Even as they lambast the effect of cryptocurrencies on monetary systems, central banks around the world are toying with the idea of digital currencies on the side. For example, the Federal Reserve has been teasing the idea of a Fedcoin for years. Rwanda’s central bank has revealed plans for a digital currency.
Mark Carney, governor of the Bank of England, called for the establishment of an alternative digital currency to displace the dollar as a global reserve currency. The digital currency, he said, would be underpinned by a network of central bank digital currencies. Carney’s proposal was described as “radical” in the media. Meanwhile, China’s central bank has raced ahead of others with its plans and may release a digital currency as soon as Nov 11 this year.
Those news items are just the tip of the iceberg for CBDCs, however. At least, nineteen central banks are already exploring the pros and cons of such an implementation. Development of monetary policies and an economic system to govern nations took centuries. In contrast, the hop from a cryptocurrency to a digital currency issued by central banks has a been a fairly short one.
Here’s a brief introduction to CBDCs.
What is a Central Bank Digital Currency?
As the name indicates, CBDC are digital currencies that are issued and administered by central banks. Unlike cash, such currencies are not printed and exist only in digital form. They may or may not be anonymous and will have a stable value as compared to cryptocurrencies.
How are CBDCs different from cryptocurrencies?
Cryptocurrencies are a form of digital currency. The defining characteristic of cryptocurrencies is decentralization. No single actor is responsible for their operations. For example, Bitcoin and Ethereum, the world’s most valuable cryptocurrencies, rely on developers and miners to power their coins. Bitcoin’s circulation and value depends on a variety of factors, such as the difficulty of its algorithm and availability of miners. Demand for Bitcoin is also organic and based on investor appetite for risk.
A CBDC presents a contrast to this approach. It is a centralized ecosystem, with a central authority (typically the central bank) responsible for the levers that determine its value and supply in the market. A central bank can increase or decrease the supply of coins in an economy and charge interest rates on those coins in response to external economic stimuli. CBDCs also contain elements of cryptocurrencies in that they incorporate cryptography in their design and may be semi-anonymous.
What are some uses of CBDCs?
CBDCs can have several functions within an economy. For example, they can be used as a medium of transaction for everyday commerce. In this type of CBDC, you will be able to purchase goods and services using digital currencies. CBDCs can also be used as a store of value. For example, you will be able to make bank deposits and earn interest on accumulated interest on digital currencies.
Then there is their use in bringing unbanked masses unbanked masses into the existing finance infrastructure. The technological underpinnings of CBDCs means that they do not require expensive physical investments in buildings and resources. Instead a simple online account, accessible via cheap mobile phones, can bring underserved parts of a population within the current finance infrastructure. Incorporating previously absent parts into an economy can boost its value.
CBDCs are also considered especially useful within the context of large wholesale markets operating within a country. Wholesale markets are generally characterized by onerous regulations which require multiple transactions and bureaucracy for compliance. Various tests are being conducted using distributed ledger technology (DLT) to streamline such transactions. The introduction of digital currencies in such transactions has the potential to make the transactions even faster by eliminating the need for a physical interface for payment processing.
How will CBDCs be made available to the general population?
There are two ways in which CBDCs can be distributed in an economy.
The first one is through the conventional, tiered banking system used by central banks, such as the Federal Reserve. In this system, the central bank distributes money into an economy through commercial banks. In turn, the banks are responsible for distributing the currency to customers and businesses.
According to reports, China has adopted a variation of the first method. In addition to commercial banks, it plans to distribute its proposed cryptocurrency through tech behemoths Alibaba and Tencent.
The second approach establishes a direct connection between a central bank and citizens. In this method, central banks will deposit virtual currencies into household or business accounts. For those without an account, CBDCs can be disseminated through cheap devices, such as mobile phones, connected to the Internet and containing specialized wallets for this purpose. The crypto wallets can be used for transactions similar to the ones conducted by banking systems. This approach simplifies monetary policy implementation because it enables central banks to directly control supply and interest rates in customer accounts or wallets.
How do CBDCs affect an economy?
Because CBDCs are yet to be fully implemented in an economy, no conclusive proof exists regarding their effect. But a couple of possible scenarios have already emerged.
As mentioned earlier, CBDCs can boost an economy by bringing previously underserved populations into the existing economic infrastructure. This is mainly because integration into the mainstream system will enable them to conduct transactions and increase the size and growth prospects of an economy.
Another possibility being suggested is the use of CBDCs in implementing negative interest rates. As growth plateaus in Western economies, negative interest rates for government bonds have mostly flopped.
Some blame it on the difficulties of a cash economy because it allows citizens to hoard money when rates dive. In a CBDC regime, central banks will be able to directly calibrate interest rates to spur growth. For example, the central bank could charge negative interest rates on customer savings accounts for digital currencies, forcing them to spend money and drive the economy.
CBDCs can also be used to distribute social service handouts or helicopter money. Some experiments to test the efficacy of Universal Basic Income (UBI) are already underway in different parts of the country. Using a CBDC to implement such a scheme will make it easy for the central bank to distribute the payments and track its usage by recipients.
What are the challenges of using CBDCs?
Privacy has emerged as the main concern about the use of central bank digital currencies. CBDCs allow central banks to monitor and track consumer accounts, providing banks with overarching powers over the entire monetary system.
Critics point to China’s shaming of debtors as an example of the perils of concentrating power and information into a single authority. As such, an appropriate level of privacy – one that allows central banks to distribute money and protects the privacy of consumer transactions – is of utmost importance while designing such systems.
Security of CBDC systems is also important. Digitizing parts of monetary policy implementation makes it susceptible to hackers and criminal elements. Nefarious elements could potentially bring down an economy by crippling the system by making it impossible to conduct transactions using CBDCs.