Guest blog post by Mirela Ciobanu, The Paypers
The topic of Central Bank Digital Currency (CBDC) is gaining momentum. Across the globe, many CBDC initiatives aim to digitalise payments, support financial inclusion, make cross border payments faster and cheaper, support fiscal transfer, etc. What is firing up discussions around CBDC and why is it important today?
Adoption of new technologies and understanding of their huge potential to support and stimulate our life has caused the world to change a lot in the last year. The current pandemic has triggered the decline of cash usage to avoid getting the virus and safeguard the most vulnerable ones (health-wise). Economic wise, as many governments wanted to protect their citizens and directly stimulate the economy down to every citizen, they offered ‘helicopter money’ via digital wallets.
Even before COVID-19, cash used in payments was reduced with many users and businesses embracing digital and innovative ways to transact like cryptocurrencies, tokens, and stablecoins. The increased smartphone adoption has led to a large volume of transactions coming from emerging economies, transactions that need fast processing (in real-time), be cheap, and inclusive. This was one of the seeds that stimulated Facebook’s project Libra (rebranded to Diem) to crack the hard soil of legacy ways of conducting payments. Connected to the social media network, Libra has the potential to reach billions of people solving problems like financial inclusion, digital identity, enabling cheaper payments, and more.
On top of all these challenges, one cannot notice the on-going geopolitical currency wars have also led national central banks to consider the use of CBDC in international transactions and investments to reduce their dependence on the US dollar. To follow their public policy objectives and evolve in this new environment, central banks are actively researching the benefits and risks of offering a digital currency to the public. There are arguments for and against issuing a CBDC, with design choices that have the potential to be an improvement over existing modes of payment. For sure, there will be no ‘one size fits all’ CBDC, the Bank for International Settlements (BIS) has assured us. What has led to this conclusion? Let us explore some things we need to know about CBDCs.
1. CBDC in a nutshell
Central Bank Digital Currency (CBDC) is the digital form of fiat money (a currency established as money by government regulation, monetary authority, or law). These digital fiat currencies will be backed by a suitable amount of monetary reserves like gold or foreign currency reserves, and each CBDC unit will act as a secure digital instrument equivalent to a paper bill and can be used as a way of payment, a store of value, and an official unit of account.
Currently, the public can hold central bank money in the form of banknotes, still, only banks and certain other financial institutions can hold electronic central bank money, in the form of central bank reserves, according to Bank of England. A CBDC would be an electronic form of central bank money that could be used by households and businesses to make payments.
CBDC would require building an infrastructure so that it can be used to make payments. This infrastructure includes the database on which CBDC is recorded, payment applications, and POS devices that are used to initiate payments. CBDC would offer users another way to pay, which aims to be faster and more efficient than we currently have, with the possibility of adding new functionality over time.
Despite the concept was inspired by Bitcoin, CBDC is different from cryptocurrency or virtual currency, as these are not issued by the state and lack the legal tender status declared by the government.
When it comes to the foundation principles and core features of CBDCs, the Bank for International Settlements (BIS) stressed that (1) a central bank should not compromise monetary or financial stability by issuing a CBDC; (2) a CBDC would need to coexist with and complement existing forms of money; and (3) a CBDC should promote innovation and efficiency.
Notable CBDC projects that have captured the media’s attention include Europe’s plan to digitalise the euro, China’s national digital currency DCEP (Digital Currency Electronic Payment, DC/EP), the US’ digital Dollar Project, and of course Facebook’s Libra.
2. Why might CBDC be useful?
According to Harro Boven, Policy Advisor at the Dutch Central Bank, there are several possible objectives for CBDC. Central Bank Digital Currency could play a role in retaining public money for general use. Digitalisation, COVID-19, better digital money options have caused a decline in the demand for cash, currently the only public form of money. This reduction in the use of cash could lead to a situation in which citizens only have access to private money, putting pressure on the one-to-one fungibility between public and private euros.
If cash use continues to decrease, CBDC could act as a back-up for the critical infrastructure in the payment system. At the moment, for instance, when you cannot pay using your mobile wallet or tapping a contactless card to the POS, you can use physical cash (though this situation is slowly disappearing due to coronavirus). But once a CBDC is rolled out, with its afferent payment rail, you can use a CBDC instead of physical cash. In this case, the infrastructure for CBDC must be sufficiently separate from the current infrastructure to prevent both from becoming disrupted.
3. The bomb everyone expects to (or is afraid will) explode – Facebook’s Libra/Diem
When Facebook announced Libra for the first time in June 2019, the world poured a storm of criticism and negative responses towards the proposed stablecoin. Meanwhile, the association standing behind the project – Libra Association (now rebranded Diem) has announced that their objective is for the ‘Libra payment system to integrate smoothly with local monetary and macroprudential policies and complement existing currencies’. Furthermore, Diem hopes to be able to collaborate with central banks on issues such as direct custody of cash or cash equivalents and very short-term government securities or the integration of the Libra payment system with CBDCs.
These CBDCs could be directly integrated with the Libra network, removing the need for Libra networks to manage the associated reserves, reducing credit and custody risk. For example, if a central bank develops a digital representation of the US dollar, euro, or British pound, the Association could replace the applicable single currency stablecoin with the CBDC. But what if the opposite effect takes place, and CBDCs are replaced with Libra?
As a result, Libra poses a risk of domestic currency substitution especially in developing/underdeveloped countries, where there is a lack of confidence in the current (local) currency. Their local users might adopt in significant numbers stablecoins and foreign CBDCs, and thus the use of the domestic sovereign currency diminishes.
4. Can China’s digital currency supplant a digital dollar as a global reserve currency?
According to David Birch, the principal threat to the role of the dollar as prime currency comes from China (not from Facebook). China’s Belt and Road Initiative (BRI) could be the perfect testing ground for the internationalisation of the digital yuan. Coupled with the massive adoption of Alipay and WeChat wallets by people living in that region, billions of users might shift from their local currencies to the new digital currency – Libra.
From a travelling perspective, though because of COVID-19 this seems far away, the cost-benefits of Chinese tourists using digital yuan when overseas on holiday may well encourage vendors in other countries to accept the digital yuan as a means of payment.
Furthermore, the fact that global trade is largely in dollars means that America can exercise soft power through the international monetary and financial system. If other digital currencies begin to offer increased efficiency, faster settlement, and lower transaction costs with clearing through a central bank, then that has political ramifications that are considerably greater than they may seem at first.
5. The impact of CBDC on user’s privacy
There is huge untapped potential with CBDC, but also important risks. While we agree that Central Banks could give rise to the integration with faster, more agile payments systems than ever before, Barry Topf from Saga Monetary Technologies says that CBDCs imply a degree of privacy loss around the anonymity of transacting with CBDC. CBDC transactions will be pseudonymous, not anonymous. If the central bank wants to see where and how much an individual is spending, it can because anonymity disappears when cash does.
Widespread usage of a CBDC could equate to huge numbers of people unknowingly granting unlimited and unrestricted access to data on their economic lives to a central authority. And there may not be a choice of opting out or being forgotten.
CBDCs are an exciting and innovative perspective to consider when talking about the future of money/transacting. Because it has a great impact on financial systems and monetary policies, the topic of CBDC is constantly debated and we expect more proof of concepts/trials to happen in the coming months and more articles and reports coming out.
Like this story? To learn more about CBDCs, the innovation they promise, and the implications and risks they pose, download The Payper’s ebook Central Bank Digital Currencies for Dummies – A Quick Guide into CBDCs.
About Mirela Ciobanu
Mirela Ciobanu is a Senior Editor at The Paypers and has been actively involved in drafting industry reports, carrying out interviews, and writing about innovation in payments and fintech. She is passionate about finding the latest news on AI, crypto, blockchain, DeFi and she is an active advocate of the need to keep our online data/presence protected. Mirela has a bachelor’s degree in English language and holds a master’s degree in Marketing. She can be reached at email@example.com or via Linkedin.