Central bank digital currencies: the future of money?

Central bank digital currencies: the future of money?

Central Bank Digital Currencies (CBDCs) are a digitalised fiat currency. Currently, 130 countries are actively researching CBDCs encompassing 98% of world GDP. Of those, 31 countries are conducting (or have completed) a pilot study.1 Some smaller central banks in the Caribbean have already issued CBDCs, and China has continued its gradual expansion of its ‘Digital Yuan’ pilot project.  So what’s the big deal?

An overdue update to money

Don’t we already have digital money? Debit and credit cards have long represented transfers of balances. More recent private payments innovations and fintechs have expanded the speed and availability of digital financial services. State-provided solutions have also long existed, including bank reserves held digitally at central banks. So, what’s the big deal with CBDCs?

There are two important angles from which CBDCs seek to overhaul the existing monetary system.

Liability matters

First, money comes in many forms, and an official digital payments option looks like an increasingly desirable capability. To the average person, a dollar in a bank account is the same as a dollar held in a digital payments account, which is the same as a dollar in paper currency. In its purest form, money is a liability. Long ago, paper currency was the liability of banks, which were created when customers deposited an amount of gold at a bank. If they chose to, customers could redeem that money for gold, closing out the liability.

Today, cash deposited in a bank account transforms into a “demand deposit.” Customers can go to the bank and withdraw their deposit whenever they wish and receive physical fiat currency (which itself is a liability of the central bank) in return. In a worst-case scenario, the bank may have insufficient cash on hand to pay depositors who are looking to withdraw their cash. This is where deposit insurance is important, which typically guarantees deposits up to a specified limit.2

In the case of digital payments services, like PayPal, Block’s Cash app, AliPay, WePay, and others, balances held on these platforms are essentially bookkeeping notes. Ultimately, the underlying funds are held by the fintech in a bank account. Movements of balances happen in a closed ecosystem where software updates who has how much at any given time. When a customer withdraws a balance from the platform, the closed ecosystem’s pool of balances is reduced, and there is a withdrawal as well from the bank account of the fintech.3 These closed ecosystems are making up an increasing share of payments. This presents risks in the event of fraud, poor governance, or a sudden loss of confidence in such systems.

Central bank digital currencies, on the other hand, are a digital form of paper fiat currency4. Such CBDCs are liabilities of the central bank, not of a private business or bank.  Central bank money is the only monetary asset without credit or counterparty risk5. Exchanges of it are considered final settlement of a debt. As transactions increasingly take place in closed digital payments ecosystems, further counterparty risk is introduced. The introduction of a CBDC would provide an official payments solution for the average person and business, helping to reduce counterparty risk in the process.

Speeding up settlement

The second way CBDCs could transform the monetary system is through the speed of transactions. Today’s banking system can be characterised as two-tier: the central bank serves as the bank to commercial banks, and commercial banks provide banking services to customers and businesses alike. When a customer makes a transaction with a business, an agreement is established where Bank A of that customer will make a transfer to Bank B of the business. Typically, the customer’s account is immediately debited, but the final transaction may take days to settle, with the conclusion of the transaction being a final exchange of central bank reserves between Bank A and Bank B. It’s only then that the business receives its funds.6

A retail CBDC would be similar to having every person transacting central bank reserves, with each transfer of CBDC being a final settlement of a transaction. Rather than a robust but slow system of checks as with today’s transaction settlement system, CBDCs should enable far smoother and faster payments, reducing counterparty risk in the process.7

Official digital currency

In essence, CBDCs seek to provide a public good, like cash, that maintains access to a trusted, state-provided mechanism for settling public and private debts. With the emergence of cryptocurrencies — and, in particular, stablecoins — combined with the falling use of cash across major economies, central banks are taking a serious look at CBDCs. Indeed, CBDCs are also a measure to assert monetary sovereignty. This is the ability for the state and its central bank to issue a national currency while independently pursuing its own monetary policy objectives—while promoting competition and innovation within and across payment solutions.

Implications for tokenisation

CBDC designs are still being explored across major economies, with few final decisions on how they may be packaged. One exciting possibility is that CBDCs may be tokenised — designed to work natively with distributed ledger technology. In much of the crypto ecosystem today, stablecoins are used in place of fiat currency because there is no other way to represent fiat currency amounts. Asset-backed stablecoins, for example, are representations of fiat currency deposits8 held by the custodian company, which issues stablecoins linked to those deposits. In the ideal scenario, each dollar of a stablecoin is backed by a dollar’s worth of dollar-denominated assets.

If tokenised, CBDCs would remove the need for the use of stablecoins by providing a blockchain-native solution, helping reduce credit and counterparty risk in the process. CBDCs could therefore help enable a financial system based on tokenisation, which would likely accelerate the speed of payments and exchanges of assets.

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  • 1Source: CBDC Tracker, as of 20 July 2023.

    2In the US, the Federal Deposit Insurance Corporation (FDIC) guarantees demand deposits up to $250,000.

    3Note that asset-backed stablecoins function quite similarly.

    4It is noteworthy that CBDC designs are not final. Access to CBDCs may be limited to select institutions, which would make them more similar to reserve balances rather than fiat currency.

    5Counterparty risk is the risk that the other party in a transaction may not fulfil its part of the deal and thus default on the contractual obligation.

    6In this scenario, banks may provide a temporary credit to the account of the business before the transaction actually settles. If settlement fails, the business would lose those temporarily-credited funds.

    7Note that some countries already have faster payment rails, especially for high value payments, without CBDCs. For example, see the UK’s Clearing House Automated Payment System (CHAPS). For lower value payments in the UK, the Faster Payments System allows transfers to take place in near-real time, with the final balance exchanged in the Real-Time Gross Settlement (RTGS) system up to three days later. In the US, the FedNow service also seeks to accelerate settlement times as well.

    8Note that not all asset-backed stablecoins are backed by fiat currency deposits.  

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