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Central Bank Digital Currencies

Central Bank Digital Currencies (“CBDC") are a new form of digital currencies, sharing similar functions and the basic value as traditional banknotes and coins in general, such as being a source of value, an accounting unit, and a tool for exchange and currency exchange operations. As the history of money tells the story of struggles to manage the payment system and the money tree, this has changed in line with advances in technological, economic, and social developments. All transactions, regardless of whether they are charged to a debit card or wired, pass through a digital network that is owned and controlled by banks.

As society is reliant on banks for its payments system, when the Covid-19 pandemic ripped through, money from the central bank poured onto the wealthy through private bankers, while everyone else suffered the effects of economic stagnation. As a result, it became impossible for central banks to regain economic momentum while keeping financiers under control. To overcome this, there is a need to end the full monopolistic power of bankers over the money tree.

Bitcoin and non-state digital currencies, although inadequate, do threaten the bankers’ monopoly over the payment system, domestically as well as internationally. Despite this, governments would not be able to assist the workforce or businesses if digital currencies were prevalent before the pandemic. CBDCs built around Bitcoin-like technologies that promote transparency offer potential for positive outcomes.

What are CBDCs?

Central Bank Digital Currencies is the digital form of a country's fiat currency whose value is backed by the central bank. The majority of CBDC operate on Blockchain technology. As opposed to decentralized cryptocurrencies such as Bitcoin, which rely on a public blockchain, central banks will issue their digital currency on a private, regulated, and enacted central bank to protect consumers.

What is the difference between a CBDC and Cryptocurrency?

It is theoretically easy to spot the similarities between these two types of digital currencies. Common features of cryptocurrencies are decentralized clearing without a counterparty or trusted third party, the dependence of ownership on encryption keys rather than accounts, as well as the possibility to change the validity through smart contracts. However, there are significant differences between the two, not least of which is that central bank digital currencies are usually correlated to the value of a currency. Meanwhile, cryptocurrencies are created by the users themselves, and their values are not fixed to a currency, but rather by the mechanisms of supply and demand, which leads to significant fluctuations in value.

Furthermore, Blockchain cryptocurrencies do not have a legal backing that responds to technical issues, while CBDCs are supported by their central banks. While it is essential to work through complex mathematical calculations to produce and distribute cryptocurrencies and facilitate transactions, central banks will process CBDC transactions and distribute them via commercial banks.

Potential benefits of adopting CBDCs

CBDCs have multiple characteristics that make this type of currency a platform that aligns with the financial stability objectives that govern international monetary institutions;

Interestingly, CBDCs have central bank backing and are thus legal currencies and this ensures an unwavering safety against cyberattacks, system failures, or disruptions. Moreover, CBDCs will shift the transfer of money directly across national borders and among banks to a new level, eliminating the interoperability between different bank systems. The conversion and the value will be the same as physical money, hence, volatility will be avoided. CBDCs may also enhance the efficiency and liquidity of payment systems because of their characteristics as fast and low-cost mediums of exchange.

The adoption of digital currencies by central banks should also have the potential of promoting competitiveness in transactional efficiency, supporting financial inclusion, especially in emerging markets, as well as boosting transparency in the tracking of transactions to combat money laundering and fraud.

Challenges and repercussions of CBDCs

While the benefits of CBDCs encourage immediate implementation, the shortcomings draw an entirely different picture. Firstly, CBDCs are not accepted outside the country where the CBDC was issued, so they are highly confined geographically. Second, having central banks issue their own digital currencies will have an immediate impact on financial institutions and banks because it means deposits are transferred from commercial banks to central banks. Subsequently, this means a potential reduction in the size of balance sheets within the banking sector, resulting in a loss of income for banks.

Additionally, competition will arise as banks will be required to become more innovative, including offering competitive interest rates or bank deposits as a strategy. However, this will ultimately lead to greater interest rates in the long run, affecting small and medium-sized businesses with low price sensitivity. CBDCs’ new investment prospects could reduce consumer deposit demand, which in turn would lower bank lending to the general economy, and ultimately impact its growth. Commercial banks will also likely borrow internationally to finance their operations, which could leave the national banking sector exposed to external factors.

Initiatives of Central Banks on a Global Scale

Central Bank Digital Currencies are becoming increasingly popular, and the interest is increasing as cryptocurrencies are becoming more popular in general. Despite its volatility, the market has seen phenomenal growth this year, which raised concerns for most central banks about the volatility of crypto markets, and the fact that countries cannot govern them.

CBDC-related initiatives are now not only limited to China, the first major economy to issue a CBDC, and allowing foreigners to use digital yuan at the forthcoming Winter Olympics 2022 by submitting passport information to the People's Bank of China. It was also reported by the Atlantic Council that 81 countries (representing 90% of global GDP) are seeking to create a CBDC, while a study conducted by the Bank of International Settlements revealed that at least a fifth of the world's population will use digital currencies within three years.

A digital Euro is also being planned by the European Central Bank to be launched by 2025, while the Federal Reserve in the United States plans to release a research paper this summer looking into the potential for the CBDC. However, CBDCs are currently only fully implemented in five countries - the Bahamas, which launched the Bahamian Sand Dollar as the first CBDC, as well as Antigua, Barbuda, Saint Lucia, and two countries in the Caribbean.

On the other hand, some central banks have preferred to completely abandon the idea of CBDCs. For instance, Ecuador has discontinued its plans due to low transaction volume and poor distribution. The Danish Central Bank also stated in 2017 that the benefits of CBDCs do not outweigh the drawbacks, with large levels of monetary transactions and the currency's peg to the Euro reducing any potential benefits.

Sweden has begun testing the e-krona as an additional payment method. Moreover, the government of Norway is still in the exploratory stage alongside the Central Bank of Norway and is currently studying the issuance of a CBDC.

CBDCs: the future of finance?

Whereas CBDCs are still at an early stage, banks, central banks, and authorities around the world are taking an extensive look at the potential societal impact and repercussions to arrive at comprehensive results. Parallel to this, the private sector is designing and launching advanced payment solutions, such as cryptocurrency payment solutions.

There is a lot of research and analysis that can be carried out within the current banking system to seize the opportunity of implementing CBDCs, which would enable us to assess the potential repercussions, anticipate upcoming disruptions, and discover the role that CBDCs would play in the digital age of the financial system. We may be able to have both public and private money equally viable, though the central banks will need to innovate technologically unlike any in the past.

This article was originally published for BSA in Gulf Business.


Omar Al Masri

Associate, Corporate

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