Central bank digital currencies (CBDCs) could be necessary to ensure innovation and competition in digital economies, the Bank of Canada said in a research paper published on Tuesday.
As the economy becomes more and more digital, several issues have emerged that could be addressed through CBDCs. These include problems linked to competition in sectors like payment options, a resulting lack of innovation and development or exploration of new technologies, and an increased risk of market power abuse by large financial bodies as cash becomes less relevant in society.
Introducing a CBDC could address these issues in a more effective way than regulations and policies would, according to the Bank of Canada.
“In general, a CBDC as a basic outside option for payments could discipline the market,” the paper said. “Further, as a competition tool, a CBDC might be simpler than developing new competition policies in the complex and changing environment of big tech, and simpler than attempting enforcement via lengthy and uncertain legal battles,” it continued.
CBDCs could also make the use and further development of technologies like smart contracts and programmable money easier as their framework could be made available for public use and therefore create common ground for innovation.
Finally, CBDCs could also protect and even boost welfare levels, according to the Bank of Canada. The potential emergence of new markets and applications could increase welfare, while the added protection of consumers against market power abuses would prevent welfare from declining, the report said.
The Bank of Canada has not yet decided whether to pursue the development of a CBDC, and is currently in the process of researching and assessing its options.
The US is at a similar point in the process of potentially creating a digital dollar. Earlier this year, Federal Reserve Chair Jerome Powell said the central bank was still exploring the potential of a CBDC and would publish a report this summer. Last week, the European Central Bank also said it was launching a two-year exploration into a possible digital euro.
Cryptocurrencies and stablecoins have boomed in 2021. And central banks around the world are increasingly keen on their own digital currencies. But how do they all work and what are they used for?
Cryptocurrencies are basically digital currencies that aren’t controlled or issued by a centralized authority, such as commercial or central banks.
These coins are sent back and forth on enormous peer-to-peer networks – essentially groups of computers that share data.
The innovation of cryptocurrencies is that the “ledger” that keeps track of transactions – known as the blockchain – is overseen and verified by network users known as “miners.” Miners collectively do the work of a central authority, checking people aren’t trying to spend coins twice, and earning newly created bitcoin in return.
“What we aim to do with the blockchain is to make this ‘trustless’ so that nobody has overall control of it,” says Ben Edgington, a software developer for the ethereum network. “It’s fully democratic [and] it’s fully accessible.”
Bitcoiners say it’s ‘digital gold’
When bitcoin was launched by the anonymous person or group Satoshi Nakamoto in 2008, many thought it could be used for payments. In reality, it’s way too volatile.
Now, many bitcoiners say its scarcity – only 21 million coins can be mined – means it will hold its value and protect investors against inflation. Others say it’s purely speculative.
Other cryptocurrencies have different uses. The ethereum network, for example, can be used to build applications like collectible “non-fungible tokens.“
Cryptocurrencies are highly risky
In bitcoin and other networks that follow its model, miners verify transactions by using large amounts of computing power to solve complex math problems. Bitcoin’s mining system uses as much electricity annually as medium-sized countries. Other cryptocurrencies are less energy intensive.
Cryptocurrencies are largely unregulated and are some of the riskiest investments out there. Bitcoin has plunged around 50% since its April record high of close to $65,000.
Wild volatility has been a huge deterrent for some investors as it can make crypto harder to use. That’s where stablecoins come in. Stablecoins maintain a “stable” value with a peg to other assets, like the dollar.
As with the rest of the cryptocurrency world, a lack of regulation means investors have almost no protection if their stablecoin suddenly collapses.
Central bank digital currencies
Countries are trying to find ways to make it easier to spend and send money – and keep control of payment systems that are increasingly private (think PayPal or Visa). A digital currency issued by central banks directly to consumers could be the answer.
Right now, private banks and payment companies are the most important players in the everyday use of money. But a central bank digital currency (or CBDC) would be a digital version of banknotes and coins, letting people hold and make payments in central bank money.
CBDCs could speed up transactions for individuals and big institutions, Chris Giancarlo, founder of non-profit Digital Dollar Project, told Insider. The DDP plans to test CBDCs in real-world situations.
“If you can send a photograph to Japan in a second, why can’t you send money in a second?” he said.
Central bankers also think CBDCs can make the financial system safer. Although unlikely, even a big global payment system could feasibly collapse.
Some bankers are concerned
One concern is privacy. Some governments may design CBDCs so transactions are anonymized, like cash, but others won’t. Privacy questions have arisen over China’s trial digital yuan.
“With a CBDC, the government would have direct access to all your spending patterns,” Bobby Ong, co-founder of data firm CoinGecko, says.
Some bankers are worried CBDCs could remove them from key parts of the financial system. CBDCs could reduce the demand for commercial bank accounts and cut banks out of the business of verifying transactions, although central banks are working on the details.
Japan’s plans for a digital yen could start to come together next year and the design of a potential central bank digital currency will be clearer then, the head of the ruling party’s digital currency initiative, Hideki Murai, told Reuters in an interview published on Monday.
“By around the end of next year, we’ll have a clearer view of what Japan’s CBDC would look like,” he said, adding this would not necessarily lead to a clear-cut decision on whether to roll out a central bank digital currency (CBDC). The Bank of Japan launched its exploration into a CBDC earlier this year and is currently researching and assessing the concept.
Murai also said having a better picture of the digital yen’s design would provide insight into how it might impact the existing financial system and institutions in Japan, which is currently undergoing significant shifts.
Private businesses have taken on responsibilities that previously fell to commercial banks, such as online settlement means, which have put the two industry groups at odds with one another. A digital yen could reverse the shift and commercial banks could benefit from this, Murai said.
“CBDC has the potential to completely reshape changes occurring in Japan’s financial industry.” he commented.
The Bank of Japan has previously said a CBDC would not significantly impact private businesses.
Murai also said the Bank of Japan would have to ensure the digital yen is compatible with CBDCs from other countries, to ensure it stays competitive against the Chinese digital yuan.
China is handing out free “red packets” of its digital yuan, worth a total of $6.2 million, in a Beijing lottery designed to test the central bank digital currency, according to reports.
Residents in China’s capital city can apply to win one of the 200,000 packets, which each contain 200 digital yuan ($31.33), Reuters reported. The digital cash, delivered via apps, can be spent at selected local retailers. The e-wallet is inspired by the Chinese tradition of giving red envelopes of money at milestone events or celebrations.
The lottery is part of the People’s Bank of China’s ongoing CBDC trials, in which the digital yuan is being tested and evaluated locally before being rolled out across the country. China is the first major economy to progress its CBDC initiative to the trial stage, with the US and the EU central banks still in the research stages of their respective digital currencies.
China is currently pursuing a two-tier approach to distributing its digital currency, in which the central bank disseminates its CBDC to the population via commercial banks.
To enter the Beijing lottery, people must apply through one of two banking apps required to participate in the trial. It will run until June 6, CNBC reported, and winners will be notified soon after and be able to spend the digital cash until June 20.
In some ways, central bankers are like the “bitcoin bros” who have sent cryptocurrencies soaring in 2021, although they might not like to think it.
While crypto fans have taken to Twitter to shout about their gains, there’s been a quieter – but no less important – surge in interest in digital currencies in the hushed offices of the world’s central banks.
The Bank of England is weighing up launching a “Britcoin”; China is racing ahead with trials of its digital yuan; and European Central Bankers are giving speech after speech on central bank digital currencies, or CBDCs. The Federal Reserve is taking things more slowly but has enlisted MIT researchers to explore the issue.
Huw van Steenis was formerly a top advisor to the governor of the Bank of England and is now senior advisor to the CEO of Swiss banking giant UBS.
A well-known figure in the City of London, he wrote the Bank of England’s 2019 future of finance report, which looked hard at the outlook for payments and the pros and cons of central bank digital currencies.
Van Steenis is clear-eyed about CBDCs, arguing that they sometimes seem like “a solution in search of a problem.” But he told Insider they are definitely about central banks keeping control of money.
A CBDC would be a digital version of banknotes and coins, letting people hold and make payments in central bank money. At the moment, the digital money people use every day is created by commercial banks and held in accounts or on pre-paid cards.
Central bankers are watching cryptocurrencies closely
Some analysts have argued that central banks have been spurred to action by the crypto boom, and fears that bitcoin could become a global payments system. Bank of America researchers posited in March that CBDCs could be “kryptonite for crypto.”
Van Steenis thinks differently. “Approximately 95% of the money in most Western markets is not actually central bank money, but it’s money held in the bank in deposits in electronic format,” he says. “The world is already one in which [central banks] play a pivotal role, but they don’t dominate.”
The real issue is ensuring the stability of the financial system, van Steenis says, and that means keeping an eye on cryptocurrencies.
Yet the crypto world is still tiny relative to the amount of money in bank deposits, he says. “So I don’t think they’re running scared on bitcoin. But what they want to know is, is there an innovation they need to adapt and borrow from.”
The key concerns are dwindling cash use and tech-firm dominance
A major worry for central bankers is that, as the use of cash dwindles, private payment systems are becoming increasingly crucial and could shake the global financial system if they fail.
“If you think about the pandemic, it’s probably fast-forwarded the shift away from cash to digital by about three to five years,” van Steenis says. “No central banker ever wants to feel they might lose control of their currency.”
A CBDC would ensure everyone has access to a risk-free payment system, proponents argue, and would make transactions safer and more efficient. Just like going directly to the airline for your plane tickets online is faster and easier than going to see a travel agent.
Many central banks around the world are also asking themselves whether they want huge US technology companies like Visa, Mastercard and PayPal to dominate their national payments systems, van Steenis says.
Another common argument is that Western central banks are racing to keep up with China’s advanced CBDC project, which they say could threaten the dollar’s dominance.
But van Steenis is skeptical. “I just don’t see the geopolitical angle is what’s driving it,” he says. “If you ask the Swedes what’s driving the e-krona, it’s much more about a reduction in cash and inclusion and their responsibility to provide to society, than it is because they’re trying to keep up with friends around the world.”
CBDCs could eat the banking sector’s lunch
Whatever’s pushing it forward, the creation of central bank digital currencies looks set to throw up a number of problems to accompany the benefits.
One concern for bankers is that the technology might eat the financial sector’s lunch. The technical term is “disintermediation” – the idea that giving people access to CBDCs could stop them from needing banks at all.
Van Steenis, who knows Wall Street and the City well, says CBDCs must be created with a two-tier system in which people continue to hold accounts at banks and payment firms.
Yet, he says there are other risks. “What happens when we think about money being moved from country A to country B? Do you then allow your monetary base to be sent to a foreign bank? In which case, how do you regulate them? Do you lose control of your monetary policy?”
Crypto community can innovate while central banks are cautious
These sorts of issues mean central banks and the governments that ultimately control them will be very cautious about building CBDCs, says van Steenis. Countries will need to debate their pros and cons in a process that might take years, he added.
Fed Chair Jerome Powell said in March that the central bank would “move with great care and transparency” and wouldn’t proceed without support from Congress.
That opens the door for others to innovate, van Steenis says, not least those in the crypto world who are developing stablecoins and attractive financial networks.
He says: “Actually, I think the crypto community does have a real window of opportunity to help define a future whilst the central banks are cautiously, but studiously, trying to progress what they do.”