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What are central bank digital currencies?

Feb 18, 2021

With a digital revolution in full swing, how long will it be until our currencies go fully digital? Tristan Perrier examines what central bank digital currencies are and when we might expect to use them.

The goal in creating retail central bank digital currencies (CBDC) is to give the public access to a digital currency that retains a certain number of the characteristics of physical currency. Like physical currency, and unlike bank deposits, retail CBDCs will constitute a direct liability for the central bank, eliminating, in principle, any credit risk for the holder. Depending on the selected architecture (direct or indirect account of the end-holder with the central bank, and/or a digital token that can be used online or offline, etc.), such currencies could offer similar advantages of portability and confidentiality to notes and coins. However, their immunity to different undesirable events would differ. For example, CBDC and physical currency would not be vulnerable to the same types of criminal activity.

Despite this, it is very unlikely we will see a major country introduce fully functional retail CBDCs this year, although central banks, including some of the larger ones, seem to be speeding up their preparatory work. The People’s Bank of China, for instance, has conducted CBDC tests in several large cities in recent weeks, while the European Central Bank recently concluded a vast survey to decide whether it will launch a concrete project in the second half of 2021. While the US Federal Reserve’s communication on the subject remains more cautious, stating that there is no “need or urge to be first”, certain central banks of smaller countries are at a more advanced stage.

What does this mean for banking systems?
Economic agents holding domestic CBDC alongside bank deposits (which are also dematerialised but are liabilities of private sector financial institutions) raises the issue of the respective roles and interactions of these two asset categories. Central banks will, in fact, have to define the future terms of competition and plan for or prevent the changes that their coexistence could bring on banks’ cost of financing, risk profile, and the mechanisms by which they normally create currency. They will also have to determine the extent of the role of intermediary played by banks in giving the public access to CBDC (since central banks thus far have not been equipped to interact directly with individuals, it is generally envisaged that commercial banks would be given this role). These are complex issues that, in addition to the technical and operational aspects, warrant a cautious pace of progress by the authorities.

A new instrument of monetary policy
At present, no major central bank seems to view CBDC as serving a primary role as a new monetary policy instrument beyond the strengthening of the legitimacy and use of the official national currency. Nevertheless, many observers (including the central banks) are reflecting on such a possibility and its major implications.

First, CBDC could lower the “effective lower bound” – point beyond which further monetary policy in the same direction is counterproductive – of monetary policy if, for example, they carried negative interest rates or, by contrast, increase it to zero if they constituted zero-rate assets which are less costly to hold (in terms of storage and security) than physical currency.

Second, CBDC could, in theory, become a “programmable currency” whose possibilities of use (time-limited, restricted to certain expenditure, etc.) could be managed dynamically by the authorities.

Other possibilities, such as new interactions between monetary policy and fiscal policy, are also envisageable. Visibility in this domain is as limited as the theoretical possibilities are vast.

CBDCs could have many consequences, some of which would be complex and difficult to figure out. Considerable work and additional testing are vital before they are introduced. However, with the gradual reduction in the use of physical money and the rapid development of digital rivals for traditional currencies, it is very likely that we will see CBDC introduced within a few years. This could impact on many sectors of domestic economic and financial life, as well as international financial equilibria.

Tristan Perrier is a Global Views Analyst at Amundi. A version of this article was originally published in The FM Report.