Bit by Bit: Decoding the Digital Currency Revolution
Key takeaways:
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Central banks globally are embracing central bank digital currencies (CBDCs) to achieve faster transactions, lower costs, improved security, and enhanced financial inclusion
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CBDCs carry potential for reduced commercial banks reliance, mobile phone accessibility, and fast cross-border transactions
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Challenges such as privacy concerns, cybersecurity risks, and the loss of transactional anonymity are undeniable
Over recent years, there has been a lot of talk around digital currency, especially crypto, both in positive and negative light. While the jury is still out on crypto and the value it brings, central banks are emerging with plans for their own digital currencies. This may not be surprising since we have long departed on a digital revolution, but simultaneously, it is difficult to imagine how this will actually work. The selling point of most digital currencies is their decentralized nature, which many expect to be the future of currency. However, this no longer holds when central banks start issuing their own digital currencies, so the response of both fiat money users and crypto fans remains to be explored.
Let’s take a step back; central bank digital currency (CBDC) is the digital form of a national currency issued and controlled by the country’s central bank. It is simply the digital representation of fiat money since the goal is for the public to use the CBDC in daily transactions regulated by the central bank. Some have compared CBDC to stablecoins, which are a type of private cryptocurrency designed to minimize price volatility and maintain a stable value relative to a specific asset or a basket of assets by being pegged to another currency, commodity, or financial instrument. The major difference is that CBDC is the currency itself, not pegged to a currency, and is centralized.
Status quo
While in Europe and the US, this type of digital currency is a relatively new development, some countries have already implemented it. For example, the central bank of the Bahamas created the Sand Dollar, Nigeria has its Naira, the Reserve Bank of India launched its Digital Rupee, and Russia followed suit with the Digital Ruble. Other countries launching in 2023 include Canada, Australia, Brazil, China, Japan, Jordan, Laos, Kazakhstan, Philippines, Saudi Arabia, and Turkey, among others. Even though these are only pilot launches, CBDCs seem to be quite widespread already. As Figure 1 shows, most of the world is at least in the research and development stage.
Figure 1: CBDC progress around the world
Source: Atlantic Council, CBDC Tracker
So why are central banks all over the world now interested in issuing digital currency? At this point, the European Central Bank has likewise announced its plans to launch a CBDC in the near future, and the US too, even though some Fed officials disagree on whether such currency is needed. The recently increased interest may partially be attributed to the success of China’s digital yuan, launched in 2019 as a pilot, which is now being extended to its entire population, increasing the government's already strong control and aligning with China’s interests in becoming the world’s reserve currency, a title currently held by the US dollar. The initial increase in interest leading to research and development by many countries may have been propelled by Facebook’s announcement of its own digital currency, but it has since scaled back its plans.
Let’s quickly clarify the two types of CBDCs: Wholesale CBDCs and Retail CBDCs. Wholesale CBDCs are used for transactions between banks, created to facilitate cross-border transactions among international financial institutions with reduced costs and increased speed. Retail CBDCs are a currency distributed directly to people by the CB and the direct replacement of fiat money for consumers. Figure 2 shows most countries piloting CBDCs in 2023 have chosen implementation of both types by building a hybrid infrastructure, allowing for full integration of digital currencies.
Figure 2: Countries' choice of CBDC type
Source: Atlantic Council Research
A general motivation for central banks is undoubtedly the reduction in frictions thanks to using a digital currency since banks would be intermediaries only processing the digital transactions. In some approaches to the implementation of retail CBDCs, the central bank has the potential to cut out commercial banks completely, where the digital currency would flow directly between consumers and the central bank through digital wallets, as Figure 3 depicts. However, there are some obvious issues with such an approach since banks perform a critical economic role by creating and allocating credit (loans), which, when we imagine the vastness of personal and corporate loans granted, would be tremendously difficult for the CB to achieve alone. Going along with that, all power, data, and, therefore, risk would be carried by this sole institution, creating the potential for increased privacy and cybersecurity threats.
Figure 3: Currency system overview
Source: Banking hub
Pros and cons: An ECB perspective
In general, the various benefits of CBDC encompass speed of payments in national and international transactions, the decreased overhead costs of commercial banks and CB, which allows for significantly lower transaction costs, and potentially reduced dependence on commercial banks and similar institutions. There is a further possibility for financial inclusion through CBDCs being widely accessible through a mobile phone without a traditional bank account, which is especially applicable to emerging economies and less developed countries, ultimately boosting their GDP and aiding consumers. However, if this truly is the case, it remains a question because these people may conversely prefer physical cash as it allows for true anonymity.
Another quoted benefit is enhanced payment security through mobile phones and reduced chances of fraud, as transactions could be signed digitally using private key cryptography. The way this works is that digital currency wallets automatically create cryptographic key pairs - a private key and corresponding public key. The private key is known only to the owner - the initiator of the transaction, and used to sign off on it, which authenticates the transaction. The receiving user employs the public key to unlock and validate the digital signature, receiving the money. Consequently, fraudulent transactions are prevented by the need for a two-way confirmation to unlock the transaction, as any alterations would generate a new pair of keys, disallowing the current ones to be validated.
“A digital euro would provide an anchor of stability for our money in the digital age.”
(ECB)
To take advantage of all these benefits, the ECB is now cooperating with national central banks of EU member countries to create its own CBDC as an equivalent to cash, hence seemingly choosing the retail CBDCs route, although a hybrid infrastructure could also be expected. Their goal is to create a pan-European solution to make payments frictionlessly using a digital wallet from any EU country, focusing on speed and cross-border transactions. The ECB is keen on the digital euro to bridge the gap between private (commercial bank) money in deposits and public ECB money (cash and bank reserves) by offering public money digitally alongside the current private money because the demand for cash, and therefore ECB money, is rapidly declining. This way, they want to support digitalisation and, through it, boost economic growth, potentially providing more financial resilience against fluctuations in crypto assets and unregulated payment forms.
As we can see, demand for digital currencies is rising among central banks, who aim to offer faster transactions, lower costs, better security and plenty more. Yet there is further research necessary into risks and approaches to mitigate them while still deciphering how to actually develop the currency and build the platforms in a way that achieves the promised advantages. But will this really be the case, or will the challenges faced overshadow the benefits? Will consumers be willing to fully adopt CBCD for their daily transactions on a large scale? Such questions remain unanswered as the future of central bank digital currencies remains hazy. For now, we, in Europe can only wait for the ECB to publish its current research, where development will likely be initiated and more information will follow.
These issues will be further explored once research progresses and large-scale deployment of the CBDC becomes realistic, at which point CBs will discuss privacy and other concerns in more detail. Nevertheless, the ECB has been transparent about risks and potential scenarios it may face in publicly available reports, showing promise.
Bottom line
As we can see, demand for digital currencies is rising among central banks, who aim to offer faster transactions, lower costs, better security and plenty more. Yet there is further research necessary into risks and approaches to mitigate them while still deciphering how to actually develop the currency and build the platforms in a way that achieves the promised advantages. But will this really be the case, or will the challenges faced overshadow the benefits? Will consumers be willing to fully adopt CBCD for their daily transactions on a large scale? Such questions remain unanswered as the future of central bank digital currencies remains hazy. For now, we, in Europe can only wait for the ECB to publish its current research, where development will likely be initiated and more information will follow.
