Central bank digital currencies will revolutionise money, hence the authorities are treading cautiously. But developments in January suggest they are entering their next phase of development. By Justin Pugsley. 

What is happening?

Most central bankers have utter contempt for cryptocurrencies, such as bitcoin and ether. Their latest bout of volatility merely reinforces their views that they are not ‘real’ money. 

Reg rage anxiety

But stablecoins — digital tokens backed by fiat currencies — can’t be so glibly dismissed. Apart from the financial stability risks posed by poorly backed stablecoins, they could blunt the effectiveness of monetary policy. They also have the potential to bypass much of the current financial infrastructure. That makes central bank digital currencies (CBDCs) a potent geopolitical factor. 

The US in particular could find it more difficult to impose financial sanctions on other countries as CBDCs could, in time, circumvent the existing US-centric payment infrastructure through blockchain technology. Unsurprisingly, the US Federal Reserve (Fed) is wary of not undermining such crucial infrastructure as it is so important to US soft power. 

That is a dilemma for them, because China and the EU could supplant the global role of the dollar by making their currencies more digitally ‘user friendly’. China’s renminbi is already seeing greater use in Africa and the digitised version would be the ‘financial lubricant’ for the ambitious Belt and Road Initiative. 

It is with these considerations in mind that the Fed, the UK House of Lords and a Swiss consortium aired their views on digital currencies. 

The Bank for International Settlements, the Swiss National Bank and the SIX exchange conducted experimental trades using digitised currencies and securities, and found that they worked well. Their Helvetia Project is expected to continue. 

The US and UK have looked at CBDCs being made available alongside physical cash, which could have profound implications for banks. Much of their thinking was quite negative, with talk of consumer privacy being at risk, central banks becoming too powerful and the financial system being potentially radically transformed. However, they did acknowledge the possibility of reduced costs to the economy and the emergence of alternative payment systems. 

Why is it happening? 

Investigations into CBDCs by central bankers are accelerating with practically all of them now studying their potential design and impact. This comes despite Meta, owner of Facebook, abandoning its Diem stablecoin project due to regulatory hostility. Ironically, Diem was the catalyst that injected the CBDC debate with its current sense of urgency. But while Diem was stuck on the sidelines, other stablecoin issuers forged on with their own offerings, hoovering up billions of dollars in the process — meaning that central banks had to take notice. 

Their primary concern appears to be centred on not disintermediating commercial banks and undermining their stability. The difference between CBDC and e-money is that the latter is a claim on the central bank and the former on commercial banks. It is a crucial difference. 

In theory, consumers could keep their CBDCs at the central bank or in their own separate digital wallets. That could lead to real-time bank runs or force banks to pay more interest to attract savings, as consumers could instantly move their money to the central bank. 

Central banks do not want to hold consumer accounts and do all the work of anti-money laundering checks. They are discussing creating ‘frictions’ so tidal waves of CBDCs couldn’t exit the banking system at warp speed in the event of a financial crisis. 

What do the bankers say? 

Bankers have mixed views about CBDCs. A wholesale version could create considerable efficiencies around trading, settlement and clearing. Though it could make some activities, such as market making more challenging. Instant settlement would require them to hold sufficient cash and stock to consummate trades. That comes at a cost. 

However, retail CBDCs are more problematic for banks as it could undermine their deposit-taking and payment activities. In this area, they are lobbying hard to be part of the CBDC design debate. Fortunately for them, central banks appear to share many of their concerns.

Will it provide the incentives?  

CBDCs look increasingly inevitable — indeed, China is already well advanced in this area. The probable designs that will be adopted are likely be based on a two-tier model, similar to China’s. 

The central bank would be responsible for the CBDC blueprint and possibly the e-wallet design and some of its underlying infrastructure. Commercial banks would take care of the e-wallet’s administration and distribute CBDCs to the wider economy, much as they do physical cash. 

But that still leaves plenty of details to be filled in — that is likely to emerge later this year.

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