Why did the need for Central Bank Digital Currency (CBDC) emerge?
Let's dive into the main developments that may lead to the need for CBDC.
Decline in cash payments: There is a significant decline in payments made via cash. By cash, we mean banknotes, which are issued by Central Banks (CBs) and used in the execution of monetary policy and ensuring financial stability.
Rise in transfers of bank deposits and use of credit and debit cards: Majority of the payments made today are not made in cash or reserves (electronic CB money held by commercial banks and selected financial institutions). They are mostly made via transfers of bank deposits through retail interbank payments systems and card networks.
New forms of money and payments: There are new forms of money and payments emerging, such as stablecoins (cryptoassets) whose value is backed by another asset. They propose to create digital tokens that target to represent and store value besides the platform allowing the tokens to be transferred.
Sounds good! But why are these factors important for the CBs? In other words, what are the substantial consequences of these developments?
Ensuring the resiliency of the payments system: With the decrease in cash payments and increase in card payments, there is a concentration risk due to the reliance mostly on this single electronic payment method. What happens if there is a disruption to these payments systems? CBs are responsible to ensure the financial stability and such situations may pose risk to it. Therefore, by creating CBDC and its payment system, CBs can offer a contingency plan for such situations by allowing both the households and the financial institutions to hold and use CBDC as a payment method. CBDC could serve as a substitute for card networks when card networks suffer outages.
Addressing the deficiencies of widely used payment systems: The card payment system has its own deficiencies. For instance, a merchant could wait up to 3 days to receive funds. However, CBDC may improve the speed of transactions and ensure efficiency of payment systems. Second, cards have costs for businesses and eventually these costs are passed on to consumers. However, CBDC may offer a lower transaction cost and enhance the cost efficiency of payment systems. Third, CBDC platform could increase the competition and innovation among firms as they may offer innovative ways of CBDC-related payment services to consumers and new ways to link these services to the digital economy. Fourth, credit cards do not allow micropayments at a low cost. However, CBDC may also allow micropayments. Last but not least, cross-border payments are slow, expensive, and opaque. Senders usually do not know when the payment will be settled and how much will be charged for the payment. Yet, CBDC may offer a better way to provide cross-border payments. Domestic CBDCs may be linked to each other and be interoperable by enabling the 'atomic transactions' among CBDC systems.
Addressing the risks associated with the new forms of payments: There are risks associated with the new forms of payments such as cryptoassets. Depending on the nature of the asset, stablecoins may be unable to store the value in a stable way and to ensure the redeemability or convertibility at par value back to current types of money. There could be operational risks related to these new payment systems. They may even fail and their failure may become contagious to the other payment systems. These new systems may not be interoperable with each other and with other payment systems. However, CBDC is backed by risk-free CB money and this may lead to a reduction in the demand for privately-issued money-like instruments.
Meeting the needs of digital economy: CBDC could enable 'programmable money' by making transactions according to certain conditions, rules, or events. To reduce the counterparty risk and lower the transaction costs, 'atomic cross chain transactions' might be enabled. For instance, automatic routing of tax payments to tax authorities at point of sale, shares automatically paying dividends, or electricity meters paying suppliers directly. Second, CBDC can be complaint with regulations and it may decrease the money laundering and financing of terrorism and sanctions.
Enhancing monetary and financial stability: CBDC may enhance monetary and financial stability via this new form of CB money and a new payments infrastructure. CBDC may strengthen the pass-through of changes in monetary policy to the real economy. Also, the above-mentioned factors enhance stability by increasing resiliency of payment systems.
Increasing financial inclusion: Some groups in the society, especially in developing and underdeveloped countries are underbanked as they do not have a bank account and debit/credit card. Cash is the only way they can make their payments. But what if decline in cash completely rules out the use of cash one day? Therefore, CBs may provide basic accounts and electronic payment system for these underbanked groups compared to the private sector solutions which may not meet the needs of these groups.
Suppose we built the CBDC system. What kind of risks we may still need to deal with?
CBDC would still be vulnerable to a large-scale outage of electricity and data networks. Therefore, it would be better to build some kind of offline payment system of CBDC.
CBDC may displace existing payment systems and impose a concentration risk.
CBDC may potentially discourage innovation in existing as well as new payment systems that could further improve efficiency and resilience.
CBDC definitely needs a new regulatory framework!
If the substitution away from cash and bank deposits is large, it may reduce commercial bank funding, which in turn, affect credit level that banks provide negatively.
References
[1] Central Bank Digital Currency: Opportunities, challenges and design. March 2020. Bank of England Discussion Paper. https://www.bankofengland.co.uk/-/media/boe/files/paper/2020/central-bank-digital-currency-opportunities-challenges-and-design.pdf
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Big Tech vs CBDC and private banks vs CBDS: An example from China
In April, Beijing confirmed plans to pilot a digital renminbi in several districts, followed by a wider roll-out in 2022, through its ‘digital currency electronic payment’ project, known as E-CNY. Technology companies Alipay and Wechat account for more than 90% of the local retail payments market. The People’s Bank of China’s acceleration towards retail CBDC is part of a wider strategy to mitigate financial stability concerns arising from big tech’s dominance over payment services.
OMFIF’s Digital Monetary Institute was told the PBoC intends to supplement the M0 money supply – cash – and not change existing currency in circulation. The bank will adopt a two-tier model, issuing and redeeming its CBDC via commercial banks, payment services and telecoms. Commercial banks will then distribute it to the public and retail sector. This two-tier model distinguishes itself from the more contentious one-tier model, where consumers would have their own account at the central bank and receive CBDC directly. A two-tier set up ensures that commercial banks can still offer financial services to their customers.
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Next time, I will write about the potential impacts of CBDC on private banks!