David Creighton, journalist

Covid-19 has undoubtedly turbo-charged the switch to cashless transactions, and the rise of cryptocurrencies has been one of the most visible aspects of this trend. Many believe cryptocurrencies could fundamentally alter the long relationship between issuers of money, central banks and households.

But now the spotlight is on the emergence of central bank digital currencies (CBDCs) and their pivotal role in this dynamic future.

A CBDC is different from virtual currency and cryptocurrency, which are not issued by a state and lack the legal tender status granted by government.

‘It seems ironic that while many traditional banks have objected to cryptocurrencies, the real threat to their existence comes from CBDCs’

A CBDC is, in fact, more akin to hard cash – paper or coins – in that it is a high-security digital instrument. Like paper bank notes, it is a means of payment, a unit of account and a store of value. And, like paper currency, each unit is uniquely identifiable to prevent counterfeits.

Easy transfer

The International Monetary Fund defines a CBDC as ‘a digital version of cash that can be stored and transferred using an internet or mobile application'. This sovereign currency, pegged to the fiat equivalent and backed by reserves, would be issued by a central bank or central monetary authority.

A CBDC can easily be transferred peer-to-peer and implemented directly through a central bank setting up accounts for all citizens, providing payment cards and other services.

Another option for the bank would be to generate and hold digital currency, but payments would be arranged through ‘digital cash accounts’ run by other commercial organisations.

Growing acceptance

Public acceptance of CBDCs will be crucial if the concept is to become widely accepted, and there are indications that this acceptance is growing. In a recent survey conducted in 10 countries by European deep-tech company Guardtime, almost two-thirds of respondents indicated that they would be ‘likely’ to make use of CBDCs upon their launch.

‘People worldwide have embraced rapid digitisation during the coronavirus crisis and that appears to be reflected in the relative enthusiasm for the launch of digital currencies from central banks,’ notes Luukas Ilves, Guardtime’s head of strategy.

In describing the macroeconomic impact of CBDCs, Michael Taylor, ACCA’s economist, notes that direct transfers to households, achieved quickly with little administrative cost, would be one of the advantages of such a currency. ‘Some countries, such as the US, adopted this during the Covid-19 crisis, but the process was rather slow and conducted through the tax system; a CBDC would give the authorities an additional effective tool in stimulating an economy in recession,’ he says.

‘In a truly cashless society, central banks would also be able to introduce negative interest rates without limit. At present, adoption of negative interest rates on retail deposits would merely result in a flight to physical cash.’

Speed and security

On a broader, practical level, the CBDC offers far greater technological and physical security because of the risk of theft when carrying cash. As David Walker FCCA, managing partner at accountancy firm Moore Cayman, explains: ‘The use of blockchain technology means that the counterfeiting risk is much less likely because each digital currency unit is assigned a digital serial number. It is also trackable in real-time.

'In contrast, it may be unfeasible to track banknote serial numbers. A central bank can thus monitor digital currency, which can be audited through an almost immutable decentralised ledger or more likely a permissioned ledger.’

Boost efficiency

CBDCs could also boost efficiency and therefore the rate at which money is exchanged. Walker believes stablecoins, backed by a reserve asset, already show what is possible. ‘They are private or decentralised offerings of collateralised tokens pegged one to one to an existing fiat currency and are truly excelling at increasing the rate of monetary transactions,’ he says.

‘In a time of Covid-19, where central banks have been playing with experimental economics such as negative interest rates to increase the velocity of money, this feature of digital currency looks very attractive.’

Crossborder benefits

Walker adds that, in crossborder transactions, payments made using a CBDC could be made directly, without the need for the Swift wire payment system or the US dollar as a reserve currency, 'cutting out the need for an intermediary; payment transfer times could be reduced to near real-time, too’.

To date, five Caribbean nations have introduced CBDCs. And according to thinktank the Atlantic Council, 81 countries – representing over 90% of global GDP – are considering introducing a CBDC.

‘Considering that some countries, like Hong Kong and Switzerland, peg their currencies to the fiat currency of other countries, they have in concept already tokenised fiat currency,' Walker explains. 'It’s easy to see the incentive for such countries to make these tokens electronic with digital identifiers rather than physical ones.’

Such developments could challenge existing financial institutions. ‘It seems ironic that while many traditional banks have objected to cryptocurrencies, the real threat to their existence comes from CBDCs,’ notes Walker. ‘If central banks allow direct customer deposits, this will diminish the need for traditional bank services, which may become limited to borrowing, lending and foreign exchange transactions, plus perhaps slightly higher interest yielding accounts.

Economies of scale

The number of traditional banks will probably decline as economies of scale become vital to compete in the digital payment market, Walker suggests.

However, a move to CBDCs will inevitably raise questions of security. As Burkhard Balz, member of the executive board of the German Bundesbank, warned during a speech in July 2021: ‘If a solution for paying offline with the digital euro – that is, without an internet connection – was offered, it would have to be set up in a safe and secure way.’