer than CBDC and tend to take out CBDC deposits and try to convert the more liquid form — cash. However, in most countries, credible deposit insurance and the presence of relatively more liquid assets like government bonds will discourage people to do so. In the worst-case scenario, if a run occurs, it will be easier to manage with CBDC than it will be with cash.
In countries where rates are highly volatile and inflation is high, people might begin to substitute their currencies for more stable currencies.
The implementation of a full-scale CBDC will require central banks to take care of multiple functions like payments value chain, consumer interface, making front end wallets, technology maintenance, monitoring transactions, etc. Failure at any one of these functions will be a threat to the reputation of the Central Bank. However, this is an obstacle that can be dealt with by partnering with companies that specialize in providing these tech solutions. Also, in the event of CBDC’s demand being high, the central banks will be in a tiff as to how to allocate funds across the banking systems. This may potentially open gates for political interference.
In countries where rates are highly volatile and inflation is high, people might begin to substitute their currencies for more stable currencies. This could also happen in relatively more stable economies in times of crisis, where citizens might see a lot of incentive to hold money in a bigger, more stable currency.
If consumers start moving all of their money from commercial banks to CBDC, it would disrupt the banks’ business model and cause financial instability in the country. A BIS report says, “a central bank digital currency could allow for digital runs towards the central bank with unprecedented speed and scale at the click of a button.” However, this can be dealt with by introducing limits to the percentage of holdings that can be done in the traditional bank and digital accounts or by using interest rates to influence the transactions.
Final thoughts
Although the adoption of new digital technologies on a country-level may take a long time typically, central bank digital currency is rapidly positioning itself to become the new norm. It remains simply a matter of time for the remaining issues and implementation work to be sorted out, which could take easily 3–5 years for most blockchains.
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