Sachin Somani

The rise of Central Bank Digital Currencies

By Sachin Somani, Global Director, Customer Proposition, Refinitiv

December 2021 in Digital Currencies

As the use of cash declines in major economies, what factors should central banks consider when developing digital currencies in order to benefit both people and commercial banks? And how will they operate alongside existing cryptocurrencies?

  1. A central bank digital currency (CBDC) is a form of virtual money issued and backed by a central bank. Several factors are influencing central banks to develop their own digital currencies.
  2. There are several considerations for central banks to consider when designing and adopting a digital currency. Implications for the commercial banking sector must be considered.
  3. Many issues relating to the adoption of CBDCs are the same as those for the private crypto markets. A CBDC is able to operate alongside privately issued cryptocurrencies.

According to the Atlantic Council’s CBDC tracker, 87 countries, representing over 90 percent of global GDP, are now exploring CBDCs. This global interest is being driven by factors including:

  • The use of cash is declining as more economies and consumers adopt electronic payment methods such as credit cards and payment gateways.
  • Increased efficiencies in the wholesale, as well as retail, payment systems mean that cross-border payments can now be made faster and with reduced risk.
  • Developing economies benefit from the removal of low-value coins from their systems, which are costly and difficult to maintain.
  • If private e-money became more widely accepted than a central bank’s currency, people receiving government funds would be at a disadvantage compared to those receiving private money. This could also impact monetary policy and financial stability for countries.
87 countries are now exploring CBDCs

Designing central bank digital currencies

Central banks looking to issue a CBDC must consider who should be given access to the currency. It is crucial that a CBDC should have all the features of a fiat currency. For a central bank to act as a central counterparty (CCP), there must be interoperability between the fiat currency and the CBDC.

A CBDC needs to be widely accepted and recognised as legal tender within that country. When issuing a CBDC, the central bank should guarantee at par convertibility between the fiat and digital currencies.

The degree of anonymity is also an important consideration. The argument has been made that a CBDC brings a degree of anonymity to electronic payments, such as is afforded by cash. Full anonymity, however, is not an acceptable feature of a CBDC.

Central banks must also decide whether a CBDC should have interest-bearing characteristics. A holder of the CBDC should not be permitted by the central bank to provide lending facilities.

Implications and challenges of adopting a CBDC

Banks and non-bank financial institutions will be impacted by a central bank issuing a CBDC. There are implications for the financial sector as a whole, since deposits will be transferred from commercial to central banks, thereby reducing the aggregate size of balance sheets within the banking sector. Commercial banks will need to innovate to remain competitive. They might choose to offer competitive interest rates or bank deposits, which could lead to increasing lending rates, which impact SMEs and individuals with low price sensitivity.

It is also likely that commercial banks will choose to borrow from overseas to fund their operations, exposing the banking sector within their jurisdiction to external factors. While some countries have already taken the lead in deciding which technologies will be used to implement a CBDC – whether via a centralised database or using distributed ledger technology (DLT) – other banks have yet to decide how to adapt the current infrastructure to digital currencies. They will also need to consider how these infrastructures can merge seamlessly with one another.

Central banks looking to issue a CBDC must consider who should be given access to the currency

Co-existing with crypto

The interest from central banks in digital currencies stems from an increasing public awareness of cryptocurrencies and their applications in day-to-day life.From a central bank’s point of view, use of a digital currency means that cross-border payments can be settled faster and the cost of settlement reduced, potentially improving workflow efficiencies significantly. There are also implications for financial inclusion for many emerging economies in terms of increased access to financial services, payment efficiency and cost savings.

There is no doubt that CBDCs will shortly become a reality. The infrastructures to support them will be based on many existing DLT structures that have been developed on behalf of the private coin space and decentralised finance. And, as with the private markets, the issues of trust, cost and transactional speed will be key to CBDC adoption.

There is no reason why CBDCs and privately issued cryptocurrencies cannot co-exist. However, it should be noted that, in the case of privately issued cryptocurrencies, there is a relatively high level of counterparty risk. The evolution of both markets requires continued adoption by the general public, combined with regulatory understanding, and monetary policy to be framed accordingly.