Could The Central Bank's Digital Currencies (CBDC) Replace Fiat?
The idea of a digital central bank currency (CBDC) has been considered by central banks around the world since crypto currencies like Bitcoin began to gain popularity.
Central banks around the world have two options: ban all cash transactions or allow the general population to open accounts directly at the central bank.
The problem, however, lies in the fact that both ideas can lead to opposite and rather unpleasant results.
Cryptocurrencies challenge the former monopoly of central banks in issuing currency. Threatened with the prospect of digital tokens replacing fiat currency, central banks are now exploring the idea of a digital currency issued by the central bank.
Simply put, a CBDC is a digital currency that is backed or guaranteed by a reserve bank that can be used as a means of payment settlement and a unit of account.
Two wide-ranging ideas, such as imposing a general ban on cash transactions and allowing individuals to open accounts directly with the central bank, have so far been discussed by several governments around the world.
However, the implementation of either idea could lead to two different conclusions.
Central banks adopt the idea of the CBDC
The provision of capital to finance state infrastructure and private companies was the reason for the emergence of some of the first banking services.
Since then, central banks have evolved to manage fiscal policy and introduce innovative payment settlement services. The introduction of Internet banking in the early 2000s also gave a major boost to the sector, making money easily accessible without relying on physical paper money.
It is universally regarded as the most profound technological innovation of recent times.
The global crisis of 2008 was the worst economic recession of the modern era (until the coronavirus). More than 20 major banks filed for bankruptcy after the collapse of Lehman Brothers.
In the world after the Lehman crisis, central banks lost the confidence of the masses and faced relentless media scrutiny.
The launch of Bitcoin in 2008 was intended as a direct response to this lack of faith in the banking system.
Since then, the market for crypto-currencies has grown considerably, and there are more than 3,000 digital tokens floating on the open market.
However, while the central banks first ignored Bitcoin at the time of its launch, they have now embraced the technology and are considering how their own blockcha-in-based assets might prove harmful.
In February 2015, the Bank of England became one of the first central banks to propose the concept of a CBDC in a study entitled "One Bank Research Agenda". Since then, many have questioned whether a potential CDB should co-exist with a country's fiat currency or replace it altogether.
Imposing a total ban on cash transactions
According to a report published by the United Nations, malicious actors laundered 1.6 trillion dollars, or 2.7 percent of GDP, in 2011. Cash represented a significant part of the total amount when it changed hands.
Economists and financial experts have warned that most high-denomination bills eventually end up with people involved in money laundering.
This is largely because currency is no longer part of the banking system when it is collected from banks.
Banks, on the other hand, use the cash in accounts to issue new loans to both businesses and individuals in exchange for collateral.
This flow of capital into the economy leads to increased employment, infrastructure development and resource consumption. All this contributes to economic prosperity and growth.
Economist Miles Kimball made a strong case for moving to a cashless banking system and detailed the steps needed to complete the transition.
In his blog titled "The Road to Electronic Money as a Monetary System," Kimball explained the viability of hard and soft money transitions. Central banks could mandate that all old loans issued beyond a certain size be electronically settled in the event of a hard money transition. In the case of a transition from soft money to e-money, old debts can be settled using fiat currency while new debts should be settled using electronic payments only.
However, it is important to study the percentage of cash circulation in the country before applying a general ban on cash transactions.
The implementation of a ban on cash transactions could lead to an economic crisis if a significant majority of the population is deprived of banking services and only has access to cash.
It is easier to demonetize fiat currency in countries that already have low levels of cash circulation. Most of the currency in circulation will already be in the banks and therefore normal life will not be affected.
However, this could also lead to the disruption of illicit money-laundering activities.
Allowing central banks to open retail accounts
A second alternative to the application of a general ban on cash transactions would be to allow central banks to open retail accounts directly for consumers.
A CBDC would then be deposited directly into these accounts rather than held with commercial banks. A direct result of this measure could be the collapse of commercial banks as capital is depleted in the economy.
Commercial banks are currently the lifeline of the banking sector, providing capital for loans and banking services.
Fiscal policy and the maintenance of foreign exchange reserves are more important to central banks than the provision of banking services to the masses. In fact, this is why commercial and private banks were formed in the first place.
That said, analysts have always complained that commercial banks do not pass on a change in rate reduction to consumers.
As a result, changes in repo rates do not always correspond to an equivalent change in interest and deposit rates at commercial banks. Most banks avoid passing on the benefits to consumers in order to increase their own short-term profits.
However, in a CBDC economy driven by central banks, consumers could receive the immediate benefits of a rate cut and faster settlement of international payments.
Steps to create a CBDC
A CBDC is backed by the issuing reserve bank and accepted as legal tender. The World Economic Forum (WEF), in its report published on 22 January 2020, concluded that central banks around the world have been waking up to the idea of the CBDC now more than ever.
The WEF brought together representatives from more than 40 central banks and other financial institutions to create the CBD policy toolkit.
So far, the National Bank of Cambodia, the Central Bank of Uruguay, the Bank of Thailand, the People's Bank of China and the Eastern Caribbean Central Bank have agreed to use the toolkit to develop plans for their own future development potential of the CBDC sector.
The Governments of Tunisia, Senegal, Venezuela and the Marshall Islands have successfully completed testing for the launch of the State-supported digital currency.
The central banks of Japan, Sweden, Switzerland and the euro area have joined the Bank for International Settlements in developing the CBDC. It remains to be seen whether other central banks will follow this approach towards a CBDC or not.