Central banks have begun issuing digital currency called Central Bank Digital Currencies. Linked to the official currency of the issuing nation, their worth is intrinsic.
When did you last use physical currency to pay for something? Although paper money is still used globally, it has declined significantly recently, particularly in nations struck by the COVID-19 pandemic and its attendant worries about public health and hygiene. Digital financial transactions are becoming more popular as individuals avoid using cash. Digital transaction processing has surpassed physical branch processing for banks and other financial institutions on a global scale.
Cryptocurrencies and blockchain technology, among other recent digital disruptors, have caused quite a stir in the financial services industry. Central banks have begun to take notice of digital currencies, which are a part of that narrative.
A government-issued currency not linked to a tangible commodity is known as a central bank digital currency (CBDC). Central banks are responsible for issuing these, setting monetary policy, providing financial services to governments and commercial banks, and issuing currency. German Bundesbank, People’s Bank of China (PBOC), Bank of Japan, and the US Federal Reserve System are all examples of central banks.
Despite their similarities, CBDCs are different from stablecoins. Stablecoins are a subset of private stabilized cryptocurrencies that aim to keep their value roughly constant over time by being tied to another asset, commodity, or currency. One key difference between CBDCs and decentralized cryptocurrencies is that CBDCs are issued and managed by the state.
How are CBDCs being used, and what kinds of CBDCs are there?
CBDCs come in several forms, and different countries are testing various methods. An account-based approach, like DCash, is one kind of Central Bank Digital Currencies used in the Eastern Caribbean. Customers who use DCash have an account with the bank itself. On the other hand, CBDC pilot e-CNY in China uses private sector banks to issue and manage digital currency accounts for their clients. At the 2022 Summer Olympics in Beijing, China displayed e-CNY. Athletes and spectators could use the money to buy anything at the Olympic Village shops.
In a different model, the European Central Bank considered that authorized financial institutions would distribute digital euros through a permission node of the blockchain network. Lastly, a model has gained traction among “cryptophiles” but hasn’t been thoroughly tested by central banks. In this model, users’ anonymity is ensured by issuing anonymous fungible tokens backed by fiat currency, which is government-issued but not backed by a commodity.
For what reasons have central banks started to care about CBDCs?
Four developments have probably piqued the curiosity of central banks in CBDCs:
I am declining cash consumption. Between 2014 and 2021, there was a 33% drop in the use of cash throughout Europe. Cash barely accounts for 3% of all purchases in Norway. The role of central banks in the monetary system has been called into question by this tendency.
There is a rising demand for privately issued digital assets. Digital assets, such as bitcoin, are held or have been held by 10% of adults in the UK. According to the European Central Bank, ten percent or more of families in six big EU countries have digital assets. One way of looking at consumer adoption of digital assets is as a possible threat to the value of fiat currency.
Perception of central banks as trailblazers in the payment system is fading. Central banks now have a fresh chance to take the lead in public, strategic discussions about cash use cases through CBDCs.
They are rising worldwide payment systems. A growing number of central banks are working on decentralizing control of the world’s increasingly interconnected payment systems. Many national and regional financial institutions want Central Bank Digital Currencies to improve digital payment systems.
While setting up CBDCs could have some positive effects, it could also have some negative ones. Find out more by reading on.
In what ways could Central Bank Digital Currencies be advantageous?
Proponents of digital finance hold the belief that Central Bank Digital Currencies and other new digital tools may solve numerous problems with accessibility, security, and efficiency:
They saved money. If banks and other financial institutions invested more in digital finance than physical infrastructure, they might save $400 billion yearly in direct costs. However, considering cost reductions, evaluating the substantial expenditures in new technology that CBDCs would necessitate is essential.
Quickened performance. Central Bank Digital Currencies can make electronic payment systems in numerous nations faster and more efficient. (As we’ll see later, this argument is losing some of its luster.)
Those who do not have bank accounts will have easier access. Worldwide, 1.6 billion individuals lacked access to formal financial services in 2016. Fewer than 5% of adults in the United States possess such an account. More people may have access to financial services if Central Bank Digital Currencies were available on mobile devices. There are still untapped markets that digital financial service providers may get into through mobile money. Many unbanked individuals may prefer the complete secrecy cash provides, so adoption is a possibility.
It tightened locks. By ensuring that a transaction is finalized and unalterable—even without a formal bank account—deploying a regulated digital currency accessible via mobile devices might potentially boost payment security and reduce the risks of fraud. The digital “signing” of transactions by users, made possible by the regulated use of private-key cryptography, could shorten the time it takes for a transaction to become irrevocably final and provide the parties involved more confidence.
To what extent do Cemtral Bank Digital Currencies raise concerns?
Even though central banks are looking into Central Bank Digital Currencies with a lot of enthusiasm, there are a few things to remember. Digital currency is taxable since it can be tracked and traced. According to the researchers at McKinsey, this will make voluntary adoption more difficult. Lack of technological stability is another issue. The digital form of Eastern Caribbean DCash experienced a two-month outage in January 2022 due to technical difficulties.
CBDCs need a more robust business case. One concern is that more than the relatively small payout may be required to encourage central banks to invest in the infrastructure to support digital currencies. Additionally, CBDCs could not provide the anticipated speed boost; several industrialized nations have already enabled immediate payments through legacy (nonblockchain) infrastructure. Some countries’ central banks, like Singapore and Canada, have decided that digital money does not need a better case.
How does Centaral Bank Digital Currencies function in China?
China has been exploring digital currency despite the restriction on private cryptocurrencies. The most sophisticated market application of Central Bank Digital Currencies developed thus far has been made by China’s central bank, the PBOC. Distributing and maintaining these accounts for their clients is the responsibility of private-sector banks in China’s CBDC e-CNY pilot program.
Late in 2019, the People’s Bank of China (PBOC) started experimenting with electronic currency (e-CNY) through wallet and app-based payments for public services, retail, transit, and other consumer lifestyle use cases. The pilot program swiftly extended from its original four cities to five more. By May 2022, the e-CNY pilot had processed 260 million transactions totaling over 83 billion renminbi, using 4.5 million merchant / crypto wallets.
The following advantages may be derived from an initial examination of the lessons learned from CBDC in China:
- Prompts people to get loans. You don’t need a bank account to use e-CNY. Six approved state-owned banks offer digital wallets for consumers needing an account.
- Ensures compliance with KYC regulations. Central Bank Digital Currencies, like other cryptocurrencies built on the blockchain, lets users authenticate themselves to financial institutions using digital fingerprints. This aids financial institutions in avoiding dealing with criminals who have not been thoroughly investigated for possible involvement in fraud, money laundering, or other illegal actions.
- It helps banks save money on compliance expenses. Regarding tracking and reporting transactions, Central Bank Digital Currencies might help banks save money.
- Streamlines public assistance programs. Subsidies, such as transportation for employees, may be easier to provide with the help of e-CNY.
What steps may different parties take to prepare for the future of CBDCs?
What lies ahead for Central Bank Digital Currencies is still uncertain at this point. Despite this unpredictability, central banks have five questions to think about:
- When compared to conventional currency, what is the ultimate goal of adoption? Evaluations of the present and future payment environment and reasonable adoption targets should form the basis of business cases and scenarios.
- Who are the target audiences of the Central Bank Digital Currencies? Whether individual consumers, commercial banks, or large organizations, design decisions should be segment-based. Professionals from fields unrelated to the conventional central banks should weigh in on important decisions.
- In what capacity will the Federal Reserve operate? To accomplish adoption objectives, the central bank should leverage its existing contacts with commercial banks and enterprises, regardless of whether it plans to be heavily involved.
- What are the necessary skills and resources? New decision-making methods, approaches to change management, and central banks will likely require individuals skilled in building partnerships.
- What other reforms, if any, will central banks have to impose? To accomplish their adoption goals, central banks must overcome regulation, commerce enablement, and fiscal rights obstacles.
However, other organizations also have a stake in the game, as we have seen with central banks. Different parties can get ready for the arrival of Central Bank Digital Currencies by doing the following:
- Those who build the systems that support financial transactions should make every effort to ensure their products are compatible with digital currencies.
- While addressing other needs for payment modernization, retail banks, merchants, and payment service providers should consider how much infrastructure investment is necessary to implement Central Bank Digital Currencies successfully.
- Given possible policy shifts, chief financial officers and risk officers should keep an eye on how digital currencies affect banks’ liquidity and capital needs.
- Investors should consider the impact of Central Bank Digital Currencies on popular and speculative cryptocurrency assets. Central bank solutions may slow the expansion of cryptocurrency ecosystems.
- Commercial banks must effectively determine how to monitor digital currencies for anti-money laundering and know-your-customer issues. Commercial banks are expected to shoulder the cost of KYC compliance in models that issue Central Bank Digital Currencies to customers to generate revenue through deposits.
Although much is still up in the air regarding Central Bank Digital Currencies, more information regarding their pros and cons will become available as time passes. I can tell you this much: Central Bank Digital Currencies will change the world.
Check out McKinsey’s financial services insights for a deeper dive into these subjects. For more information about McKinsey’s Financial Services Practice and job openings in the finance industry, visit the firm’s website.
