Reality of a central bank digital currency (CDBC) is coming closer. For background, the CDBC will be a digital alternative to the paper currency and unlike Bitcoin and Ethereum and other cryptocurrencies/private tokens it will be issued by a central bank like the Fed and would be a direct liability of the central bank held by the public and on par with the paper currency. The other key differences would be that CDBC would be on a government controlled platform subject to oversight and third the CDBC will denominated in local currency at a fixed value. The similarity to cryptocurrency would be that the CDBC will allow for cash to move instantly between various accounts digitally as happens now in the background when physical cash is transacted between two accounts. The advantage of CDBC lies not just in this ease and convenience but also that it could be made immune to theft by linking an individual’s CDBC account to that persons digital identity and this will reduce one of the top risks of the financial system ~ cybercrime. CDBC can also be used to provide access to the unbanked population who do not have money in bank accounts right now and are excluded form the financial eco-system and this advantage was recently cited by the current Treasury Secretary, Janet Yellen in a recent speech.
There are 2 versions of the CDBC that are possible – ‘retail’ CDBC or a general purpose CDBC that would be used by everyone to pay for goods and services similar to a paper currency and a ‘wholesale’ CDBC that would be used between the central bank and the financial institutions to settle accounts and trades and much of the current debate and noise is around the former.
Officials at the Federal Reserve Bank of Boston and MIT are working on prototypes for a Fed version of a digital currency or a Fed coin or a digital dollar as alternatively called and they are expected to publish their first results in July this year. The Fed is not alone and not the first central bank to develop a CDBC. China has already implemented a CDBC that is in a much more advanced trial phase with more than 500 million registered users; in April the Peoples Bank of China (PBOC) announced an extension of the trial phase to new regions. Currently more than a dozen countries have announced plans for a digital currency and countries like Bahamas, Russia, Brazil and Sweden are expected to have some version in circulation similar to China in a trial phase in 2022. A 2021 BIS survey of central banks found that 86% are actively researching the potential for CBDCs while 60% were experimenting with the technology and 14% were already deploying pilot projects. In fact, the BIS published a report along with seven other central banks in Oct 2020 on common principles that should be adopted by central banks in developing CDBC while recognizing that each country should have flexibility in implementation. The common principles which were recently mentioned in a speech by Fed Chairman Powell are that issuance should not compromise monetary or financial stability and that a CBDC could coexist with and complement existing forms of money, promoting innovation and efficiency.
However the development of a CDBC is said to pose the biggest threat to banks in developed economies like US and why is that?
The threat to commercial banks comes from a key policy decision for CDBC – will the CDBC provide interest like a Fed Fund rate? If so then the CDBC will be a substitute to a commercial bank deposit and could negatively affect the funding cost to banks as it will provide competition to the banks main source of funding i.e. bank deposits. To counter the interest-bearing CDBC, banks will have to offer savings rates at par with that offered by CDBC and even with that as CDBC gains widespread usage customers will tend to hold more of CDBC than money in the bank due to more trust in a central bank versus a commercial bank and the CDBC allocation will increase in times of market stress due to a ‘bank run’ which will negatively impact the liquidity of the banks in times of crisis. Another policy decision would be whether commercial banks can hold CDBC as reserves and whether in times of crisis, banks can access CDBC through the central bank’s lending facility. Lastly, the central banks also need to decide on what will be the effect of a CBDC on monetary policy and financial stability and how it can respond to macroeconomic shocks.
These considerations of commercial banks require careful deliberation in the design of a CDBC and offsetting fiscal and monetary actions are needed to address these concerns. Lot of policy considerations and research articles are available on the Fed’s CDBC site.