Bitcoin and other cryptocurrencies have become an increasingly established part of the financial landscape. Bitcoin has become a reference point for controversy since it was introduced to the world. Licit and illicit traders quickly adopted cryptocurrency. One of the primary concerns for governments is the use of cryptocurrency as a means to accommodate illegal financial transactions and anonymity. Bitcoin’s decentralized system undermines the cycle of trust. The world economy cannot be run in that manner. A cryptocurrency can be produced by anyone running a full node. Peer-to-peer transfers mean that intermediaries, like central banks, are no longer required to manage and distribute currency. This raises questions like, how do we efficiently monitor macroeconomic factors like the inflation rate, how do we sustain the sovereignty of a national currency. There are other valid concerns for governments. This article will discuss the implications and threats to financial stability. We will also highlight the advantages and concerns of central bank digital currency (CBDC).
But first, …
Money
One of the fundamental features of the earliest form of a national currency is that you could directly exchange your national currency for its value in whatever material that was backing it, for instance, gold. It was also known as a commodity currency. An example of commodity currency is the gold standard that was used before adopting fiat currency. Instead of commodity currencies, most of the world now runs on fiat currencies. The value of a fiat currency is derived from the government that backs it. Fiat currency makes control easier. This control is helpful for maintaining the health of an economy. Through central banks, governments have a centralized grasp on the production and distribution of their respective fiat currencies. Central banks can dictate the currency’s movement, adjust the amount of money in circulation, track its location in bank accounts, and tax the movement of money.
Cryptocurrencies, on the other hand, are “decentralized peer-to-peer payment networks” not backed by any government, making them virtually untraceable and uncontrollable by any government.
Regulatory Challenges
Cryptocurrencies have had a somewhat destabilizing effect on the central banks. Cryptocurrencies catalyze capital flight and make managing fiscal policy enacted by the government more difficult. The untraceable nature of cryptocurrency proves useful to circumvent capital controls. An instance of capital flight occurred in China. Chinese citizens are only allowed to buy up to $50,000 of foreign currency a year. However, over $50 billion of cryptocurrency moved from China-based digital wallets to other parts of the world in 2020, according to Chainalysis.
It could be argued that the use of cryptocurrency in investments like futures validates its attractiveness to traders. Still, the underlying markets for derivatives are unregulated. Most cryptocurrency exchanges are not registered with the Securities and Exchange Commission (SEC). The un-traceability of cryptocurrencies has deeper implications.
In light of all these challenges, central bankers have begun to explore the broader potential of digital currency, and are considering creating their own digital money. The need to simplify fiscal and monetary policy makes central bank-issued digital currency great.
What is Central Bank Digital Currency (CBDC)?
A central bank digital currency (CBDC) is the virtual format of a fiat currency for a particular government. One major advantage of CBDCs is that they can simplify the implementation of monetary and fiscal policy. CBDCs would be truly digital forms of a national currency. A well-designed CBDC system could make it simple and easy to process cross-border remittances.
Importantly, CBDCs should not be confused with cryptocurrencies created by a distributed network using cryptographic tools. While cryptocurrencies are decentralized, CBDCs are centralized. CBDCs would allow central banks to know who holds what. CBDCs are also not stablecoins, which are a form of cryptocurrency that is pegged to another asset. A CBDC would be the fiat currency. CBDC payments could be processed instantly, adequately reducing the cost of transactions. CBDC aims to introduce the best of both worlds—the security of digital cryptocurrencies and convenience, and the regulated, reserve-backed money circulation of the traditional banking system.
Benefit of CBDCs for Developing Economies
A significant population of developing economies remain unbanked and underbanked. Setting up physical banks and network connections to bring this population into the financial ecosystem is costly. They probably don’t have access to credit and can’t do business on any significant scale. With CBDCs, these economies can leapfrog. CBDCs will boost financial inclusion. A regulated, government-backed digital currency simplifies banking. Owning a digital currency wallet would be better, cheaper, and simpler than setting up a traditional bank account.
Types of CBDCs
Wholesale CBDCs
The aim of wholesale CBDCs is to settle transactions between existing financial transactions. An example of wholesale CBDC transactions is interbank payments – the transfer of assets or money between two banks. CBDCs can also automate and expedite the process for cross-border transfers. See infrastructure model in Payment Innovations Government of Developing Economies Could Endorse.
Retail CBDCs
This involves the transfer of digital currency directly to consumers. Thus, they eliminate the risk that banking institutions might become illiquid.
Some examples are CBDCs are DCash, digital yauan, eNaira, CryptoRuble, Petro, etc
Some Concerns
Considering CBDCs benefits in cross-border transfers, should they be regulated across borders? Could a strong CBDC issued by a foreign country end up substituting the local currency of a weaker country?
Interestingly, experiments are ongoing and governments are coordinating efforts to create policies that enhance cross-border trade.
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