How Far Are We From CBDC?

Coronavirus has become the boogeyman of today. From public to financial health, almost every aspect of our lives were impacted by this pandemic. It has gotten to the point where some began spreading conspiracy theories about Covid-19, claiming that everything was planned, calculated and organized by one of the world powers. 

Others believe that this crisis will trigger crucial changes in the global financial system by launching a central bank digital currency (CBDC). Now, let’s stop here and try to understand how far from the truth could it be.

What is the difference between cryptocurrencies and CBCDs?

Cryptocurrency is a highly speculative asset, not a currency. Its movement depends on the decision of centralized cryptocurrency exchanges, and not institutional investors or funds. 

Cryptocurrencies are produced by solving complex mathematical problems and governed by online communities instead of a central organism. Fluctuations in the price of Bitcoin do not depend on coronavirus or economic crisis all coincidences are accidental. The value of cryptocurrencies is determined entirely by the market, and not influenced by factors such as monetary policy or trade surpluses.

The initial intention of its founder was that it could be an equivalent of cash that could be used in e-commerce. However, in addition to its payment function, it also acts as an investment asset. And most importantly, its use as a payment mechanism in e-commerce is scarce. 

CBDCs, in turn, are traditional money, but in digital form. They are issued and governed by a country’s central bank. The unique similarity is that both, to a varying degree, are based on blockchain technology, a digital ledger that contains all the transactions ever executed in the system. Every node in the network receives the same information and each node updates the record independently.

How digital cash differs from electronic?

Electronic cash is a store of value for making payments to retailers or between devices. It is usually held at banks or on prepaid cards or digital wallets, for example, Paypal. CBDCs are digital assets, issued by central banks, which may be considered as a complete replacement for notes and coins.

CBDC is a liability expressed in existing payment units that can serve as a means of exchange (settlement), storage of value and payment method. Most CBDCs are designed for general use, although some are solely for bulk payments and settlement between central banks.

In short, CBDC is not just non-cash fiat money, but such a form that allows you to operate it not only without the intermediary of the central bank but also without the intermediary of commercial banks.

How would CBDC theoretically work?

CBDCs would function much like cash: the central bank would issue a CBDC initially, but once issued it would circulate between banks, non-financial firms and consumers without further central bank involvement. Such a CBDC might be exchanged between private sector participants bilaterally using distributed ledgers without requiring the central bank to keep track and adjust balances. It would be based on a permissioned distributed ledger, with the central bank determining who acts as a trusted node.

According to the BIS study, there are many potential technical implementations of token-based CBDCs. They could be based on DLT, with similar characteristics to cryptocurrencies, with the difference being that the central bank rather than the protocol itself would be in control of the amount issued and would guarantee the token’s value.

Motivations

As multiple studies suggest, it is all about recovering control over money. Bitcoin and other virtual currencies are not a real threat to central banks due to their high volatility. In turn, they are fret that Facebook’s Libra could reach billions and quickly take control over monetary policy, something they definitely cannot allow to happen. Even Ray Dalio stated that if he were a central bank, he wouldn’t allow any private digital currencies.

As governor Lael Brainard said, “Some of the new players are outside the financial system’s regulatory guardrails, and their new currencies could pose challenges in areas such as illicit finance, privacy, financial stability, and monetary policy transmission.”

Closely monitored CBDC experiments

Most CBDC projects are still in very early or conceptual stages, but few have made some real progress. 

A series of the islands in the Eastern Caribbean, including Grenada and Saint Kitts and Nevis have already launched their very own digital currency.

Back in December of 2019, the Central Bank of the Bahamas (CBB) has introduced a digital version of the Bahamian dollar, starting with a pilot phase in Exuma and extending in the first half of 2020 to Abaco.

China is developing the digital yuan through the Chinese payment platform Alipay, having recently disclosed a number of patents related to its own CBDC. After five years of researching the topic, the PBOC said in august that its digital currency was almost ready to be released. 

Sweden’s Riksbank is exploring e-krona, whilst Uruguay has done a pilot program called e-Peso.

The central banks of Britain, the EU, Japan, and Switzerland are examining the possibility of issuing CBDCs. The U.S. Federal Reserve is also monitoring the digital currency debate but no signs of serious activity so far, or maybe they simply do not want to show it.

According to a member of the U.S. Federal Reserve's Board of Governors, Lael Brainard, the Fed is “conducting research and experimentation related to distributed ledger technologies and their potential use case for digital currencies, including the potential for a CBDC (central bank digital currency).” 

Emerging market economies (EMEs) report stronger motivations and a higher likelihood that they will issue CBDCs. It might give emerging economies trade, payments, and monetary policy advantages.

Overall, the likelihood of issuing any type of CBDC has increased but is still low. About 70% of central banks still see themselves as unlikely to issue any type of CBDC in the foreseeable future. At the same time, the number of central banks choosing “possible” (ie neither “likely” nor “unlikely”) is falling, potentially indicating that research and experiments are helping to clarify a firmer stance on issuing a CBDC in the near term.

Why Venezuela’s El Petro failed?

El petro (PTR) is an oil-backed cryptocurrency designed at an October 2017 meeting at the Venezuelan central bank. Earlier this year, the government claimed to have fixed the value of one PTR at $60, but the market price on LocalBitcoins (a peer-to-peer bitcoin marketplace) didn’t reach even half of that. 

Despite all the attempts of President Nicolas Maduro to convert “El Petro” into a widely used currency, Venezuelans are reportedly selling it. And the reason for it is the deviation of the real exchange rate from the “official” price.

If the backing were credible and the government stable and honest and if giving the government one petro for every barrel you extract covered all royalties and taxes, a petro might be worth about half a barrel of oil. Unfortunately, el petro was on a private centralized ledger, making it even less trustworthy. According to Bloomberg, it would allow corrupt officials to expand issuance and steal the proceeds until the currency was worthless. 

In order to solve this issue, Venezuela could have implemented a public blockchain. It could have released a public register of petro sales. However, it never happened because they don’t want transparency. 

In conclusion, it failed for two simple reasons: lack of trust and high exchange rate deviations.

What would the advantages of CBDC be?

One of the main benefits of CBDCs is that they may allow making payments systems, which are often time-consuming and costly, more efficient and, most importantly, way faster.

According to ECB, CBDC could be considered a third form of base money, next to (i) overnight deposits with the central bank, currently available only to banks, specific non-bank financial firms, and some official sector depositors; (ii) banknotes, being universally accessible but arguably of limited efficiency and relying on old technology.

Theoretically, some of the main advantages include making available efficient, secure and modern central bank money to everyone, and strengthening the resilience, availability, and contestability of retail payments. With digital central bank money, governments look to enhance the transmission of monetary policy by charging negative interest rates and thus help alleviate the constraint on monetary policy transmission due to the “effective lower bound.”

In other words, if central banks achieve to solve the technical difficulties, CBDCs could allow for faster and cheaper money transfers across borders, and even improve access to legal tender in countries where cash supplies are decreasing. 

According to a World Economic Forum paper, the new currencies could offer retail investors a safer place to save, in case they will be allowed to create accounts directly with their central bank, and could reduce the cost barriers that currently leave 1.7 billion people without banking services. In addition, CBDCs could potentially make monetary policy more efficient by allowing direct pass-through of interest rates. But, most importantly, governments could receive an extra tool for surveillance. 

In total, they list a serie of key opportunities that CBDC can provide:

What are the risks of CBDC?

Unfortunately, the risks are quite high, which is why most central banks haven’t introduced CBDC. Depending on the model of CBDC, central banks may either damage commercial banks, a vital funding source for the real economy or suffer the direct risks and complications of banking the masses.

Some concluding remarks

In summary, like any innovation, central bank digital currency will have to go through multiple stages in order to be approved and actually implemented. 

One of the main downsides of CBDC is that it might be a catalyst for the further shrinkage of bank balance sheets at the benefit of non-bank intermediaries. If CBDC accounts offer relatively comprehensive account services such that many households may no longer feel a need to have a bank deposit account.

Cryptocurrencies are not a threat for cash so far mainly because of their volatility that prevents them to be widely accepted. In turn, they may see stablecoins as a bigger problem for cash in the future. 

Central banks will also have to decide either to issue tokens (similar to cryptocurrencies) or account-based CBDCs. The main downside of account-based CBDCs is that they would imply extending the role of the Central Bank far beyond its current functions. This is incompatible with the present paradigm of independent Central Banks with a specific mission of maintaining price stability. For that reason, many central banks have decided not to go ahead.

Nevertheless, countries continue to follow the topic closely. If PBOC decides to go ahead there may be pressure on the rest to follow.