• CBDCs are a special form of digital currency supported by governments and are legal tender
  • They already exist in a few small territories but China and Sweden are ahead in the race to introduce them.
  • Wholesale CBDCs are still experimental, but could help improve the efficiency of both capital market settlement and cross-border payments

Their meaning is not so clear, however. Central banks and financial markets have been engaging in digital transactions for decades. And cryptocurrencies, like bitcoin and ethereum, are already well known.

So what sets CBDCs apart from digital currency in general? And what impact are they likely to have on the financial markets?

What are CBDCs?
There is no universally accepted definition of what CBDCs are, although some of their distinct characteristics are clear.

In technical terms, “money” is a special form of money. Nowadays, currencies are normally forms of fiat money, that is, their value is backed by a government promise. This contrasts with the past where they were sometimes exchangeable for a specific amount of gold or silver. They are also legal tender in that someone who pays a debt in this form of money cannot be sued for non-repayment – although El Salvador recently made bitcoin legal tender. CBDCs are direct liabilities of central banks and are backed by foreign exchange reserves

What types of digital money don’t count as CBDC?
CBDCs differ from first generation cryptocurrencies in at least three key aspects. First, the value of CBDCs is fixed against a currency rather than potentially fluctuating in the case of cryptocurrencies.

Second, CBDCs are issued by governments rather than the private sector.

Finally, CBDCs exist on a centralized system, while first generation cryptocurrencies exist on a decentralized and distributed ledger, so any transaction must be validated by multiple independent nodes.

So-called stable coins are second generation cryptocurrencies. They include Tether and possibly Facebook’s Project Diem (formerly Libra). These are similar to CBDCs in that they have a relatively stable value and are managed over centralized networks. Their value tends to be indexed either to fiat money or to a portfolio of metals. Stablecoins are a private initiative while CBDCs are public.

What are the forces driving the adoption of CBDCs?
The growing move towards cryptocurrencies has focused the attention of central banks on digital currencies. Of particular concern is to maintain control over the money supply. If cryptocurrencies take off, it means a higher proportion of money will escape government control. The role of traditional commercial banks in holding liquidity may also diminish. In particular, Diem, who could exploit Facebook’s 2.8 billion users worldwide and act in some ways as an alternative to currency. China’s rapid advance over CBCDs also puts pressure on Western central banks to develop the technology.

In other words, the initiative to launch CBDCs comes primarily from the central banks themselves, rather than as a response to demand from consumers or private financial institutions.

What type of technology do CBDCs use?
CBDCs, like cryptocurrencies, are likely to be blockchain-based but could, in principle, be based on conventional centralized technology. Unlike traditional cryptocurrencies, the identities of the parties involved are not anonymized.

When are they likely to exist?
They are already doing it. At least in some relatively marginal countries. The Central Bank of the Bahamas, for example, launched the sand dollar, a digital version of the Bahamian dollar. Users have an electronic wallet that can be accessed by mobile devices or computers. The system facilitates cash payments among a small population spread over hundreds of islands.

Cambodia has also launched a CBDC. The Bakong can handle both riel and dollar transactions.

Where are the world’s major central banks in relation to the development of CBDCs?
According to a January 2021 survey of more than 60 central banks by the Bank for International Settlements (BIS), the central bank of central bankers, 86% explored the pros and cons of CBDCs.

The People’s Bank of China (PBOC) is ahead of its major peers when it comes to CBDCs. She has been working in this field since 2014 and is already at the stage of experimenting with digital wallets for the e-renminbi. This is arguably a response to the huge success of private sector payment systems such as Alipay and WeChat Pay. The PBOC has been working on its digital renminbi project for more than five years and there are reports that it will be launched in time for next year’s Winter Olympics in Beijing. The PBOC is also working with the Hong Kong Monetary Authority and the Central Bank of Thailand on a joint project on cross-border currency payments.

Francesca Fornasari

Francesca Fornasari, head of foreign exchange solutions at Insight Investment, says that over time this could lead to a greater international role for the renminbi. “One of the questions is, if it’s easier to pay in renminbi, as it goes digital, will that share change? However, she says it will likely be a slow process, as the PBOC fears the potentially destabilizing consequences if its currency becomes more globalized.

In contrast, the European Central Bank (ECB), the Bank of England and the US Federal Reserve are all in exploratory stages in terms of introducing CBDCs. The ECB’s discussion of the digital euro, for example, remains timid. He did not announce any precise conclusions on the form that the architecture will take. The Swedish Riksbank is said to be relatively advanced in its plans to launch a pilot project for the electronic crown.

It should also be noted that the exact characteristics of the architecture are not clear in most jurisdictions. For example, it would theoretically be possible for individuals to have direct CBDC accounts with central banks, although this is unlikely. The exact role that commercial banks should play is still undecided.

What implications would CBDCs have for institutional markets?
The development of wholesale CBDCs is the origin of the retail variant but they could have substantial benefits for institutional markets. These include faster transactions, lower costs, and the ability to split assets.

A key point to understand is that CBDCs provide only one way to help apply Distributed Ledger (DLT) technology to institutional markets. There are other avenues they could take. More generally, the trend is towards tokenization, that is to say the creation of a unique digital representation of assets. This could be achieved using CBDC technology, but it would also be possible to mine other forms of stablecoins.

As a recent Bundesbank statement noted, “It is possible to build a technological bridge between blockchain technology and conventional payment systems to settle securities in central bank money without the need to create a digital currency of central bank “.

However, Iota Kaousar Nassr, a policy analyst at the OECD, says there are potential benefits to going the CBDC route. As she stated in a recent webinar hosted by the International Capital Markets Association: “Using CBDC versus stablecoins for the settlement of tokenized assets may have some advantages, because for users it reduces any counterparty and credit risk ”. She says that she believes the introduction of CBDCs could be a powerful catalyst for the development of tokenized assets.

The recent BIS survey identifies several possible motivations for the introduction of wholesale CBDCs. A lot of attention is paid to the efficiency of cross-border payments. Another driver is the improvement of cyber resilience.

What difference could CBDCs make to the implementation of monetary and fiscal policy?
CBDCs could have important policy implications. For starters, they make it easier for authorities to monitor the state of the monetary system than if physical currency plays an important role. They could also facilitate the application of monetary policy. For example, if consumers held money in digital wallets rather than physical currency, it would be more difficult for them to evade official policy measures. “If the central bank decides to charge negative rates, you have nowhere to hide,” says Fornasari. CBDCs also pave the way for new policy tools such as injecting money into the economy more effectively in times of crisis.

CBDCs could be used to promote financial inclusion. There were an estimated 1.7 billion adults worldwide in 2017 without access to bank accounts, according to a World Bank estimate. CBDCs could help give them access to financial services.

However, some fear that CBDCs will be destabilizing if their appearance involves a leak of bank deposits.

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