Why Central Banks are Adopting Digital Currencies

Cryptocurrencies shift from anarchy to acceptance

The acceptance of cryptocurrencies by government banks is revolutionizing global finance — is it a good thing?

By Irving Wladawsky-Berger

A decade after Bitcoin was created in October of 2008 with the release of Bitcoin: A Peer-to-Peer Electronic Cash System, The Economist concluded that it and other cryptocurrencies were “useless.”

“Bitcoin, the first and still the most popular cryptocurrency, began life as a techno-anarchist project to create an online version of cash, a way for people to transact without the possibility of interference from malicious governments or banks,” the publication argued. “A decade on, it is barely used for its intended purpose. Users must wrestle with complicated software and give up all the consumer protections they are used to. Few vendors accept it. Security is poor. Other cryptocurrencies are used even less,” according to the publication.

Fast forward to the May 8 issue of The Economist where a full reversal can be found. In an assessment of central bank digital currencies (CBDCs) — i.e., e-dollars, e-yuans, or e-Euros — the publication said these are “the digital currencies that matter.”

“Bitcoin has gone from being an obsession of anarchists to a $1 trillion asset class that many fund managers say belongs in any balanced portfolio.

… Yet, as our special report explains, the least noticed disruption on the frontier between technology and finance may end up as the most revolutionary: the creation of government digital currencies, which typically aim to let people deposit funds directly with a central bank, bypassing conventional lenders.

The Rise of Govcoins

These govcoins are a new incarnation of money. They promise to make finance work better but also to shift power from individuals to the state, alter geopolitics and change how capital is allocated. They are to be treated with optimism, and humility.”

Let me summarize a few of the key points in The Economist’s special report.

• Over 50 governments are exploring digital currencies. In October 2020, the Central Bank of The Bahamas issued the digital Sand Dollar , the first nationwide deployed CBDC.

The Sand Dollar has the same value and consumer protections as the traditional Bahamian dollar, to which it can be instantly converted. The Bahamas also introduced the Sand Dollar prepaid card in collaboration with Mastercard , which can be used to pay for goods and services anywhere Mastercard is accepted. (See related story here.)

China has a major e-yuan pilot underway. Over 500,000 individuals received 200 yuan ($30) from the government, which they can use to pay for goods and services using an e-yuan digital wallet offered by six commercial banks. Legally, e-yuans are as real as traditional hard cash.

A few weeks ago, the U.S. Digital Dollar Project announced that it will launch at least five programs over the next 12 months to explore the uses and designs of a U.S. e-dollar. The European Central Bank, meanwhile, has been developing the concept of the digital euro by conducting practical experiments and engaging with stakeholders and the broader public. And in April, the Bank of England announced the creation of a taskforce to coordinate the exploration of a potential U.K. CBDC.

• Motivation: Why are governments and central banks planning to issue digital currencies? A major motivation is the promise of a more efficient financial system. According to The Economist, the operating expenses of the global financial industry amount to over $350 a year for every person on the planet.

Government e-currencies could provide a cheaper, central payment hub that could make finance more accessible, especially for the 1.7 billion people around the world who lack a bank account.

E-currencies would enable direct payments to every citizen receiving government funds, such as social security, unemployment benefits, financial aid for low-income families, or economic relief during a crisis like Covid-19.

Avoiding the Wild West

Another important motivation is “a fear of losing control” to bitcoin, ether and other cybercurrencies, as well as to privately run digital currencies like Ripple’s XRP, or Facebook’s Diem, formerly known as Libra. “Unsupervised private networks could become a Wild West of fraud and privacy abuses.”

“For ordinary users, the appeal of a free, safe, instant, universal means of payment is obvious. … The hard truth is that monetary authorities have long felt uneasy about the weaknesses of banks. These include the share of people that are unbanked, even in rich countries, the high costs of payment methods and the inordinate cost of cross-border transactions (which eats into remittances to poorer countries). The appeal of a cheaper, seamless system has accelerated faster payment projects around the world.”

• Red flags: Could the emergence of CBDCs threaten the traditional banking system? Private banks provide financial services to individuals and firms by collecting deposits, holding in reserve a fraction those deposits and lending out the remainder. In America, around 90% of money is in private bank deposits. “In other economies the share is higher: 91% in the euro area, 93% in Japan and 97% in Britain.”

The idea of a central bank providing a wallet app and digital money directly to citizens is a a truly disruptive force — the reason central banks are taking a cautious approach.

If citizens can convert bank deposits into CBDCs with a simple swipe, it could end up disintermediating the banking systems by attracting a large portion of current deposits.

Banks would be forced to find other sources of funding for their loans, or other institutions would have to do the lending that fuels business creation, the housing market, and economic growth.

Public Confidence at Stake

In addition, instead of protecting financial institutions by being the lender-of-last-resort , central bank accounts might actually lead to private bank runs. Confidence in the financial system is underpinned by people’s expectations that they can always transfer their assets into cash — the safest form of money. In a crisis, many might thus choose to transfer their money into the safety of e-money in a central bank account.

Red flags: Should we worry about the potential misuse of CBDCs by a government to control its citizens? Think, for example, of instant e-fines to punish citizens for state-disapproved behaviors. “Cash is not traceable, but digital money leaves a trail,” notes The Economist. “Exclusively digital money can be programmed, restricting its use. This has benign implications: food stamps could be better targeted, or stimulus spending made more effective. But it also has worrying ones: digital money could be programmed to stop it being used to pay for abortions or to buy books from abroad.”

“Yet there should be ways to minimize each of these problems. The best defense against the unhealthy spreading of state influence over lending decisions is to keep the current fractional-reserve system alive. This may mean constraining the scope of CBDCs and managing them at arm’s length from the central bank — perhaps through third parties. They should not pay interest and the value of their balances should perhaps be capped. CBDCs may risk empowering authoritarians, but in democratic countries there is usually adequate separation of powers within government to stop this.”

“Governments and financial firms need to prepare for a long-term shift in how money works, as momentous as the leap to metallic coins or payment cards,” writes The Economist in conclusion. “That means beefing up privacy laws, reforming how central banks are run and preparing retail banks for a more peripheral role.

State digital currencies are the next great experiment in finance, and they promise to be a lot more consequential than the humble ATM.”

Originally published at https://blog.irvingwb.com.