Long Read: Central Bank Digital Currencies (CBDCs)

The New Face Of A Cashless Society

While the third Bitcoin halving has come and gone and while Facebook is getting a license in Switzerland for their controversial digital currency project Libra, the central banks are also busy preparing for the final evolutionary step of governmental money – get ready for fully digital money and a cashless society.

What Is A CBDC?

CBDC is defined by Investopedia as a digital form of a fiat currency of a particular nation (or region), e.g., the Euro or U.S. dollar, and is issued and regulated by the competent monetary authority of the country (e.g., the ECB or Federal Reserve).

Each CBDC unit acts like a secure digital instrument equivalent to a paper bill and can be used as a mode of payment, a store of value, and a unit of account. Like a paper-based currency note that carries a unique serial number, each CBDC unit is also distinguishable to prevent imitation.

We believe that CBDCs will play a significant role in the years to come. The current COVID situation will only speed up the already existing process leading to the “cashless society.” There will pressure to go digital in most segments of our lives, and our money will not be an exception.

Researchers at the Bank of International Settlements, an international financial institution owned by central banks which fosters international monetary and financial cooperation, has said that 80 percent of central banks all around the world are undertaking extensive work on CBDCs.

CBDCs will bring many advantages: lower crime rates because there will be no tangible money to steal, less money laundering because there will always a digital trail of payments, less time and costs associated with handling paper money as well as storing and depositing it and easier currency exchange while traveling internationally. However, we have to keep in mind that there are also some serious disadvantages which will bring new risks and should be kept in mind. We will look into more detail of these pros and cons below:


What Are The Potential Odvantages of CBDCs?

Crime reduction and easier scrutiny of public spending

Statistics show that the preferred mode of payment for illicit activities, such as bribery, for example, is cash. This is because cash payments cannot be easily tracked compared to bank transfer payments, where large-scale criminal activity is much easier to detect. After all, such transfers are easily traceable.

In this regard, a significant advantage of CBDCs may also be public control over public money (i.e., money used by governments, municipalities, etc.). Because all the transfers will be traceable, the public will and should have the power to double-check how public money is handled, i.e., exactly how much and with whom are units of government spending. Because CBDCs allow every transfer to be traced, they should help prevent misappropriation of public money. A greater part of public expenditure would, accordingly, be under closer scrutiny by the people, which is undoubtedly how a truly democratic system should work.

Another point connected to crime reduction is that since people will not have physical cash with them, there should be a lessening of street crime and violence – there will simply be nothing to steal.

Public policy goals and lower costs

There are definite costs connected with the creation and distribution of physical money. Such costs may be significantly reduced with money being fully digital.

Christine Lagarde (then managing director of the IMF), at the 2018 Singapore Fintech Festival, presented the argument for governments to issue CBDCs as a means to achieve public policy goals which private companies are less motivated to achieve:

“Having central banks issue, the digital currency can bring about financial inclusivity, better security, and consumer protection, as well as allay privacy concerns.”

She also made clear that the public sector expects that private companies and startups will come up with innovative financial solutions based on CBDCs. The main public policy goal in this area is to prepare the groundwork for further innovation of that sort:

“The advantage is clear. Your payment would be immediate, safe, cheap, and potentially semi-anonymous. And central banks would retain a sure footing in payments. In addition, they would offer a more level playing field for competition and a platform for innovation. Meanwhile, your bank or fellow entrepreneurs would have ensured a friendly user experience based on the latest technologies.

Let’s put it a different way: the central bank focuses on its comparative advantage — back-end settlement. Financial institutions and startups are free to focus on what they do best — client interface and innovation. This is a public-private partnership at its best.”

Monetary policy

If blockchain and similar technology achieve the promise of handling a large number of transactions simultaneously, then CBDCs could become substitutes not just for physical cash but also for bank reserves.

Currently, reserves at a central bank are maintained by deposit-taking lenders. CBDCs could change this system by allowing any holder of a CBDC to have a deposit at the central bank directly, potentially making the state the monopoly supplier of money to retail customers.

As Agustin Carstens, the general manager at the Bank for International Settlement, noted recently, “If the central bank becomes everybody’s deposit-taker, it may find itself becoming everybody’s lender too.”

But why would central banks want to demote their own banking systems? One answer, looking at Europe and Japan, is that negative interest rates are doing that anyway. Lenders are starved of profit because while the central bank charges them for keeping money on deposit, they can’t as easily pass on those negative interest rates to their own depositors. If the global economy gets mired in long-term stagnation, as a result of the COVID situation or otherwise, official digital currencies will at least be an efficient way of monetary easing without involving banks.

Ethical money and other innovations

With a fully digital money, other non-monetary policy related experiments and innovations will be possible, as well; for example, all money could be set to automatically devalue itself slowly, encouraging its owners to spend it.

But CBDCs will also allow businesses to attach certain “electronic caveats” to their digital money. For instance, one could mark its digital money as ethical or sustainable, so it could only be spent at other ethical or sustainable places down the line.

Another example may be that parents could restrict their children’s allowance only to be spent on wholesome pursuits, like books, and prohibit it from being used in fast-food restaurants. A similar approach could also be used for certain state benefits, with governments labeling certain CBDCs as allowed to be spent on only specified products or services.

In other words, because CBDCs will be fully digital, it also means they will be fully programmable, providing vast options for potential innovation.


Disadvantages Of CBDCs

Privacy is a significant concern

It is no surprise that governments and their (especially tax) agencies would love solely digital transactions. Without cash, it would be nearly impossible to hide from the financial authorities. Also, the easily trackable records that cashless payments would leave behind would immensely help police and similar public protection agencies.

But public agencies are not the only ones who could take advantage of the data created by CBDCs. Look at what Facebook and Google are doing today with our information for advertising purposes. Having access to data on every single purchase one makes would be extremely valuable to such companies.

So, once this digital information about money transfers exists, it will become a target of government agencies such as the police and intelligence services, and be trafficked to insurance companies, tax collectors, fraud squads, and even marketers.

The promise is that banning cash would end black markets. Still, for many honest citizens, the end of paper cash could bring many unsettling downsides. Credit card transactions are already trackable, and CBDCs could bring that lack of anonymity to every single transaction you make.

While anonymous digital money is technically possible (see, for example, cryptocurrencies such as Monero or Zcash), governments are unlikely to pass up the chance to have all currencies tracked as they move through the system (like credit card transactions) and to require access to the history carried along with it by a digital currency.

The rich vs. the poor

A precondition for CBDCs to fully work on a whole society basis is to have everyone banked, i.e., everyone will need to have a bank account, which will work as a digital wallet for their CBDCs. The problem is, of course, that there are still many people in the world who are unbanked – they don’t have a bank account.

A cashless society would be an additional negative for such people. They would not be able to use government money to satisfy their basic needs. They would only be further marginalized and without support. In other words, the poor and those without bank accounts will have difficulty paying and receiving everyday payments.

Another problem that CBDCs may bring is that they could create different playing rules for different social classes. Governments may, for example, issue exceptions for payment anonymity either for themselves or for big corporates. Also, because CBDCs will be fully in the hands of governments and their banks, they will be in full control of lending mechanisms. This could create further challenges for the poor to get appropriate access to capital to help them improve their life situation.

Furthermore, it can also be argued that some may find it harder to control spending when they don’t see physical cash leaving their hands. The roll-out of the cashless society will, therefore, need to be slow so that people will get used to the new paradigm.

And lastly, having the whole money system in the hands of governments and banks may create, for example, a situation where banks start charging fees to compensate for possible negative interest rates (which had been becoming a new norm). There will not be much that the general population can do about it (e.g., one will not be able to “withdraw” cash from a bank charging such fees).


Technology breakdowns

Technology is vulnerable to glitches, outages, and mistakes. This will be no different for CBDCs. Technology breakdowns may leave people without the ability to make transactions at potentially crucial moments. Also, as payments move online, there would be an increased risk of crimes such as identity theft, account takeover, fraudulent transactions, and data breaches, all due to the higher volume of cashless transactions and more points of exposure for the average consumer.

We should learn from the world of private cryptocurrencies where data breaches, online thefts, and other types of hacks are quite a frequent phenomenon. These unfortunate situations could expose personal information as a result of data breaches, and hackers may drain bank accounts, leaving people with no alternative source of money.

And, of course, the technology risk lies not only in the hands of hackers, but it can also result from the system itself having issues, leaving the entire society without the possibility of payments if it breaks down.

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