Central Bank Digital Currencies Poised to Disrupt the Global Financial System

Central Bank Digital Currencies Poised to Disrupt the Global Financial System

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It’s been over 100 years since the paper money was created, with cash dating back to the 19th century. Technology has given rise to the internet and mobile payments, and the global financial system is ripe for a modern version of money. Digital assets have caused a paradigm shift in the global economy. No longer is cash king, though it is arguably still needed. Cryptocurrencies such as bitcoin, however, have reshaped the financial landscape. Bitcoin is not the only cryptocurrency but it is the biggest — with a market capitalization of USD 291 billion — and was the first on the scene nearly 12 years ago. 

The flagship cryptocurrency has two use cases: as a store of value, similar to gold, and as a payment method. To that end, it has disrupted central bank-issued fiat money in economies around the world as people learn the benefits of sending money in a peer-to-peer fashion without a middle-man such as a bank. P2P transactions are cheaper, faster and more efficient than what the legacy financial system has to offer. Feeling threatened, policymakers at first shunned bitcoin. Many countries have since begun to take a lesson from cryptocurrencies, however, and focus their efforts on developing their own digital assets, the result of which has been the emergence of central bank digital currencies, or CBDCs, led by China. CBDCs, which are built on the blockchain, are the next step in the evolution of digital currencies that began with bitcoin and other cryptocurrencies and expanded to a market segment known as stablecoins – digital currencies that are backed by a fiat currency, such as the U.S. dollar, euro or GBP, and therefore don’t exhibit the same wild volatility that is inherent with cryptocurrencies such as bitcoin. Facebook has its own blockchain-based payments system, which is called Libra and comprises stablecoins that will be backed by a single as well a basket of fiat currencies. Rather than staying on the sidelines, many countries have made strides this year toward launching their own CBDCs, following in the footsteps of first-movers.

CBDC Overview

In a nutshell, a central bank digital currency is merely a digital version of fiat money such as the euro, GBP or U.S. dollar, for example. The CBDC would be issued by the central bank of that country and would serve as a replacement for the physical version of those currencies. Countries in Europe, Africa, South America and Asia have already welcomed digital payments, so this concept would not be much of a leap there.

The CBDC serves as the umbrella category for these central bank-issued currencies but each government would tailor their digital assets to reflect their own needs. For instance, will the CBDC be available for all of the public to use, or will its use case be limited for certain types of transactions, such as settlements among banks? A country could also decide to limit the use of CBDCs between central banks themselves.

First Movers

China has a first-mover advantage for a CBDC with the advent of the digital yuan. This digital currency is currently in the pilot phase in which USD 1.5 million, or 10 million digital yuan, were expected to be distributed to the public via the city of Shenzhen and the People’s Bank of China (PBOC), the central bank. China’s digital yuan differs from bitcoin in that it was issued and controlled by the central bank while bitcoin is run by computers.

The program was targeting 50,000 locals who would be chosen via a lottery system. Once selected, users would be able to spend the CBDC that was gifted to them across thousands of merchants in the city’s Luohu District where companies like Huawei and Tencent are located. Some of the retailers that have signed on for the program include Walmart, local grocery stores and pharmacies. The CBDC could not be transferred to other users, nor could it be stashed away in a bank account. Any of the funds that were not spent would be returned to the government.

The Shenzhen CBDC pilot program comes under the umbrella of the Chinese government’s broader digital currency electronic payment (DCEP), which is another digital yuan pilot program in the country. Under this program, the digital yuan is being piloted across nine cities, which in addition to Shenzhen includes Hong Kong, Macau and Guangzhou.

As of the latest data, China had processed CNY 1.1 billion (USD 162 million) worth of digital yuan payments. Each person or entity that transacts with the digital yuan must have their own digital wallet from which to access the CBDC. China has witnessed the creation of more than 113,000 wallets for individuals and nearly 9,000 for corporations.

While China is among the first countries to develop a CBDC, it was officially beat to the punch by the Bahamas, which already introduced its version of a CBDC, the Sand Dollar, nationwide to its population of 393,000.

Estonia

Just because a country might not have been the first to pursue a CBDC doesn’t mean they are out of the race. Estonia is a great example of this, as the government previously denied any plans for its own digital currency before recently announcing that it has begun researching the idea. The Baltic country has officially launched a two-year program that will explore how “technologically suitable” a central bank-issued digital currency would be. An Estonian CBDC would “give residents and businesses new ways to deposit and use money. “

Blockchain startups are already well-versed in the design of digital currencies, and therefore it is not unusual to see central banks teaming up with these companies to make sure that they do things right. The Bank of Estonia has selected Guardtime and The SW7 Group to collaborate on the idea.

Given its technological prowess, Estonia would be a shoo-in for a CBDC. Estonia already has a jump start with its e-government technology, though the platform has been riddled with some security issues. To be sure, the country has been on-again, off-again about its interest in a digital currency. 2020 has been the year of the CBDC, however, and apparently, they did not want to be left out.

Estonia’s government already uses what’s known as the Keyless Signature Infrastructure (KSI) blockchain, which it launched alongside Guardtime to bolster security and privacy. It is on this platform that the country would likely build its own digital currency. Considering that Estonia is part of the EU, it isn’t an island unto itself in launching a CBDC, as the broader Eurosystem is involved. In light of its research project, however, Eesti Pank would like to be engaged with the process.

Digital Euro

When bitcoin came on the scene, regulators were inclined to stick their heads in the sand. But now that the broader cryptocurrency market is worth $454 billion, policymakers can no longer ignore it. And now that they are “going down the rabbit hole,” as the crypto community calls it, regulators are finding that digital currencies have quite a lot of benefits for the economy: payments over the blockchain are faster (real-time) and cheaper to send vs. legacy bank settlement systems.

So rather than deny it, European regulators are beginning to embrace tech innovation. To start, the European Central Bank (ECB) has published a high-profile report on the topic of their efforts surrounding central bank digital currencies, one that the cryptocurrency industry has taken as a sign of validation. It states that a digital euro should be a front-burner issue so that citizens will be able to access digital money as the world moves in this direction.

While a digital euro would provide another option for Europeans to make payments, there are other scenarios in which it could play an even more important role, such as in the event of a sharp decline in the use of cash, if other electronic methods became unavailable or if “foreign forms of digital currencies took over.” As a result, the ECB sees a need to prepare for a digital euro now so that they are prepared to issue it when needed. ECB President Christine Lagarde appears to be on board, having said that a digital euro would serve as another option to “private digital currencies” as well as a complement to cold hard cash.

The key risks for a digital euro include cybersecurity and privacy issues. The Eurosystem is expected to decide one way or the other on the ECB’s proposal by mid-2021.

Meanwhile, European policymakers have also set their sights on providing a regulatory framework for CBDCs. Financial authorities and nearly two-dozen of the world’s biggest countries are behind a collaborative effort to develop a framework by which CBDCs can be issued and regulated. The Group of Twenty (G20), which includes finance ministers and central bank governors from the European Union and beyond, is teaming up with the International Monetary Fund (IMF), the World Bank and the Bank for International Settlements (BIS) to create this regulatory framework.

They are targeting year-end 2020 for a comprehensive rulebook on stablecoins — which are digital currencies that are backed 1:1 (generally) by a fiat currency and thereby are less volatile — as well as an overview of CBDC technology, design and experimentation. The financial authorities expect to have the infrastructure in place to support CBDC between the participating countries by year-end 2025.

In addition, the IMF published a report in which it acknowledged that CBDCs could be a tool in the monetary policy toolbox by which policymakers can provide a benefit. Policymakers also warn that CBDCs are not the solution to every crisis and will not serve as a panacea for the global economy. They tout use cases for CBDCs such as:

  • Cross-border payments
  • Currency substitution
  • “Unit of account/payments tool”
  • A “set of CBDCs…used for both international and domestic transactions”

Germany Not Sold on a CBDC

German officials are less sold on the idea of a central bank digital currency. According to reports, a Bundesbank official has warned that the potential launch of a digital euro should be accompanied by guardrails that limit the way the CBDC is used.

Burkhard Balz, who is a member of the board of the Bundesbank, said that a digital euro should be reserved for payments and should not be used as a store of value like gold or bitcoin for that matter.

He is worried that if a CBDC resembles fiat money, users could convert their funds into digital euros and withdraw them during times of catastrophe, thereby creating liability for the central bank. Balz would like to see a cap placed on the amount of digital euros that citizens can hold at one time. He has also suggested a tiered system that would prevent a “digital bank run.” The Bahamas, for instance, has placed a limit on the amounts that can be used in CBDC accounts.

The Bundesbank is engaging in the broader digital euro discussions but at the same time, German officials are exploring alternatives to a CBDC.

Sweden & Norway

Sweden considers itself the country with the “lowest use of cash” globally. At the current pace, Sweden is on track to be 100% cashless within the next couple of decades. Stefan Ingves, who is at the helm of the Swedish central bank, is wildly in favor of a central bank digital currency.

Much of his enthusiasm is fueled by the fact that much of Sweden’s population has already moved away from cash. Indeed, the Swedish central bank, Riksbank, is pushing the e-krona, and monetary policymakers are urging lawmakers to move in the direction of digital money.

Sweden is actually one of the first-mover countries as well, having launched a pilot program for its distributed ledger technology-based e-krona, a government-issued digital currency. The trial, which was launched in early 2020, is ongoing and is set to be complete in February 2021 — at which time it could be extended.

The way that Sweden’s e-krona would work resembles China’s digital yuan. Central bank nodes (servers) are responsible for issuing the e-krona to central banks. The banks then distribute the digital currency to locals, including individuals and businesses. The e-krona are stored in digital wallets, which could be stored on a smartphone or other device. Users can then send peer-to-peer payments like they would send an email.

Norway is another country that is weaning itself off of cash. One of the key motivations for issuing a CBDC is the rise of digital payments. In Norway, cash payments represent a mere 4% of all financial transactions. Incidentally, this cash usage is below pre-COVID levels. Norway, however, is not interested in being among the first countries to deliver a digital currency, in this case, digital krone.

Norway’s central bank, the Norges Bank, is expected to publish its study on a possible CBDC in 2021, though it still considers the development of a digital krone “some way off.” The issuance of a CBDC, they believe, would have “considerable consequences in a number of areas.” Central bankers are therefore focused on pursuing a well-informed decision considering it would alter the scope of the monetary system.

The United States Takes a Backseat to Innovation

The United States has taken a backseat for digital asset innovation.  Policymakers have said that they are not interested in being first with a digital currency, though they are finally willing to at least consider one with the aim of possibly creating a CBDC in the next few years.

Cryptocurrency market leaders are worried that the United States is being too passive about digital assets and therefore is falling behind other countries, mainly China. Brain Armstrong, CEO of U.S.-based cryptocurrency exchange Coinbase, said:

Meanwhile, Jerome Powell, chairman of the Federal Reserve, has said that he’s much more interested in getting a CBDC right than “winning the digital currency race.”

U.S. Treasury officials have acknowledged that they are studying the concept of a CBDC. The hangup appears to be about striking a balance between protecting consumers’ privacy and preventing nefarious activities from taking place, such as money-laundering. On the plus side, they have their eye on the cost benefits of a digital currency.

Conclusion

Blockchain startup ConsenSys has been doing quite a bit of work with different central banks around the world. According to them, one of the biggest hurdles to CBDC adoption is the fact that central bankers are afraid of the effect that digital currencies will have on commercial banks.

ConsenSys explains that there are ways by which a government can prevent mitigate the damage to commercial banks so they would not become obsolete. For instance, they point to the Bahamas in which the Sand Dollar CBDC accounts are capped at a certain amount. The company also suggests that central banks would not pay interest on CBDC accounts so they would not be competing with traditional interest-bearing accounts.

According to PwC, it is a matter of when, not if, central bank digital currencies make their debut. The firm points to a shift in the tone of the speeches by central bank officials, which was decidedly negative during 2017-2018 and has since turned much more positive.

Researchers suggest that the process will begin with experimentation, which appears to be the phase that several countries are in now, followed by a “clear concept of money issued by the central banks” as well as a regulatory and economic framework that manages to strike a balance between tech innovation and offsetting the risks.

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