Multiple central banks are exploring digital currency avenues, but it's a long and winding road. By Ben Edwards.
3When Facebook announced its Libra digital currency project in 2019, central banks around the world looked on with unease. If a private entity with a user base the size of Facebook’s could launch a currency and attract significant uptake, it could severely hinder central banks’ ability to control monetary policy, raising potential financial stability concerns.
“That really jolted central banks into action because they didn’t want a big private institution to start playing the World Central Bank and actually have a big chance of succeeding given the amount of people who use Facebook,” said Teunis Brosens, a senior economist at ING.
Since then, central banks have been ramping up their digital currency plans. While Facebook’s Libra project (later rebranded Diem) crumbled under regulatory scrutiny and was ultimately shelved, 130 countries are now exploring the possibility of issuing digital currencies – so-called CBDCs (central bank digital currencies) – up from just 35 in 2020, according to the Atlantic Council, a US think tank. As many as 64 countries are now in an advanced phase of exploration, either developing, piloting or having launched a live CBDC.
China, for instance, began a still ongoing pilot programme back in 2019. Brazil and India have both trialled projects and plan to go live in 2024. Countries including Australia, Thailand and Russia are continuing with pilot programmes, according to the Atlantic Council.
Some countries have already gone live. The Bahamas was first in October 2020, launching the sand dollar – a CBDC that is pegged to the US dollar. Others in the Caribbean region have followed, with the East Caribbean Central Bank launching a blockchain-based digital currency called D-Cash in April 2021, before Jamaica issued the Jam-Dex in July 2022.
Nigeria also became the first African country to issue a CBDC in October 2021, with the launch of the eNaira.
Major advanced economies are taking CBDCs seriously as well, with the European Central Bank and the Bank of England both considering minting their own digital currencies. The EU is expected to vote to move ahead with its digital euro plans in October, which would pave the way for launch as early as 2026 (though market participants expect it to take longer).
“The digital euro would be a key benchmark – a major central bank launching this initiative in earnest will have a transformative impact,” said Ousmene Jacques Mandeng, a visiting fellow at the London School of Economics.
The Bank of England launched a consultation paper on the digital pound earlier this year – nicknamed britcoin – with the bank now in the design phase of the project. No decision has yet been made about whether to launch a digital pound.
“The UK has a potential advantage here because obviously the governance that the Bank of England has to deal with is way more simple than what the ECB and the EU faces,” said Brosens. “So, if the Bank of England and the UK Treasury want to, they have an opportunity to leapfrog the ECB and get to market sooner.”
Reasons why
There are a number of reasons why central banks are pushing ahead with their CBDC plans, not least because economies are becoming increasingly digitised.
“We are seeing the growth of different forms of digital money including stablecoins and crypto assets, and so in some respects it is an obligation to continue to give access to central bank money to the broader population and to commerce at a time when more and more money is moving to a digital format,” said Keith Bear, a fellow at the Cambridge Centre for Alternative Finance and a member of the Bank of England’s CBDC Technology Forum.
In the UK, cash usage declined to just 15% of all payments in 2021, compared to about 60% in 2009, according to the Bank of England.
“Digital currency has basically replaced fiat currency in day-to-day transactions,” said Paul Donovan, chief economist at UBS Global Wealth Management. “In the UK, now we use paper currency as a form of saving – bank notes under the mattress – more than we use it for transactions. The only transaction I still use physical cash for is paying my boxing trainer, every other transaction I do is electronic.”
As central banks lose their grip on the overall money supply, some are seeking to turn the clock back to a time when the majority of cash in circulation was directly controlled by the central bank.
“The onward march towards private sector digital money has not made central banks obsolete but it has certainly blunted some of the weapons that they had to be able to control the economy,” said Donovan.
Another reason some central banks, particularly in emerging markets, are considering issuing CBDCs is to boost financial inclusion. About 1.4 billion people worldwide lack access to a bank account, according to the World Bank. Often, those are in rural communities in developing economies where the cost to serve is prohibitively high for commercial banks, leaving room for greater state intervention.
“Some countries have said the central bank should have a role in financial inclusion, and that CBDCs provide a very interesting, potentially lower cost mechanism to drive inclusion, be it how you distribute government benefits or tax rebates and so on,” said Jason Ekberg, head of corporate and institutional banking at consultancy Oliver Wyman.
Some smaller countries are also worried about the risk of a potential dollarisation scenario where the population moves away from the local currency in favour of a US dollar-pegged digital currency.
“The reality is that in a world of stablecoins and CBDCs, if US dollar tokens are more accessible than, say, physical US dollars are today, there would be a greater risk of flight,” said Ekberg.
Other, smaller nations may wish to encourage the growth of their local financial markets, viewing a CBDC as a way to break the dominance of more entrenched foreign institutions, he said.
However, those CBDCs that have already been launched or in advanced pilot programmes have been slow to gain traction. In China, digital yuan transactions accounted for just 0.13% of all currency in circulation last December, according to Deutsche Bank. By the end of October last year, 98.5% of eNaira wallets downloaded in Nigeria had remained unused, according to the IMF.
Those experiences are unlikely to be instructive for developed economies, which have far more complicated banking systems to deal with, says Donovan.
“If you are talking about a relatively underdeveloped economy by international standards with perhaps a less sophisticated banking system or less trust in the banking system, or a very cash-based economy or even a barter-based economy, then the implications of a CBDC there are going to be very different from, say, countries like the United Kingdom, where cash is almost obsolete,” Donovan said.
Some universal lessons may still apply, not least that countries considering CBDCs need to have strong stakeholder engagement and a willingness to test and learn.
“This isn’t something where you go live and expect everything to change overnight; you need an 18 to 36-plus-month plan about how it is going to be rolled out,” said Ekberg.
No guarantees
Countries shouldn’t take success or adoption as a given either.
“One common denominator among many of the projects so far is that most of the thinking has gone into the technology and the infrastructure, and much less thinking appears to have been invested into what’s the actual use case – how do we actually convince people to use this?” said Brosens. “So you really see some of these projects struggling to gain further adoption for this reason.”
A more generous view is that it takes more time for people to change their habits than typically anticipated.
“People are used to paying in a certain way,” said Marion Laboure, a senior strategist at Deutsche Bank Research. “Even in China, where people are used to paying digitally, the level of adoption for CBDCs is still quite low. So it’s probably going to take some time in advanced economies to change people’s habits, especially when we are used to paying with plastic cards.”
Yet even if it takes time to change habits, central banks need to ensure there are compelling reasons for consumers to voluntarily use CBDCs rather than being coerced into adoption. Former Bank of England governor Mervyn King has already branded CBDCs a “solution without a problem”.
“If it’s only for payments, in the same way as you make card payments to merchants today, or making person-to-person payments, which you can do with certain bank accounts, then there’s no significant advantage to using a CBDC, and that won’t help adoption,” said Bear. “So there’s call for significant experimentation to understand what the art of the possible is and where there is actually value in a CBDC.”
Government-related payments are an area ripe for CBDC usage, said Ekberg. “If you have payroll taxes to pay, you could have a CBDC account so that you can then reconcile with the government at the end of the year,” he said. “You could also imagine any kind of state-owned institution, such as transit systems, where payment in CBDCs could be embedded.”
Another potential use case is to ring-fence CBDCs for specific transactions.
“CBDCs could enable something central banks like to call purpose-bound money, which can help the development of more complex forms of payments,” said John O’Neill, global head of digital assets strategy at HSBC. “That could be money which might be paid based upon a particular trigger event, or restricted to certain types of payments.”
Singapore’s central bank published a white paper earlier this year outlining its concept for a purpose-bound money protocol, which could support more reliable e-commerce transactions by keeping payments in escrow and only releasing funds once an order is fulfilled.
When it comes to potential use cases, there also needs to be a distinction drawn between retail-targeted and wholesale CBDCs, said Mandeng.
“Many arguments are being brought forward to justify why central bank money is needed for retail payments, but those arguments tend to be rather weak,” he said. “For wholesale, it’s a completely different argument when it comes to the interbank market and large value payments because there is a lot of functionality that token-based mediums can provide.”
Those potential benefits include greater programmability and traceability, as well as the ability to facilitate instant transactions that could improve securities settlements or cross-border payments, said Mandeng.
“It’s really about expanding the capabilities and functionalities of our financial market infrastructure, so for wholesale, there seems to be pretty broad-based consensus that this will strengthen our financial systems’ capability to meet actual and future demands,” he said.
Wholesale benefits
Until recently, most central banks had been focused predominantly on developing retail CBDCs that are aimed at the broader population. In 2021, just 8% of central banks said they would issue a wholesale CBDC in the near term, but that number rose to 16% in 2022, according to the Bank for International Settlements.
“There is much more value added in wholesale in terms of efficiency gains, cost reductions, higher speed of payments and so on,” said Brosens. “What I hope is that if central banks must start with a retail CBDC, then they ensure it is at least compatible or interoperable with on-chain distributed ledger technology, because that’s where most use cases could be developed and the most value created.”
Introducing CBDCs is not without risk. One common concern among market participants is the risk of disintermediation in the commercial banking system, which could have implications for financial stability.
“If CBDCs become widely adopted and there’s a transfer of people’s money from commercial bank accounts into a CBDC wallet, that obviously has an impact on the commercial banks’ balance sheets, which will have a knock-on impact on their lending capacity and potentially their stability,” said Bear.
This means central banks need to balance the potential benefits of issuing a CBDC while ensuring it doesn’t pose a threat to commercial banks’ business models, he said.
One proposal to mitigate this risk is to introduce holding limits on CBDC balances. The ECB has talked about a limit of €3,000, while the Bank of England is mulling allowing holdings of up to £20,000. Another proposal is to ensure that CBDC balances held at the central bank won’t pay any interest.
“The general assumption is that if central bank digital currency is issued, it would be filtered through the retail banking system,” said Donovan.
Concerns that consumers would close their existing bank accounts en masse and pile into CBDCs are also likely overcooked.
“If the general public is driven by security concerns and would rather have his or her balance in, say, a Bank of England CBDC rather than at a commercial bank, then we would probably have already seen much more migration from small banks to big banks or from private banks to public sector banks,” said Mandeng.
Even after the collapse of Silicon Valley Bank in the US earlier this year led to a wave of deposit withdrawals, the US$200bn of outflows only represented about 4% of small bank deposits, according to ING.
“There’s no evidence that the public would actually run into CBDC,” said Mandeng. “Therefore, the financial stability impact and the monetary policy concern is very limited.”
While imposing holding limits might dampen the attractiveness of CBDCs, some bankers argue it is not dissimilar to the relationship people have with physical cash.
“ATM withdrawal limits are a fairly good analogy here, because there’s only a certain amount of physical cash people want to carry because of security, so people are used to having practical limits for the amount of money they can hold outside the banking system,” said O’Neill.
Control concern
A potentially far bigger concern is around privacy and the level of control issuers would have over users’ ability to spend their own money.
“You could construct a scenario where a government may control the use of CBDC for political means,” said Donovan. “There are various ways they could do that. They could freeze your account. Or they could restrict how people spend their money – they could say you can buy food, but you can’t buy any form of transportation. So there is a real legitimate concern about the degree of political control that this gives.”
Other potential risks might occur in a wholesale scenario if CBDCs are used for cross-border payments.
“That could lead to the accumulation of large offshore balances of CBDC, which could have a monetary policy impact,” said Mandeng. “If non-residents, for some reason, reacted differently to central bank monetary policy, it could undermine the central bank’s ability to transmit policy.”
Despite the number of central banks exploring CBDC issuance, there is unlikely to be an imminent deluge. Some 68% of central banks said they don’t plan to issue a retail CBDC any time soon, according to a BIS survey.
“The runway for doing this for any country is quite long, so as central banks move forward, they’ll have plenty of time to see if their peers are choosing to move forward,” said O’Neill. “This is not a one-size-fits-all topic. There are good reasons for some countries to proceed and good reasons for others not to.”
A large advanced economy going live with a CBDC project could, however, create some momentum for others to follow in quick succession.
“There is a fairly steep learning curve around this; however, once you have the likes of the ECB implementing the technology, it would start creating interesting potential synergies and peripheral use cases that start linking to international markets,” said Ekberg. “So you could imagine a scenario where one market could lead this movement, followed by a clustering of other markets around it.”
By thinking of CBDCs as an innovation project rather a new channel for retail payments, central banks could potentially reshape the way people and businesses think about money and enhance the way financial markets work.
“If they take a pragmatic approach and really focus on innovation and the functionality and optionality it can provide, then central banks can really equip our financial systems with broader capabilities than they do today,” said Mandeng. “If they are sufficiently motivated, then central banks have an historic opportunity to make our financial systems better.”
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