As central banks move forward with digital currency experiments, financial institutions must stay abreast of developments or risk being left behind.

As someone who has watched crypto-assets and cryptocurrencies rise and fall, and rise and fall, and rise and — well, you get the idea — over the past decade, it intrigues me that we are now reaching some form of respectability and understanding. I’ve never been a fan of unregulated currencies and markets but, at the same time, I knew that these emerging digital markets would eventually become regulated — and now they are.

We have regulated exchanges and even regulated funds, but regulated currencies have still been a way away, until now. Now, central banks worldwide are rushing to create central bank digital currencies (CBDCs). The idea is to replace dirty bank notes that transmit viruses, like Covid-19, with a digital equivalent. The pandemic has ignited these efforts in 2020, and turbo-charged a rush to experimentation.

For example, the Bank of England (BoE) published a discussion paper on the theme in March 2020, stating that: “A CBDC could provide households and businesses with a new form of central bank money and a new way to make payments. It could ensure that the public has continued access to a risk‑free form of money issued by the central bank, which may be especially important in the future as cash use declines and new forms of privately-issued money become more widely used in payments. CBDC could also be designed in a way that contributes to a more resilient, innovative and competitive payment system for UK households and businesses.”

A good fit?

This sounds great, but it is not without challenges and issues. The Bank for International Settlements published a white paper in August that summed it up well. It notes that a CBDC focus is higher in economies “where the informal economy is larger” and “with higher mobile phone usage and higher innovation capacity”.

However, one of the big issues of CBDCs is whether they are used directly from the central bank to the recipient or via an intermediary, such as a commercial bank. “Many central banks are pursuing models where a CBDC is a direct claim on the central bank, but with private intermediaries,” says the paper.

If central banks circumvent the commercial banks for the issuance of monetary supply, then our system of thinking about money is changed forever.

There are surely many unknowns in the way in which CBDCs will play out, but we can map these as known unknowns in most cases. If central banks circumvent the commercial banks for the issuance of monetary supply, then our system of thinking about money is changed forever. Some call it decentralised finance (DeFi); however, there are still some hurdles to reaching that state.

For example, many of these CBDC projects are experimenting with distributed ledger technologies and blockchain. The issue with this is that the benefits of such technologies are decentralisation, scalability and security, but not all three at the same time. Effectively, one offsets another. Some call this a 'trilemma'.

Equally, any CBDC rollout raises key questions around the current banking structure and what happens if some countries migrate to a CBDC and others do not.

Moving forward

Nevertheless, the debate moves faster and faster. The BoE, Sweden’s Rijksbank, the European Central Bank and the Federal Reserve in the US have all announced commitments to move forward with experiments in CBDCs. The furthest forward of all these central banks is the People’s Bank of China.

The Chinese central bank launched a CBDC research unit all the way back in 2014. China first mentioned the prospect of a CBDC 2016 and the Chinese ministry of commerce released a notice stating that it launched a digital currency pilot programme on August 14, 2020.

When the world’s largest economy moves to digital currencies, which they will and will be the first, you know that this is not just a political play — it’s an economic power play.

CBDCs are all about creating digital economies that can thrive and prosper post-Covid. Is your country ready? Are you ready? Will CBDCs just be another form of currency for commercial banks to transact? Or will they become a new form of liquidity that needs no intermediary?

Lots of tough questions to be answered. I would suggest, modestly, that you explore these questions before you find yourself faced with them without having any answers.

Chris Skinner is an independent financial commentator and chairman of the London-based Financial Services Club.


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