It all started with Facebook announcing the efforts to launch its digital currency Libra. As the debate over the future of fiat intensified, Central Banks all over the world decided that it was time to invest resources to explore and develop digital currencies, of their own. Since then a substantial number of CBDC (Central Bank Digital Currency) projects have been announced, and China is all set to launch theirs soon. this April.
According to a survey conducted by BIS (Bank of International Settlements), 70 percent of the Central Banks are either engaged in or are about to start their work for developing CBDC. Although most of these banks are working individually, experts suggest that for CBDCs to work and survive against the other digital currencies, the Central Banks need to pursue a collaborative avenue.
They need to work together to figure out the make and design of the CBDC, and for drafting the monetary policies surrounding it. A unified approach will help them understand the financial stability and the impact of the digital currency, insights that they can implement into the making of the currency.
The Interest in Central Bank Digital Currencies
One might think, why the sudden interest in developing central bank digital currencies? Well, there are ample reasons behind that. If you look at the current scenario, digital currencies are gaining immense popularity and the usage is rapidly growing. With social giant Facebook announcing the launch of Libra, there is a concern in the fiat world and the traditional outfits are worried that they might lose their monetary control.
Another valid reason is the reformation of the legacy systems. The financial architecture and the payment processes have issues, that the Central Banks hope to find and fix through their CBDC initiative. In a World Bank report, it was mentioned, that many Central Banks were able to determine the major issues with cross border payments while tweaking with their digital currency projects.
CBDC and Cryptocurrency – The Difference
The fundamental difference between central bank digital currencies and cryptocurrencies is decentralization. While a digital currency might be an enhancement of the fiat for the Central Banks, it is not built on a decentralized platform like the crypto. This means that although digital, the shots will still be called by a central body.
CBDC is more like the digital version of fiat. It will be issued and governed by the respective central banks. The argument put forth by the banks is that decentralization is not favorable for CBDC as it has the potential to influence tax evasion or funding for illegal activities.
Unlike crypto, the value of the CBDC will not depend on market performance. It will be influenced and guarded by monetary policies, trade surpluses, and regulatory compliances.
CBDC Collaborations by Central Banks
BIS (Bank of International Settlements) released a report that was based on a survey that the organization conducted on all the Central Banks involved in CBDC projects. The report cited that around 80 percent of the banks were looking at both general and wholesale purposes of digital currencies. Around 40 percent of the banks have progressed to the proof-of-concept and around 10 percent have pilot projects under development.
The BIS report also implored that the banks should work together to figure out an optimal design for the CBDCs. They further mentioned that besides looking for ways to improve the existing system, the banks should look at risks outside the periphery of the financial structure.
This year has seen Central Banks move passed their CBDC projects and shift to a more collaborative approach on a global scale. Some we have mentioned below:
The Group of Six
A BIS initiative, the organization has formed a group of six leading Central Banks which includes the Bank of England, Central Bank of Canada, Central Bank of Sweden, Bank of Japan, ECB and Swiss National Bank. The group of six will be co-chaired by the BIS’ Innovation Hub head, Bank of England’s Deputy Governor, along with the chair of the Committee on Payments and Market Infrastructure (CPMI). It will also include the senior members of respective central banks. The aim is to collectively explore and assess the potential of digital currencies within the respective geographies.
The European Central Bank Task Force
The European Central Bank or ECB formed a task force of experts in 2019 to analyze the relevance and outcome of launching CBDCs. It will help the banks to consider and implement the merits such as financial inclusion, payment privacy, and consumer protection.
The task force was initiated by the ECB President so that they can play an active role in exploring the benefits of using central bank digital currencies and to foster cost-effective and quick transactions.
CBDC Toolkit by the World Economic Forum
A consortium of more than 40 central banks, academic researchers, financial institutions and international organizations along with the World Economic Forum have developed a framework named the CBDC Policy-Maker Toolkit, which will help the central banks to design, evaluate and deploy their respective digital currencies.
The toolkit contains information on wholesale, retail, cross-border and hybrid central bank digital currencies for both the developed and emerging economies. It will help the policymakers to evaluate whether the CBDC is fit for their economy, providing a comprehensive guide in all stages of evaluation, designing, and deployment. It will also make the banks aware of the potential risks so that they can have a contingency plan in place.
The Optimal Design of Central Bank Digital Currencies
The CBDC must have an optimal design, considering the significant impact it will have on the financial system. The optimal design ensures that the digital currency has a good enough cost-benefit balance, along with the inherent ability to manage the potential unintended risks.
The goal is to make the CBDCs widely accessible to the general population. That can be made possible in two alternative ways:
- Be offered as deposit accounts with the banks to all households and corporations.
- Be offered as a digital token currency that will circulate in a decentralized manner without the involvement of a central body
However, the second option is not favored by most, as they fear that it might compromise with the security of payments.
Noted Benefits of Using CBDCs
Since the focus shifted to digital currencies, central banks have been analyzing how the introduction of CBDC might affect the monetary policies and financial stability.
- The payments will become more efficient while keeping control of money on the hand of the state. Central banks have determined that it will reduce the payment settlement time and cost, thus boosting the economic growth of geography. They aim to make secure and efficient CBDC available to all while strengthening availability, accessibility, and resilience of retail payments, especially in countries with underdeveloped banking systems.
- Mass adoption of CBDC will allow the central banks to have better control over illegal financial activities like money laundering, terrorist financing, etc. That way the users will be at a lesser risk of becoming victim to violent crimes. It will reduce both costs of insurance and security measures that one usually employs when keeping cash within the business premises.
- CBDC can potentially improve the overall effectiveness of monetary policies. If there comes a time when digital cash replaces the fiat then it will significantly lower the interest rates below the zero-lower bound, promoting macroeconomic stability. The variable interest rates on the CBDCs will make way for a monetary policy that is non-redundant, improving the effectiveness of the policies.
- The idea of CBDC originated from the need to bring financial stability and macroeconomic stability. The introduction of CBDC will minimize the role of banking systems in the creation of money through sight deposits. With lower bank deposits, fractional reserve banking can be limited which will fortify financial stability.
- Last, but probably not the least, CBDC can potentially lower the risks of liquidity concentration and credit risks in payments, which will result in a safe financial system.
The way that the Central Banks are advancing in this area, CBDCs might become a reality soon. However, there are still questions like when and what will be the implications. We will like to conclude, by the World Bank’s observation that the issuance of CBDC needs a unified approach so that it does not hurt the financial stability of geography or on a global scale. Nevertheless, there is no doubt that the future of digital currencies both centralized and decentralized look brighter as time passes.