Central Bank Digital Currencies: The next big thing in global finance

Interest in bitcoin and other cryptocurrencies is surging and central banks don’t want to be left behind by financial innovation.

Around 80 percent of the world’s central banks are examining how to launch digital versions of their own currencies. Financial institutions around the globe have started embracing this evolution as they are currently buzzing with discussions around a revolutionary concept; a form of money one cannot see but its impact is long-lasting, and that concept is called ‘Central Bank Digital Currencies’ (CBDC).

The idea of digital money is not new, many of us use debit and credit cards or payment apps for transactions, but what would make a CBDC different?

One of the big financial developments over the last few years has been the rising popularity of cryptocurrencies, with one in particular – Bitcoin standing out. Following Tesla’s announcement that it bought $1.5 billion worth of bitcoin in February 2021, the cryptocurrency surged to new highs, giving it a market capitalisation that is even larger than the world’s two largest payments’ processing companies (VISA and MasterCard).

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Unlike traditional money, cryptocurrencies are not issued by a central bank, but rather via a decentralised network of computers typically using block-chain technology. Even Facebook is trying to get in on the act, with the 2019 announcement that it would develop its own digital currency known at the time as ‘Libra’ and now rebadged as ‘Diem’. It was at that point that central bankers’ began to realise that they were really under some threat and the question at that point became ‘…if we can’t beat them, do we join them?’

Investors in bitcoin believe that because there is a theoretical cap in the number of bitcoins that can ever be mined, the cryptocurrency would become increasingly valuable at a time when central banks have been printing more money than ever before to arrest the economic fallout from the pandemic; that is why people sometimes call bitcoin ‘Digital Gold’.

Many central banks have worried that the widespread adoption of these independent cryptocurrencies could weaken their control over the financial system. This could cause financial instability, especially because cryptocurrencies do not have the legal or regulatory safeguards that central bank money does. In light of these facts, the idea of issuing a digital currency of their own thus arose.

Currently, regular bank deposits, cash and cryptocurrencies issued by the private sectors such as Diem and bitcoin all have a few features that make them useful, but the hope is that publicly available CBDC’s would have all these desirable characteristics. Unlike savings in the commercial banks, which rely on the bank’s promise to fulfil, CBDC’s are recognised by law and backed by the power of the central bank that cannot go bankrupt.

For example, if a commercial bank collapses, part of one’s savings could be potentially wiped out but this would not be the case for CBDC’s that could be as trusted as cash, as convenient as a payment app yet also benefit from the block-chain technology, which underpins cryptocurrencies.

Also, just like cash, CBDC’s could be distributed through commercial banks’ avoiding too many disruptions to the financial system or the central banks having to deal directly with millions of citizens or businesses. This sequence could be likened to the dynamics obtainable with the current banknotes during retail payments, just that this time, it is digital.

This means that everyone could have access to this digital currency, which could bring a lot of benefits. It could make payments faster allowing for immediate settlements and no processing delays, and it could also make payments cheaper.
In the US for example, the aggregate cost of making retail payments ranges from 0.5% – 0.9% of GDP; digital currencies would however reduce those costs. It also means that more people could have access to electronic payments. Currently, over 1.7 billion adults across the globe don’t have access to the financial system and even in a developed economy like Nigeria, more than 30% of the population don’t have a bank account. Issuing digital currencies could also make it easier for governments to deliver stimulus cheques or even go one step further and make targeted payments to those deemed most in need.

How soon could CBDC’s become a reality?

China is a major economy most advanced in its CBDC development. The Peoples’ Bank of China has been running tests of its digital currency since April 2020 with the help of four banks in the country. Tens of thousands of consumers have already been involved with the pilot spending $299 million US dollars (2bn Chinese Yuan) in over 4 million transactions.

For China, it could also be a means of re-asserting control over a financial system challenged by the rapid growth of Fintech companies. There may also be a geopolitical consideration for China, providing a mechanism to shift away from using the US dollar.

But it is not just China; the European Central Bank has plans for a digital Euro, although it may be a few years before it is available. Christine Lagarde of the European Central Bank in an ECB forum stated, “We are going to have to address all the issues of anti-money laundering, financing of terrorism, the privacy of users and all their information and input the appropriate technology that would carry that digital currency; and this is a project that would probably take us 2-4 years before it is launched.”

This has got people wondering whether issuing a CBDC could interfere with the effectiveness of the monetary policy. A lot depends on how much people would use CBDC’s and no central bank wants them to completely replace traditional cash but rather complement it. One risk that would be associated with CBDC’s is that in an extreme situation such as after a financial crash, you could observe people withdrawing their deposits from commercial banks and opting to store their money in digital currencies backed by the central banks.

As we move towards a more cashless society, would CBDC’s ever become as trusted and as convenient as banknotes? Quite possibly, but may take months maybe even years. However, the trust derived from money is built on trust in the currency. Hence, should the CBDC gain more trust than current banknotes in the nearest future, then the end of banknotes may just be lurking around the corner.