Why do central banks attach so much importance to digital currencies?

Money is heading for its biggest transformation in centuries. Modern technology, and even the Covid-19 pandemic, are pushing consumers to opt for cashless spending, and with alternative concepts like Bitcoin gaining popularity, central banks are moving quickly to ensure they don’t fall behind. Central banks have pledged to build a payment system that is safer, more resilient and cheaper than private payment systems.

Central banks in the Bahamas, Eastern Caribbean Currency Union (ECCU) and Nigeria have become pioneers in central bank digital currencies (CBDCs) , while China, the euro zone and others are experimenting in this area. Meanwhile, the Federal Reserve and Bank of England have been far more cautious in this regard.

  • What would a central bank digital currency look like?

On the surface, at least, a CBDC is not much different from electronic money in a bank account and using a bank card, smartphone or app to send bank funds around the world. The key difference is that this central bank-provided currency, or CBDC, is a risk-free asset like cash . For example, a $1 paper bill is always worth $1; while $1 in a commercial bank account, although theoretically convertible to paper currency as needed, is subject to the bank’s solvency and liquidity risks. This means that consumers may not always be able to use it, and may even lose it in rare cases. CBDC, like paper money and coins, will be a direct liability of the central bank .

  • How will CBDC change payments?

CBDCs can take many forms, but one of their goals is to speed up payments . In the current system, commercial banks use the central bank’s currency to settle net payments to each other, but for technical and operational reasons, this process is often not instantaneous, so there is credit risk during settlement.

  • What does CBDC have to do with cryptocurrencies?

Apart from the underlying technical design, the two have little to do with each other. CBDCs are conceptually different from cryptocurrencies such as Bitcoin, which are too volatile to be used as a store of value and not widely accepted to be used for payments. Bitcoin is more of a speculative asset. One of the main demands of Bitcoin proponents is its decentralization, which means it has no central control and transactions are recorded on a public distributed ledger. CBDCs are controlled by central banks.

While some countries are experimenting with the full or partial use of distributed ledger technology (i.e. blockchain) for CBDC, that does not mean they will eventually use the technology. The European Central Bank, for example, has raised concerns about the environmental footprint of running a parallel blockchain infrastructure , and has launched another system in 2018 that may be more suitable.

  • What are the different types of CBDC?

There are two main tracks: wholesale and retail . In retail projects, CBDC will be issued through a central bank account for the general public or a commercial bank account in cooperation with the central bank . A CBDC-based system has no credit risk: funds are not on the balance sheet of intermediaries, instead, transactions are settled directly and instantly on the balance sheet of the central bank . The retail approach may be especially helpful for consumers who do not have access to traditional banking services. However, some countries, such as Denmark, have ruled out the possibility, as it could leave banks vulnerable to depositors fleeing to central bank accounts. Other central banks have said they will cap their CBDC reserves to guard against such financial stability risks. In a wholesale CBDC project, the digital currency would be limited to banks and other institutions to make payment flows within the existing financial system faster and cheaper, while being less disruptive to the overall structure of the industry .

  • Which countries are experimenting with CBDC?

According to the International Monetary Fund (IMF), around 100 countries are in various stages of CBDC exploration (see chart below). India has shocked the payments world by announcing that the central bank will issue a digital rupee as early as the next financial year. China, meanwhile, rolled out a digital yuan to athletes and spectators ahead of the 2022 Beijing Winter Olympics to test its appeal to foreigners. Some islands in the eastern Caribbean that share a central bank have launched their own digital currency, DCash: Last year, a volcanic eruption in St. Vincent and the Grenadines forced thousands to evacuate their homes, an action seen as an important part of the rebuilding effort.

Why do central banks attach so much importance to digital currencies?

In the above figure, the yellow part represents countries that have issued CBDC; the pink part represents countries that plan to issue CBDC; the light blue part represents countries that are actively exploring the feasibility of CBDC; the dark blue part represents countries that are conducting CBDC research. Source: Bloomberg

  • Which countries are not trying?

The Federal Reserve has been slow to embrace digital currencies, but recently it took a critical step with the publication of a 35-page discussion paper outlining a range of potential CBDC benefits. The Fed, however, has not made a firm conclusion on whether it would be prudent to issue such a currency, and in any case said it would not do so without White House and Congressional support. The Bank of Canada has not found an urgent reason to use a digital currency, but will continue to build the technical capacity to issue a CBDC and monitor developments that could increase its urgency.

  • What are the advantages of CBDC?

If central banks can overcome the technical difficulties, digital currencies could enable faster and cheaper money transfers within economies and across borders . CBDCs could also improve access to fiat currency for countries with reduced cash supplies. In areas where private financial institutions find it unprofitable to operate, a CBDC could improve financial inclusion and build resilience in areas prone to natural disasters, according to a report by the International Monetary Fund . Christine Lagarde, president of the European Central Bank, believes a digital euro could become particularly important if protectionist policies disrupt Europe’s main external payment services. For China, a digital currency offers a possible way to keep up with and control a rapidly digitizing economy. On the other hand, it could also provide the government with an additional surveillance tool.

  • What are the disadvantages?

If a CBDC is issued the wrong way, the risks are enormous, which is why most central bankers have so far been very cautious. Commercial banks are an important source of funds for the real economy, so the central bank faces two risks when issuing CBDC: one is to cut off the business of commercial banks, and the other is to assume the direct risks and complexity of public banking business, depending on the model for CBDC. For central banks, problems managing a new business can undermine the public trust that underpins their occasionally unpopular moves, such as interest rate hikes.

Furthermore, some researchers are skeptical that current blockchain technology can support a large number of simultaneous transactions . A People’s Bank of China official said its research showed that the capacity of the bitcoin blockchain was far below the peak demand of 92,771 transactions per second at China’s Singles Day shopping extravaganza in 2018. Other research has found that Ethereum handles an average of 15 transactions per second, while Visa’s network can handle 24,000.

Posted by:CoinYuppie,Reprinted with attribution to:https://coinyuppie.com/why-do-central-banks-attach-so-much-importance-to-digital-currencies/
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