Seven Key Takeaways You Need to Know About Central Bank Digital Currencies (CBDCs)

20 Nov, 2019 12:11
source: Jonathan Lee

Author: Jonathan Lee, C Block Capital, Hong Kong
Editor’s Note: Jonathan currently works at an activist hedge fund based in Hong Kong. Jonathan has worked, lived, and studied in North America, in the Middle East, and across Asia. Previously, he was with a blockchain start-up and he is a regular speaker at global FinTech and blockchain conferences around the world. He has also spent many years in large-scale project management at one of South Korea’s biggest conglomerates, GS Holdings Corp. Jonathan started his career in the oil industry in the United Arab Emirates and Saudi Arabia and then transitioned into the financial & digital assets world in Hong Kong.

As of late, there has been global buzz around Central Bank Digital Currencies (or CBDCs). After Facebook’s announcement of its proposed Libra currency, it was learned that China’s Central Bank would be releasing their own version, which has been under development behind closed doors since 2014. Other central banks in Europe and North America have also been studying, exploring and experimenting with CBDCs. But what’s really going on? Why are CBDCs important? Do we need them? What are the implications? How will they be designed? I have listed seven key takeaways you need to know.

I. Every CBDC will initially be launched for country-specific and policy-driven objectives.

Every central bank must carry out deep, internal studies of their own economy and determine the best fit for their country. Some country-specific aspects to consider would be things like:

– Population size of the country
– How many people in the country are banked versus unbanked? Would financial inclusion be a good country-specific goal?
– What are the existing payment infrastructures in place? Do people mostly still use cash? Or is it already a cashless society
– Should the CBDC be used at the wholesale level or at the retail level?

Some of the policy-driven aspects would be things like:

– Is our monetary sovereigntyat risk? Could launching a CBDC protect our sovereignty
– Should it be interest-bearing? Impact on financial stability and monetary policies
– Will it help to tackle tax evasion? Counter capital flight, money launderingand terrorist financing
– Should the CBDC function just like cold hard cash? For example, should it be kept anonymous and untraceable? Or should every transaction be monitored?

In short, CBDCs will initially be designed and launched for domestic use only. After country-specific and policy-driven factors are addressed, CBDCs can then go for cross-border objectives.

Bonus Takeaway: Although carrying out comprehensive studies are required, even the most holistic CBDC solution cannot achieve all objectives

II. For cross-border payments, interoperability between other CBDCs will be very challenging and problematic. It will be like trying to fit squares into circles repeatedly.

China wants to be one of the first, major powers to issue a CBDC (nobody knows exactly when, but possibly as early as 2020). Considering its size and economic might, China’s CBDC will not be ignored. Other countries will most likely design their CBDC to ensure that it is indeed compatible with China’s. So, being an early-mover, the standards could potentially be set by China’s central bank and the internationalization and digitalization of currencies will probably happen. But, some of the difficulties that will be faced between different countries will be things like

– Cross-border useand transfer limit
– Managing cyber threats
– Differences in KYC/AML standards
– Differences in systems, i.e. different blockchains or different underlying technologies, different e-wallet standards
– And more

These can only be solved through polite persistence and international cooperation. Finally, assuming that these issues are solved and everything works wonderfully, don’t forget about currency exchange risks. Those will still be there.

III. For monetary policies to work,CBDCs must be interest-bearing and the economy must be cashless. But in practice, this will be very hard to do.

If many people are still holding cash (M0) and a country has a significantly high unbanked population, monetary policies via CBDC measures will not be very effective. Theoretically, everyone must convert their cash holdings into CBDCs for monetary policies to have any meaningful effects. So, how do you incentivize people to convert? A proposed way of doing this could be done by applying:

  1. Negative interest rates on cash deposits (instead of deposits growing with interest, they are decreasing)

However, this would not necessarily enact people to convert to CBDCs. The most likely immediate response would be people actually withdrawing from their bank accounts and physically holding cash. At least 0% on hand is better than -1% in the bank, right? Plus, people would probably find other alternatives. So, how could this be better controlled? The second ingredient needed could be that:

  1. CBDCs are interest-bearing

Initially, this may seem like a plausible idea, but there would be severe implications. If CBDCs are interest-bearing, even at low rates, commercial banks would be under threat. Central banks would be viewed as a competitor or as the enemy – and this would not be a good thing. Even worse, if the central bank offers higher rates than commercial banks, it is likely that many would withdraw and place their holdings with the central bank instead. Even if this helps achieve the goal of conversion in some way, existing short-term and long-term deposits in M1 and M2 could be affected in the process, potentially causing financial instability and commercial banks taking the hit.

As we can see, in practice, this will be very hard to do. It really depends on the central banks’ goals and evaluating what it takes to get there.

Bonus takeaway: Therefore, most CBDCs will not be interest-bearing and they won’t be expected to have monetary policy influence (at least, for the time being). Later in the future, if successfully launched and integrated with an economy, it is foreseen that the use of CBDCs could become just an additional tool among an existing arsenal of tools available today to affect monetary policy.

IV. Marginal Utility: If the marginal utility to launch a CBDC is low, then why bother? Some countries may never issue one – and that’s fine.

Does every country need to launch a digital currency? No. Countries like South Korea claim they don’t need to launch a CBDC because they already have robust electronic payment infrastructures in place. The average South Korean adult has 5.2 bank accounts and 3.6 credit cards and their banked population is more than 95%. In other words, there is almost no marginal utility to design and launch a CBDC. Plus, it requires a lot of resources to build and launch one. Sweden also, is already cashless, so it may not be worth it for the Swedish to do so either. But they haven’t officially decided yet.

But, who knows – Koreans may change their mind later in the future when they witness multiple countries seamlessly interact with each other through cross-border transactions and the Koreans realize they are left out of the picture.

V. Central Bank Digital Currencies are not cryptocurrencies. They are just digital extensions of cash (M0).

Cryptocurrencies such as Bitcoin and Ethereum, by nature, are decentralized and are not backed by assets nor fiat reserves. CBDCs on the other hand, will mostly operate on centralized systems and are indeed backed by proven reserves. CBDCs may adopt some elements of cryptocurrencies, i.e. the way it transfers value without an intermediary, but it is foreseen that CBDCs will be “better” than cryptocurrencies because they will have the underlying trust of sovereign currency and the central bank, whereas cryptocurrencies do not.

China also made it clear that it calls their CBDC as a form of digital currency electronic payment (DCEP) and that it should not be confused with it being classified as a cryptocurrency.

Food for thought: Researchers argue that because CBDCs are just digital extensions of cash, it should function just like cash; it should be anonymous, untraceable, and non-interest bearing. If your country or central bank issued a CBDC, do you think it should function anonymously and be left untraceable? Or would you be OK with the central bank being able to monitor every transaction?

VI. Public-Private Partnerships: Central Banks will need to partner with private companies.

Central Banks do not have the capabilities to distribute CBDCs. They will need to outsource the distribution of CBDCs to private companies or financial institutions to provide face-to-face services and on-boarding.

We can see how this could work by studying China’s CBDC model. Through a two-tiered structure, AliPay and WeChat Pay will act as distribution channels and be customer-facing. Businesses will not be competing with the central bank. By doing so, there will be no disturbed “peace” if the CBDC were to be rolled out. This is a great example of a potentially strong public-private partnership – and there will certainly be more of these worldwide.

VII. Looking into the Future: Interesting domestic and international use cases

– As mentioned by PwC’s crypto team in Hong Kong, if CBDCs are successfully launched and fully integrated, this could provide the issuing central bank the ability to track metrics of an economy, such as a country’s inflation rate and GDP growth rates in real-time. Combined with big data analytics and AI capabilities, this could be a real game changer and open a path to a new future.

– Should a country be hit with a major natural disaster, such as an earthquake or a tsunami, relief could easily and quickly be provided to those affected at home or abroad. It would be interesting to track how donations are managed, where the funds flow and whose hands it specifically ends up in. The charity industry will be impacted

– Cross-border transactions for massive, international projects or initiatives could also be simplified. For example, China’s One Belt One Road Initiativehas 60+ participating countries with 60+ different currencies involved. It sounds messy to manage, but having CBDCs to unify and simplify international transactions between countries could make things a lot easier. However, this won’t happen flawlessly unless interoperability problems and currency exchange risks are addressed (as mentioned above in #2).

Concluding Remarks

Customer preferences around the world are changing. The way money is stored, saved, spent, and transferred are changing. Central banks are responding to the reality that this change is happening – and it’s happening very quickly. Digital currencies, either privately issued at the company level (i.e. Facebook’s Libra) or publicly issued at the government level, will be an unavoidable part of the global monetary system as the decline in use of cash continues to accelerate worldwide. This is why CBDCs are such a big deal. It is in the central banks’ best interest that they are neither left behind nor displaced.

So, there you have it. I hope the above takeaways are helpful. Let’s see how this really plays out in the future – it’s an interesting time to be alive.

References: OMFIF, IBM, PwC Hong Kong, Binance Research

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Other articles from the author include
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2. Three Crucial Trends We Will Probably See Happening