Central Bank Digital Currencies

Hana Zahra

The decline of cash usage in recent years has become increasingly evident as more people opt for cashless payments in their day-to-day lives. With the rise of blockchain technology and cryptocurrency, Central Banks are experimenting to incorporate this form of technology into their financial system; introducing us to a new digital currency — the Central Bank Digital Currency (CBDC). To date, 114 countries, representing over 95 percent of global GDP, are exploring a CBDC; whether that may be in the development, pilot or launch phase.

What is a Central Bank Digital Currency (CBDC)?

CBDCs are national digital tokens issued by a central bank which are pegged to the value of that country's fiat currency. Holding CBDC is essentially like holding currency notes, but in digital form rather than cash. Generally, there are two types of CBDCs; wholesale, used primarily by financial institutions, and retail, for consumers and businesses. What sets CBDCs apart from cryptocurrency (which also uses the same technology ie blockchain) is that the former is centralized, representing a direct liability of central banks, whereas the latter is decentralized.

Prospects of Introducing a CBDC

CBDCs require a complex and robust regulatory framework such as consumer protection and antimoney laundering before adopting this technology. According to the IMF, Central banks should also tailor CBDC plans to fit their country’s needs and circumstances as it is not one-size-fits all framework. The policy aspects are also paramount, including developing new legal frameworks, regulations, and case law. But most importantly, a significant level of trust from citizens will be needed to ensure the success of CBDCs. All in all, only time will tell if CBDCs will be able to successfully usher a new frontier for the digital economy.

What can CBDC offer?

Some economies may utilize CBDCs to strive towards achieving public policy goals such as financial inclusion. In other cases, it could provide an essential backup in the event that other payment instruments fail. It may also be used as a tool to promote innovation in payment services and streamline monetary policy transmission. Since it is backed by a regulatory body, it is more stable and less volatile than the current cryptocurrencies in existence, providing stable exchange of currency. Additionally, international transactions via CBDC would be better facilitated as the structure of payment would be more direct and easier to track. This helps to overcome the current hassles of cross-border payment such as time lag which increases counterparties’ exposure to credit and settlement risks. Furthermore, a transparent ledger also assists central banks in preventing fraud, tax evasions and money laundering.

Potential Risks

CBDC issuance carries operational risks to the Bank as many of the proposed design variants involve the centralized collection of transaction data. From a privacy perspective, such information could be used by cyberhackers to surveil citizens. Thus, making cyberattacks one of the prominent risks posed if Central Banks issue CBDCs. Moreover, if users withdraw too much money all at once, it could cause a run on banks. This affects their ability to lend and sends a shock to interest rates, impacting countries with unstable financial systems more severely. Central Banks can also implement restrictions on the types of transaction allowed, hold more leverage with interest rates, and even fix a date by which the programmable CBDC expires.

References https://www.atlanticcouncil.org/cbdctracker/ https://www.imf.org/en/Publications/fandd/issues/2022/09/Picture-this-Theascent-ofCBDCs#:~:text=Users%20might%20withdraw%20too%20much,data%20priva cy%20and%20financial%20integrity. https://www.investopedia.com/terms/c/central-bank-digital-currencycbdc.asp https://www.investopedia.com/terms/c/central-bank-digital-currencycbdc.asp https://www.imf.org/en/Publications/fandd/issues/2022/09/Central-bankersnew-cybersecurity-challenge-Fanti-Lipsky-Moehr