What are Central Bank Digital Currencies (CBDCs)?

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Photo by Dmitry Demidko on Unsplash

Background

Let’s start with banks. Why do individuals and corporations deposit money in banks in the first place? Because keeping cash under your mattress is impractical. And, as a bonus, banks pay interest on deposits (although not much). This system benefits everyone: Depositors have a (relatively) safe place to store their money; borrowers can make investments they would not otherwise have had the funds to make, thereby stimulating the economy; and commercial banks can profit off the difference between the interest on their loans and deposits.

Commercial banks must hold a certain percentage of their deposits as reserves and can lend the rest. (The US has had a 0% required reserve ratio since the start of the COVID-19 pandemic in March of 2020.) A bank with $10 million in deposits in a jurisdiction with a 10% required reserve ratio can have up to $100 million on its books in depositor’s accounts. Where does the extra $90 million come from? Well, it’s just numbers on a screen — a promise that, if desired, can be exchanged for cash. The system relies on the banks’ credit.

But there’s a risk that a commercial bank — a private entity — may not be able to honor that IOU; borrowers default, and banks fail. Yes, there are systems in place to mitigate these risks, like the central bank’s role as a lender of last resort and deposit insurance (provided by the FDIC in the US). But, when many borrowers default, central bank loans are really only postponing the problem. And deposit insurance, although valuable for depositors, costs banks premiums and only insures up to $250,000 per account.

So, what’s a CBDC?

A central bank digital currency (CBDC) is, well, a digital currency issued by a central bank. Each unit is uniquely identifiable and, just like cash, is a direct liability of the central bank. On the other hand, today’s digital currency is the liability of the issuing bank — it’s an IOU, in principle redeemable for central bank-backed currency.

How would it work?

CBDCs could use either a central or distributed ledger. A central ledger would be nothing but a single set of digital records of transactions held by the central bank. A distributed ledger would use blockchain technology — just like with today’s cryptocurrencies, all network participants would continuously check encrypted transaction records. The difference, of course, is that the central bank would control the money supply. The problem with the latter option is that it is slow and requires a possibly impractical amount of energy and computing power, although blockchain technology is becoming more and more efficient with time.

Changes to banking

Instead of having accounts with commercial banks, individuals and organizations would all have an account with the central bank in the form of a digital wallet. The end of deposits seems to present a problem: Where do banks get funds to lend? We certainly don’t want to make it impossible for people to get a mortgage or businesses to borrow to invest in capital. We don’t want the central bank to be the sole lender. The solution? Make the central bank the “lender of first resort.” Today, central banks lend to commercial banks only as a last resort. In a CBDC world, banks borrowing from the central bank would be the norm. Instead of paying depositors interest (effectively “borrowing” from them), banks would pay the central bank a low interest rate on the funds they loan out. Like they do now, banks would make money on the spread between the rate they pay and the rates they charge. Credit would remain available, but risk in the banking system would be significantly reduced — depositors would no longer have to worry about commercial banks’ solvency. Currencyholders’ risk would be the same as when they hold cash. So bank runs would be impossible: Bank runs happen when faith in commercial banks’ IOUs declines, but CBDCs would eliminate those IOUs.

Additionally, CBDCs would make payments and transfers far more efficient. Transaction costs could be effectively zero, and transactions of any amount would be instantaneous, passing only through a single clearing house — the central bank’s ledger.

Furthermore, since banks’ business would no longer depend so heavily on their established credit and reputation (which are critical in today’s competition for deposits), there would be significantly lower barriers to entry for the industry. Apps and services built off the centrally-managed CBDC platform would boom; greater competition would encourage new, more user-friendly features, which would be better for consumers.

New monetary policy tools

Today, central banks have three primary tools to control the money supply. The first is the discount rate — the interest rate they charge commercial banks on short-term loans. The second is open market operations, where the central bank buys and sells government bonds — buying injects money into the economy, and selling pulls money out. These two tools affect the interest rate in the overnight interbank lending market, known as the federal funds rate. The federal funds rate, in turn, affects the interest rates that banks charge on loans. In rarer, more extreme situations, central banks can also modify reserve requirements, as the Federal Reserve did in 2020.

With these three tools, central banks can control the amount of money flowing through the economy. With more money in the economy, interest rates are lower, making it cheaper for individuals and firms to borrow and invest. A higher money supply speeds up the economy, leading to more growth, higher inflation, and lower unemployment, and a lower money supply slows down the economy, leading to less growth, lower inflation, and higher unemployment.

CBDCs would give central banks two new tools. First, the discount rate would have new significance: Since banks would be borrowing explicitly to lend, there would be a near-perfect correlation between the interest rates banks they charge and the rate they pay. Second, central banks would control the interest they paid on deposits, allowing them to put cash directly in individuals’ and firms’ hands. This differs from the indirect approach of injecting money into the economy via commercial banks or the bond market. In short, central banks would have more direct control over interest rates and the money supply.

Other implications

CBDCs would also make it easier for governments to make transfer payments, like welfare. Rather than relying on transfers through commercial banks, funds could be instantly transferred to digital wallets. Additionally, a central database of transaction records would help regulators sniff out suspicious payments and potentially simplify the calculation of income tax payments. On the other hand, CBDCs cause data privacy concerns. Of course, many don’t like the idea of the government having data on all their transactions.

Furthermore, a centralized system would concentrate the risk of a computer breach. Currently, the risk of system breaches is spread out. When a breach occurs, a relatively small amount of data is compromised, and only a small part of the system goes down. But with a centralized system, a breach would be catastrophic. Everyone’s data could be compromised, and the entire national payments system might go down. However, security would certainly be much better, since central banks have their government’s resources at their disposal. So although a breach would be far more destructive, it would also be far less likely.

Conclusion

CBDCs would disrupt the traditional structure of the banking system. Individuals and firms would still have access to credit, but the system would have much less risk. It would be easier for regulators to uncover fraud. Payments would be more efficient and streamlined, and central banks would have more direct control over interest rates and the money supply, helping them react faster to changing circumstances. Although CBDCs would be accompanied by privacy concerns, these would be more than compensated for by benefits that would be felt all across the economy.

Further reading

China’s central bank recently launched a digital yuan. Users need only a phone number to create a digital wallet, showing that CBDCs can help improve financial inclusion.

Here is an article from Deutsche Bank on the digital yuan.