Bitcoin and most other cryptos aren’t pegged to anything tangible.
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Bitcoin may be stealing the spotlight, but central banks are racing to develop their own digital currencies—aiming to blunt the appeal of the crypto and other virtual monies.
Central bank digital currencies, or CBDCs, aren’t in widespread use from any major countries. But China is well on its way with a CBDC, and others could be soon. More than 60 central banks are now exploring or actively developing CBDCs, according to PwC. And “efforts to introduce CBDCs are gaining momentum,” according to a report by Morgan Stanley.
China is the furthest along, having launched pilot programs for a digital yuan, or renminbi, in several mainland cities.
The European Central Bank recently completed a public consultation period on a digital euro. ECB President Christine Lagarde said in late March that the ECB’s governing council would decide on moving forward with a digital euro in mid-2021. She added that a rollout could still take four years.
The Federal Reserve is also exploring a digital dollar. A study being conducted by the Boston Fed and the Massachusetts Institute of Technology is expected to be released this fall.
A CBDC is essentially a digital version of a traditional currency. It could be used instead of checks, banknotes, or some other form of money. Consumers or businesses could hold CBDC deposits directly at a central bank, transacting through an app or other payment system.
The race to develop CBDCs is being driven by several trends. One is the meteoric rise of Bitcoin and other cryptos. Thousands of varieties are now in circulation, led in popularity by Bitcoin. Their total market is worth an estimated $2.2 trillion, about half of that in Bitcoin, according to Citigroup. And cryptos are rapidly working from the digital fringes into the mainstream financial system.
The rise of cryptos poses challenges to central banks and financial authorities. Transactions in alternative currencies aren’t as easy to track as those that run through banks and other traditional intermediaries. Central banks worry about losing control over monetary systems, keeping tabs on cash in circulation, and implementing monetary policies like negative interest rates, which could be far less effective if more of people hold and transact in cryptos, rather than standard money.
Cryptos may also undermine countries’ capital controls, such as blocking outflows of their currency or suspending access to bank deposits during a financial crisis, since cryptos operate in an alternative financial system. Turkey, for instance, recently saw the value of its lira plunge 12% and had to calm the markets on fears that it would impose new restrictions on foreign exchanges of its currency. The country’s central bank recently banned the use of crypto-currencies for transactions in goods or services.
“If you are a central banker today and you love Bitcoin, you are crazy,” said Henri Arslanian, global crypto leader at PwC, in a Citi report. “It is like the taxi driver being excited to see Uber come into their market.”
CBDCs differ from cryptos in a few key ways. For one, the CBDC would rise or fall in value with its base currency, just like cash. And supply wouldn’t be constrained since central banks can print as much money as they like, offloading it to paper currency, digital tokens, or entries in a financial ledger.
Bitcoin and most other cryptos aren’t pegged to anything tangible. They live on distributed ledgers, or blockchains, and their supplies may be systemically constrained—in Bitcoin’s case at 21 million tokens. Consequently, people hold cryptos like Bitcoin as a hedge against “fiat” currencies losing their value through inflation and rising money supply, known as currency debasement.
But CBDCs could erode some of the appeal of cryptos. For one, CBDCs could be exchanged instantaneously, 24/7. They could replace cash in the banking system, bringing in people who don’t have bank accounts.
Transaction costs could also be lower since CBDCs could cut out commercial banks or other intermediaries. And they could quickly gain traction for international money transfers. Roughly 250 million people send over $500 billion in cross-border remittances annually, paying an average fee of 7%, according to Arslanian.
CBDCs also appeal to central banks as a means of tracking money in circulation. Payments apps in China like Alipay and WeChat are now used extensively instead of cash, creating new hurdles for authorities to track and monitor transactions. Financial authorities also worry that apps from companies such as PayPal Holdings (ticker: PYPL) and Square (SQ) are making it easier to transact in cryptos. Black-market activities like money laundering and tax evasion are already tough to track with cash; the crypto world only complicates it.
“The reality is that CBDCs give us a fighting chance against money laundering and illicit activities,” said Arslanian.
A major CBDC used in global commerce probably won’t emerge for some time. Political and technological hurdles will likely take years to overcome. The privacy of a CBDC—or lack thereof—could also slow adoption. Moreover, their use as legal tender is questionable, depending on whether a CBDC is account- or token-based, according to the International Monetary Fund.
Wholesale CBDCs, used for interbank transactions and financial settlements, are also much further along than retail, which consumers and businesses use; 70% of wholesale CBDC projects are already in pilot testing, according to PwC, versus just 23% of retail.
So far, the Bahamas’ “sand dollar” and the Bakong, a CBDC launched by the Cambodian central bank in November, are the only ones in use outside China.
But China’s digital yuan may pave the way for an explosion in CBDCs over the next few years. About $300 million worth of digital yuan transactions have taken place in the mainland, according to PwC. The Chinese government is expected to try and push it into wider circulation in time for the Beijing 2022 Winter Olympics.
One takeaway: While cryptos and CBDCs may co-exist, commercial banks could face stiffer competition for deposits and transaction fees.
“Commercial banks will face the risk of disintermediation,” said Morgan Stanley in a report. Consumers could transfer their bank deposits to CBDC accounts, cutting out commercial banks, and people could then easily use payment apps for transactions. “These factors will increase competitive pressures on commercial banks,” Morgan Stanley says.
Banks will have to find a way into the CBDC system to avoid being cut out of the new digital-money world.
Write to Daren Fonda at [email protected]
