CBDC Part 1: The What and Why

Some time ago, I was asked by a reader to write about Central Bank Digital Currencies (CBDC) and the latest thinking around this new form of payment/asset. And while I am on record as being sceptical about Bitcoin and other first-generation cryptocurrencies, I am quite optimistic that CBDC will become a reality and an important and possibly the dominant form of digital currency in the future. There is a lot of research going on in this field with 86% of all central banks surveyed by the BIS last year stating that they are engaged in CBDC work. That is up from 65% three years earlier. And let’s not forget that in 2020, the central bank of the Bahamas became the first one to issue retail CBDC.

However, there are so many things going on in the world of CBDC that it is impossible for me to summarise everything in one post. So, I came up with a series of four posts to explain the four key issues around CBDC. Starting with this one, every Wednesday, I will write about CBDC. In this first part, I will describe what I mean by CBDC and what the reasons are for a central bank to consider creating them. Next week, I will write about the operational challenges of CBDC as a replacement for physical cash and in part three about the risks of CBDC. In the final part, I will focus on the relationship between CBDC and physical cash and monetary policy. If you haven’t planned any vacation this summer, this should be something fun to look forward to.

What are CBDC?

To start with, let’s be clear that when I use the term CBDC I will mostly talk about retail CBDC, that is digital currency issued by a central bank, accepted as legal tender in a country, and widely available in public. There are also wholesale CBDC which are designed for special purposes like trade finance that I will ignore in this series. And then there are synthetic CBDC, i.e. digital currencies backed by central bank assets that could be issued by commercial banks or money market funds, in theory. The problem with synthetic CBDC is that they are unlikely to become legal tender while cash and CBDC are. And if you ask me what it means to be legal tender, I will not go into a lengthy discussion of the legal requirements and simply state that for all practical purposes, legal tender is everything that you can pay your taxes with. It is this status as legal tender and the fact that it is issued by a central bank that differentiates CBDC from other forms of electronic money and makes it a form of cash.

Difference between CBDC and other forms of digital and physical currency

Source: Kiff et al. (2020)

Why CBDCs?

But if CBDC are just a form of digital cash, why do central banks want to issue that in the first place? There are several reasons why CBDC might be a good idea:

• Financial stability: At the moment, we witness a proliferation of digital currencies. While the supply of any one digital currency like Bitcoin may be limited, there is absolutely no limit to how many digital currencies are created and put into circulation. I once read a story about a guy who wanted to create a cryptocurrency for cosmetic and plastic surgery… You may say that this “democratisation” of finance and money is a good thing, but I can assure you, it is possibly the most dangerous side effect of the current cryptocurrency boom. There is a good reason why central bank currencies were invented in the first place. If you study medieval Europe when every principality issued its own currency, you will quickly learn that trade and economic activity were severely hampered by this plethora of currencies. At every transaction, people had to look up the exchange rate between one currency and another, and the exchange rate varied over time and as a function of distance from the nearest bank who would accept it as a form of payment. Think about a world in which you would have the US Dollar, British Pounds, Euros, Romanian Leus, Mongolian Tögrögs and dozens of other currencies all used at the same time at the same shop. Good luck figuring out how much something costs and if you have been ripped off by the vendor.

  In fact, even with one single currency in place, the cost of paying with cash is much larger than most people are aware of. Studies have shown a cost of using physical cash to private businesses (mostly the retail sector and banks) of 0.2% of GDP in Norway and Australia, 0.5% of GDP in Canada, and 0.6% in Belgium. Creating a plethora of digital currencies competing with each other would increase these costs significantly and increase the risk of currency crashes within an economy and reduced financial stability. Thus, if you can’t avoid the rise of digital currencies, you at least can make sure they are designed and managed in the safest and cheapest way possible.

• Payment efficiency: The significant costs of payments performed with physical cash and other forms of payment may be reduced with digital currencies if they are fast enough to handle the thousands, if not millions of transactions per second that are done in cash every day. First-generation digital currencies are unable to handle these transaction volumes (another reason, why I think they are merely a gimmick), but central bank digital currencies are designed from the get-go as an efficient means of payment and would provide central banks more control over a crucial part of our financial infrastructure and thus further reduce risks of financial instability.

• Payment safety: Contrary to what private companies may want you to believe, it is in the best interest of businesses to spend as little on IT security as possible. IT is a crucial balancing act. Spend too little on IT security and your data will be stolen and you may even go out of business. Spend too much and your profit margins will shrink and your share price declines. Thus, for a private company, the incentive is to always spend as little as necessary to avoid major disasters. A central bank does not have these profitability concerns and only has to maximise the trust in its digital currency. Thus the incentive of a central bank is to spend as much on IT security as possible in order not to endanger a loss of trust by the public in CBDC.

• Antitrust: With the use of digital currencies comes the ability to collect an enormous amount of data on how people use the currency. Private companies can use this data to sell it to advertisers and other businesses (see Google or Facebook). Furthermore, if a company is big enough, it can effectively prevent any competition from rising due to its market power (see here for a discussion). 

• Financial inclusion: This is arguably not a big issue in developed markets as can be seen in the chart below, but in emerging markets, there are often millions of unbanked citizens and people who are unable to even get access to a bank. The success of electronic payment systems like PayTM in India shows that with the help of digital currencies, millions of people could get easy access to money.

• Monetary policy implementation: Finally, many central banks think about CBDC as a means to enhance the implementation and effectiveness of monetary policy. This is such a wide-ranging and (in developed markets) important topic, that part 4 of this series will entirely be dedicated to this topic.

The reasons for CBDC

Source: BIS