Central bank digital currencies (CBDCs) bring some of the potential benefits of private blockchain-based cryptocurrencies to public money under national central banks’ authority, with DCash from Eastern Caribbean Central Bank being an excellent example.
Slumping cash usage has spurred some countries to explore CBDCs as an avenue to improve transaction efficiency, lower service delivery costs and increase financial inclusion.
Wholesale CBDCs
CBDCs may be used by both individuals to pay businesses or each other (retail CBDC), and financial institutions to settle trades in financial markets (wholesale CBDC). They differ from cryptoassets like Bitcoin and Ethereum which are privately issued and unbacked by central banks – these private currencies often fluctuate drastically in value making payments impossible.
Although CBDCs are relatively new, they’ve gained interest among central banks around the world due to changes in payments, finance and technology. A 2021 BIS survey discovered that 86% of these central banks were actively researching CBDCs with 60% testing or deploying pilot projects as a result.
CBDCs provide faster and cheaper transactions compared to current systems; instead of taking several days for bank transfers between banks to clear, instantaneous transfers would take place instantly on a blockchain, eliminating intermediary parties altogether. They may also help lower the costs associated with implementing monetary policy by central banks in stimulating economies more effectively.
However, it must be remembered that CBDCs introduce central banks into an already highly competitive payments industry. To be successful, they will need to outcompete existing private-sector payment processors while also meeting privacy and security considerations. It is therefore imperative that central bank design choices reflect both their current and anticipated payments landscape as well as realistic adoption goals.
Retail CBDCs
CBDCs can be used by non-bank public consumers for retail payments (known as “retail CBDC”) or by financial institutions to settle trades on financial markets (known as wholesale CBDC). Both types are currently being developed in several countries; retail CBDCs may take the form of digital coins stored in wallets and accounts, or an app or service which allows people to transact using this currency.
CBDC has experienced worldwide interest due to several reasons. COVID-19’s pandemic accelerated shifts towards digital payments and e-commerce while the popularity of cryptocurrencies such as Bitcoin has opened new opportunities for central banks to explore innovative payment systems to supplement current ones.
CBDCs offer many potential advantages to payments ecosystems; however, their design and deployment must take careful account. Retail CBDCs should meet public policy objectives without undermining private intermediary roles or creating unintended side effects; retail CBDC projects therefore often include legislative input as well as public scrutiny from a range of stakeholders including legislators, payments ecosystem members and the general public – for instance The Bahamas recently chose this approach and in 2020 launched their Sand Dollar initiative with Mastercard Island Pay in partnership.
Stablecoins
Stablecoins are an emerging cryptocurrency type backed by reserve assets like gold or the US dollar, designed to reduce volatility relative to unpegged cryptocurrencies like Bitcoin. Stablecoins can be used for various purposes including value transfers and international payments as well as trading on crypto exchanges or as the underlying asset in DeFi (decentralized finance) transactions.
Stablecoins are subject to oversight by central entities and must comply with Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements. Furthermore, issuers of stablecoins possess the authority to freeze tokens on certain addresses, while cooperating with law enforcement in investigations related to money laundering or illicit activity.
Stablecoins depend on their reserves for value, so if investors lose faith in these assets, the coin could lose its price peg – known as a run – similar to when depositors withdraw funds from an underperforming bank. Stablecoins backed by physical assets may even suffer more rapidly if forced by central entities to sell assets in order to redeem tokens more rapidly.
Algorithmic stablecoins rely on algorithms to control how many coins they release in response to price fluctuations, but this approach carries its own set of risks. Terra, an algorithmic stablecoin backed by US dollars, had its peg broken in May 2022 resulting in investor displeasure and sending the price plummeting precipitously.
Challenges
CBDCs (Digital Common Denominated Currencies) are digital versions of national fiat currencies issued and maintained by central banks to promote financial inclusion and enable effective monetary policy implementation. Over 100 countries are actively researching CBDCs; more than two dozen globally distributed stablecoins already exist.
Launching CBDCs poses challenges for central banks. For example, they must adopt new decision-making and change management practices; optimize infrastructure design choices so as to support CBDC use; and attract talent with experience forming partnerships across sectors.
Though CBDCs present challenges, it would be mistaken to dismiss them outright. CBDCs could assist central banks in meeting their public-good objectives such as maintaining public trust in money, maintaining price stability and creating safe payment infrastructure systems and infrastructures that reduce transaction fees while simultaneously increasing cross-border payments quickly, financial inclusion, transmission of monetary policy transmission.
McKinsey anticipates CBDC will become increasingly popular with central banks as the world embraces digital transactions, as it serves to preserve existing cash values while increasing efficiency, safety, and transparency within global financial systems. Furthermore, CBDCs may help prevent potential cash shortages during crises.