(Santeri Viinamäki, CC BY-SA 4.0)
From its very beginnings central banking has always been based on payment services, and payment-related innovations, i.e. systems enabling immediate settlements in the interbank market, have always been its integral part.
At present, payment services are changing at a rapid pace, as users expect increasingly faster and easier ways to make payments at any time and place, which is also a reflection of the progressing digitalization. In addition to changes in the methods of payments, even the type of money that we use could change. Although cash payments continue to play an important role, new technologies and entities entering the payments market — such as Facebook — constitute a growing challenge for the traditional bank payment systems.
In response to these market transformations, some central banks have recently engaged in studies and analyses which aim to determine how a new, digital currency issued by the central bank (central bank digital currency, CBDC) could replace traditional money. These institutions include, among others, the central banks of Sweden and Uruguay. CBDC could constitute another innovation in payment systems and financial intermediation.
The ongoing debate concerning the possible issuance of CBDCs is primarily the result of interest in technological innovations for the financial sector, the emergence of new entities in the payments market, increased interest in so-called privately issued digital tokens, decreasing use of cash in some countries, and the need to create new monetary policy tools in order to manage future crises.
The term “central bank digital currency” does not yet have a clear, universally accepted definition. It is assumed that this is a new form of fiat money issued by the central bank, which constitutes a liability of the central bank, denominated in the existing unit of account, and used both as a medium of exchange and as a measure of value.
However, as a new form of money intended to serve as legal tender, CBDC would differ from other forms of money issued by central banks. Central banks are already providing digital money in the form of traditional reserve accounts or settlement accounts held by commercial banks and some other financial institutions.
A CBDC intended for retail payments could be widely available to the general public within the given country, but in a dematerialized form. CBDC could be used just as easily in transactions between individuals, between individuals and companies, and in transactions between enterprises in which any possible amounts could be transferred. This would mean that such transactions would be similar to today’s transactions between depositors in commercial banks, with the difference that they would take place with the direct participation of the central bank.
The concept of CBDC therefore raises questions about the role of the currency issued by the central bank, the direct access to its liabilities, as well as the structure of financial intermediation. At the same time, the current approach to central bank money is so well-established, both in the financial system and in society at large, that any possible digital change would have many consequences, both positive and negative.
The use of cash in some countries is declining, sometimes significantly. One example of this process could be Sweden, where the use of cash has fallen to such an extent that an increasing number of commercial outlets do not accept cash at all, and most bank branches have eliminated cash services.
On the other hand, in some countries, such as Uruguay, a large part of the population does not participate in the official financial system and is unable to make full use of the possibilities that it provides. Therefore, the introduction of CBDC could have a positive effect on financial inclusion.
In recent years, technological progress has greatly improved the convenience and efficiency of the digital forms of payment instruments used in the private sector, compared with the traditional paper money issued by the central bank.
Some countries have already adopted or are in the process of examining the public demand for faster and more convenient payment solutions that are compatible with the new digital and mobile technologies. Some of these solutions provide real-time or near real-time settlements and are available almost all the time. The one exception in this regard is cross-border retail payments, which are usually slower, less transparent and more expensive than domestic retail payments.
In the future technology will probably offer even more possibilities to increase convenience and safety, reduce costs and further improve the resilience to cyber risk.
In this context, two issues are particularly important from the point of view of the central banks. Firstly, as institutions of public trust and public responsibility, central banks need to design the money they issue, and possibly regulate any private forms of money, in a way that meets the needs of the users. Secondly, they must ensure that the money meets important social criteria: price stability, wide availability and verifiability, as well as safety and efficient allocation of resources.
Additionally, central banks will prefer forms of money which support other public policy objectives, and in particular the effective conduct of monetary policy, financial stability and counteracting money laundering and terrorism financing, including measures for the protection of consumers of financial services.
From the users’ point of view, it can be assumed that they would prefer a form of money that maximizes the private benefits and minimizes the associated costs and risks. As a means of payment, cash is characterized, in principle, by significant transaction costs, i.e. the need to meet in person and to withdraw cash which can be difficult in remote locations, as well as susceptibility to theft, and the lack of profit in the form of interest. At the same time, however, it offers immediate settlement, lack of cyber risk, and full anonymity.
If there was a CBDC widely available to the general public, intended for use in retail payments, this new form of money could be used in transactions just as easily as cash. It would enable payments on demand, without any amount limits, without restrictions on acceptance, and with the use of any device. It could also provide access to other financial services — such as consulting — on more favorable terms, and possibly also nominal interest. This would constitute a notable improvement compared with cash settlements.
The demand for CBDC will depend on its design, including in terms of the selected technology, i.e. account-based CBDC or token-based CBDC, and the extent of its availability. It could be high in countries where there has been a significant decrease in the amount of cash in circulation in recent years, as well as in countries with limited banking penetration and with unreliable settlement platforms.
It should be emphasized that one particularly important criterion is the ability to make anonymous transactions, that is, the extent to which identities and transactions are or may be disclosed to the participants of the transactions, third parties, and the public administration. Market participants may prefer at least some degree of anonymity, which makes it possible, among others, to avoid the profiling of customers through the commercial use of personal data, and to limit exposure to hacker attacks.
The introduction of CBDC would have an effect on the conduct of monetary policy and the transmission of monetary policy impulses to the real economy. The consequences of issuance of CBDC would directly depend on the extent of access to the new money, and whether it would be interest-bearing. Economic analyses conducted so far indicate that wider digital access to the liabilities of the central bank could strengthen the transmission of interest rate impulses to the money markets and credit markets. At the same time, the implications for monetary policy would be greater if CBDC became an attractive asset for investors.
An additional argument for the introduction of CBDC is its possible use as an additional tool of monetary policy in managing future crises. Such conclusions apply in particular to developed economies, where the recent global financial crisis clearly demonstrated that the effectiveness of interest rate policy may be limited by the existence of cash. If CBDC was adopted by all financial market participants in the future and cash was eliminated, then ultra-low effective interest rates would be possible.
CBDC could have a strong effect on financial stability and banking intermediation if it is positioned to compete with bank deposits, that is, if the new currency is interest-bearing.
The commercial banks’ reaction to the introduction of CBDC, as well as their ability to defend their existing business model, will depend on their market strength and the ability to boost the attractiveness of deposits and to replace the deposits lost in favor of CBDC with other forms of financing.
Meanwhile, the reduced attractiveness of bank deposits could lead to a reduction in the scale of financial intermediation and could also affect market discipline as well as the costs and stability of bank financing. At the same time, under certain conditions, CBDC could facilitate so-called “digital bank runs”, that is, sudden and significant withdrawals of deposits from banks in favor of the easily accessible, safe and liquid digital alternative at the central bank. Even if deposit insurance is provided, the stability of retail financing could deteriorate because the risk-free digital currency of the central bank would constitute a very safe alternative.
Moreover, from the point of view of the central banks, the introduction of CBDC would primarily increase their role in financial intermediation, which could threaten the existing, two-tier banking system based on the so-called fractional-reserve, and could significantly affect their functioning and even their independence.
On the other hand, CBDC could provide benefits in the form of more secure and efficient payment and settlement systems. Given the fact that CBDC could allow for the creation of digital records and digital traces, this could, in turn, have a positive effect on the fulfilment of requirements relating to anti-money laundering and countering the financing of terrorism, and could also help in reducing informal economic activities.
Regardless of whether central bank digital currency is deemed desirable in the shorter or longer term, the studies and experiments carried out so far have identified a number of legal, technical and operational issues that central banks and other entities must take into account before CBDCs are considered a payment instrument appropriate for wide-scale application.
For example, not all central banks have the authority to issue digital currency and to expand access to their balance sheets. The issuance of a digital currency could also require changes in legislation, which can be a very time-consuming process. Moreover, it is still not clear whether the benefits from the introduction of CBDC would ultimately outweigh the risks, and what the optimal way to design such a new currency and its features is. In particular, the issues of privacy, data security and cyber threats constitute a major challenge within a digital environment.
Before the recent financial crisis, the idea of a digital currency that serves as legal tender would be have been considered unusual. However, due to the current conditions and the experiences of the post-crisis period, some central banks have taken action towards implementing the idea of CBDC. The history of money suggests that although its basic functions may not change, its form keeps evolving in response to the needs of users. CBDC may simply be the next milestone in the evolution of money.
The views expressed in this article are the private views of the author and are not an expression of the official position of the NBP.
