Digital currencies

7 February 2024
Central bank digital currencies

With the growing acceptance of cryptocurrencies, it is no surprise that governments are exploring digital versions of their own currencies. While these hold potential benefits, they also spark concerns about privacy and freedom. Additionally, their rollout might pose challenges for fintech companies, big banks, the crypto industry, and – if you’re investing in any of them – your portfolio.

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What are CBDCs?

A central bank digital currency, or CBDC, is a digital form of a country’s traditional, fiat currency. Think: digital US dollars perhaps, or – as is already being rolled out in China – a digital yuan.

So instead of printing physical money, a central bank would issue electronic coins backed by the government. To be clear, using this digital currency isn’t the same thing as paying with credit cards and payment apps like you do right now. Those are just ways to move money electronically. A CBDC turns money into computer code.

According to the Bank of International Settlements, 93% of the world’s central banks have launched studies of digital currencies, and 15 CBDCs are expected to circulate publicly by 2030 (you can track their progress with this online tool). Some say it’s a sign that central banks are essentially all fighting for control of their monetary systems, with the crypto market becoming more of a challenge to fiat currencies and threatening the tools central bankers rely on to control their economies.

What are the benefits of CBDCs?

There are quite a few. They can’t be counterfeited, and they make it easier for governments to spot criminal activity and track money flows. And since CBDCs have the same value as their paper versions, they’re expected to be a lot less volatile than cryptocurrencies. They should also allow for instant and cheap money transfers (including across borders) that could boost economic activity, as well as give unbanked and underbanked people better access to the financial system.

But what’s not immediately apparent from a consumer standpoint is how much simpler it would be for governments to quickly implement economic measures. Had CBDCs been in place during the pandemic, for example, authorities could have distributed stimulus payments more quickly and easily, depositing them directly into people’s digital wallets. What’s more, because digital money can be easily tracked, it’ll allow authorities to better assess whether this sort of fiscal policy is working or not. The same is true for monetary policy, which is the process by which a central bank controls the supply of money to promote price stability and economic growth.

Finally, CBDCs can be “programmed”. China has tested expiration dates for its digital yuan to encourage users to spend it quickly – useful in times when the economy needs a jump start. And perhaps even more importantly, the Bank of England has said that its digital pound would allow parents to program their kids’ allowance so they can’t buy candy with it. Phew.

What are the drawbacks of CBDCs and what can be done about them?

Programmable money that’s very traceable sounds great, but therein lies the biggest argument against CBDCs: they would give unprecedented power to policymakers, allowing them to track people’s spending in real-time and keep a record of all money movements in their economies. That sparks important debate about privacy and basic freedoms. It’s what makes the idea controversial, with some going so far as to call for an outright ban.

The thing is, many of its issues can be effectively addressed with proper implementation. This relies crucially on two main principles:
1) The introduction of a digital currency must be a complement to, rather than a replacement for, physical banknotes, giving people the option to use cash if they wish. And it’s important that governments explicitly guarantee that banknotes will remain a widely accepted payment method.
2) The design of a digital currency should prioritize privacy. Like with cash, transactions with digital dollars should not require identification, a bank account, or the divulgence of personal information for basic financial activities. That’s the approach being explored by the Bank of Canada, which says it’s keeping those privacy considerations in mind.

What industries could be disrupted by CBDCs?

1) Payment companies

These digital currencies could cut payment companies out of the equation completely. The digital yuan, for example, is designed to move money from A to B instantly, removing the need for the private electronic payment systems dominated by Ant Group’s Alipay and Tencent’s WeChat Pay – companies, coincidentally, that China has cracked down on in the past.

In other places, CBDCs could be designed to work with private payment companies or to replace them altogether, as China’s would. And if it’s the latter, that would be bad news for companies like Block (formerly Square), PayPalMastercardVisa, and Global Payments.

2) Traditional banks

A “bank run” happens when a lot of customers – worried about the safety of the financial institution – rush to withdraw their physical money at once. Now imagine those clients, with a touch of a button, could move their money into a CBDC that’s stored virtually at the central bank. It could make bank runs a lot easier and more common – not great news for the financial sector.

Authorities could put measures in place to prevent this, mind you – by limiting the amount of CBDC people are allowed to hold, for example. But bank runs aren’t the only issue here: even in good times, customer deposits – an essential source of cheap funding for banks – could still flow out of the system if people simply prefer to hold digital money stored with a central bank. In that scenario, banks would have to look for alternative, potentially more expensive sources of funding, which could substantially dent their profits.

3) Crypto

A digital currency revolution could go in one of two directions. In the first, regulators might increasingly crack down on the crypto market and push their CBDC as an alternative. In an extreme situation where a country’s entire monetary system converts to a CBDC, the government could ban people outright from using them to buy crypto. That scenario would be bad for crypto prices and the stocks of companies exposed to the wider crypto market, like Coinbase.

In the second scenario, a government embrace of a CBDC could end up accidentally boosting the crypto market. For one thing, cryptocurrencies like bitcoin have a limited supply that (in theory) makes them a good store of value. The supply of CBDCs, on the other hand, could constantly be inflated by governments, eroding the purchasing power of those digital currencies.

And for another, CBDCs would amplify one of bitcoin’s major appeals: anonymity for the user. That’s because they’d be government-controlled, whereas cryptocurrencies operate on decentralized systems out of governmental reach. If the push towards CBDCs makes people feel like they’re losing their privacy and basic freedoms, it could actually drive them toward anonymous, decentralized cryptocurrencies.

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