Central Bank Digital Currency (CBDC) has recently been a widespread issue in the financial world. Several Central Banks are conducting research to determine the technological and economic viability of introducing digital money that is a liability of the central bank and the implications for financial regulation, liquidity, etc. So, what exactly is CBDC? How does it vary from physical currency and money in your bank account? Why is CBDC such a big deal, and how will it affect financial institutions?
What is CBDC?
A CBDC is a digital currency regulated by a central bank and has legal tender status. In the case of the United States, it would be the Federal Reserve making bank reserve legal tender. A Central Bank Digital Currency would be a liability of the Federal Reserve that an individual, business, or other entity that is ineligible to hold bank reserves, is allowed to hold. From the individual’s perspective, they would see it as bank account that is held at the federal reserve rather than their commercial bank.
How does CBDC vary from the Physical currency and money in your bank account?
A central bank digital currency is similar to a digital version of the Federal Reserve notes in your wallet (cash) . However, holding and exchanging actual cash is inefficient and time-consuming. That value would be considerably more convenient and efficient if it were represented digitally.
There are two different characteristics necessary to distinguish between the different options for money, meaning physical cash, money in your bank account, and a possible CBDC. These characteristics are what entity is it a liability for and is it physical or digital.
Physical cash is a liability of the Federal Reserve (it literally says Federal Reserve note on the bills) and it is in a tangible form. A possible CBDC would be similar in that the holder has the Fed as the counterparty, but it would be held in a digital form. In terms of the money held in your bank account, those are technically liabilities of the commercial bank denominated in dollars. One of the perks of being a bank is that they can “transform” their digital liabilities (your bank account) into physical cash which is a liability of the Fed.
It is more of a bank promise to provide you with a tangible cash upon request. Hence why is it called a note. It is the responsibility of the bank to satisfy those requirements. Usually, a bank has no problem honoring that guarantee. Thus the distinction between your money in the account and physical currency becomes blurred. This distinction is critical if the bank collapses and goes bankrupt. You can’t hold anybody to your claim since you don’t have legal cash in your checking account, only the “bank’s guarantee,” and you’ll lose your money if the bank collapses. Worse, if many individuals believe their bank is going to go bankrupt, they will withdraw their funds to avoid losing them. When a large number of a bank’s clients do this, known as a “run on the bank,” the bank’s solvency is further eroded, perhaps resulting in its failure.
How do banks provide loans?
Suppose a company wants to expand and needs a loan to do it. The bank offers them money after a screening procedure, but only under specific terms, the most significant of which is the repayment timeline and interest rate. But where does the loan money come from? When a loan is created, the bank credits the borrowers checking account and boom, money now exists. That is quite literally what happens and why demand deposits (checking account money) is a liability of the commercial bank. Now, there are regulations on how much commercial banks can do this, but these just muddy up the accounting and with some financial engineering, the bank is not really restrained at all. So that bares the question, how would this change if it were the Federal Reserve creating the loans to businesses and individuals? However, to answer this question, more details on the implementation of such a currency would be require and most of the papers published by the Fed and other entities are just discussion papers at the moment.
What are the advantages of CBDC?
CBDCs possesses several intriguing advantages according to the authors. The following are likely the most important:
- You wouldn’t have to rely on the bank’s stability since the CBDC would have legal tender status and wouldn’t be your bank’s responsibility. Your money would be secure, regardless of how well the bank performs.
- The Central Bank would be able to impose its monetary policy in a much more direct manner since it would have more lethal energy to accomplish one of its key goals: guaranteeing financial stability.
- The CBDC would have no liquidity risk, meaning there would always be enough to maintain liquidity in markets (their argument).
What will be the role of banks in the future?
One could ask what the banks would do if you owned CBDC and had an account with the central bank.
The vital role of the bank as a loan provider would be jeopardized, but banks have a considerably better understanding of their client’s requirements and desires than central banks. As a result, they may be far more creative regarding money-related services. Various financial services, such as a convenient mobile banking platform, innovative mobile payment methods, or even investment and financial advice, might help a bank stand out.
That being said, one possibility is that the infrastructure of the current commercial banking system would be maintained, as why create something new when the structure already exists. Essentially, the commercial banks would act as intermediaries and operate and compete in the open market for CBDC services. At least this is one possibility that is being discussed.
Would the CBDC have an impact on the economy?
If a large percentage of the bank’s customers choose to hold CBDC instead of a bank account, the bank will have less capital available to offer loans, making them more costly and have much tighter lending requirements.
The consequence is that a hasty adoption of CBDC without mitigating measures might have a significant and negative economic impact. It’s undoubtedly one of the main reasons why central banks haven’t rushed at the chance to establish a digital currency with legal tender status but are instead researching the best ways to handle the problem.
Why would someone choose CBDC over a bank account?
The critical reason consumers may choose a CBDC as a bank account is that CBDC is unaffected by bank failures. Meaning no credit or liquidity risk.
Additionally, money transfers between banks and across national borders become significantly easier. To make such payments, different bank systems would not need to communicate. All that’s required is for the central bank’s records to be updated. The method is speedier and less expensive because of its simplicity. Also, Money laundering would be easier to detect.
In the future, CBDC might reduce the risk for users while allowing banks to focus on providing services.
You can read the discussion paper yourself HERE.
And an overview of the paper can be found below.
https://jamesdforsythe.com/united-states-central-bank-digital-currency-on-the-horizon/
