It has become clear that digital currencies have become much more than a passing fad. As well as the rise of private cryptocurrencies, governments around the world have increasingly looked towards developing their own central bank digital currency (CBDC).
These CBDCs refer to a digital currency issued by central banks that is universally accepted as a flat currency for general use, replacing some of the cash that is currently in circulation.
One of the countries leading the way in this area is China. There has been lively discussion regarding China’s CBDC plans in recent years, notably since the launch of a prototype in four Chinese cities (namely Shenzhen, Suzhou, Xiong’an New District and Chengdu), as well as the release of the Draft Law of the People’s Bank of China (PBC) in October 2020, which granted the currency legal status.
Given its scale and potential reach, China’s CBDC is expected to be one of the world’s largest, but it is not the only country exploring this option. Others include Sweden, which is developing its E-krona, Bahamas with its Sand Dollars, as well as countries including Ukraine, Uruguay, and the Marshall Islands.
For the last few years, the Monetary Authority of Singapore (MAS) has been working alongside a consortium of financial institutions for a proof-of-concept project to conduct inter-bank payments using Blockchain technology, called Project Ubin.
Speaking in mid-2020, Sopnendu Mohatny, Chief Fintech Officer for MAS, said that the plans for Singapore’s own CBDC were moving ahead.
“What we’re missing is the decision of a central bank to issue a digital currency into the network. I think it will take some time, but hopefully as soon as possible,” he said in a webinar hosted by enterprise blockchain firm R3.
Mohanty referenced the rapid rise of China’s supply chain blockchains when discussing the need for Singapore to develop its CBDC.
“This is already production ready with transfers happening on the blockchain. Why are we lagging with putting in place a payment system which is compatible with this new way of doing things? That urgency has to be there,” he said.
Globally there has been a rapid increase in interest in CBDCs in recent years, and a survey of 66 central banks, conducted by the Bank for International Settlements (BSI) in January 2020, found that about 80% of central banks globally are involved in researching the impact of CBDCs, with some going further and conducting feasibility studies.
Competition with the private sector
Interest in CBDCs has increased for various reasons, including greater competition from private cryptocurrencies, one of the most impactful of which was the announcement of Facebook’s Libra, now called Diem, in mid-2019.
Given its significant potential based on its ability to reach more than two billion users, the Libra announcement “in particular seems to have created a greater sense of urgency among central banks given the possibility of currency substitution away from flat currencies”, said Ramkishen S Rajan, Yong Pung How Professor at the Lee Kuan Yew School of Public Policy.
Professor Rajan argues that CBDCs will speed up the transition towards a cash-free society, with the COVID-19 pandemic having significantly boosted digital payments and further reduced the demand for cash-based transactions.
“CBDCs are expected to improve efficiency of payment systems given that the costs of payment processing of cash can be relatively high,” Professor Rajan said.
He added that in countries where the private sector has come to dominate payment systems (such as China, where an estimated 90% of mobile payments are handled by two providers), CBDCs can help alleviate concerns about risks to payments should one of these platforms face major disruption.
“In such a case, the motivation for a CBDC would be to strengthen and build the central bank electronic payments system as a means of mitigating the dominance of few large private players in the payments network,” Professor Rajan said, adding that CBDCs can also improve the transparency of cash transactions, as well as alleviate risks of tax evasion, illicit payments, and money laundering.
Other benefits of CBDCs include enhancing the effectiveness of monetary policy, as well as making fiscal stimulus more effective by helping to improve the targeting of government transfers to households or companies in the event of an economic downturn.
The risks and concerns of CBDCs
Yet there are also concerns about the rise of CBDCs, Professor Rajan added, including the risk of the diminished role of commercial banks and existing private payment systems.
The Chinese model suggests a way through this by creating a two-tier system. Central banks issue the digital currency – in parallel with notes and coins. But commercial banks and payment companies distribute the digital currency to the public via mobile wallets.
Although CBDCs can help promote financial stability, there is also the risk they could lead to a run on banks during periods of stress, as households convert bank deposits to CBDCs. This in turn could lead to a contraction of bank funding and curtail overall liquidity, he said.
There are also ethical concerns surrounding private cryptocurrencies, notably worries they could be used to fund criminal or socially undesirable activities "given the anonymity of those using the currency".
"In addition, one cannot neglect the environmental costs of Bitcoin and other proof-of-work currencies which need large amounts of energy for mining," he added.
Policy prescriptions
Professor Rajan added that the small segment of the population holding and trading cryptocurrencies meant concerns about financial instability caused by CBDCs were not likely to become a macro-problem in the immediate future.
"However, policymakers need to pay close attention to ensuring that there are no macro-financial repercussions which could occur if more agents (individuals, financial and non-financial companies) start taking stakes in private cryptocurrencies," he said. "As private cryptocurrencies have started becoming more mainstream, some countries have banned the use and trading of private sector cryptocurrencies," which is not always easy.
Other countries have allowed the use and trading of cryptocurrencies but have adapted regulation accordingly, including by ensuring that crypto transactions are brought under the area of anti-money laundering laws, and warning the public about the risk of these assets.
As the cryptocurrency space looks to expand even further in the future, an increasing number of countries are exploring the option of introducing their own CBDCs, likely resulting in their rapid growth in the future.
(Photo: Chronis Yan)