Why Do central Banks Create Digital Currencies?

Experts are already citing central bank digital currencies (CBDCs) as one of the most important trends that will shape the future of money in the next decade. According to a report by the Bank for International Settlements, as of early 2019, 70% of central banks were engaged in CBDC research. Due to the coronavirus pandemic, the work on creating digital currencies in different countries will only accelerate – that’s without a doubt.

On August 19, The Block published a report on the current development of CBDC. It details why governments around the world are betting on CBDC, how digital currencies differ from traditional fiat, and what central banks have learned from research.

Incentives for the release of CBDC

Today, central banks already practice virtual currency emission, and a significant proportion of payments and transfers are made in non-cash form. The differences between CBDC and the existing system are as follows:

  • CBDC will simultaneously increase competition and stability in the financial sector as banks squeeze technology companies and cryptocurrencies;
  • CBDCs can improve financial inclusion by offering new payment infrastructure with lower transfer costs. It will also make it easier for central banks to operate in a digitized economy;
  • Digital currencies will expand the fiscal policy instruments available to regulators. Due to the transparency of CBDC, it is easier for regulators to control the work of deposits and loans at negative rates. More transparent data on payment flows will improve the quality of macroeconomic statistics;
  • CBDCs also encourage the use of local currency to pay for goods and services, which is especially important in countries prone to “dollarization”;
  • The “commercial” version of CBDC (when the digital currency is available only to banks) will reduce settlement risks, ensure round-the-clock availability of liquidity for banks, cut costs for cross-border transfers, etc.

Retail CBDC

Although the “commercial” CBDC is considered as a safer option for the stability of the financial system, for mass users it is the “retail” CBDC that is of interest – a full-fledged replacement for ordinary currency, which can be used to pay for goods and services, stored in a bank account, etc.

Sweden became one of the first countries whose authorities thought about CBDC. The reason is the extremely low use of cash (they accounted for only 5% of all household payments, while 60% were paid with bank cards). Testing of the e-krona began in 2017 (information about the plans appeared in the media a year earlier). After three years of study, it entered the pilot stage. In the development of CBDC, the regulator has been assisted by Accenture – it is responsible for payments, deposits, transfers, and other functions on the R3 Corda Blockchain.

Uruguay, one of the most economically prosperous countries in Latin America, piloted its own CBDC (e-peso) from September 2017 to April 2018 among consumers and businesses. Instead of a distributed ledger, digital wallets operated by the state telecommunications company Antel worked. At the same time, the e-peso system provided for anonymous transactions and transfers without an Internet connection, and each e-peso “banknote” had a unique cryptographic signature. Now the results of the project are being assessed in terms of the feasibility of user anonymity, the possibility of introducing “interest rate” instruments, and the overall impact on the economy.

Commercial CBDC

Another type of digital currency is the so-called Commercial CBDC (Wholesale CBDC). This currency is for limited use by specialized organizations. As planned, only banks have access to w-CBDC. The scope of use of the w-CBDC is limited to the areas of interbank transactions, settlement of transfers, clearing operations, and international trade (where banks often act as guarantors for transactions).

Commercial CBDC is a further development of the existing practice, in which the central bank issues currency to a virtual account and gives access to it to banks, and they, in turn, distribute the currency further throughout the economy.

However, compared to the current system, the w-CBDC has several advantages. Firstly, it is the round-the-clock availability of funds, whereas now the central bank approves applications manually. Secondly, all transfers are recorded in a more reliable distributed ledger, which increases the efficiency of settlements, and the central bank acts as a source of funds and, therefore, a guarantor for obligations, which avoids credit risks.

Among the main experiments of the w-CBDC, researchers noted the project of the ECB and the Bank of Japan (Project Stella), the Bank of Canada (Project Jasper), the Monetary Authority of Singapore (Project Ubin), as well as Hong Kong and Thailand.

In all cases, w-CBDC testing was carried out using popular enterprise blockchain platforms: R3 Corda, Quorum or Hyperledger Fabric. Although Blockchain is considered by some to be an optional technology for CBDC.

It was in the European-Japanese Project Stella that “anonymity vouchers” were used. These are special electronic certificates that a platform participant could receive. Transactions with attached vouchers could go through without confirmation from the ECB: the sender only needed to indicate the amount, recipient ID and activate the anonymization function (the voucher used in this case “burned out”). In this scenario, the identities of the participants were not verified.

Chinese digital yuan

Perhaps the most attention is now riveted to what the digital currency of the world’s second economy will be like. The first work on the “digital yuan” started back in 2014.

This summer, a pilot experiment began in several cities to pay with the digital yuan for small purchases by residents in the field of catering, trade, and education (in total, more than 20 companies and four state banks are involved in the test). DCEP is also planned to be used for large commercial transactions and in the taxi service.

Judging by the ongoing experiment, the digital yuan will become a full-fledged replacement for cash. There are all conditions for this: China today is the largest market for mobile payments with over a billion users.

The Chinese authorities want to bring digital currency closer to cash in terms of anonymity, as can be seen from the patents registered by the People’s Bank of China. DCEP is planning to incorporate “controlled anonymity” into its architecture. This means that different participants in the system will have limited information about each other. However, government agencies can easily obtain the data they need. Offline transactions should become another characteristic of the “cash” of the digital yuan.

CBDC is really a unique innovation that will completely change the financial system we know today. The world is heading towards a mass digitalization and digital currency is a further step towards it.

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