Central bank digital currencies (CBDCs) could improve payment systems, promote financial inclusion, protect against financial fraud and accelerate the transition to a cashless society. But there are potential downsides in terms of consumer privacy and threats to cyber-security.
The use of cash is declining across the world, falling by 35% between 2019 and 2020, according to a recent UK Finance report. In the UK, cash accounted for just a fifth (17%) of all payments in 2020, down from more than a half (56%) a decade earlier.
With over a quarter of all payments in the UK made via contactless methods, consumers are looking for convenient ways to spend their money in a digital world. The banking sector as a whole is starting to increase its digitalisation with the emergence of digital banks such as Monzo, Revolut and Starling in the UK, and the growth of vendors such as Alibaba’s Ant Financial and Tencent’s WeBank in China’s financial sector.
One of the biggest changes coming to the banking sector will be the emergence of central bank digital currencies (CBDCs), which are digital currencies created and controlled by central banks such as the Bank of England in the UK, the European Central Bank (ECB) in the Eurozone and the Federal Reserve (the Fed) in the United States.
Comparisons are often made with cryptocurrencies since some proposed CBDCs could make use of the ‘blockchain’ technology that is used in many popular cryptocurrencies. But CBDCs will be controlled by central banks via their own private blockchains to ensure privacy and avoid the many security and volatility issues faced by cryptocurrencies. As a result, CBDCs will be quite distinct from cryptocurrencies such as Bitcoin and Ethereum.
In this article, we explore what CBDCs are, why governments are trying to create them, how far advanced they are, and the risks associated with these new currencies.
What are CBDCs?
CBDCs are forms of regulated, government-issued electronic money. While most cryptocurrencies, like Bitcoin, are decentralised assets and a pure ‘peer-to-peer’ version of electronic money (Quinn, 2021), CBDCs will be governed by central banks such as the Bank of England, the ECB and the Fed.
CBDCs are being developed to replace national currencies and move to a cashless society. Indeed, 86% of central banks are actively researching CBDCs, 60% are experimenting with CBDCs, while 14% are deploying pilot projects, according to a recent Bank for International Settlements (BIS) survey.
The Bahamas became the first nation to introduce CBDCs with the ‘sand dollar’ in October 2020, while Nigeria became the first African country to launch a digital currency – the eNaria – in October 2021. In China, the digital renminbi (e-CNY) is being developed for cross-border use, while in the United States, two CBDC initiatives are under way. In September 2021, Fed chair Jerome Powell said that the central bank is ‘working proactively to evaluate whether to issue a CBDC… I think it’s more important to do this right than to do it fast’.
Why are governments trying to create CBDCs?
There are several reasons why governments might introduce CBDCs. Here, we discuss some of the most important motivations.
First, there is a threat posed by cryptocurrencies and ‘stablecoins’ like Tether. Almost every central bank has written white papers on cryptocurrencies. While many cryptocurrencies could never replace a national currency due to practical reasons – such as the large transaction fees, scalability issues in terms of transactions and the large volatility (see Quinn, 2021 for an excellent discussion) – central banks are concerned that they are being left behind in this digital revolution and want to move with the times. The growing interest and use of cryptocurrencies are a challenge to national currencies and issuing CBDCs will help counteract that growth.
Second, CBDCs should improve the efficiency and safety of both retail and large value payment systems. On the retail side, the focus is on how a digital currency can improve the efficiency of making payments, for example, by speeding up transactions at the point of sale, online and peer-to-peer. There could also be benefits of having a CBDC for wholesale and interbank payments since, for example, it could facilitate faster settlement and extended settlement hours. Further, CBDCs could improve cross-border payment efficiency. They have the potential to improve counterparty credit risk for cross-border interbank payments and settlements by offering 24-hour availability, anonymity and eliminating counterparty credit risk for participants.
Third, the introduction of CBDCs would speed up the transition to a cashless society. Cash use is falling at a dramatic rate due to the ease of payments using cards, apps and contactless payments. Cash costs money to mint – for example, a $100 note costs 14 cents to print – so a cashless society reduce costs for central banks. Cash is also difficult to trace, which makes it attractive for tax evasion, money laundering and illegal transactions. It poses a greater security risk when transporting funds and making payments as there is no record of exchange. It could be that future governments wish to remove cash to reduce crime and improve tax receipts.
Fourth, CBDCs may improve financial inclusion. More than 1.7 billion adults around the globe (and 4% of the UK population) are ‘unbanked’, referring to a person ‘not having access to the services of a bank or similar financial organisation’. CBDCs could promote financial inclusion among these unbanked populations by giving them access to a safe place for their savings and eventually, access to credit.
What are the risks of CBDCs?
One concern about CBDCs is that they would require centralisation of the banking sector, which would amplify the threat of cyber-attacks. Just as the failure of any one bank erodes confidence in banking, a CBDC could potentially relocate this risk to central banks. This would negate the benefits of strategic risk-sharing structures and distance between participants in the financial system.
That said, the technology of the blockchain is very secure and transactions are highly compartmentalised, which means that the central bank could potentially operate a distributed system, thereby spreading the risk and consequences of any possible cyber-security breach more widely.
A CBDC could also represent a potential encroachment on consumer privacy and protections. With a CBDC, the central bank could easily block the use of funds of individuals or groups who fall out of favour with the government. The use of money (a public good to which equal access is a human right) and how it is saved, sent, spent and secured, should be as free as possible while maximising the penalty on bad actors. US Congressman Tom Emmer wrote: ‘Central banks increase control over money issuance and gain insight into how people spend their money but deprive users of their privacy,’ adding, ‘CBDCs would only be beneficial if they are open, permissionless and private.’
There is a concern that financial inclusion has declined further during the pandemic, as efforts to digitise money have been supercharged. This could be exacerbated with the introduction of CBDCs as they may be beyond the reach of those with older devices or without access to digital wallets. Care will be needed to avoid further disenfranchising the old, poor and vulnerable.
It is inevitable that central banks will issue CBDCs in the future given the dramatic move to online banking and the speed of digitalisation. The design of these CBDCs may differ substantially across nations, but in all cases, the central bank will still be in charge of the currency.
They will no doubt disrupt the banking industry and enable more people to be banked, offer faster services and deliver credit to businesses on better terms, while also preserving liquidity and efficiency in capital markets. While some degrees of privacy will be lost, the benefits from protection against fraud and other crimes may more than compensate.
Where can I find out more?
- The Bank of England’s CBDC website offers lots of resources on CBDC design and implementation.
- The ECB’s CBDC website offers details on the research of CBDCs at the Eurozone’s central bank.
- The BIS executive summary on CBDCs as well as links to other policy documents.
- The CBDC tracker offers up to date information on CBDCs status around the globe.
- CBDC considerations, projects and outlook.
Who are the experts on this question?
- Tom Mutton, Director Fintech, Bank of England
- Manisha Patel, Senior Analyst, Digital Currencies Team, Bank of England
- Raphael Auer, Principle Economist, Bank of International Settlements
- Linda Schilling, Olin School of Business at Washington University, St Louis
- Eswar Prasad, Cornell University