Today we can observe changing habits and patterns of how payments are conducted. Although still prevalent, cash is becoming less popular and it is being replaced by different kinds of digital payments. The financial ecosystem is growing rapidly and many digital currency concepts have emerged that make it easier to get away with money. Moreover, as more purchases are made online, the pandemic has naturally helped to increase the use of digital currencies.
A central bank digital currency (CBDC) could completely revamp the global financial system as we know it. Through CBDC’s, fiat money will become truly digitalised and finalise the merger between monetary and fiscal policy.
The development and implementation of digital government money is not necessarily a trend or development one might trade, but rather represents what could be the biggest change to how the financial system is constructed and operates, and is a development everyone must be aware of and would do well to educate them on.
Central Bank Digital Currency
The currency is controlled by the central bank – i.e. the CBDC supply is fully regulated and determined by the central bank. A CBDC differs from a traditional cryptocurrency stable coin where the issue is not controlled by the bank, but rather a group of individuals. Cryptocurrencies, as we know them today, are very volatile and lack government support – the CBDCs address these concerns while at the same time using the basic distributed ledger technology of cryptocurrencies.
Governments that legally recognize the CBDC in the jurisdiction of the central bank can use them to make payments to anyone and every business must accept them.
In simpler terms, CBDC is short for Central Bank Digital Currency, an electronic form of central bank money that citizens can use to make digital payments and store value. A CBDC offers three main elements:
- A digital currency
- Issued by the central bank
- Universally accessible
CBDCs are categorized into two different proposals based on the targeted users:
Retail Central Bank Digital Currency
Retail CBDC, based on distributed ledger technology, is traceable, anonymous, and available around the clock. It offers possibilities for interest rate applications, as well. Due to these advantages, a retail central bank digital currency focuses, in particular, on supporting the general public. Additionally, it helps lower the cost of cash printing and promotes financial inclusion.
Wholesale Central Bank Digital Currency
Wholesale CBDC increases payments and security settlement efficiency while resolving liquidity and counterparty risk issues. It’s a great fit for financial institutions which have reserves deposited in a central bank. With their capability to improve wholesale financial systems’ speed and security, even central banks consider wholesale central bank digital currency a favored alternative to existing systems today.
Currently, several central banks are considering issuance of CBDC and they are working on the general design of such a system. There are various CBDC setups considered. Depending on the setup that is finally applied, there is a different impact on banks. The strength of this impact will be determined by several features of this newly designed system.
One of the most important questions is how CBDC will be stored. It is assumed that there are three major options for this matter. It could be stored directly in accounts held at the Central Bank, in banks or at various third party providers as tokens in electronic wallets or combinations of the above options. From a bank’s perspective of course the least impactful solution would be a setup with CBDC assets stored only at banks. The most impactful one for banks would be a setup where various providers are entitled to keep CBDC and can offer additional payment services also related to fiat currency. Clients will be enabled to keep this currency (CBDC) on wallets provided by these third parties.
Way of exchanging CBDC
It will be crucial from a bank’s perspective which entity will have an entitlement to exchange CBDC against fiat currency. Opening this service to various providers would have the most serious impact on banks, however restricting it to the Central Bank only, will also deprive banks of profits from transaction processing due to outflow of deposits in fiat currency to CBDC.
Means of exchange
Decision on how CBDC could be obtained will be another factor impacting the whole financial system and banks. There are different considerations which setup should be applied. The least impactful approach would be when only government bonds are directly exchangeable for CBDC. A more liberal approach would enable purchasing CBDC by cash. The most impactful approach would allow direct exchange of banking deposits in fiat currencies into CBDC.
Regulatory requirements
Minimum requirements defined by local regulatory bodies in order to offer services related to CBDC (e.g. a wallet for CBDC storage, payments and exchange) will determine the entry barriers and thus the competition in the CBDC system. While these features are the most important when analyzing the potential impact of the CBDC system on banks, there are also other considerations that should be mentioned. They include the approach to the CBDC implementation itself – whether it will be done gradually or issued as a one batch (“big-bang”). Moreover, there is the question whether CBDC will bear interest rates and if yes, how they are different compared to fiat currency interest rates. Also the level of existing interest rates and the economic situation in general will have considerable importance, because they will trigger general demand for CBDC (considered as a safe form of holding assets) and consequently the total value of assets converted into CBDC.
Difference between CBDC and Cryptocurrency
CBDCs are not designed to compete with crypto currency. Crypto assets are based on technology designed to circumvent authority and banish central bank money to create economic anarchy. They have become popular more as an investment vehicle and less of a medium of exchange. CBDCs on the other hand will essentially track physical currency.
Whether it can emerge as an instrument of investment will be dependent on its design, ease of availability and fluctuations in value, if any. CBDCs will have to be a public good provided by the central bank. The pandemic has pushed consumers to go increasingly cashless and CBDCs might complement, rather than replace, physical cash in the system. If implemented, a CBDC would be a claim on the central bank issuing it.
A main difference that CBDC would have from cryptocurrencies is that the former would be centralized unlike the latter.
Conclusion
Central Banks have started exploring CDBC issuance as a new form of money. CBDC is expected to serve as digital money to solve the diminishing use of cash in some countries and others are considering CBDC as an innovative method that brings financial stability in the economy. However, CBDC acting as a new payment technology may soon be available in a number of countries around the world and situations like COVID-19 may ignite this process. Central Banks can benefit and learn from each other by sharing best practices, approaches and technologies mutually and thus contribute to the most advanced payment platform in the financial system. Central banks in the UK, Sweden, Euro Area, Canada, China and India are among those who are exploring the feasibility of a CBDC.
