Last updated on November 17th, 2022 at 12:51 pm
Throughout history, financial foundations have grown in accordance with the available technologies. A lot of recent payment innovations are based on improvements to the underlying infrastructures that have been in the works for many years. Retail payment demand is evolving, and this transition came sooner than expected due to the Covid- 19 pandemic, with fewer cash transactions and an incline toward digital payments. These digital transactions are facilitated by commercial bank money; however, inspired by blockchain technology, several central banks are actively working on CBDCs as a more sophisticated representation of central bank money for the digital economy and a way to incentivize safe, convenient and efficient payment systems.
What is a CBDC?
Central Bank Digital Currency (CBDC) is a digital form of fiat money developed by governments on centralized blockchains. CBDCs are established as money by government regulation (that is, by “fiat”) and serve as an electronic record or digital token of the issuing country’s official currency. It enables the government to maintain total control over the network. CBDCs can be classified into two categories: Wholesale and Retail.
Wholesale CBDCs are specifically designed to be used between banking institutions. Regulated financial institutions are built on a two-tier structure, the central bank is placed at the foundation of this system and the Payment Service Providers (PSP) facilitate online and offline electronic card payments. Commercial banks and other PSPs are granted accounts by the central bank, and domestic payments are settled on the central bank’s balance sheet. Financial institutions can execute and settle transactions using interbank payments, potentially speeding up and automating cross-border transfers with the help of wholesale CBDCs.The present settlement systems primarily use a single currency. However, under a wholesale CBDC model, all of the benefits of blockchain and related technology would be used, resulting in quicker, smoother, and perhaps more trustworthy transactions. Another advantage of settlement in wholesale CBDCs is that it allows ensuring that payment can only settle on the condition of the delivery of another payment or the transfer of an asset, i.e., there can be a type of conditional payment.
On the other hand, Retail CBDCs are much more of an inclusive innovation as it allows the transfer of funds between consumers. They have the potential to alter the already existing two-tier monetary system. by making the money in the central bank to be directly available to the general public. These retail CBDCs can be quite literally considered as cash that is issued by the monetary authority of the country.
What problems does it solve?
According to the International Monetary Fund, Central banks have several potential benefits to gain from CBDCs, and these are highlighted below:
- Cost of cash is the cost of managing cash which is pretty high in some countries, it accounts for 5-10 per cent of the bank’s operating cost. This can be due to the territory being particularly large, or isolated areas such as small islands. CBDCs have the potential to reduce this expense.
- CBDCs may offer the public a safe and liquid government-backed form of payment that does not need individuals to even have a bank account (with a commercial bank). The introduction of CBDCs can provide consumers with equitable access to financial services. Some central banks see this as critical in a digital environment where cash use is declining, particularly in nations with limited banking sector penetration.
- CBDCs can contribute to the payment system’s stability. Some central banks are worried about a few major corporations (some of which are foreign) growing controlling the payment system. In such an environment, central banks see CBDCs as a way to strengthen their payment system’s resilience.
- Some central banks see CBDC as a means of countering privately created digital currencies, some of which may be denominated in foreign currencies. These central banks feel that a domestically created digital currency backed by the government will lead to a decrease in the adoption of decentralised currencies.
- Some central banks believe that a CBDC based on Distributed Ledger Technology (DLT) may be valuable in the future to pay for emerging DLT-based assets. If these assets become more prevalent, DLT-based currency could enable automated payments when assets are supplied. In order to build DLT-based asset markets, several central banks are considering solely issuing CBDC to institutional market players.
- CBDCs are seen as a way to improve monetary policy transmission. The premise is that an interest-bearing CBDC would boost the economy’s reaction to changes in the policy rate. CBDC may be used to charge negative interest rates during prolonged crises, violating the “zero lower bound” constraint to the extent that cash became expensive.
How does a CBDC differ from today’s fiat money?
Retail CBDCs will be issued by the government (via its central bank) while existing digital fiat currency is typically issued by a commercial bank. For retail customers, their fiat money that is deposited in their bank accounts is, in reality, “commercial bank money”. The value of commercial bank money and the fact that people trust it is a result of its one-to-one convertibility to government/central bank money (such as cash) by said commercial banks. However, when commercial banks become insolvent, their retail customers stand to lose all of their deposited money or at least the portions that exceed any amounts guaranteed by a particular country’s Deposit Guarantee Scheme.
However, a retail CBDC would be a direct claim on the central bank that issued it (just like paper money is), which in effect makes it “risk-free”. The central bank can always honour the retail customer’s claim since it can simply issue some new retail CBDCs to pay its liabilities. Therefore, from the perspective of a retail customer, this makes retail CBDCs a safer type of money than one issued by a commercial bank.
Have any countries issued CBDCs so far?
The global pandemic has sped up the transition from a manual to a digital world for many countries that were already moving towards a ‘cashless’ society. Some countries are currently at the stage of conducting pilot programmes to investigate the viability of CBDC. For that, they have expanded the central bank’s allocation of resources to CBDC and fintech research. Various nations are evaluating and revising laws to support CBDC, if it is issued, and are actively researching the possible consequences of rival CBDC designs.
Another group of nations has increased the resources committed to CBDCs and payment systems; nonetheless, they are constrained in testing hands-on technologies, thus they are largely concentrating on analysis. Although CBDC is still a possibility for these nations, they are also actively looking into other options. The last set of countries sees no urgent need for CBDC and instead wants to focus on enhancing existing payment arrangements and improving regulation.
The CBDC tracker from The Atlantic Council, states that 87 countries that makeup over 90% of the world economy, are in the process of exploring CBDCs. 9 countries have already launched their digital currency. These include The Bahamas, Nigeria and seven countries in the Eastern Caribbean (Saint Kitts and Nevis, Antigua and Barbuda, Saint Lucia, Montserrat, Dominica, Saint Vincent and the Grenadines Grenada). These countries are known to be tax havens, CBDCs have the potential to safeguard the prospects of economic sanction.
Another 14 nations are currently testing pilot versions of their digital currency, the Digital Yuan being the most talked about. As it is a significant step that will assist the Chinese government in streamlining international trade with countries and organisations that have signed on to the Belt and Road Initiative.
A few other nations that are currently in the testing stage include Sweden, South Korea and Thailand, which is working on a “Multiple Central Bank Digital Currency Bridge” in partnership with China and the United Arab Emirates. Countries have also been collaborating with other corporate banks and institutions to design their CBDCs, such as the oil-rich country of Bahrain, which has chosen to collaborate with corporate banks such as JP Morgan to patent their unique system of cross-border payments, which will be settled in US dollars. Similarly, the Republic of Palau recently partnered with Ripple to explore the country’s first national digital currency and its use cases. The United States is also still in the research phase, with the Boston Fed and researchers at MIT focusing on Retail CBDCs. Their goal is to figure out how to make a digital currency that is fast, secure and resilient, and is able to fulfil the needs of the world’s largest economy.
Conclusion
In conclusion, CBDCs provide a distinct chance to create a technologically sophisticated representation of central bank money. International collaboration is critical in realising the full potential of CBDCs for efficient cross-border payments. Cooperation on CBDC designs will also provide new avenues for central banks to combat foreign currency substitution while simultaneously strengthening monetary sovereignty.
Currently, CBDCs are in a very early stage in terms of what they can achieve. In order to explore its utmost potential, it is necessary to continue deepening the analysis of CBDCs in terms of design and interoperability with non-CBDC payment infrastructures, both from a practical and theoretical perspective.
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