Central Bank Digital Currency is one of the most common mentions in the world of finance presently. Before diving into their definition, it is important to reflect on the context underlying the rise of Central Bank Digital Currencies. The financial crisis of 2008 introduced massive changes in the financial landscape alongside the tenets of the trust of people in the banking system. The emergence of cryptocurrency provided proof of the same with the launch of Bitcoin at the beginning of 2009.
Beginning of Central Bank Digital Currencies
Cryptocurrency provided an alternative method for storing money and conducing payments without depending on conventional banking systems and government controls. Switch to 10 years later; cryptocurrencies are now serving prominent challenges to the conventional precedents of the financial system. Central banks presently face a massive threat from cryptocurrencies, especially towards their central role in monetary policy. Therefore, many developed banks are looking into the possibilities of introducing a Central Bank Digital Currency.
Many central banks have started to evaluate the potential of introducing their own digital currencies. The emergence of digital currencies, success of new technologies in financial sector, and reducing use of cash have prompted the notion of introducing digital currencies. The introduction of CBDC will definitely have prominent implications for the role of central banks. In addition, it will also have a formidable influence on financial intermediaries.
Many central banks already provide access to personalized digital account-based central bank money to banks and a select few institutions. On the other hand, cash is available, albeit presenting declines in safety of CB money with the decline in use of cash. Furthermore, the complexity of the existing financial system reflects the need for careful considerations towards any potential changes.
Defining Central Bank Digital Currency
So, what is a Central Bank Digital Currency? As a matter of fact, one can encounter multiple definitions of Central Bank Digital Currencies, as they refer to multiple concepts. Basically, Central Bank Digital Currency is an electronic form of central bank money. The Bank of England has described certain traits of Central Bank Digital Currency as follows,
- Broader accessibility in comparison to reserves
- Potential for better functionality in case of retail transactions, when compared to cash
- Capability for bearing interest, with realistic assumptions of paying a rate that is different from reserve rates
- Distinct operational structure in comparison to other types of central bank money, thereby allowing flexibility for serving different core objectives
Why Are CBDCs Needed?
Now, it is important to reflect on the necessity of issuing Central Bank Digital Currency. Here are some of the notable reasons for issuing a CBDC.
- CBDCs ensure public access to legal tender if cash is no longer available commonly for some reason. In the form of legal tender, CBDCs would have legal recognition as a form of payment alongside representing a claim on the central bank or government.
- Central Bank Digital Currency can also enhance the safety and efficiency of retail as well as large-value payment systems. In addition, CBDCs can also ensure promising advantages for interbank and wholesale payments.
- CBDCs can also address the competition from private e-money providers with their wider accessibility.
- Most important of all, CBDCs can also speed up the shift towards a cashless society. In addition, a digital currency with credibility of a central bank could address the regulatory concerns efficiently.
- Finally, wholesale Central Bank Digital Currencies can resolve setbacks with cross-border payments. The benefits of wholesale CBDCs offer round-the-clock availability, reduced counterparty credit risk for parties in the transaction, and anonymity.
Features of Central Bank Digital Currency Design
With the potentially revolutionary design and a wide assortment of benefits, it is reasonable to wonder about the possible designs. Many factors have considerable influence on design choices for CBDCs, such as accessibility to interest-bearing characteristics and degree of anonymity. However, it is important for CBDC to share equal value like other forms of government-backed money, thereby showcasing full faith and credit of the issuing government. Therefore, a central bank should work as the central counterparty for all payments involving CBDCs. In order to achieve the same, CBDCs should have the following traits,
- Central bank should offer a direct guarantee of at-par conversion of CBDCs into cash or reserves
- The digital currency must be available to public without any restrictions
- The digital currency must have recognized as legal tender in concerned country
- Central bank could have the option of paying interest on CBDC liabilities that is similar to interest rate structure for other government liabilities as well as the wider monetary policy and financial stability objectives of the central bank
- The digital currency can assume various forms on the basis of new crypto technology or the existing payment infrastructure technology
Challenges for Central Bank Digital Currency
Although a Central Bank Digital Currency definitely seems to present considerable opportunities, it also comes with prominent challenges such as,
- Influence on interest rates
- Financial stability risks
- Reducing the intermediary role of banks
- Helicopter money
- Reduction in effective lower bound
With so much hoopla around Central Bank Digital Currency, blockchain is definitely gaining more attention. The distributed ledger technology can support the development of CBDCs while catering to its fundamental objectives. Furthermore, blockchain has the potential for transforming international trade by introducing various benefits. So, it is the go-to technology for establishing the foundations of Central Bank Digital Currency.
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