Central bank digital currencies (CBDCs) have been characterized as a solution in search of a problem, but central banks seem resolute in their ultimate adoption, in spite of implied threats to commercial banks and financial stability.
According to the Atlantic Council there are now 105 countries whose central banks’ are actively developing CBDCs – that’s triple the number from as recently as 2020. Developing economies, particularly in the Caribbean, have been at the forefront. Notable early schemes include “Project Sand Dollar” in the Bahamas,
DCash by the Eastern Caribbean Central Bank, and eNaira of the Central Bank of Nigeria.
DCash by the Eastern Caribbean Central Bank. Source: https://www.dcashec.com/
China leads the way on CBDCs
By some distance the leader is China’s central bank digital currency, the e-CNY, which debuted in front of an international audience at the Beijing Winter Olympics last year. At home, the People’s Bank of China (PBOC) is in testing mode. Globally, China is thought to be focused on setting regulatory standards that will influence the workings of other countries’ CBDCs.
In spite of low adoption rates, the e-CNY is by far the largest CBDC pilot in the world with RMB 13.61 billion in circulation and 260 million wallets. Pilot regions now cover 25 cities, and the PBOC has relentlessly expanded the economic activities that are part of the state-enabled payments network, including public transportation, public health checkpoints, COVID test centers, integrated identification cards to receive and pay utilities, and tax payments and refunds. Testing has also begun on technical and programmability functions like smart contracts for B2B and B2C functions, e-commerce, and credit provision.
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No consensus on CBDC objectives
The PBOC’s ambition is echoed elsewhere. An OMFIF survey of central banks for its Future of Payments 2022 report, found that two-thirds of its respondents expect to issue a CBDC within 10 years. Of those central banks who don’t expect to issue a CBDC, most are actively considering the prospect, and surveyed banks have a median of five employees dedicated to research or development of CBDCs.
Critics of CBDCs are quick to label the medium as “a solution in search of a problem” and indeed the OMFIF survey shows a wide variety of objectives for pursuing CBDC adoption with no identifiable consensus. No central bank cited improved cross-border payments as their main objective in developing a CBDC. “Preserving the central bank’s role in money provision” was the second most reported main objective behind “Other” – a category that included a range of objectives including digitalization, improving the resiliency and efficiency of payments systems, and interoperability.
“Preserving the central bank’s role in money provision” harks back to the origins of CBDCs: a reaction to the emergence of private digital currencies that threatened to rival fiat money in terms of credibility and a process that began in earnest with the launch of the ill-starred Facebook-backed ‘Diem’ digital currency. Though this threat (and that arising from other cryptocurrencies) has diminished, a raft of other reasons have been advanced in support of CBDCs (as above) but for Europe there is the additional incentive in developing a euro CBDC: namely, the dollar’s dominant role as the global reserve currency and the similar dominance of perceived ‘American’ payment schemes such as Visa and Mastercard.
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Cash usage and the euro CBDC
Hence, nowhere is the debate around CBDCs as intense as in Europe. A decision on the digital euro, or possible digital euro (PDE) (the acronym preferred in the literature) is not expected to be made until 2026/7, following a testing and legislative phase.
Central to that decision is the level of cash usage. As use of cash declines, a risk-free digital euro would be universally accepted across the euro area, cutting off the potential for other digital currency issuers (including, say, the PBOC and a digital renminbi) to supplant European central banks.
Cash as a percentage of transactions and as a percentage of transactions value in the eurozone has fallen steadily. Yet, in the 21 years of their existence, euro banknotes have increased seven times in value, up to EUR 1.6 trillion – a compounded annual increase of about 10%. The corresponding figure for the US dollar is 6.5%, the British pound, 5.2%, and the Swiss franc, 4.4%.
The enduring popularity of euro-denominated cash indicates confidence in the currency: the PDE and other forms of CBDC seek to replicate this. The popularity of euro cash is not explained by a rise in illegal activities, according to the ECB, which notes that the rise in cash has been smooth – not a characteristic of indicators of criminal activity – while the increase in euro coins shows more or less the same pattern (and criminals and tax evaders are unlikely to make extensive use of coins).
CBDC and the threat to commercial banks
But CBDCs also have a problem with perception, not least in the mind of the consumer. For the public, the difference between a CBDC and a bank deposit will be difficult to discern. Digital currency accounts will be offered almost exclusively by banks. Banks will be responsible for onboarding and offboarding, KYC and
AML checks, and providing all of the services normally associated with deposits such as online banking, payments cards, apps, and so on. Opening a CBDC account will involve the same process, same information, same forms to fill as a normal deposit at a bank.
This suggests another threat, specifically to commercial banks – namely the substitution of CBDCs away from bank deposits rather than paper currency. As the ECB notes,a replacement of bank deposits for PDEs implies, euro for euro, a decline in the bank balance sheet, and a corresponding increase in the ECB balance sheet. This would have the effect of decreasing bank liquidity with a contractionary effect: banks would be less inclined to lend out to households and businesses.
CBDC threatens financial stability
For central banks, the existence of CBDCs also gives rise to issues around the conduct of monetary policy and for financial stability.
According to a survey commissioned by the ECB, most people do not understand the difference between commercial bank money and central bank money. Tellingly, they do not seem to appreciate the fact that commercial bank deposits are risky to some extent, whereas ECB deposits are riskless. While in normal conditions that may have little import, it becomes crucial in a banking crisis and the potential for a bank “run” on their deposits.
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Technological factors have also increased the speed of bank runs and the euro CBDC would compound the problem by offering a risk-free online alternative to bank deposits where, in the absence of full banking union, there is a crucial lack of area-wide deposit insurance. With this in mind, the ECB intends to set a limit to the maximum holding of PDE, possibly EUR 3,000.
CBDC integration promises to be a significant operational challenge but given that CBDCs will eventually become legal tender, participation will be compulsory – in Europe and beyond. On balance, despite sceptics as to the business rationale, for commercial banks it would seem wise to assume CBDCs are inevitable and plan accordingly.
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