Why do central banks attach so much importance to digital currency?

By Carolynn Look, Bloomberg

Editor: South Wind

Money is heading for its biggest transformation in centuries. Modern technology and even the coronavirus pandemic are driving consumers toward cashless spending, and as alternative concepts like Bitcoin gain popularity, central banks are moving quickly to ensure they don’t fall behind. Central banks are promising a payment system that is safer, more resilient and cheaper than private payment systems.

Central banks in the Bahamas, the Eastern Caribbean Currency Union (ECCU) and Nigeria have already pioneered central bank digital currencies (CBDCs) , while China, the eurozone and other countries are experimenting in the field. Meanwhile, the Federal Reserve (Fed) and the Bank of England (Bank of England) have been much more cautious in this regard.

1. What would a central bank digital currency look like?

On the surface at least, CBDC is not much different from electronic money in a bank account and using a bank card, smartphone or app to send bank funds around the world. The key difference is that this money provided by the central bank (i.e. CBDC) is a risk-free asset , just like cash. For example, a $1 paper bill is always worth $1; while $1 in a commercial bank account, although theoretically convertible into paper currency as needed, is subject to the bank's solvency and liquidity risks, which means that consumers may not always be able to use it, and may even lose it in rare cases. CBDC, like banknotes and coins, will be a direct liability of the central bank .

2. How will CBDC change payments?

CBDCs can take many forms, but one of their goals is to speed up payments . In the current system, commercial banks use central bank money to settle net payments with each other, but for technical and operational reasons this process is not usually instant, so there is credit risk during settlement.

3. What is the relationship between CBDC and cryptocurrency?

Aside from the underlying technical design, the two have little to do with each other. CBDCs are conceptually different from cryptocurrencies like Bitcoin, which are too volatile to be a store of value and not widely accepted to be used for payments. Bitcoin is more of a speculative asset. A major appeal of Bitcoin supporters is its decentralization, meaning it has no central control and transactions are recorded on a public, distributed ledger. CBDCs are controlled by the central bank.

While some countries are experimenting with using distributed ledger technology (i.e. blockchain) in full or in part for CBDC, this does not mean they will end up using it. For example, the European Central Bank has expressed concerns about the environmental footprint of running a parallel blockchain infrastructure and has already launched another system in 2018 that may be more suitable.

4. What are the different types of CBDCs?

There are two main tracks: wholesale and retail . In a retail project, CBDC would be issued through central bank accounts for the general public or through commercial bank accounts that work with the central bank . A CBDC-based system has no credit risk: funds are not on the balance sheets of intermediaries, instead, transactions are settled directly and instantly on the central bank's balance sheet . The retail approach could be particularly helpful for consumers who do not have access to traditional banking services. However, some countries, such as Denmark, have ruled out this possibility because it could leave banks vulnerable to depositors fleeing to central bank accounts. Other central banks have said they would set a cap on CBDC reserves to guard against such financial stability risks. In a wholesale CBDC project, the digital currency would be limited to banks and other institutions to make payment flows within the existing financial system faster and cheaper, while being less disruptive to the overall structure of the industry .

5. Which countries are experimenting with CBDC?

According to the International Monetary Fund, about 100 countries are at various stages of CBDC exploration (see chart below). India shocked the payments world by announcing that the central bank would issue a digital rupee as early as the next fiscal year. China, meanwhile, launched its digital yuan to athletes and spectators ahead of the 2022 Winter Olympics in Beijing to test its appeal to foreigners. Some islands in the Eastern Caribbean that share a central bank have launched their own digital currency, DCash: last year, a volcanic eruption in St. Vincent and the Grenadines forced thousands of people to evacuate their homes, and the move was seen as an important part of the reconstruction effort.

In the above figure, the yellow part represents countries that have issued CBDC; the pink part represents countries that plan to issue CBDC; the light blue part represents countries that are actively exploring the feasibility of CBDC; the dark blue part represents countries that are conducting CBDC research. Source: Bloomberg

6. Which countries are not trying?

The Fed has been slower to warm to digital currencies, but it recently took a key step by publishing a 35-page discussion paper outlining a range of potential benefits of a CBDC. However, the Fed did not reach a definitive conclusion on whether issuing such a currency would be prudent, and in any case said it would not do so without support from the White House and Congress. The Bank of Canada has not seen a compelling reason to use a digital currency, but will continue to build the technical capacity to issue a CBDC and monitor developments that could increase its urgency.

7. What are the advantages of CBDC?

If central banks can overcome the technical difficulties, digital currencies could enable faster and cheaper money transfers within economies and across borders . CBDCs could also improve access to fiat money in countries with reduced cash supplies. An IMF report said CBDCs could increase financial inclusion in areas where private financial institutions find it unprofitable to operate and build resilience in areas prone to natural disasters . European Central Bank President Christine Lagarde believes a digital euro could become particularly important if protectionist policies lead to disruptions in Europe's main external payment services. For China, digital currency offers a possible way to keep up with and control a rapidly digitalizing economy. On the other hand, it could also give the government an additional surveillance tool.

8. What are the disadvantages?

The risks of issuing a CBDC in the wrong way would be huge, which is why most central bankers have been very cautious so far. Commercial banks are an important source of funding for the real economy, so the risks central banks face when issuing CBDCs are twofold: one is cutting off commercial banks’ business, and the other is taking on the direct risks and complexities of mass banking, depending on the model of the CBDC. For central banks, problems in managing a new business could undermine the public trust that underpins their occasionally unpopular moves, such as interest rate hikes.

In addition, some researchers have expressed doubts about whether current blockchain technology can support a large number of simultaneous transactions. An official at the People’s Bank of China said its research showed that the capacity of the Bitcoin blockchain was far below the peak demand of 92,771 transactions per second during China’s Singles Day shopping extravaganza in 2018. Other studies have found that Ethereum processes an average of 15 transactions per second, while Visa’s network can handle 24,000 transactions.