To defend their turf — and prevent extreme decoupling — central banks are keen on designing their own network of digital payments by officially issuing what is called a Central Bank Digital Currency, or CBDC.
The landscape of payments is changing rapidly. In recent years, many proposals for digital money have appeared to facilitate the turn away from cash and a few systems are already in operation. Naturally, the ongoing pandemic has contributed to the surging use of digital currency as more shopping is done online. A technological revolution is underway.
The rise of blockchain and the simultaneous development of cryptocurrencies and mobile payment systems have fuelled a new wave of both excitement and scepticism at the same time. The disruptive potential of electronic money and the system of distributed ledgers (DLT) that underpins it has garnered interest from central banks and private financial institutions alike. While some adore the transparency and decentralised nature of DLTs, others are quick to dismiss it as a feature coined by idealists operating outside the banking system.
Virtual cash is seen as a double-edged sword mainly because of its fundamentally transnational character. It holds promise as there are efficiency gains to be had in terms of tapping unexplored commerce and investment avenues. Monetary and financial transactions could be boosted by the ease of access and the sheer resilience of the technology. The transition also presents enormous potential in the sphere of policy. But the risks are dire as well, although some concerns may be premature. Governments have been grappling with issues like financial data security, tax evasion and money laundering, and the likelihood of disturbances in money supply and exchange rates.
One issue is a particularly major sticking point for central banks. There is a tacit realisation that abandoning control over monetary policy is not an option. So to defend their turf and prevent extreme decoupling, central banks are keen on designing their own network of digital payments by officially issuing what is called a Central Bank Digital Currency or CBDC. The novelty of such general-purpose CBDCs lies in its character of being legal tender. This transition can contribute to diversity and innovation in the payment market.
Designed to be a completely safe virtual store of value, such a system would be universal, freely convertible into cash at a fixed rate, and subject to pre-defined policy norms. At the same time, it is meant to be denominated in local currency, which would bear interest on the central banks’ balance sheet. Against this backdrop, both retail and wholesale CBDC possibilities are being discussed. The former type is meant for direct use by savers and the latter exclusively for commercial lenders subject to directives from the central bank.
A fully functional CBDC has never been implemented anywhere, partly because of technological handicaps. Hence, given the absence of empirical data, it is difficult to estimate the true costs associated with such a transition. Gauging the efficacy of monetary policy under such conditions is another big challenge. Naturally, the official views on issuing CBDCs, in light of these uncertainties, have been mixed so far. Yet four-fifths of all central banks are said to be involved in researching options for designing suitable CBDCs. Early on, central bankers were hesitant but growing familiarity with the idea has helped. According to a report by the Bank for International Settlements, central bankers around the world are growing more optimistic about the eventual efficacy of CBDCs.
Truth be told, if private digital currencies are allowed to dominate the ecosystem, there is more than a slight chance that these could eventually replace the legal tender cash. After all, the competition posed by the likes of Tencent and Google in the digital space is intense. And many such players have been loath to support interconnectedness between platforms. Once big enough, these firms can use their market power to block competitors and extract more profits. This is usually deemed detrimental to consumer interest.
Central banks and governments have been paying close attention to these developments. The desirability of CBDCs is understandable in this context. But central banks, besides having to prevent crashes and failures, first need to ensure the integrity of their networks to facilitate the gradual shift away from cash. Public confidence will be missing otherwise. Countries like China and The Netherlands have already started experimenting with their digital fiat albeit on a limited scale. Sweden is likely to follow suit with its e-krona. A US Fed coin issued as the digital greenback is also thought to be on the cards. The European Central Bank (ECB) appears excited as well.
Central banks increasingly look to draw on lessons offered by cryptocurrencies and private digital-payment systems. They undoubtedly want to tap the efficiency gains and harness the resilience of the technology. ‘Permissioned’ systems are expected to do away with the fully decentralised ones but still retain some of the latter’s advantages. On the technical front, so far the main focus of central banks has been on reducing transaction costs and making the CBDC platforms more programmable. The Dutch Central Bank (DNB), especially, is embracing the need for anonymity that crypto-enthusiasts adore. But the big question that lurks is whether or not CBDCs can add reasonable value to the economy.
There are some bittersweet considerations when it comes to responsibilities. Central banks could perhaps target monetary stimulus better as individual beneficiaries and vulnerable sections could be identified quickly and assisted during times of economic stress. They may also be able to earmark account top-ups for designated purposes. But adding all these features could bring in complications and affect the ease of access and undermine the ready fungibility of money. Also, these extensive powers with the central bank may spark privacy concerns, especially authoritarian governments can use it to keep track of all transactions and exercise more control over the public.
There are implications for monetary policy too. For advanced economies, negative interest rates may become easier to implement as digital fiat can be directly programmed to do so. That is, assuming physical cash is done away with. Otherwise, savers could just hoard physical cash. It pays to note that deeply negative rates can undermine confidence in the currency and prompt a rush to gold or other such assets.
There is an additional concern that if the public is allowed to convert their deposits into their CBDC accounts, commercial banks may be robbed of their primary funding source. Depletion of demand deposits from the banking system would mean a forced reliance on costlier alternatives like wholesale funding. Moreover, the central bank could be compelled to accept the risky role of a financial intermediary during times of crisis, as all funds are likely to flow into its books. Issuance and withdrawal limits could perhaps help address some of these vulnerabilities, but not all.
As far as the transnationality of electronic money is considered, national jurisdictions and the broader cyberspace could conflict over monetary control soon. At its extreme, its ability to flow too freely across borders compared to traditional currencies could create instability internationally. Hence, there is a temptation to enact deep regulations concerning the use of money and at the same time construct parallel structures to exert more control over cyberspace. Although some form of control is inevitable, the international financial community is likely to be wary of digital bureaucracies.
The broader cyberspace that hosts such platforms is notorious for its lack of transparency, security threats, and potential for malevolent activities. And technology failures are commonplace, especially in the government. But besides these vexing challenges, digital fiat opens up a world of welfare-enhancing possibilities. Like any innovative idea, CBDCs are not devoid of risks. Digital cash will have to be scrutinised and improved along the way. Central banks could cherish new flexibilities in policy but are wise to be treading a cautious path. Finally, user preferences will undoubtedly be a crucial factor in determining the macroeconomic effects of CBDCs. On the technical front, first, the focus must be on developing and enhancing the accessibility of CBDCs.
Puraskar Chakrabarti is a research intern at ORF Mumbai.
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