While CBDCs are still a relatively new concept, they have gained significant attention due to their potential to transform the financial system.
What are CBDCs, and how do they work?
Central Bank Digital Currencies (CBDCs) are a new form of digital currency that will be issued and backed by central banks. Unlike traditional currencies, which are typically issued by the central bank in the form of physical banknotes and coins, CBDCs will only exist in a digital form that is stored and transferred using electronic devices such as smartphones and computers.
While CBDCs and bank deposits can both be transferred digitally, there are at least five key differences between CBDCs and bank deposits that are worth being aware of.
- Issuer – CBDCs are issued by central banks, whereas bank deposits are created by commercial banks when they receive deposits from a customer.
- Centralization – CBDCs will be centrally managed and controlled by the central bank, whereas bank deposits represent a deposit holder’s claim on one specific bank.
- Accessibility – Similar to cash, CBDCs should be available to all individuals and businesses, regardless of whether they have a bank account. Bank deposits, on the other hand, are only available if you have an account with a particular bank.
- Permanence – CBDCs represent a direct claim on the central bank, which can always make good on its obligations. In contrast, bank deposits are a claim on a particular commercial bank, and so the value of deposits can be lost or reduced if the commercial bank becomes insolvent.
- Legal tender status – CBDCs are designed to be a digital form of legal tender, meaning that they can be directly used to settle a transaction between two parties. In contrast, bank deposits are not legal tender, which means that final settlement needs to occur through a process of interbank settlement, which may occur with a delay of several business days.
Potential benefits of CBDCs
The benefits of CBDCs remain largely theoretical since few countries have launched them on a large scale. Investigation and testing is underway in various countries, including in China since 2020, and Sweden since 2017.
CBDCs offer at least seven potential benefits.
1. More efficient transactions
CBDCs offer the potential for faster payments by allowing for near-instantaneous settlement. This will be particularly beneficial for individuals and businesses engaged in cross-border transactions where transfers routinely take several business days to settle using existing payment networks like SWIFT. This could reduce the need for financial intermediaries and significantly lower transaction costs.
2. Lower transaction costs
CBDCs have the potential to significantly lower transaction costs for businesses and individuals. Unlike traditional payment methods, which often involve intermediaries and fees, CBDCs can be transacted directly between two parties. CBDCs can not only reduce transaction costs but also the costs associated with cash handling, storage, and transportation.
3. Increased security of digital payments
CBDCs have the potential to reduce the risk of fraud, counterfeiting, and cyber-attacks. Since CBDC transactions can be recorded on a blockchain with advanced encryption and authentication features, this should make CBDCs highly secure and resistant to hacking.
4. Reduced counterparty risk
CBDCs should reduce counterparty risk by providing a direct claim on the central bank, which in most countries is the most reliable counterparty in the financial system. This should increase overall financial stability.
5. Increased financial stability
CBDCs should inspire more confidence from anyone using the financial system, leading to increased financial stability. Since CBDCs represent a direct claim on the central bank, and central banks can always create more currency to make good on their obligations, there is essentially no credit risk. In contrast, commercial banks can from time to time fail to meet their obligations. This can happen because a commercial bank does not have enough capital to cover all of its liabilities (solvency risk), or because the commercial bank does not have enough liquid assets on hand (such as cash and marketable securities) to meet a sudden increase in withdrawals from deposit holders (liquidity risk).
6. Improved monetary policy transmission
Since each individual and business would have an account directly with the central bank, CBDCs will enable central banks to more directly control the money supply and interest rates. As a result, central banks will be able to respond to economic shocks and manage inflation more quickly and precisely, reducing the time it takes for changes in monetary policy to have an effect on the economy.
7. Enhanced traceability
CBDCs should make it easier to track transactions, which could help to combat money laundering and other illicit activities, as well as enable more efficient and accurate tax collection.
Risks associated with CBDCs
While CBDCs offer many potential benefits, they also pose many potential risks.
While it is possible that key risks can be successfully managed, reduced, or avoided, it is worth noting that the risks associated with CBDCs will not impact all stakeholders to the same degree.
Central banks are actively working to address key risks. However, in doing so they have an institutional incentive to prioritize systemic risks, such as those associated with cyber-attack, financial instability, inflation, and system failure. In contrast, there are other risks, such as the risk to privacy, that are faced primarily by individuals and businesses. Policy makers and central banks may be unable to appropriately understand and manage those risks. For example, central banks are unlikely to see any problem with collecting information about the income, transactions, and financial assets of every individual and business in the economy.
At the very least, the risks posed by CBDCs highlight the need for careful planning and widespread community consultation before CBDCs are officially launched within an economy.
Below we outline five of the key risks associated with CBDCs.
1. Cyber risk
CBDCs are digital currencies and are therefore vulnerable to cyber-attack. Although CBDCs will obviously be built with the most advanced security protections, technology is constantly changing and so CBDCs may from time to time become vulnerable to various forms of cyber-attack.
A successful cyber-attack on a CBDC system could lead to the widespread loss of funds and theft of personal information, which could have serious consequences for a large number of users.
2. Financial stability risk
Although CBDCs could increase financial stability by boosting confidence in the financial system, they could also negatively impact financial stability. If the widespread adoption of CBDCs lead to a significant shift away from traditional bank deposits, then this could affect the ability of banks to fund themselves.
A shift away from commercial banks might lead to increased collaboration between traditional financial institutions and technology platforms. For example, Apple has recently offered a high yield savings account in partnership with Goldman Sachs. This form of innovation is likely to increase both financial inclusion and financial stability.
However, a shift away from commercial banks might also lead to consolidation in the banking industry as small players are acquired by larger rivals, resulting in much larger banks. This could undermine financial stability because these new mega banks might not only be too big to fail, but also too big for the government to bail out.
In the worst-case scenario, a shift away from traditional bank deposits could lead to the failure of a number of large commercial banks. This could lead to loss of investor confidence, financial contagion, disruptions to financial markets, and a credit crunch. This might ultimately lead to collapsing asset prices, widespread defaults, catastrophic financial losses, and economic recession.
3. Inflation risk
Since CBDCs will make it easier for central banks to implement monetary policy, they may intervene in the economy too much and too often. This could lead to a sharp increase in the money supply, leading to a rapid increase in the general level of prices.
If an economy were to experience a period of stagflation, which involves falling economic activity and high inflation, the central bank would be placed in a bind. It would face the unenviable choice between raising interest rates to tame inflation or lowering interest rates to stimulate economic activity but at the cost of sacrificing the value of the currency.
Central banks must be extremely careful in how they manage monetary policy in a world of CBDCs. Inflation risk will be ever present, and must not be allowed to eventuate.
4. Operational risk
CBDCs will require a significant amount of new infrastructure to be put in place. This could lead to operational risk if there are issues with the design or implementation of these systems.
5. Privacy risk
The adoption of CBDCs raises serious privacy concerns. Central banks will gain access to a wealth of information about users’ transactions and spending habits. This could potentially be used for surveillance or other purposes, raising questions about the balance between privacy and the need for transparency and oversight.
The bottom line
While CBDCs offer numerous potential benefits such as more efficient transactions, lower transaction costs, and increased security of digital payments, they also pose some serious risks such as the potential for cyber-attack, high inflation, the disintermediation of commercial banks, and a loss of personal privacy.
Pilot testing of CBDCs is currently underway in various countries, and any plan to implement a CBDC will need to be carefully evaluated to ensure that the benefits outweigh the risks.
As the world continues to embrace digital technology, the question remains, are CBDCs the future of money?
Individuals, businesses, governments, and central banks must take an interest in and engage with this important issue. By moving forwards cautiously, we can hope to harness the benefits of this new technology without rushing blindly forwards into a dystopian future where individual freedoms and privacy rights unintentionally become a thing of the past.
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