Central Bank Digital Currencies, Part 2

Previously, I gave a brief history of CBDCs, what they are, and how they compare with traditional cash. In this second part, I will discuss the costs and benefits of introducing a CBDC.

Technology develops at a rapid pace, and keeping up with it is sometimes not only desirable but actually necessary! However, jumping on the train — much less being the locamotive itself — might not always be a good idea. It is often more important to get something right than to get something first, and this will likely hold true for Central Bank Digital Currencies as well.

So, what could be the benefits of CBDCs? Here are a few aspects:

  1. Substantially reducing costs related to cash circulation
    For any economy, there are direct and indirect costs related to cash. This could include labor (sorting and counting), insurance, theft, holding excess cash, transport, etc. These costs start to really add up, and they are hidden from the general public — most people aren’t aware of them at all. A well-developed retail CBDC could potentially abolish 90% of cash-related costs in the long term, which can be one of the motivating factors for governments.
  2. Increasing payment system stability
    Over the last 2 decades, payment systems have been gradually consolidated into the hands of a few very large corporations. This fact is something that some central banks are starting to worry about. For them, a CBDC could be a path towards developing their own new payment systems, which in turn would increase payment system stability.
  3. Increasing financial inclusion for citizens
    The number of unbanked or underbanked individuals remains quite high in the world. Obviously, this differs significantly based on the state of a country’s economy, but it also means that many people still do not have access to modern services that can save time and money. In this aspect, a CBDC could be a trusted, safe, and fast means of payment that does not require traditional bank accounts or debit cards.
  4. Improving cross-border payments
    As noted in the October 9th report from the Bank for International Settlements (BIS), cross-border payments continue to be quite complex as they involve numerous players, time zones, jurisdictions, and regulations. This makes them slow, expensive, and inefficient. Thus, a CBDC that is compatible with other CBDCs could be the way to simplify cross-border payments such that payments could actually become borderless.

Now, let’s look at the potential costs as well:

  1. Facilitating “bank runs” in times of economic crisis
    As I described in the first part of this series, holding a CBDC means having a claim directly on the central bank’s balance sheet, just like holding cash. Cash does not pay any interest, and holding excess amounts of it comes with an opportunity cost when it is not deposited in an interest-bearing instrument. Thus, generally people with large amounts of cash take advantage of commercial bank accounts. However, even though there are relatively good mandatory deposit insurance practices all over the world, if crisis strikes, holders of a well-developed CBDC could instantly withdraw funds from commercial banks and “save” them with the central bank. It would complicate the liquidity problems for commercial banks that they face during an economic crisis and could ultimately lead to their bankruptcy.
  2. Breaking up the banking sector
    And speaking of deposits, they actually represent a significant portion of a bank’s balance sheet. If an interest-bearing element was integrated into the CBDC, it would mean that people could actually earn interest directly from the central bank. This kind of system could potentially cause the banking sector to break down. Banks would now have to compete with the central bank for client deposits, leading to increased interest rates on deposits, translating into increased interest rates on loans, and subsequently causing a decrease in the availability of cheap long-term financing for the economy.
  3. Risks related to cyber security and CBDC management in general
    A digital currency will inherently have cyber security risks. It is quite difficult to simultaneously offer state-of-the-art security features and convenient ease of usage. As BIS mentions in their questions to guide further research, a balance will need to be achieved among open access, offline usage, and broad support from payment system providers with security considerations. A CBDC will be “representative” of its central bank, and any coordinated sophisticated cyber attack could be devastating for the economic and financial stability of the whole country.

What’s next?

CBDCs are progressively being developed by leaps and bounds by many countries. The value in them as seen by countries in different stages of their economies is not the same, but many of the general benefits are expected to be similar.

In the third and final post on this topic, I will look at the current state of development achieved by various countries and what the future could bring in this field.