Why CBDCs (Central Bank Digital Currencies) are becoming popular among central banks across the world?
Global financial Crisis — The genesis of crypto assets
The global financial crisis marked a turning point in the history of financial institutions, instruments, and, perhaps most importantly, people’s faith in their governments’ financial systems.
In the wake of this, the financial landscape was completely altered. It came as no surprise when in 2009, Satoshi Nakamoto wrote his manifesto on bitcoin called “Bitcoin: A peer-to-peer Electronic Cash System”. This essentially was the beginning of a decentralized alternative to the current fiat monetary system. Bitcoin, which was initially valued at around 39 cents in 2010 rose in value over the years reaching its current value of almost $60,000 per bitcoin.
Central banks all over the world were taking notice of this development and realized that opposing this digital alternative to fiat currency would be ineffective in the long run. As a result, central banks throughout the world began evaluating and comprehending the possible consequences of implementing digital fiat currencies, or CBDCs (Central Bank Digital Currencies). CBDCs will essentially perform all of the functions of traditional money, including mechanism of payment, store of value, and unit of account. Central banks throughout the world conducted large-scale pilot studies to describe the benefits and hazards of CBDCs. The following are the major possible benefits as drafted by them:
Central Bank Digital Currency vs Fiat currency
Cash payments are already becoming obsolete throughout the world due to the convenience of digital payments via cards or contactless applications. Because of the risk of contamination, the current pandemic has restricted the usage of cash as a means of payment even more.
Cash also has certain inherent drawbacks, such as being difficult to trace, making it vulnerable to unlawful activities and corruption. CBDCs can help with this by keeping a record of transactions. There is also the risk of transporting large sums of money. This might imply that the government will aim to phase out cash in the future in favor of digital fiat money.
CBDCs will also assist to reduce the cost of exchanging outdated and useless currency. Overall, we may surmise that the implementation of CBDC will facilitate the transition to a cashless society.
To counter the threat posed by cryptocurrencies to the monetary system — Best of both worlds
As outlined earlier, the idea of CBDCs was directly inspired by cryptocurrencies (bitcoin to be precise). The blockchain technology behind bitcoin is revolutionary in itself. In its early years, bitcoin struggled due to its poor reputation and amid allegations over the anonymity of its transactions which made it perfect for illegal activities. In 2014, Mount Gox, which handled over 70% of crypto transactions had to be liquidated which further tarnished the reputation of cryptocurrencies. Despite all this, crypto-assets rose steadily in value and market capitalization. In 2013 they had a market capitalization of around 10 billion USD, and in 2017 around 570 billion USD. But in 2018, after the Chinese regulators banned crypto exchanges in China, the prices of bitcoin tumbled drastically, making the crash the worst in its small history (even worse than the dot com crash).
This underlines the excessive price bubbles and volatility that accompanies the cryptocurrency markets. Being unregulated, having no intrinsic value, and under the purview of no sovereign governments, makes crypto assets a danger to fiscal policy across the world.
CBDCs’ primary goal is to combat such decentralized digital currencies, whose volatility and uncontrolled nature might disrupt economic institutions if left uncontrolled. CBDCs, unlike cryptocurrencies, would be centralized and controlled by national Central Banks in order to improve financial intermediation.
Counter to terrorism financing and money laundering
CBDC’s planned structure would allow it to track and record every transaction that occurs. This will stop criminal activity like anonymous payments related to unlawful trades. If an unlawful transaction occurs, it can be undone and the victims’ money returned to them.
Most illegal actions are coupled with a financial activity that can be easily prevented or repaid since they can be linked to their specific location using CBDCs. This will deter would-be criminals from pursuing such illegal pathways for fear of being readily reprimanded. CBDCs have the potential to be the most effective weapon against terrorist financing and terrorism in general. As a consequence, taxpayers’ money will be saved in the millions of dollars, which would otherwise be utilized in counter-terrorism operations.
Because governments can constantly keep an eye on the illicit movement of cash among persons or institutions, digital fiat currencies can also act as a deterrent to corruption and incidents of money laundering. This will compel financial and political institutions to be more open to their citizens, adding another degree of accountability. Of course, all of this is dependent on the morality of the different administrations.
Reducing tax evasion
One of the proposed benefits of CBDCs would be an ease in tax collection protocols and thwart efforts for tax evasion. Tax theft and underreporting is one of the major concerns of the economies around the world. Over the years, individuals and institutions with the help of lawyers, bankers, and financial experts have come up with methods to evade or minimize taxes. This has continuously undermined efforts from the governments and Federal banks to optimize fiscal policies and improve economic growth.
There are several strategies for tax evasion and avoidance. Fake tax returns, presenting false financial statements, offshore banking, and unreported employment are all examples. All of these behaviors can be considerably decreased with the efficient usage of CBDCs.
As the accounts will be centralized with minimum interference from the intermediaries, governments can directly deduct taxes from the private accounts of individuals and institutions thus making the whole economic system much more efficient and effective.
Secure instrument of digital payment
CBDCs might be a viable source of digital payments in both retail and institutional systems. A national standard digital payment system administered by central banks will not only increase payment efficiency but also build public faith in the national payment and economic system.
There may also be advantages to using a CBDC for wholesale and interbank payments. It might lead to speedier settlements and shorter settlement periods.
Another perceived utility of digital fiat currency is offering security to money deposits in case of a financial crisis. Traditionally as observed during various financial meltdowns, savings of depositors and investors are mostly wiped out which causes mass distress. This results in increasing distrust in the national banking system and financial instability in extreme scenarios. A CBDC would offer an alternative lower risk option during periods of economic instability.
Potential benefits to trade — cross border transactions
During the experimental phase, when central banks were assessing the implications and advantages of CBDCs, joint research conducted by the Bank of England, Canada, and Singapore investigated the use of CBDCs as efficient instruments for cross-border payments. Cross-border payments have traditionally been inconvenient, time-consuming, and inefficient. Technology has the potential to significantly improve it while also addressing stalled transactions. This would also have a considerable influence on the debt markets’ efficiency and openness.
Having a centralized directory of all the transactions might play a crucial role in solving issues with offshore movement of funds to escape financial authority in a particular jurisdiction. Countries might be incentivized in using transaction history to improve transparency in the conduct of their respective financial institutions.
Another possible benefit of CBDCs that has been proposed is the reduction of counterparty credit risk for cross-border interbank payments and settlements as a result of the elimination of commercial intermediaries participating in the aforementioned payments.
Financial Safety and stability
The Great financial crisis of 2008 underlined the risks associated with the fractional reserve banking model of commercial banks. Fractional reserve banking means that banks are only supposed to keep a fraction of their reserve as actual cash available for withdrawal and can use the rest of the capital for lending, thereby expanding the economy further.
Now during a financial crisis when panicked depositors choose to withdraw cash from their accounts en masse, the banks are unable to furnish cash and are forced to shut down or liquidate. This essentially wipes out the savings of the public. CBDCs, in theory, can reduce such risks as the need for cash would no longer be there. But this would introduce problems for the commercial banking system as a whole.
CBDCs can also minimize the use of deposit insurance plans. Deposit insurance or protection is a safety put in place to protect depositors’ money in the event that banks are unable to fulfill their customers’ debts.
The issue with deposit protection systems is that they encourage banks to take risks, such as incurring bad debts in order to enhance profits. Banks will act properly and take fewer risks if deposit protection is not available.
Low barrier of entry
According to the World Bank, there are more than 2 billion individuals worldwide who do not have bank accounts. The majority of them live on the African subcontinent, highlighting the absence of financial inclusion. This can happen for a number of reasons, including poverty (because people are unable or unwilling to pay bank account costs), a lack of access to physical bank accounts, or a lack of clear identifying information.
CBDCs can assist governments in boosting their citizens’ financial inclusion. It enables central banks to have cheap adoption costs and fewer barriers to entry since it is accessible to everyone with a mobile device and an internet connection. Transaction costs will also be reduced in the case of digital currencies, incentivizing the poor to use them. Furthermore, because the technology behind CBDCs will allow for the tracking of payments, there will be no need to know your customer’s identifying information. M-Pesa (mobile-based money transfer and microfinancing service) in Kenya is an excellent model for financial institutions to evaluate the benefits of CBDCs in this respect.
It can act as a Fiscal stimulus (Deflationary economy)
Milton Friedman in 1969 coined the term Helicopter money in his paper “The Optimum Quantity of Money”. Helicopter money has been suggested as an alternative to Quantitative Easing (part of the monetary policy in which the Central Bank purchases financial assets such as government bonds in order to inject money to stimulate the economy) during a deflationary economy, in which the interest rates keep on plummeting. In a deflation, the businesses are reluctant to spend more as the purchasing power of money keeps on increasing over time.
According to the description of helicopter money, the Central Banks as a measure to arrest declining interest rates would directly inject private accounts of institutions and individuals with base money to increase inflation. Traditionally, this is done by tax rebates as a means of fiscal stimulus.
However, by employing CBDCs, Central Banks may deposit funds directly into private accounts without going via middlemen. This would make the procedure much more efficient and effective.
Elimination of the Effective Lower Bound (ELB)
The CBDC’s interest-bearing architecture, as well as the depreciation of paper money, would also contribute to enhanced macroeconomic stability because interest rate changes would no longer be confined by an effective lower limit in reaction to a deflation scenario.
It has been discussed that employing CBDC would eliminate the ELB on policy interest rates since holding large sums of cash to avoid negative interest rates would be impossible. The cost of storing cash raises the lower bound on negative interest rates. This would empower Central Banks to impose the necessary macroeconomic measures based on the conditions.
It has long been discussed through various research papers over the years to essentially remove the lower bound provided by the central banks as inflation buffers and CBDCs can act as an effective monetary tool for that.
Conclusion
Cryptocurrencies are challenging the traditional financial system, and against this backdrop, Central Banks across the globe confront the prospect of individuals being able to store, spend, and move wealth without relying on fiat money. This is a significant challenge to the conventional function of Central Banks in monetary policy, thus it is not surprising that there is a growing movement among developed banks to evaluate and comprehend the possible impacts of instituting a CBDC.
