Central Bank Digital Currencies (CBDCs): what you need to know

Central Bank Digital Currencies (CBDCs): what you need to know

Over the past months, we’ve heard more and more rumours about the European Central Bank and the Bank of England working on so-called ‘Central Bank Digital Currencies’, namely the digital pound and the digital euro. What does this mean for consumers and businesses?

In this article, we are going to delve into the realms of so-called ‘CBDCs’ and analyse the current state of development, giving you better insight into what the current status is and what to expect in the next couple of years.

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What are ‘Central Bank Digital Currencies’ (CBDCs)?

The term ‘Central Bank Digital Currency’ is a word looking to describe a form of digital currency or money which is issued directly by a central bank, similar to how cash is directly created by the central bank.

As opposed to cash, currently, most money is created through fractional reserve banking via the banking system giving out loans to businesses.

However, while CBDCs are supposed to work as cash does, they would be issued and transmitted digitally through ledgers and wallets, in a similar way as decentralised cryptocurrencies work, however, controlled by a country’s Central Bank. The goal is that this sort of directly central-bank-created money should complement or replace cash.

The overarching idea is that opposed to cash, these digital currencies would function similarly to cash but have added advantages for monetary policy and fighting crime such as money laundering.

What is the current level of development?

A handful of countries have already tested and issued CBDCs, with varying implementation and design. Nigeria and China are two examples that are at the forefront of issuance.

At the moment, however, these digital currencies are issued alongside normal cash and currency, and are only sparsely used.

In China, as an example, the digital yuan has reached a volume of $250bn in transactions — on the face, it sounds like a high volume, however, with an equivalent of $2.3bn of digital yuan in circulation, this represents only 0.16% of China’s monetary supply.

Potential benefits CBDCs

The reasons why central banks around the world are looking into CBDCs are numerous. However, the following advantages clearly stand out:

Increased efficiency and lower costs

CBDCs can streamline payments by enabling direct transfers between accounts without intermediaries such as banks or payment processors. It thus reduces transaction costs and settlement times, and can have a beneficial effect for consumers, who tend to bear the costs of private payment services.

Financial inclusion

In particular in developing countries, CBDCs can enable access to financial services for the underbanked by providing a digital payment option that is directly accessible on a smartphone. Many private solutions exist already, such as M-Pesa, a form of mobile money in Kenya, which is one of the defacto standard ways of paying in the country.

Security benefits

As digital alternatives to cash, CBDCs offer security advantages. They eliminate counterfeiting risks and allow central banks to verify transactions directly. Encryption and digital ledgers supposedly protect against fraud and cyber threats.

Monetary policy transmission

CBDCs give central banks greater ability to implement monetary policy changes. Interest rates on digital currency could be directly adjusted and directly impact how consumers deal with the money. This should, in theory, allow more precise calibration of policy transmission and enable benefits and other state support to be directly dropped into an eligible person’s wallet.

Payment system resiliency

CBDCs offer a backup payment rail if private systems fail, since central banks control the ledger. This is a form of disintermediation of the private banking system with the aim of improving payment efficiency, financial inclusion and reducing fees.

Drawbacks of CBDCs

Several risk factors explain the hesitancy about introducing CBDCs quickly and without a broader, societal discourse:

Tax implications

How CBDCs are treated from a tax perspective is still unclear. There are questions about how financial transactions conducted with CBDCs would be reported to tax authorities, as they would open up possibilities of directly taxing transactions at source, for example, to enable an immediate VAT deduction or surcharge.

Technological stability

As a new technology, the stability and reliability of CBDC systems have yet to be proven over time. Any outages or disruptions to a CBDC network could erode trust and discourage use. Any proposed system needs rigorous testing and solid cybersecurity measures to prevent hacking or exploitation. Also, the payment infrastructure must be able to handle large transaction volumes securely.

Privacy concerns

Depending on the design, CBDCs may enable governments to monitor citizens’ financial transactions and behaviour closely. This raises privacy issues and fears of overreach. However, some CBDC models provide more anonymity and less traceability of payments.

Financial stability risks

Widespread adoption of CBDCs could disrupt traditional banking models, especially if businesses and consumers hold CBDCs instead of commercial bank deposits. This could lead to changes in credit availability and banking liquidity. Hence, it is important that proper regulation is implemented by design if CBDCs are issued alongside the existing private banking system.

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Looking ahead

Central Bank Digital Currencies or open payment rails, such as India’s Bharat Bill payment system, clearly have a lot of benefits for countries that are chronically underbanked and operate largely on a cash basis or via privately owned digital payment services.

However, for consumers in developed countries, the benefits may be limited, as numerous efficient private payment services already exist and transaction costs are low. As a result, scrutiny in the UK, the US and also in Europe will be higher in order to determine if benefits actually outstrip concerns such as privacy and technological risks.

Being clearly a significant change in how the banking and payment system operates, we expect a longer political, business and consumer discourse about an eventual introduction (or banning) of such digital currencies in most of the world.

G.C. Wagner

Gustav Christopher is a writer specialising in finance, tech, and sustainability. Over 15 years, he worked in banking, trading and as a FinTech entrepreneur. In addition, he enjoys playing chess, running, and tennis.