The rapidly evolving digital payments landscape, and in particular the advent of cryptocurrencies and stablecoins and their underlying technology the blockchain, has led central banks to turn their focus on the possibility of issuing central bank digital currencies (CBDCs).
A survey of 65 central banks carried out by the Bank of International Settlements in late 2020 reported that more than 85% of central banks are working on CBDCs with the majority moving from conceptual research to actual experimentation. In Europe, both the Bank of England and the European Central Bank (ECB) are examining the benefits and downsides of CBDCs and possible design choices.
CBDCs should be distinguished from cryptocurrencies and stablecoins. A CBDC is a digital form of fiat money that is a direct liability of the central bank and denominated in the official currency unit. In contrast, cryptocurrencies, such as bitcoin, are not backed by any identifiable issuer, while stablecoins are digital tokens that seek to maintain stable value relative to fiat currencies and have an identifiable issuer or represent a claim on underlying assets or funds.
CBDCs can be either wholesale or retail depending on the parties allowed to access the central bank’s balance sheet. In case of wholesale CBDCs, access is restricted to financial institutions. Wholesale digital central bank money already exists in the form of deposits held by banks at the central bank. A retail CBDC is a digital form of fiat money that is directly accessible to households and businesses and can used by the public for retail payments.
Retail CBDCs
Research and experimentation on CBDCs revolves mostly around retail CBDCs, which are considered to be a real game changer with the potential to upend the retail payments industry and the financial system.
Account-based retail CBDCs would allow the public to open accounts with the central bank, which would be responsible for recording transactions. In a token-based system, the central bank currency would be in the form of a digital token, which would be transferred from one party to another in decentralised manner, much like cash circulates in the economy today.
According to proponents of retail CBDCs, their adoption would transform the payments landscape bringing substantial benefits both in terms of cost savings and efficiency gains. Retail CBDCs have the potential to significantly improve cross-border payments making them faster, cheaper and more transparent.
Digital currencies backed by the central bank could become a safe haven for depositors who could convert huge amounts of commercial bank deposits into CBDCs
Moreover, CBDCs could lead to greater payments diversity and promote financial inclusion, especially in emerging markets where large percentages of the population are unable to access the formal financial sector.
Furthermore, the declining use of cash, which is accelerated by technological developments and the Covid-19 pandemic, may exclude the public from accessing risk-free central bank money. Providing a safe and reliable means of payment is one of the missions of central banks, which can be accomplished with the issuance of CBDCs.
As far as monetary policy is concerned, a remunerated CBDC would support the transmission of monetary policy by offering central banks an additional monetary policy instrument. Interest paid on CBDCs could be used as a monetary policy tool allowing central banks to immediately pass on policy rates to the public. In addition, CBDCs could facilitate so-called helicopter drops, namely direct transfers of money to the public in order to boost demand.
Furthermore, in case that cash is abolished, central banks would be able to overcome the ‘zero lower bound’ problem and push rates deeper into negative territory. Digital currencies issued by central banks would also counter the growing influence of stablecoins, which can jeopardise monetary sovereignty.
Significant risks
Nevertheless, the adoption of retail CBDCs poses significant risks for the financial system and in particular the risk of disintermediation of banks. Digital currencies backed by the central bank could become a safe haven for depositors who could convert huge amounts of commercial bank deposits into CBDCs.
Banks would have to replace the deposits lost with more expensive wholesale funding and even curtail their lending activities. CBDCs could also aggravate a systemic banking crisis by triggering digital bank runs.
Various technical solutions have been proposed, including two tier remuneration of CBDCs. The first tier would serve as a means of payment and the central bank would apply, up to a quantitative ceiling, an interest rate high enough to make the CBDC attractive to the public. In the second tier, a lower less attractive rate would be applied to larger amounts.
Overall, CBDCs promise to fundamentally reshape the financial system. Nevertheless, interest in CBDCs is driven by a diverse set of motivations. For instance, the ECB remains sceptical towards CBDCs arguing that the demand for cash is still strong in the eurozone.
Moreover, financial inclusion concerns that might prompt central banks in emerging markets to issue CBDCs are less pressing than in developed economies. As a result, the decision on the introduction of CBDCs and their design features depends on the needs and individual circumstances of each economy.
Alexandros Seretakis is an assistant professor in law at Trinity College Dublin.
