Should we care about central bank digital currencies?

The concept of central bank-issued digital currencies has been the talk of the town in the crypto- ad banking communities for a while, but as we are getting into the new decade, news of various central banks either researching or announcing that they will launch digital currencies that have exploded. What are the motivations behind this rise in popularity, what are the potential consequences and does national bank-issued digital currencies make sense in a borderless digital world?

Although central bank digital currencies (CBDC) often is translated to state-issued cryptocurrencies that are not necessarily the case. Unlike cryptocurrencies, CBDCs are fully regulated by the issuing state and abides by a central authority, similar to fiat currencies. CBDCs are not decentralized, and while some are implemented with distributed ledger technology, others have concluded that blockchain is not the answer for CBDCs.

According to a report issued by the Bank for International Settlements (BIS), as many as 70 percent of financial authorities worldwide are researching CBDCs. In a follow-up this year, BIS states that 40 percent of central banks have already reached a proof of concept stage for DBDC.

What may have sparked the fire to accelerate these developments may have been Facebook’s unveiling of the Libra cryptocurrency last year. Shortly after the announcement, European central banks and parliament members stated their worries that something of this magnitude could instantly become systemic and called out for regulators to be on high alert.  G7 also announced that they will set up a high-level forum to examine the risks of such currencies to the financial system with regards to financial stability as well as money laundering shortly after the announcement.

Some analyst believe that Libra could pose a threat to Chinas ambition to launch a digital yuan, and could usher in a new type of “currency competition” and force China to rethink how it deals with the realities of the digital world.

While a global digital currency partially controlled by Facebook may pose a threat to the future of money and privacy, Kenneth Rogoff, warns that a state-run Chinese digital currency with global ambitions is what we really should worry about. Rogoff’s biggest worry is the implications of a Chinese-governed global digital currency on the underground economy. Although decentralized cryptocurrencies play a role in the shadow economy today, they are not that efficient. Restrictions on withdrawals and exchange make cryptocurrencies to illiquid to reach enough scale.  A Chinese-back digital currency, on the other

hand, could in cases where Chinese interest coincides the west allow the Chinese government to not only allow trade with sanctioned countries like North Korea, but also see anything and everything.

However, a widespread adoption of a Chinese-controlled digital currency may still threated the role the USD has in global financial markets, and also replace USD as reserve currency in emerging markets tightly connected to Chinese trade, such as sub-Saharan Africa. As a result, several speakers at this year’s WEF at Davos called for a digital dollar as a response to the emerging Chinese digital Yuan, stating that Users of the U.S. dollar are “underserved by an analog currency in a digital world”. Earlier this month, FED announced that they are in fact researching a DLT-based digital dollar. ECB is not sitting idly by, and have similar efforts underway.

There is no doubt that central bank digital currencies has geopolitical implications that affect not only which currency will act as the main reserve for global trade, but also privacy and tax purposes. As a result, various contenders are ramping up their CBDC efforts in an attempt to either maintain status quo in current financial markets, or shift the power away from western dominance over global finance.

When exploring CBDC it is also important to understand the motivation for why National governments with no ambitions to replace the USD as a global main reserve are also exploring CBDCs. One of the reasons for smaller national currencies prepares a CBDC of their own is to make sure the tools to enforce a sovereign monetary policy is ready for a digital age. After all, fortune favors the prepared mind. In this case, collaboration is key for future interoperability, and several national banks have already partnered up to research this topic and assess potential use cases for digital currencies.

On the other hand, a future where physical cash seize to exist is a highly plausible scenario. Even for countries like Germany, where cash accounts for nearly 70 percent of transactions, cash usage is predicted to decline in the near future. Although near-extinct in some parts of the world such as Scandinavia, physical cash has some inherent traits such as a credit risk-free alternative to bank deposits, availability for everyone as well as anonymity.

Even though a central bank-issued digital currency seeks to possess similar traits as cash, digital currency may have consequences for both banks, financial stability, and monetary policy. As an electronic store of value, central bank digital currencies may challenge traditional bank accounts as the primary store of value, thus affect the banks’ balance sheets. As a consequence, banks would have to shift from deposit-based funding to wholesale funding. This may ultimately reduce bank lending and economic growth. The central bank may become a direct competitor to commercial banks and not only potentially create a 100 percent reserve system, but in the utmost consequence become an active arbiter over who should and shouldn’t be granted credit.

When looking at a potential implementation, a possible CBDC solution must also follow several architectural design principles regarding scalability, interoperability, accessibility, security, and flexibility. The solution must be able to scale in terms of both user and usage growth. The solution must be independent of devices and operating systems, as well as adapt to changes in this landscape in order to be accessible for everyone. The solution must also follow universal design principles, be user-friendly enough to cater to everyone and be available 24/7 every day of the year. Needless to say, security must be state of the art and a CBDC must comply with applicable financial regulations.

With the cost, complexity and potential consequences of a central bank digital currency, a key question is whether a CBDC ever will reach widespread enough adoption to pay off. The Bank of Korea has taken a firm stance in this subject and states that a CBDC will not only destabilize the market and be costly to society, but also for some reason cause a moral hazard.

Some may ask, why not just use bitcoin? With the main motivation for central banks to maintain control over monetary policy and ensure financial stability, it is certain that highly volatile and decentralized digital currencies is out of the question. Libra could once be seen as a strong contender, but since the announcement of Libra less than a year ago, the concept has deflated, and several key partners have left the consortium.

The fate of CBDCs are yet to be decided, and only time will tell how this will play out. However, with the potential implications on everything from monetary policies, global trade and commercial banking, this is definitely an area to watch in 2020.