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A Brief Introduction to Central Bank Digital Currencies
In recent months the Bank of Namibia (BoN) has intensified its efforts to explore central bank digital currencies (CBDCs). The basic idea of a digital currency is to – either partially or wholly – replace the need for paper notes and coins as a means of exchange with computer-based money-like assets.
The emergence of Bitcoin in 2009, and the establishment of a decentralised (blockchain-based) ledger for transaction execution and record keeping, has led to a widely traded currency outside the control of an exclusive monetary authority, such as a central bank. Thousands of similar cryptocurrencies have since been created and collectively account for billions of US dollars in global transaction volume every day. Extreme price volatility, strong price correlation to Bitcoin, and the association with scams and Ponzi schemes have, however, hampered their utility and adoption as a practical medium of exchange.
This led to the creation of stablecoins which aim to combine the technical capabilities of digital assets, while providing an alternative to the price volatility that has historically been characteristic of most cryptocurrencies. Their value is pegged to a unit of an underlying asset and the coins are backed with sovereign-issued tender (like the dollar or euro), highly liquid reserves (such as government treasuries), or commodities.
The rapid rise in the circulation of stablecoins over the past couple of years has led to around 100 central banks around the globe now actively exploring the establishment of their own stable digital currencies. The interest was further driven by the Covid-19 pandemic which induced a shift towards digital, contactless payment habits, as well as concerns about the impact of unregulated privately issued stablecoins on financial stability and traditional monetary policy.
There are, however, still many unanswered questions surrounding CBDCs. The fact that central banks are exploring a multitude of approaches means that there is no standard, or universally accepted, CBDC issuance model. Therefore it is too early to forecast what the fate for CBDCs will be. Some of the unanswered questions hinge on whether central banks (particularly the BoN) will first focus on retail use, where individuals could essentially use CBDCs as digital cash, or wholesale use to enhance domestic payment systems or for cross-border applications.
The design approaches which central banks are exploring are vastly different. An account-based model, which is currently being piloted by the Eastern Caribbean Central Bank, promotes the idea of consumers holding deposit accounts directly with the central bank, essentially bypassing financial intermediaries, such as commercial banks. Another approach, like the one China’s CBDC pilot is exploring, entrusts financial intermediaries with distributing CBDCs. This allows central banks to benefit from the experience of intermediaries in areas such as onboarding of consumers and anti-money laundering checks.
The ECB meanwhile is following an approach which allows licensed financial institutions to each operate a permissioned node of the blockchain network as a channel for distributing the digital euro. A potential fourth model would allow fiat currency to be issued as anonymous fungible tokens that protect the privacy of the user, although it is difficult to see central banks going for this approach. The endgame of CBDCs will ultimately be decided by the use case (either retail or wholesale) and the willingness of the market to adopt them. The implications of CBDCs for monetary policy could become interesting as well and are worth exploring. With current fiat currencies, central banks use monetary policy to keep the prices of goods and services we buy stable. It is thus the job of the central bank to make sure that inflation, the rate at which the overall prices for goods and services change over time, remains low, stable and predictable. Monetary policy tools, such as interest rates and quantitative easing, are used to control the overall supply of money that is available to the market, thereby controlling consumer spending and credit extension.
With CBDCs being digital they are in effect programmable and can supply information on the economy directly to the central bank. These features enlarge the monetary authority’s toolkit with which to implement decisions as well as the amount of data on which such decisions are based. It allows for the direct implementation of monetary policy, rather than through the indirect banking channel. Currently, central banks can only reduce interest rates to slightly below zero when they want to stimulate economic activity, as individuals would just switch to holding paper currency which would not lose its value due to deeply negative interest rates.
CBDCs could promote price stability, although it would undoubtedly be somewhat controversial. Another advantage of CBDCs is that they will allow for greater financial inclusion by providing unbanked individuals living in remote areas access to the payment system. They could also facilitate faster and cheaper cross-border payments.
Some of the drawbacks to CBDCs, however, are that central banks, and by extension governments, gain extraordinary power. The business of banking would be absorbed by the state, and authoritarian ambitions would reduce individual freedom. Under an account-based approach, financial intermediaries would continue to see the same types of transactional data that they currently do, but they might be forced to harvest and monetise user data to make up for lost net interest income. A CBDC could come with concentration risk, as the various ways of making payments that we currently have could possibly be reduced to one.
The ultimate question is: How are CBDCs different from the money that exists in digital form in our bank accounts? The South African Reserve Bank’s response to this is, “when money is held in a commercial bank in digital form, it represents an amount owed to you by that bank, and is thus a claim that you have against the bank. It can be withdrawn in its physical form, but only if the bank is solvent. A CBDC is backed by the central bank and is thus a liability on the central bank’s balance sheet. With a CBDC you therefore do not have to rely on a particular bank’s solvency to maintain your balance.”
It is admirable that the BoN is exploring CBDCs and trying to keep up with the technological developments of its peers in the developed world. However, as the BoN’s governor rightfully cautioned, CBDCs are still in their infancy and there is still a lot of uncertainty surrounding them. We expect answers on these uncertainties to become clearer over the coming years as CBDCs become more widely available, and the financial industry confronts what could perhaps be one of the biggest disruptions in its history.
Danie van Wyk – Head: Research
