Central Bank Digital Currencies (CBDCs) are, in the eyes of some investors, the next stage in the evolution of cryptocurrency. To others, they represent the antithesis of the decentralized ideal of crypto and give far too much power to centralized authorities. Of course, some also consider that all crypto and blockchain represents tech snake oil, which is neither needed nor wanted.
However, CBDC adoption may be coming. The UK’s Bank of England is hiring a Head of CBDC to test out the concept of digital sterling — ‘Britcoin’ — which is likely to be in circulation by 2030. The US Federal Reserve Bank of New York is moving forwards with a pilot program, and the European Central Banks hopes to decide whether to create a digital Euro by Autumn. And both China and India have already launched their own versions already to some degree.
Indeed, Atlantic Council research shows that 114 countries representing 95% of global GDP are exploring their own CBDC. And while there is no guarantee that the concept will replace mainstream fiat currency, it is important for investors to understand the basics.
Central Bank Digital Currencies explained
One of the key issues surround the use of crypto as actual currency is the acceptability problem. Most Bitcoin holders, for example, hold Bitcoin as an investment rather than as a currency to actively be used.
A CBDC on the other hand would be issued directly by a central bank, and would be expected to be used in-store or online as seamlessly as traditional fiat. And its value would remain stable, such that one unit of digital currency would have the same value as the corresponding banknote.
Initially, CBDCs would not replace cash, but unlike current cryptocurrencies, a CBDC would be issued by a central bank and backed by the state.
Some central banks are keen on the idea of CBDCs as they are seen as useful for adapting to the digital age, while others are simply investing in the idea to ensure they do not fall behind in the tech race. The way people pay for things is changing — cash use is falling dramatically, while digital payments are becoming far more common.
For perspective, consider that cash was king only two decades ago, but was replaced by physical card payments in the 2010s. Nowadays, many consumers pay for items online, or with their phone or smartwatch in physical shops. With new forms of money constantly cropping up, CBDCs could form part of the solution to any increased risks to a state’s financial stability.
The general idea is that a digital currency would simply be an online version of a state’s physical banknotes. This would maintain the ‘uniformity of money,’ and could also help to maintain trust in the banking system, while also improving efficiency and creating innovation.
For context, trust in a central bank used to stem from confidence in physical banknotes, and creating a new CBDC could re-anchor this trust as physical cash use falls. Roughly 95% of payments in developed countries are digital already.
What is clear is that all central banks tinkering with the idea of a CBDC plan to impose strict limits at first to understand any impact on the financial system, and to ensure disruption would be minimised. However, this limit would be high enough to allow for day-to-day spending.
CBDCs: for and against in brief
Running currency from a centralized ledger is going to come up against fierce opposition.
Part of the problem is educational. Most people think that money is created by central banks already, but this is rarely the case. Instead, most digital money held in bank accounts is actually created by commercial banks.
The everyday investor is often under the misconception that banks lend out money from deposits already taken, but in reality, a bank creates new money when it gives out a loan when it deposits the new cash into the customer’s bank account — lending money they don’t own at a rate of interest. This is a simplification, but the basic premise is valid.
A CBDC would instead be issued by the central bank, giving it far more control over the money supply — for better and for worse. Some countries are pondering changing the monetary system to only allow commercial banks to lend money borrowed from the central bank, a so-called full reserve banking system. But the ripple effects could be catastrophic for growth.
However, it’s worth noting that there are two proposed uses of CBDCs, with very different use cases. Wholesale use would simply be an improvement on the current system that allows banks to send money to each other, would be unlikely to affect the average citizen, and is therefore fairly uncontroversial.
The second use case is retail, where consumers interact with the central bank’s ledger directly to conduct everyday transactions from grocery shopping to paying their mortgage. This does offer the potential for cheap, faster payments where the government could even directly intervene with stimulus or social benefits cash. In addition, there’s a much stronger potential for governments to track money laundering, crime, and financial abuse.
However, there are two huge risks. The first is privacy. It’s perhaps not controversial to state that public confidence in government and international institutions is at a low. Allowing an apparatus of the state — and regardless of perceived independence, central banks can always be brought under control by government — access to every person’s account and spending details is for many a bridge too far.
Canada already set a precedent when it froze protesting truckers’ bank accounts containing their traditional fiat currency, but a CBDC would give states far more power. A state would have ultimate control over a citizen’s currency, being able to freeze accounts of any person deemed a risk, or even put in place social programs to prevent purchases it deems unacceptable.
China may find rapid success with its e-CNY program, as the country’s one-party control over the populace, including the social credit system, will make it easier to get mass compliance. Individuals in Australia, Europe, the UK, and in particular the US may resist the introduction of any type of CBDC.
Another complexity will be the IT literacy required to see mass adoption — the move to online banking and the closure of physical bank branches have created their own problems already.
In summary, CBDCs cover multiple different types of proposed centralised monetary systems, all of which have unique advantages and setbacks to consider in 2023 and beyond.