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Could Central Bank Digital Currencies Ever Replace Fiat Money?

5 mins
Updated by Gerelyn Terzo
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In Brief

  • Cryptocurrencies are defying the age-old monopoly of central banks on issuing currency.
  • A central-bank digital currency is backed by a reserve bank and can be used as a means of payment and unit of account.
  • Central banks have been waking up to the idea of CBDC now more than ever.
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The idea of a central bank digital currency (CBDC) has been under consideration by central banks across the globe ever since cryptocurrencies such as Bitcoin started gaining popularity.
As a precursor to implementing such a nationwide digital currency, central banks across the globe have two options: bar all cash transactions or allow the general population to open accounts directly with the central bank. The problem, however, lies with the fact that both these ideas can lead to opposite and some rather unsavory results. Cryptocurrencies are defying the age-old monopoly of central banks on issuing currency. Threatened with the prospect of digital tokens replacing fiat currency, central banks are now exploring the idea of a central bank-issued digital currency. Put simply, a CBDC is a digital currency that is backed or guaranteed by a reserve bank that can be used as a means of payment settlement and unit of account. Two broad ranging ideas, such as imposing a blanket ban on cash transactions and allowing individuals to open accounts directly with the central bank, have been mooted so far by various governments around the world. However, the execution of either idea could lead to two different conclusions. Germany Euro Digital Crypto

Central Banks Embracing the Idea of CBDC

Providing capital for financing state infrastructure and private businesses was why some of the earliest banking services first emerged. Since then, central banks have evolved to managing fiscal policy and introducing innovative payment settlement services. The introduction of internet banking in the early 2000s provided a great impetus to the sector as well, making money easily accessible without relying on physical paper currency. It is universally regarded to be the most profound technological innovation in recent times. The global crisis of 2008 was the worst economic recession of the modern era (until coronavirus). More than 20 major banks filed for bankruptcy after the collapse of Lehman Brothers. In the post Lehman crisis world, central banks lost confidence of the masses and faced unrelenting media scrutiny. The launch of Bitcoin in 2008 was meant to be a direct response to this lack of faith in the banking system. Since then, the cryptocurrency market has grown manifold, and there are more than 3,000 digital tokens floating on the open market. However, while central banks first disregarded Bitcoin at the time of its release, they have now embraced the technology and are considering how their own blockchain-based assets could prove to be disruptive. [Bloomberg] In February 2015, the Bank of England became one of the first central banks to propose the concept of a CBDC in a study titled “One Bank Research Agenda.” Since then, many question whether a potential CBDC should coexist with a country’s fiat currency or replace it entirely.

Imposing a Blanket Ban on Cash Transactions

According to a report published by the United Nations, malicious actors laundered $1.6 trillion, or 2.7 percent of the GDP in 2011. Cash represented a major chunk of the total amount when it changed hands. Economists and financial experts have warned that a majority of the high denomination notes eventually end up with people involved in money laundering. [Business Insider] This is largely because currency is no longer a part of the banking system when it is cashed out from banks. Banks, for their part, utilize cash parked in accounts to issue new loans for both businesses and individuals in exchange for collateral. This flow of capital in the economy leads to a rise in employment, development of infrastructure, and consumption of resources. All of these contribute to economic prosperity and growth. Economist Miles Kimball made a strong argument for moving to a cashless banking system and detailed the steps needed to complete the transition. In his blog titled ‘The Path to Electronic Money as a Monetary System,’ Kimball explained the viability of hard money and soft money transitions. Central banks could order all old loans issued beyond a certain size to be settled electronically in case of a hard money transition. In the case of a soft money transition to electronic money, old debts can be settled using fiat currency while newer debts must be settled using electronic payments only. It is, however, important to study about the cash circulation percentage of the country before implementing a blanket ban on cash transactions. Implementing a ban on cash transactions could lead to an economic slump if a significant majority of the population is deprived of banking services and only has access to cash. It is easier to demonetize fiat currency in nations that already have low levels of cash circulation. A majority of the currency in circulation will already be with banks and, hence, normal life will not be affected. However, this could also result in a disruption of illicit money laundering activities.

Allowing Central Banks to Open Retail Accounts

A second alternative to implementing a blanket ban on cash transactions would be to allow central banks to open retail accounts directly for consumers. A CBDC would then be directly deposited in these accounts rather than held in commercial banks. A direct result of this move could be the collapse of commercial banks as capital dries up in the economy. Commercial banks are currently the lifeline of the banking sector, as they provide capital for loans and banking services. Fiscal policy and maintaining forex reserves are more important points for central banks than providing banking services to the masses. In fact, this is why commercial and private banks were formed in the first place. Having said that, analysts have always complained about commercial banks not passing on a change in rate cuts to consumers. [CNBC] As a result, changes in repo rates don’t always correspond to an equivalent change in interest and deposit rates at commercial banks. Most banks avoid passing on the benefits to consumers to boost their own short-term earnings. In a CBDC economy fueled by central banks, however, consumers would be able to receive immediate benefits of a rate cut and faster settlement of international payments.

Steps for Creating a CBDC

A CBDC is backed by the issuing reserve bank and accepted as legal tender. The World Economic Forum (WEF), in its report published on Jan. 22, 2020, concluded that central banks across the world have been waking up to the idea of CBDC now more than ever before. The WEF gathered representatives from more than 40 central banks and other financial institutions to create the CBDC Policy-Maker Toolkit. So far, the National Bank of Cambodia, Central Bank of Uruguay, Bank of Thailand, People’s Bank of China, and Eastern Caribbean Central Bank have agreed to use the toolkit to draw up plans for their own potential CBDC in the future. Governments of Tunisia, Senegal, Venezuela, and the Marshall Islands have completed successful trials for the launch of state backed digital currency. The central banks of Japan, Sweden, Switzerland, and the euro-zone have joined hands with the Bank of International Settlements for developing CBDC. It remains to be seen whether other central banks follow this approach toward a CBDC or not.


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Rahul Nambiampurath
Rahul Nambiampurath's cryptocurrency journey first began in 2014 when he stumbled upon Satoshi's Bitcoin whitepaper. With a bachelor's degree in Commerce and an MBA in Finance...