Payment modes are ever-evolving. It has changed dramatically in recent years that subject experts believe the evolution is much beyond the control of existing infrastructure. Let’s look at the payment switches that have globally taken place. In Africa, the unbanked have been enabled to make payments using their mobile phones. In Asia, there has been a move to reduce the number of cash payments by reducing large denomination notes and removing coins. In Europe and U.S., online transactions and card payments have curtailed the use of cash significantly. In South America, both Argentina and Venezuela have implied Bitcoin for money transfer as an alternative to the hyperinflation of their fiat currency. So many changes from time to time…….
This article tries to comprehend what Central Bank Digital Currencies (CBDC) are all about, their opportunities and obstacles, and most importantly why it demands our attention.
So before we head, it’s quite important that we understand what is money as CBDC is all about money.
Basically, there are two forms of traditional money when it comes to a developed country.
- Fiat money, the legal tender in the form of notes and coins, which are accepted by countrymen as a means of settling a debt.
- Commercial bank money generated through fractional reserve banking.
Fractional Reserve Banking ???
A banking practice where banks hold only a fraction of the customer’ money as reserves. The rest of the deposits are utilized for making loans, thereby, essentially creating new money. Commercial banks hold these balances at the Central Bank to facilitate electronic settlement in Real Time Gross Settlement (RTGS) systems. This is how it works.
Well… you might be thinking why spilling the unnecessary beans when we are here to discuss Central Bank Digital Currencies. The idea is to tell that this Commercial bank money we saw is nothing else but electronic Central Bank money.
What is the big deal huh…..??
Here we go…..
According to the Bank of England, CBDCs are a form of electronic Central Bank money that:
- Can be broadly accessed than reserves.
- Equips greater functionality than cash for retail transactions.
- Has separate operational structure to other forms of Central Bank money.
- Potential to serve different core purposes.
- Gives great interest at a rate that would be different from the rate on reserves.
Alright! But, what does that mean?
In simple terms, Central Bank Digital Currency is nothing else but a government-backed cryptocurrency. Cryptocurrency is known for both its risks and opportunities. The risks derivates from cryptocurrencies not holding any inherent value, their volatility in the price and most importantly, not being regulated by any.
The Central Bank Digital Currency via bringing cryptocurrencies come under the geometry of a Central Bank or the government of a country, promises to come above these limitations. It is trying to generate fit-for-purpose money that can be used for social benefits and other targeted payments in a country. CBDCs aims to be instrumental in supporting the public policy objectives of the government by providing a safe and resilient means of payments.
For that, you need to know the difference between Central Bank Digital Currencies in contrast with cryptocurrencies.
The fundamental distinction is as follows:
CBDCs are legal tender under the jurisdiction of its issuing Central Bank.
CBDCs are recognized as a valid form of payment in the relevant jurisdiction, while cryptocurrencies are accepted only on a discretionary basis.
Payments made using a CBDC is legal in contrast with cryptocurrencies.
Isn’t it spellbinding??
Now let’s see why everyone is looking forward to CBDC. Why there is great fanfare for it.
>> Public Access To Legal Tender: A CBDC would guarantee that the general public has always access to legal tender. For example, if for some reason cash were no longer widely accessible, the public can access cryptocurrencies then. Under CBDC, both cash and cryptocurrencies are legally recognized forms of payment and represent a claim on the Central Bank or government.
>> A transition towards a less-cash society: Banknotes and coins are costly to produce, distribute, handle, and replace. Currently handling costs related to cash are cross-subsidised by commercial bank’s revenues.CBDC via tabling digital exchanges could generate a less-cash society. However, it doesn’t mean there will be a ban on banknotes and coins in presence of CBDC. But with an increase in favour of digital transactions, there will be a definite cutback in the withdrawal of cash from ATMs.
>> Improve the efficiency of payment systems: CBDCs could give further impetus to innovations that promote the efficiency of payment systems. For instance, in the retail space, CDBC could focus on how a digital currency could boost the payment systems at POS. Also, CBDC at interbank payments; for example, CBDC could facilitate faster settlement and extended settlement hours.
>> Improve cross-border payments efficiency: A joint study published by the Central Banks of Canada, the U.K. and Singapore focused on the potential for a CBDC to improve counterparty credit risk for cross-border interbank payments and settlements.
The current model for cross-border payments relies upon Central Banks operating the RTGS infrastructure which has certain downsides like time lags for payments, during which counterparties are exposed to credit and settlement risk. On the other hand, a jurisdiction-specific CBDC can be exchanged across borders and could significantly improve counterparty credit and payment and settlement risks.
This is the main reason why there is a race happening right now, between countries and organizations to get to the market first and become a globally accepted CBDC that can be exchanged across borders.
Well, some challenges need to be taken care of with CBDCs to work. Let’s have a look at them as well.
Some of these challenges include:
- Bank runs to CBDC
A bank run occurs when many clients withdraw their money from a bank as they believe that the financial institution is, or might become, insolvent.
2. Role of Commercial Banks
The transfer of deposits from commercial banks to CBDC would have implications for bank funding and liquidity if this movement is not offset by other agents moving from CBDC to deposits.
3. Financial Exclusion
A less-cash economy can either increase or decrease financial exclusion. There is a risk that de-cashing could increase financial exclusion if the interests of vulnerable groups such as the aged, disabled and poor are overlooked.
To conclude we could say that, with a changing payments landscape, Central Banks have recognized that they too need to develop and incorporate new technology. If a private e-money issuer was to control the majority of payments in a country (Libra now renamed as Diem), the Central Bank would lose its ability to implement monetary policy.
At the same time, there are challenges that a Central Bank needs to overcome to gain the upper hand in this race. Introducing CBDC would have a seismic effect on the banking system. It may provide citizens with an alternative and safer means of storing money, thereby reducing the risks on deposits held with commercial banks.