Since the inception of blockchain in 2008, many have questioned its long-standing place in the finance world. With initial offerings being limited to cryptocurrencies such as bitcoin, experts remained divided on its effectiveness to alter the financial system. Despite this divide, an array of blockchain uses have emerged, further strengthening the place of cryptocurrencies and digital assets in the global financial system. As this has occurred, more attention has been placed on the value of introducing digital assets to the mainstream financial framework. Decentralised blockchain currencies such as bitcoin (BTC) and Ethereum (ETH) have already displayed their value not only to the global currency system as a medium of exchange but also as growth assets. From a Government perspective, the introduction of Central Bank Digital Currencies (CBDCs) offers an opportunity to utilise the benefits of distributed ledger technology for the global push to a cashless society. As much as 70% of the world’s Central Banks conducted some level of research on the topic in 2019.1 CBDCs can be defined as a digital form of fiat money, used as a store of value and a medium of exchange. It is issued by the state and acts in the place of cash.2 This, in turn, can be utilised for monetary policy, wholesale interbank settlement and/or retail transactions.3
CBDCs Vs Cryptocurrencies
While distributed ledger technology (blockchain) is the underlying foundation for CBDCs and crypto assets, there are some inherent differences to be noted. The main focus of crypto assets is to provide a decentralized platform; thus no single entity can limit nor alter information that is passed through the network.1 In comparison, it is likely that any CBDCs (wholesale or retail) will operate on a private blockchain, managed by the Central Bank. While this allows for a more secure distribution of the money supply, participants and token volume can be controlled.
This potential for risk of increased financial monitoring has already been shown in China’s beta testing of their Digital Currency Electronic Payment (DCEP) currency. As the country controls the money supply and broad financial system, a complete change to DCEP would allow for tighter regulations to be implemented instantaneously.4 Without any proposal of a regulatory body, there is potential for severe ramifications, particularly for oppressed and minority groups. As the nation has limitations on capital outflows for residents already, many turn to cryptocurrencies (particularly stablecoins) to conduct transactions unapproved by the regime. Many argue that this value increase that has been placed on cryptocurrencies by the Chinese middle and upper class is fueling the government’s drive to implement DCEP. However, it could be that the integration of the nation’s CBDC may push many of the nation’s residents further into the crypto space.
Government Costs Vs Benefits
Some fail to see the value in such a drastic shift to a cashless society, although implementing CBDCs could increase market efficiency radically. From a legal perspective, a CBDC is likely to limit potential money laundering, tax evasion and illegal transactions due to the nature of its records. This will increase tax receipts for the government as well as reduce crime.
Seigniorage will also skyrocket as the production cost is decreased in comparison to the intrinsic value of the token. In 2020, the USA is predicted to spend US$877.2 on fiat currency production.5 It should be noted that this represents a reduced annual fee due to decreased cash demand as a result of Covid-19. This alone would display the potential for savings if cash were to be replaced entirely by CBDCs.
Implementing CBDCs does not alter the basic mechanics of monetary policy, although its effectiveness is dependent on access and desirability. Transparency and strength in the transference of policy rates onto consumers is likely to improve. This remains dependent on regulations, intraday use, and its ability to be interest bearing. Similarly, the introduction of CBDCs will assist in alleviating the 0% lower bound constraint, allowing for more efficient expansionary policy action.6
While research is being conducted across the globe, there is a limited understanding of the potential roadblocks countries may face. The role of the Central bank must be reassessed if they are to limit the potential for negative externalities.4 Certain CBDC frameworks position central banks to take on an increased amount of financial risk by adopting a degree of the responsibility currently faced by commercial banks. If errors were to occur, the Central Bank could be exposed to severe reputational damage which may impact the government also.
Although the adoption of CBDCs will drastically decrease settling costs and time, interoperability remains one of the biggest challenges for global integration. To successfully allow for full compatibility across nations, coding languages, regulations, and general infrastructure must be alike.7 While certain regions have signed agreements to allow for such compatibility, others show no signs of committing resources to this important task. China has launched beta testing for its DCEP currency, utilising applications such as Alipay and Wechat Pay as essential foundations of delivery to its consumers. Despite the issue, it presents for global interoperability, China’s leading position raises the concept of integrating privatised service providers to settle transactions. In the same way, the current framework relies on providers such as Western Union and Swift, a global financial system based on CBDCs will likely require intermediaries to validate inter-chain transfers.5 Whether this becomes the role of the private sector or an independent public entity will largely depend on the timing of nation adoption.
Commercial Banks Costs Vs Benefits
The impact of CBDCs on commercial banks relies on the structure proposed by their Central Bank. The integration of wholesale CBDCs is unlikely to change the existing relationship between commercial bank and consumer. This benefits the banks by speeding up transactions and reducing costs. There is also the potential to have 24-hour money markets, which is currently only available in select countries such as the USA and Australia.8
The introduction of retail CBDCs presents a different set of issues for commercial banks. While Central Banks may choose not to disrupt the current financial framework initially, the banks will face increased competition and decreased demand. The already highly competitive environment could be swarmed with Central Banks and big tech companies, leading to major industry disruption and a shift in the role of banks. This is likely to impact their liquidity and yield, forcing them to place riskier investments and ultimately increasing exposure to economic fluctuations.6
Introducing an alternative risk-free asset to the economy will also increase the likelihood of bank runs when consumer confidence plummets. Due to the instantaneous nature of the transactions and the core framework of the banks, the Central Bank will be able to provide currency in real-time. This poses great risk to destroy commercial banks in the event of an economic struggle such as the GFC or Covid-19 pandemic. To limit the potential of such runs, policymakers could introduce notice periods on withdrawals or balance limits on CBDC account holders. However, this could tamper with the efficiency of the model.9
Consumer Costs Vs Benefits
Consumers will be presented with an opportunity to access a practically risk-free interest-bearing asset similar to short-term government bonds. This allows for an alternate investment that can be used to hedge risk in other areas such as the property or share markets.10
Some argue that the immediate nature of CBDC transfers and payments is no great advancement on the current systems in place. While a large portion of the world has near-instantaneous digital payments, there are still nations that have extended settling periods, particularly in peer to peer digital transfers. In Australia, private company Osko has implemented a system that allows this for known contacts. Although this still operates on an I-owe-you system due to the nature of the commercial banking framework.11 CBDCs will alter this dramatically by allowing for instant value transfer, irrespective of whether the recipient is a merchant or a peer.
Additionally, it will negate any fees involved as there will be little to no need for intermediaries that will skim payments. This is particularly valuable for those that make transfers internationally regularly. On average, sending remittances costs 6.67% of the transfer value. If this were to drop below 1%, almost US$20B would be saved annually.12 With the introduction of CBDCs, it is viable for fees to fall significantly, theoretically to 0%.
Although accessibility is a main feature of CBDCs, there is a risk of some individuals being unable to utilise its effectiveness, particularly if cash is to be phased out alongside. In 2018, a Deloitte survey found that only 73% of respondents globally access online banking, followed by 59% who use mobile banking apps.13 While this is only based on a survey, it is indicative of the fact that a large portion of the globe still relies heavily on cash as a medium of exchange. Despite digital adoption rates increasing in the coming years, some individuals will probably be left behind if CBDCs were to replace physical dollars completely.
For consumers, CBDCs offer an important upgrade to the current cash system. While this is the case, individuals face the risk of their data being used and analysed by their government. From detailing location to purchase history and contacts, there is potential for national interest to potentially impact the individual’s financial freedom.
CBDC’s would offer a valuable alternative to cash, although a fundamental aspect of the setup process is the creation of government-issued digital wallets. The security concerns alone warrant insight; however, the main issue lies in the fact that lower socioeconomic communities often lack proper identity records, particularly in emerging economies. While it is typical for lower socioeconomic individuals to be left behind when the global economy develops, many of these people are positioned uniquely. In developing nations, financial repression is commonplace. Cryptocurrencies such as bitcoin have offered a promising alternative to unstable and corrupt banking systems.14 As cryptocurrency adoption is increased in developing economies, financial freedom and certainty are magnified, ultimately resulting in increased financial security for all wealth classes. This raises the question of which countries will choose to implement CBDC’s and how much of their motivation will be driven by government interest more so than economic freedom.
For consumers, CBDCs offer a more guided integration of distributed ledger technology into our financial system when compared with decentralised cryptocurrencies. This would likely allow for a transition that focuses on preserving the government control of money supply. In recent years, mainstream media and governments have portrayed decentralised currencies as volatile, while only being useful for criminals and speculative traders. This has been promoted to justify the use case for a government-led alteration to the current financial system as opposed to the disruption that cryptocurrencies may have on the current systems. Despite these attempts to tarnish value, the introduction of cryptocurrencies in developing nations has offered a promising alternative to their unstable financial and banking systems with minimal side effects.15 Although there is potential for CBDCs to further the protection from unreliable systems, the potential faults and motivations ought to be considered.
How CBDCs will impact the global financial system
As the globe moves steadily towards a cashless society, many nations are close to developing sustainable CBDC models. Following closely behind China, Sweden, and Korea are also enacting pilot programs to assess the frameworks they have developed.16 While these instances are not indicative of an immediate revolution to their financial systems nor the global financial atmosphere, it does provide unparalleled learning experiences for all those focused on developing CBDCs. The largest barrier to wide adoption remains the lack of in-depth research on the topic. As such, a large portion of the world is looking at these ongoing trials to assist the development of their own programs.
As there is a major focus on mitigating risks and concerns, there is potential for countries that are making leading-edge decisions to capitalise on a first-mover advantage. For example, if beta testing is successful in Sweden, their framework will likely be adopted by the entire European Union. Other major competitors on a global front have potential for great influence over the development of CBDCs in isolated nations. China is pushing to ingrain a digital yuan in its financial system with hopes to replace the US dollar’s place as the leading world reserve currency.17
As the developed world has the tools to implement CBDCs most effectively, we will likely see a strong uptake among these countries. For CBDCs to be adopted in these nations, a strong inter-currency settling system must be in place. As a result, it is expected that the properties of groundbreaker models will be integrated into their own systems. Due to pushback by commercial banks and other invested parties, it may take years for this process to run its course. It is expected that because of this, the private sector will aid in the development of structural components to make inter-currency transfer possible sooner. Despite this, each nation’s regulatory standards should aim to protect consumers from an over-reliance on the private sector to limit unnecessary security risks and fees.
While some may argue the developing world is likely to benefit the most from global adoption, the effectiveness of cryptos in simplifying the remittance process challenges the need for CBDC implementation. Particularly in regions such as Africa which have seen a sharp uptick in private investment into crypto fintech. In countries that are seeing the benefits of these private investments, many governments may not see the value in implementing such a costly venture into their already restricted budgets. It also needs to be taken into consideration that several emergent economies still face turbulent political instability and leaders that may use properties of a CBDC model for personal and party benefit.
While the model has its merits, an independent governing body must be implemented to monitor the actions of governments and their implementation/use of a CBDC model.
Central Bank Digital Currencies are promised to be an exciting development over the next decade. As the world turns away from cash, it offers an opportunity to refine both national and global financial systems. While an abundance of time and resources must be committed to arrive at the goals many nations have set, the opportunity this model presents exceeds the outdated cash system in place. It has the potential to increase efficiency and reduce costs while solving an array of issues faced across the globe. There is no perfect way to integrate CBDCs into the current financial system, although they hold a strong place in the future of the global financial structure. Despite their promise, value must be placed on the protection of the public and their rights. While the buzz around CBDCs validates the place being carved for digital assets in the future, it also highlights the importance of cryptocurrencies and their value to individuals that seek a hedge to inflation, a diversified portfolio and financial freedom.
1. PWC. (2019, November). The Rise of Central Bank Digital Currencies (CBDCs) . Retrieved from PWC: https://www.pwc.com/gx/en/financial-services/pdf/the-rise-of-central-bank-digital-currencies.pdf
2. Ward, O., & Rochemont, S. (2019). Understanding Central Bank Digital Currencies (CBDC). Retrieved from Institute and Faculty of Actuaries: https://www.actuaries.org.uk/system/files/field/document/Understanding%20CBDCs%20Final%20-%20disc.pdf
3. Consensys. (2020). Blockchain Solutions for Central Bank Digital Currency (CBDC). Retrieved from Consensys: https://consensys.net/solutions/payments-and-money/cbdc/
4. Ibid, 3.
5. US Federal Reserve. (2020). How much does it cost to produce currency and coin? Retrieved from US Federal Reserve: https://www.federalreserve.gov/faqs/currency_12771.htm
6. Bank for International Settlements. (2018). Central Bank Digital Currencies. Retrieved from Committee on Payments and Market Infrastructure: https://www.bis.org/cpmi/publ/d174.pdf
7. NASDAQ. (2020). It’s Critically Important Central Bank Digital Currencies (CBDCs) Are Interoperable. Retrieved from NASDAQ: https://www.nasdaq.com/articles/its-critically-important-central-bank-digital-currencies-cbdcs-are-interoperable-2020-06
8. Cliffe, M., & Cocuzzo, C. (2020). Central Bank Digital Currencies: Challenges for commercial banks. Retrieved from ING: https://think.ing.com/articles/central-bank-digital-currencies-challenges-for-commercial-banks/
9. Ibid, 1.
10. Ibid, 1.
11. Eyers, J. (2018). Big banks turn on Osko as the ‘new payments platform’ rolls out. Retrieved from Australian Financial Review: https://www.afr.com/companies/financial-services/osko-campaign-to-promote-big-bank-payments-innovation-20180830-h14qau
12. World Bank. (2020). Remittance Prices Worldwide. Retrieved from The World Bank: https://remittanceprices.worldbank.org/en
13. Srinivas, V., & Wadhwani, R. (2018). The value of online banking channels in a mobile-centric world. Retrieved from Deloitte: https://www2.deloitte.com/us/en/insights/industry/financial-services/online-banking-usage-in-mobile-centric-world.html
14. Rao, P. (2018). Africa could be the next frontier for cryptocurrency. Retrieved from United Nations: https://www.un.org/africarenewal/magazine/april-2018-july-2018/africa-could-be-next-frontier-cryptocurrency
15. Rao, P. (2018). Africa could be the next frontier for cryptocurrency. Retrieved from United Nations: https://www.un.org/africarenewal/magazine/april-2018-july-2018/africa-could-be-next-frontier-cryptocurrency
16. Ma, R. (2020). How Central Bank Digital Currencies Could Change The Future Of Payments. Retrieved from Forbes: https://www.forbes.com/sites/forbestechcouncil/2020/06/22/how-central-bank-digital-currencies-could-change-the-future-of-payments/#43e69d4e6102
17. Huang, R. (2020). China Will Use Its Digital Currency To Compete With The USD. Retrieved from Forbes: https://www.forbes.com/sites/rogerhuang/2020/05/25/china-will-use-its-digital-currency-to-compete-with-the-usd/#4fee440b31e8
Zerocap provides digital asset investment and custodial services to forward-thinking investors and institutions globally. Our investment team and Wealth Platform offer frictionless access to digital assets with industry-leading security. To learn more, contact the team at [email protected] or visit our website www.zerocap.com