Kawshika Puttur explores how Central Bank Digital Currencies are providing central banks with new hope for monetary policy sovereignty.
The Covid-19 pandemic emergency has underscored the need for an efficient, fast, and contactless payment system. The effects of the pandemic have given credence to a movement that was already gaining momentum: decentralised cryptocurrencies. Crypto is upending the frontier between finance and technology, with market capitalisation reaching US$ 3 trillion in 2021—a 12-fold surge since 2020.
Crypto assets present a panoply of opportunities but at the same time also bring challenges. Whether it be peer-to-peer lending, speculative investment, cross-border transactions or currency conversion, cryptocurrencies cater to the needs of their users faster and more cost-effective than traditional currencies—although speed and savings come at a cost. Cryptocurrencies are more vulnerable to theft through cyber attacks. Anonymous and unregulated crypto assets facilitate illicit and illegal transactions, difficult for authorities to trace. Further, a lack of effective monitoring may lead to regulatory arbitrage.
Evidence suggests that emerging markets are adopting cryptocurrencies at a faster pace than advanced economies. Relatively weak financial sectors in emerging markets are infamous for reducing confidence in local currencies, incentivising individuals to resort to crypto as a more reliable store of value. Some users prefer digital currencies as they impose few restrictions on exchange rates and make the transfer and storage of foreign assets cheaper and easier, attractive features for those sending remittances. Cryptocurrencies may also serve as an alternative to inefficient payment networks in developing countries.
Despite the promise of crypto, the mushrooming of digital currencies may trigger “Cryptoization,” a sudden and dramatic shift from traditional fiat to digital currency. This large-scale shift in the base currency may hamper the efforts of central banks to achieve policy objectives. Moreover, the ensuing currency mismatch has the potential to cause significant financial instability.
In the same vein, the emergence of private digital currencies was a wake-up call for central banks. In 2019, Facebook unveiled plans to launch its own cryptocurrency Libra (now known as Diem). Central banks were immediately apprehensive. Diem raised the possibility of a popular decentralised currency outside the control of central banks: strong networks effects, owing to Facebook’s 2 billion users, could lead to Diem becoming a widely accepted means of payment. There is also concern about the control that private enterprises, such as Facebook, may exert over the monetary base, wrestling control of monetary policy away from central authorities.
Ledger of Last Resort
Ironically, embracing the crypto revolution may be the optimal response for central banks’ who hope to preserve monetary sovereignty. Central bank digital currency (CBDC) may be the latest weapon in the monetary policy arsenal. A CBDC is a digital version of physical money issued by central banks; backed by a state guarantee, it is a relatively secure and less volatile means of payment than conventional digital currencies. Interest in CBDCs has been growing for some time. Since 2016 the Monetary Authority of Singapore has been investigating the wholesale introduction of a CBDC as part of Project Ubin.
The world’s first CBDC, the Sand Dollar, was introduced by the Central Bank of the Bahamas in October 2020. The Sand Dollar was introduced in response to the destruction caused by Hurricane Dorian in the Bahamas. The event took the lives of many residents and left many buildings, including banks, in ruin. In the aftermath, Bahamians had little to no access to cash. The Sand Dollar, therefore, offered access to transactions without the need for a bank account.
Elsewhere, many central banks are exploring CBDC as an alternative to physical cash. In February 2020, Sweden’s Riksbank began a year-long pilot project for its e-krona digital currency. Shortly after, in May 2020, Banque de France and Societe Generale, a private bank, used the blockchain to issue covered bond issuance worth €40million. There is also interest in emerging markets; for instance, in April 2020, China began internal testing to assess the feasibility of its e-yuan currency.
The waning use of cash was already noticeable before the development of digital currencies. The proliferation of digital transactions and contactless payments has caused the use of cash to plummet. The pandemic has accelerated the shift away from cash. The concern for central banks is that cash is losing its potency as a medium of exchange. Through the introduction of CBDCs, central banks may regain control of the monetary base. Whatsmore, central banks may use CBDCs to curb the monopoly power that tech giants may assert on private payment networks. CBDCs may also lower operational expenses, and thus, enhancing the current payment system.
The lack of regulatory oversight over digital currencies is also a concern for central banks. Crypto markets are notoriously volatile. A substantial shift towards cryptocurrency could create a shock that would destabilise financial markets, especially given the potential for the collapse of major private digital currency providers. While CBDCs cannot reverse the trend towards cryptocurrencies, they may offer more stability in the market; for example, promoting financial stability through the effective management of liquidity squeezes.
Similarly, interest-bearing CBDCs have the potential to improve the transmission of monetary policy by increasing the sensitivity of the economy to changes in policy rates. During protracted economic downturns, CBDCs may also be used to set negative interest rates to stimulate investment and consumption. At a more fundamental level, CBDCs foster financial inclusion by allowing residents to access transactions without a bank account. As of 2020, approximately 2 billion people had no access to financial services. CBDCs can help to bridge the gap between the unbanked and the global financial system.
Despite the many potential benefits for central banks, the introduction of CBDCs may be fraught with pitfalls. Once ascendant, CBDCs may induce customers to transfer deposits in commercial banks into centrally-backed digital currencies, leading to commercial banks suffering from disintermediation if they run short on deposits. Moreover, CBDCs may facilitate the entry of non-bank institutions into the payments market, which may further exacerbate disintermediation for commercial banks if non-banks influence credit allocation. Commercial banks may be required to pay higher interest rates to countervail a deposit shortage—reducing their profits. Households may also face difficulties whilst trying to match payments on long-term mortgage debts with quick redeemable deposits. In the event of a financial crisis, a deluge of savings could seek refuge in safer CBDCs, which may intensify financial stresses and even culminate in bank runs.
The proliferation of cyberattacks in recent years has raised concerns around the security of the CBDC systems. Although the current payment system is exposed to cyber threats, CBDCs would demand an entirely new approach to cyber resilience. As centrally-issued digital currencies would have to be readily available to anyone to be effective, they may feature many points vulnerable to attack. Hence, central banks will have to ensure that effective risk management frameworks are in place to mitigate cyber risks surrounding CBDCs.
Another downside of CBDCs is the threat to privacy. Digital currencies may offer central banks the ability to perform domestic surveillance. Many have speculated that the launch of the e-yuan in China is, in part, an effort to monitor private spending. CBDCs may not offer the same level of anonymity as fiat currencies and other forms of digital currencies, as the underlying blockchain technology records all transaction data. It is conceivable that central banks will use such data to identify users. Thus, authorities should be transparent about their privacy policies to protect users of CBDCs.
If crypto assets fall short of their promise, the outlook for the global financial system is gloomy. Nevertheless, the introduction of CBDCs could prove to be a game-changer in challenging private payment networks, promoting stability in financial markets, and fostering financial inclusion.
Given the prevalence of current trials and the extensive research undertaken by central banks, it is clear that CBDCs are nearing circulation. Their trajectories remain, however, uncertain.