What are central bank digital currencies—and why are central banks creating them?

TO RETAIN CONTROL of their monetary systems, which are increasingly being threatened by the rise of online payments and the gradual demise of cash, global central banks are now coming to the view that they must replace cash with a digital alternative, that is, issue so-called central-bank digital currencies (CBDCs). One survey estimates that some 86% of central banks are engaging in some sort of CBDC work. European central bankers expect to launch a digital euro by 2025. The Bahamas issued its nationwide CBDC known as the “sand dollar” in 2020. China is likely to officially launch its version of CBDC this year. America’s Fed is studying whether to create a digital dollar. Nepal will also conduct a “feasibility study” of a CBDC, according to a recent NRB report.

A CBDC is a digital form of fiat currency that is issued by central banks. Money issued by central banks is a liability of them; deposits with commercial banks are their liability. Though digital versions of cash already exist, such as money held in bank accounts or payment apps, CBDC differs from existing digital money. Money held as a CBDC is like a deposit with the central bank, and therefore a liability of central banks rather than a liability of a private financial institution. 

Until recently the idea of central banks issuing digital money seemed impractical, but that view has changed now, reckons the Bank for International Settlements, a club of central banks. There are several reasons for this shift in thinking. Covid-19 has also accelerated the transition of people using online payments rather than paper money.

Though a small number of countries were already looking into CBDC (for instance, Riksbank, the central bank of Sweden, began e-krona project in 2017. Sweden’s cash transactions comprised only 13% of all retail transactions in 2018.), the primary reason that prompted this radical shift was Diem (formerly Libra). 

With central banks’ presence in digital payments, chances of financial instability arising from failures of private payment systems will also be reduced

In 2019 Meta, formerly Facebook, proposed its first digital currency (which would be pegged to fiat currency) and a cross-border payments system known as Diem. This quickly generated backlash from government regulators across the world, killing the project. They thought Diem would undermine monetary sovereignty and financial stability if Meta’s more than 2 billion users suddenly adopted a new currency as a medium of exchange, over which central banks would have no control.

If everyday transactions depend on private firms rather than on central banks, it will chip away at central banks authority—which guarantee that the general public can use cash to buy things. And if people switched to payment platforms offered by tech giants, such as Facebook or Apple, and once popular enough, such firms could exploit this to their interests, say, stopping people from shopping elsewhere but at stores they want them to buy things. Cryptocurrencies like bitcoin and stable coins (which derive their value from fiat money) also pose threats to central bank money. In fact, CBDC was inspired by bitcoin and similar other blockchain-based cryptocurrencies.

At present, digital payments systems, which are flourishing, rely on private companies, such as credit-card companies, banks and big tech firms. By providing a new method of payments via CBDC as cash falls out of use, central banks could make the payments industry more competitive, as well as diversify payment options. With central banks’ presence in digital payments, chances of financial instability arising from failures of private payment systems will also be reduced.

Monetary authorities also recognize the weaknesses of online payments systems: they could suffer from hacking or power outages. To avoid this, central banks hope to offer a safe alternative. Central bankers also want to tackle banks’ high costs of payment systems and exorbitant fees of cross-border remittance through a cheaper, efficient system. In poorer nations, with CBDCs, authorities think the financial system will become more inclusive, bringing unbanked citizens into the system. This will in turn boost economic development.

Central banks also see many benefits to CBDCs. They will have an easier time tracking digital money, unlike cash, which is hard. CBDCs are less prone to counterfeiting. They enable micro-transactions. CBDC may allow for automatic routing of tax payments, making tax evasion hard. Central banks could make direct transfer of digital money to residents of a region hit by a natural disaster.

Another reason for this rush is as the global economy becomes increasingly digitised, cash is falling out of use. The future digital economy will need a fresh payments system, and the current system may fail to deliver this. This is where CBDCs fit in; they could be programmed to meet future needs. 

Yet in an attempt to solve old problems, CBDC will create new ones. One of them is that CBDC implementation may cause banking system disintermediation. CBDC will allow people to park their money at the central bank, and if most people do so, then commercial banks will be deprived of deposits. Since banks depend on deposits to make loans, provision of credit will be lowered. Its displacement will mostly hurt poorer nations, like Nepal, which still rely on them for credit. 

Where things get really interesting is CBDC could help usher in new possibilities for monetary policy. At the moment, interest rates cannot be negative (negative rates aim to boost economic activity by encouraging spending), because savers can switch to cash, which is equivalent to an interest rate of zero. From a theoretical perspective, CBDC could allow for negative rates, since it can be programmed. But, for this to happen, countries would have to eliminate cash entirely, because people could hold on to cash over digital fiat.

For now, central banks around the world will continue issuing paper money and coins. But central-bank digital currencies are well into the future and could upend the existing financial system.