As cryptocurrencies have gained popularity and traction, some fear their decentralized, unregulated nature could have catastrophic consequences for the global financial system. This has led to calls for central banks to issue their own digital currencies (CBDCs).
The total market capitalization of cryptocurrencies now exceeds $2 trillion. Apart from the general hype of appreciating assets, cryptocurrencies have several unique features that lend to their appeal. These include aspects of its underlying blockchain technology, such as decentralization and transparency.
However, many in the traditional financial industry are much warier of cryptocurrencies. Besides some seeing them as a speculative bubble, others fear they may threaten the traditional financial system.
Some even speculate that their unregulated nature could lead to a global financial catastrophe should they gain enough leverage.
In light of these concerns, monetary authorities, in particular central banks, have been developing their own digital currencies.
They hope to utilize the advantages and efficiency of the underlying blockchain technology while maintaining regulatory authority and stability.
Defining a CBDC
Fiat currencies issued by central banks across the world ostensibly work the same way. However, each bank’s monetary policy is unique to the situation of each country or region under its authority.
In the same way, CBDCs will also vary largely according to the needs of each country or region. Despite the high potential for variation, many CBDCs will likely have similar characteristics.
For example, a CBDC will be an electronic record or digital token representing the virtual form of a fiat currency of a particular region.
In this way, they would act as a digital representation of a country’s fiat currency. Similarly, a suitable amount of monetary reserves will likely back them—for example, gold or foreign currency reserves.
This is one way in which they differ from cryptocurrencies, which have no reserve maintenance to back up their valuations.
Another potential difference is the centralization of CBDCs. Although CBDCs may utilize blockchain technology, the network would be under the control of the issuing monetary authority.
Changpeng Zhao, CEO of Binance, the world’s largest cryptocurrency exchange by volume, recently highlighted some of these differences in an interview with Bloomberg.
For instance, whereas many cryptocurrencies are capped to curb inflationary tendencies typical of fiat currencies, as an instrument of monetary policy, central banks will be able to issue as many CBDCs as they see fit.
Varieties of CBDCs
In a world filled with a variety of complex payment methods, including cash, cards, bank transfers, and now cryptocurrencies, there could be a similar variety of CBDCs that play a host of different roles.
The Bank of International Settlements (BIS) demonstrates this in the ‘Money Flower’ diagram.
Source: Bank of International Settlements
Generally speaking though, CBDCs will largely fall into two categories, which are included in the diagram above: Wholesale CBDCs and general-purpose and retail CBDCs.
According to BIS, “the wholesale variant would limit access to a predefined group of users, while the general-purpose one would be widely accessible.”
A report by PwC on the current state of CBDCs globally makes a similar distinction. It characterizes retail CBDCs as ones that citizens and businesses can hold and use as a form of digital cash.
Retail versus financial
On the other hand, wholesale CBDCs would generally be restricted to financial institutions, primarily using them for interbank payments and financial settlement processes.
According to the report, retail CBDC projects seem to be at a more advanced stage, particularly in emerging economies.
These countries may lack a robust financial and payments system, so financial inclusion is a key priority for these retail CBDCs. The report lists the Bahamas and Cambodia as having the only retail CBDC projects that have gone live.
Meanwhile, the report says that so far, there are no live wholesale CBDCs projects. This is because their pilot phases tend to be much longer than retail CBDCs, despite having shorter research stages on average.
Whereas retail CBDCs are more prominent in countries with emerging economies, wholesale CBDCs are being developed in countries with more advanced economies that feature mature interbank systems and capital markets.
In a majority of these cases, these projects would also facilitate cross-border connectivity and interoperability.
CBDC developments in different countries
According to a recent survey, 80% of the world’s central banks are researching or experimenting with issuing a CBDC.
The Chinese project
The most advanced pilot project so far is taking place in China. The country launched its project in April 2020.
Over the past year, China has made several developments with their “digital yuan,” spreading it with different trials. There are estimates that over RMB 150 million ($23 million) of the digital yuan is currently in cirulcation.
The People’s Bank of China (PBOC) aims to increase domestic use of the digital yuan by the 2022 Winter Olympics in Beijing.
However, there are concerns that China could be striving to become the world’s reserve currency with this digital currency.
Although, the Head of the Payment Systems Department at the Bank of Japan (BOJ), Kazushige Kamiyama, feels that these concerns are overblown. Kamiyama is confident that “the dollar’s status as the key global currency won’t change so easily.”
Kamiyama also expressed skepticism about the digital yuan. He noted that the PBOC has been working on a digital currency since 2014.
“I believe technology is constantly evolving, and the technology that they’re using currently might become outdated.”
“It might even hinder further technological innovation,” he said.
Additionally, he said that for a currency to become popular, it has to be safe, have a stable value, and move without restrictions. This implies that the yuan doesn’t meet those standards.
Kamiyama is also responsible for the research and development of his own country’s digital currency.
Last month, the BOJ initiated the first phase of experiments for its CBDC. Kamiyama said that the BOJ participates in group studies with the Bank for International Settlements and six central banks, including the US Federal Reserve (Fed) and the European Central Bank.
Despite advancing to the experimental stage, Kamiyama said the BOJ had no specific plans to issue a CBDC.
Digital currency in the US
Meanwhile, the US is conducting its own trials for the development of a “digital dollar.” The Digital Dollar Project (DDP), a non-profit partnership between consultancy Accenture and the Digital Dollar Foundation, is launching at least five pilot programs over the next year.
The projects intend to complement other important CBDC work, including those of the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology.
In a recent interview with 60 Minutes, Federal Reserve Chairman, Jerome Powell, spoke about the development of the digital dollar. He said that the Fed is currently “evaluating” it.
According to Powell, the Fed is considering whether a digital dollar would actually benefit the public in an advanced economy where fast digital payments already exist.
Additionally, while the use of cash has fallen dramatically in these other countries, in the US, “Americans still like to use cash,” Powell said.
Ultimately, Powell emphasized that the Fed would take its time in potentially delivering a digital dollar. This is due to the importance of the dollar as the world’s reserve currency.
“We do not need to be the first ones to do this,” he stressed. “We want to get it right, and that’s what we’re going to do.”
CBDC pros and cons
However, some countries may not issue CBDCs. This is because doing so comes with a list of benefits and drawbacks.
One potential benefit would be reducing the high cost of managing and transferring cash.
For retail CBDCs, expanding financial inclusion would enable those who are unbanked to get easier and safer access to money. This could potentially be as convenient as accessing money through their phone.
Finally, something as large and ungainly as monetary policy could flow more quickly and seamlessly through using CBDCs.
However, there are several potential drawbacks that central banks would need to seriously grapple with as well.
Centralizing a system designed to be private could produce a backlash among users and create cybersecurity risks. The regulatory authority of central banks could also be undermined because current regulations may be ill-equipped to deal with the new forms of money.
Retail banks often act as a buffer between consumers and the central bank. As such, issuing CBDCs directly to citizens to use as cash could compromise central banks’ role and stability.
For instance, citizens could withdraw too much money out of banks at once. This could trigger a run on banks, which could be devastating for a country’s central monetary authority.
Removing this buffer could additionally result in a wider presence of central banks in financial systems. This may lead to them falling under the sway of political interference.
While it is not yet clear how digital currencies may come to prominence, central banks aren’t turning a blind eye to these new financial avenues. Over the next few years, it will become clearer exactly where CBDCs will become central and where they will fail.