Will CBDCs Eliminate the Need for Commercial Banks?
Disruption of the traditional banking model by digital assets
This research was sponsored by Luno Global, a platform that allows users to buy, save and manage cryptocurrencies.
Prompted by technological innovations in the financial arena, the interest in central bank digital currencies, or CBDCs, intensified as a result of the global pandemic. Currently, nine countries have launched a CBDC, while 78 are in the research or development phase, according to the latest figures provided by the Atlantic Council.
Research into CBDCs began several years ago, but the increased use of digital payments during the pandemic brought them further into the limelight. While there are many benefits to CBDCs, including improved financial inclusion and more efficient monetary policy, there is also the possibility of disrupting the traditional banking model.
Countries can design their CBDC to be wholesale, where commercial banks remain intermediaries and handle retail payments; or retail, where consumers would hold their digital fiat currencies directly at the central bank.
Reasons governments are exploring CBDCs
As emerging economies try to alleviate the challenges of cross-border transactions, some, such as El Salvador, have adopted bitcoin as legal tender. Cross‐border remittances are expensive, slow and lack transparency — and they make up a large portion of activity in emerging market economies.
Estimates from the World Bank show remittances sent in 2021 to low- and middle-income countries (except China) rose to almost $590 billion, up 7.3% from the year before. This figure is expected to exceed the combined value of overseas development assistance and foreign direct investment going to those countries.
World Bank figures reveal that the cost of sending $200 worth of these remittances averaged 6.4% of the amount transferred during the first quarter of 2021 — and additional data revealed that these transfers are the most expensive when they go through banking channels as opposed to digital channels.
To solve these challenges, some countries look to traditional cryptocurrencies such as bitcoin, while others are researching their own digital currencies.
But as global corporations transact over $23 trillion per year in cross-border transactions, the benefits go beyond individual remittances. A recent paper by consulting firm Oliver Wyman stated that a multi-currency CBDC (mCBDC) network has the potential to dramatically decrease settlement time and save $120 billion annually in transaction costs.
Payment system disruption
Commercial banks are already feeling the impact of blockchain technology and digitization as payment providers such as PayPal and Venmo disrupt the typical banking model. The ability to transact on the internet has changed the logistics of banking, whereby a physical location is no longer needed.
A study by the Federal Reserve showed that cash usage has steadily decreased since 2019, while the use of credit cards and ACH payments has increased.
Cash usage on the decline
Quantum Economics spoke with Dr. Kimmo Soramäki, founder and CEO of technology firm FNA, who stated that a U.S. wholesale CBDC would provide non-bank providers direct access to wholesale accounts at the Federal Reserve and could allow them direct access to the settlement of transactions without going through a bank tiered system.
“This will offer lower costs, lower banks’ dominance and lower counterparty risk, resulting in better opportunities to innovate,” he stated. However, this could also place added pressure on the traditional banking model.
Current landscape
Of the current CBDCs in existence, all are using the retail model:
Sand Dollar: the Bahama’s digital currency was the first CBDC launched and follows a retail model. However, it can only be used in the Bahamas.
DCash: the Eastern Caribbean’s digital currency, launched in March 2021, has expanded to seven nations.
ENaira: Africa’s first CBDC, Nigeria’s digital fiat currency had over 500,000 downloads in the first month.
China was the first country to use paper currency in 770 BC, and currently, it is on track to be the first major economy to issue a fiat digital currency. While most of the larger economies are exploring the possibilities of a CBDC, China has made the most progress with its wholesale version of the eCNY.
The digital fiat currency has been tested through multiple pilot runs in several cities. More recently, a free digital yuan wallet app, the Digital Currency Electronic Payment (DCEP), was launched in select cities in China on both the iOS and Android stores.
In the first week of launching, the South China Morning Press reported that downloads of DCEP surpassed those of WeChat. China has been targeting a full rollout in advance of the upcoming Lunar New Year and the 2022 Beijing Winter Olympics, where foreign visitors will have the opportunity to download the DCEP app at the games.
China has also been a frontrunner in mBridge, an initiative to build infrastructure that will connect CBDCs. The collaboration to reduce the costs and increase the speed of cross-border payments includes the People’s Bank of China, the United Arab Emirates, the Hong Kong Monetary Authority and the Bank for International Settlements.
Commercial banks and competition from central banks
A CBDC has the ability to improve financial inclusion, provide better informed monetary policy and reduce systemic risk. In addition to privacy concerns, a CBDC can potentially lead to disintermediation or the shrinking of a commercial bank’s balance sheet.
In the traditional financial intermediation model, consumers deposit funds with banks and they are paid interest at a short-term lending rate. The banks then loan a portion of that money at a long-term, and typically higher, interest rate.
Referred to as maturity transformation, banks take short-term sources like deposits and use them for long-term financing, such as mortgages, which is a major source of income for commercial banks.
A retail CBDC could essentially give consumers the option of establishing a deposit account directly with a central bank, potentially endangering maturity transformation for commercial banks. In this case, the central bank would be a competitor for the assets commercial banks use to make long-term loans. The BIS has stated: “A CBDC (like other forms of digital money) could lead to higher volatility in deposits and a significant, long-term reduction in customer deposits.”
If a central bank were to issue a digital form of a country’s currency, bypassing financial intermediaries, the impact could be substantial. According to the Bank of England,“…a very large or rapid shift from deposits to CBDC could have significant implications for the amount and cost of credit that the banking sector could provide to the economy and the way the Bank achieves its objectives.”
By issuing a CBDC, the central bank could become a competitor to financial intermediaries. If a large number of savers attempted to withdraw money at the same time, the probability of default increases, which could motivate more individuals to try to withdraw their funds. In recent times, the vulnerability that commercial banks face due to maturity transformation became rather evident during the global financial crisis of 2007–2009.
In the event of a bank run, a commercial bank would need to liquidate long-term investments to satisfy short-term needs. The central bank, however, does not have the ability to call on long-term assets.
The future of banking
More governments have been exploring and researching CBDCs and their impacts in the past several months, including the U.S.
The Fed recently issued its CBDC white paper, but instead of actionable policy items, the central bank is instead seeking public comment. The Fed did indicate that creating a retail model, where an individual holds an account at the central bank, would: “represent a significant expansion of the Federal Reserve’s role in the financial system and the economy,” and would favor an intermediate model.
While the Fed has asked for public opinion, there is already opposition mounting. Minnesota Rep. Tom Emmer has introduced legislation prohibiting the U.S, from issuing a retail CBDC, citing privacy concerns.
As countries increasingly experiment and issue digital currencies, the impacts on traditional banking, known and unknown, are about to be discovered.
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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