Interest in bitcoin and other cryptocurrencies may be surging, but central banks don’t want to be left behind by financial innovation. In fact, more than 80% are examining how to launch digital versions of their own currencies – The Digital Currency.
In 1694 the Bank of England became the first public bank to regularly issue banknotes as an alternative to coins, as a means of payment. Three centuries later, it’s primarily tasked with maintaining price stability, much like any other central bank across the world. But these cautious institutions are now buzzing with talk of a revolutionary concept, a form of money you cannot see: central bank digital currencies.
The idea of digital money is not new. Many of us use debit and credit cards or payments apps for transactions, but what would make a central bank digital currency different?
Why Central Banks want to launch digital currency?
One of the big financial developments over the last few years has been the rise in popularity of cryptocurrencies, with one in particular, bitcoin, standing out. Following Tesla’s announcement that it bought $1.5 billion worth of bitcoin in February 2021. The volatile cryptocurrency’s price surged to new highs. Giving it a theoretical market capitalization that is even larger than the world’s two largest payments processing companies: Visa and MasterCard.
Unlike traditional money, cryptocurrencies are not issued by a central bank, but rather via a decentralized network of computers, typically using block chain technology. Even Facebook is trying to get in on the act with the 2019 announcement that it would develop its own digital currency, known at the time as Libra and now rebadged as Diem.
Investors in bitcoin believe that because there is a theoretical cap on the number of bitcoins that can ever be mined, the cryptocurrency will become increasingly valuable at a time when central banks have been printing more money than ever before to arrest the economic fallout from the pandemic. That’s why people sometimes call bitcoin ‘digital gold’.
Many central banks are worried that the widespread adoption of these independent cryptocurrencies could weaken their control over the financial system. This could cause financial instability, especially because cryptocurrencies do not have the legal or the regulatory safeguards that central bank money does. So why not issue a digital currency of their own?
Advantages of Central Bank Digital Currency [CBDC]
Currently, regular bank deposits, cash and cryptocurrencies issued by the private sector, such as Diem and Bitcoin. All have a few features that make them useful. But the hope is that publicly available CBDCs would have all these desirable characteristics. Unlike your savings in a commercial bank, which rely on the bank’s promise to fulfill. CBDCs are recognized by law and backed by the power of the central bank, which cannot go bankrupt.
For example, if a commercial bank collapses, part of your savings could potentially be wiped out. But this wouldn’t be the case for CBDCs, which could be as trusted as cash, as convenient as a payment app. Yet also benefit from the same block chain technology which underpins cryptocurrencies.
And just like cash, CBDCs could be distributed through commercial banks. Avoiding too much disruption to the financial system or the central bank having to deal directly with many millions of citizens and businesses. This means that everyone could have access to this digital currency, which could bring a lot of benefits. It could make payments faster, allowing for immediate settlements and no processing delays. And it could also make payments cheaper.
Situation in U.S.
In the U.S., the aggregate cost of making retail payments ranges from 0.5% to 0.9% of GDP. Digital currencies would reduce those costs. It also means that more people could have access to electronic payments. Currently, over 1.5 billion adults across the globe don’t have access to the financial system. And even in an advanced economy such as the U.S., more than 6% of Americans don’t have a bank account.
Issuing digital currencies could also make it easier for governments to deliver stimulus checks. Or even go one step further and make targeted payments to those deemed most in need.
How soon could central bank digital currency become a reality?
China is the major economy which is most advanced in its CBDC development. The People’s Bank of China has been running tests of its digital currency since April 2020 with the help of four banks in the country. Tens of thousands of consumers have already been involved with the pilot. Spending two billion yuan in over four million transactions.
For China, it could also be a means of re-asserting control over a financial system challenged by the rapid growth of fintech companies. There may also be a geopolitical consideration for China, providing a mechanism to shift away from using the U.S. dollar.
But it’s not just China. The European Central Bank has plans for a digital euro. Although it may be a few years before it is available.
Impact on monetary policy
This has got people wondering whether issuing a central bank digital currency could interfere with the effectiveness of monetary policy.
A lot depends on how much people would use CBDCs. And no central bank wants them to completely replace traditional cash, but rather to compliment it. One risk associated with CBDCs is that in an extreme situation, such as after a financial crash. You could see people withdrawing their deposits from commercial banks and opting to store their money in digital currencies backed by the central bank.
As we move towards a more cashless society, will central bank digital currencies ever become as trusted and as convenient as bank notes? Quite possibly, though it may take months, maybe even years.