CBDCs Explained

Ideas and implications behind the drive for sovereign digital currencies

This research was sponsored by Luno Global, a platform that allows users to buy, save and manage cryptocurrencies.

Since the beginning of time, money has taken various forms, from cattle and shells to today’s paper and coins. Over the years, money has become increasingly digital, and the next step in this evolution is materializing in the form of central bank digital currencies (CBDCs).

First introduced in 2020 with the Bahamian sand dollar, more were launched in 2021. These included the Eastern Caribbean dollar (Dcash) and Nigeria’s eNaira. Currently, over 80 countries have taken steps to research a CBDC, with 14 past the analysis stage and exploring a full launch.

CBDC are digital currencies, but they’re not cryptocurrencies. They’re issued by the central bank and are fiat currency, but they’re not traditional paper money. And there’s a variety of ways that they can be issued.

So what are the primary reasons a government would launch a digital version of its currency?

The Digitization of Money

A CBDC is the digital form of a country’s fiat currency and differs from cryptocurrencies such as bitcoin or ether. Similar to paper money or coins, a digital fiat currency is backed by the full faith and credit of the issuing government. Further, most CBDCs leverage blockchain technology, just like many other digital currencies do.

At the same time, most traditional cryptocurrencies are decentralized networks based on blockchain technology. As they are not issued by any governing authority, they are designed to be free from government intervention or manipulation. Meanwhile, stablecoins act like cryptocurrencies, but they are pegged to another asset, most typically a currency such as the U.S. dollar or euro.

Given the rising acceptance and popularity of both cryptocurrency and stablecoins, countries are increasingly investigating their own CBDCs. And monetary policy authorities are urging countries to act quickly given the competition from new digital assets, as well as the ways technology firms are challenging traditional banking institutions.

“Central banks have a responsibility to ensure that citizens have access to the safest form of money — central bank money — in the digital age,” said European Central Bank President Christine Lagarde

Living in a Cashless Society

CBDCs have the ability to revolutionize payments, provide greater payment efficiency, and improve financial inclusion. Interest in these digital fiat currencies was prompted by technological innovations in the financial arena, and the global pandemic further accelerated the push for digital currencies.

COVID-19 highlighted the limited access the more vulnerable members of society have to the banking system. As alternative forms of currency, CBDCs could increase financial inclusion and provide enhanced access for those without bank accounts.

According to a 2019 survey conducted by The Federal Deposit Insurance Corporation, roughly 7.1 million U.S. households were estimated to be unbanked. The number increases substantially outside the U.S., as approximately 1.7 billion adults do not have a bank account, according to the latest data from the World Bank.

As for the causes involved, the most-frequently cited reason was a lack of money, with the second being that people “Don’t trust banks.”

The pandemic highlighted the challenges citizens face by not having access to a bank account. There was an increase in the number of merchants not accepting cash, and the volume of online ordering increased for everyday household items, including groceries. In a move away from cash, nearly one-third of consumers recently surveyed by American Banker had changed their method of in-store payments from cash to digital.

Instead of having to go through a financial intermediary, mail checks or debit cards, a CBDC would provide account holders with the ability to quickly transfer funds to individuals or businesses through the use of a digital wallet.

Ease of Cross-Border Payments

Transferring money between countries is a time-consuming and expensive process. By occurring in real time, CBDCs could ease the difficulty of cross-border transactions relating to time zone and exchange rate differences and expedite the process of sending money across borders.

Given the impact these digital fiat currencies could have on cross-border payments and global remittances, they have become a focal point of many policy makers. The World Bank Group and the Bank for International Settlements issued a joint report, stating that “CBDCs have the potential to enhance the efficiency of cross-border payments,” as long as they are implemented properly.

Effective Monetary Policy

By using CBDCs, government officials could potentially obtain a far more detailed sense of economic and business activity — and could access that information in real time. Armed with this data, central bankers and policy makers could distribute stimulus directly to specific industries, issue government benefits to designated individuals and also collect taxes.

Each country’s digital currency would have varying levels of access and degrees of privacy, depending on the design choices of the government.

Types of CBDCs

As countries develop their own CBDCs, governments need to consider who will be issuing these digital fiat currencies, how they will be distributed, and where the assets will be held. Further, policy makers will need to determine whether they want to use a wholesale, retail, or hybrid CBDC.

Wholesale CBDCs are designed for transaction payments and settlements between financial institutions and can be utilized for both domestic or cross-border payments.

The use of a wholesale CBDC would include making transfers between central banks and private banks, and it would involve the settlement of interbank transfers and related wholesale transactions. Most of the major developed economies, including Germany, France and the U.S., have been experimenting and testing with wholesale CBDCs.

In early October, the Banque de France furthered its experiment to evaluate the usefulness of blockchain technology through a series of bond transactions, part of a larger initiative that began last year, which will also include repo and interest payments, securities issuance and transactions involving primary and secondary markets.

And more recently, the Banque de France and the Swiss National Bank successfully completed the first cross-border CBDC trial. Coordinated in conjunction with the BIS, Project Jura explored international settlements between financial institutions.

On the other hand, a retail CBDC would eliminate the need for an intermediary and involve direct transfers between the central bank and consumers. A retail CBDC would be similar to current electronic retail payment systems and would involve either a digital wallet — similar to what China has been issuing in its e-Yuan trials, or a token.

Of the CBDCs that have been launched, all are retail. The eNaira, rolled out in Nigeria, is a retail digital currency designed to complement the existing physical currency, and it is available through two applications that are accessible on both the Google and Apple app stores.

Monetary Evolution

Emerging economies are rolling out their CBDCs ahead of their developed counterparts, as their levels of financial inclusion lag, and other major economies, including China and South Korea, are in advanced stages, with the possibility of China launching its e-Yuan in time for the 2022 Beijing Winter Games.

All of the four largest central banks — the Bank of England, the ECB, the Bank of Japan and the U.S. Federal Reserve — are exploring the design and implications of a CBDC. In the U.S., the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology’s Digital Currency Initiative have joined together in an effort to leverage various technologies to develop a hypothetical digital currency platform.

Further, the Federal Reserve Bank of New York will be partnering with the BIS Innovation Hub on an initiative designed to evaluate digital currencies, including CBDCs. However, the Fed is still undecided about the next steps for a digital dollar.

CBDCs could provide governments with improved monetary policy tools and efficient real time analysis. They could change the way consumers and businesses transact, make payments more efficient and improve financial inclusion. However, privacy issues need to be explored and addressed.

This content is for educational purposes only. It does not constitute trading advice. Past performance does not indicate future results. Do not invest more than you can afford to lose. The author of this article may hold assets mentioned in the piece.

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