Promising future of Central Bank Digital Currencies

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Promising future of Central Bank Digital Currencies

Sunday, 26 September 2021 | Piyush Kamal

CBDCs based on transparency-enhancing blockchain are a promising way to achieve three objectives: liberating the payment system from rentiers, guaranteeing unprecedented transparency regarding how much money is plucked from the money tree, and democratising access to the tree’s fruit

The digital currency has so far managed to emerge as one of the strongest flavours within the current financial market. What makes digital currencies different from all their predecessors are the tremendous new functionalities they promise to offer. It’s the financial equivalent of the leap from postal service to email.

Money basically performs three functions. As a medium of exchange, it enables transactions that otherwise would require difficult bartering (as in trading chickens for a car).

As a unit of account, it allows one to know whether one has saved or not over the past year. And as a store of value, money enables current income to finance future purchases.

According to the IMF, the opportunity for Central Bank Digital Currencies (CBDC) depends solely on its ability to improve upon these three core functions of money.

Interestingly, the idea of CBDC is gaining support from the financial establishments such as the Bank for International Settlements, known as the central bank of central banks. These financial gatekeepers are embracing CBDC because they can see that if they do not someone else will.

A recent survey by the Bank for International Settlements indicates that 86 per cent of the central banks are actively researching digital currencies. And almost

60 per cent of banks are in the testing phase.

According to some estimates, a fifth of the global population will be exposed to a central-bank digital currency within three years. By 2027, some $24 trillion of assets around the world is expected to be in digital form.

Dollar & Changing Financial Landscape

Though the US dollar remains the world’s dominant reserve currency, the downward trend in the global reserves of the US dollar to a 25-year record low of 59 per cent has managed to stump many.

Some cite a combination of nations shifting away from the USD and the rising status of competing currencies like the euro, the Japanese yen, and the Chinese yuan as factors in the USD’s slump. But others are of the opinion that the hegemony of the US dollar doesn’t seem to be under any threat in the near future.

Russia and China have both stepped away from an uncertain and politically entangled US dollar in recent years, with the Central Bank of Russia (CBR) ditching over US$101 billion in dollar-denominated reserves in early 2019. China on its part has loosened its grip on US government securities, with a reported 20 per cent decrease in these holdings over roughly seven years, according to US Treasury Department data.

Digital currency based on blockchain looks promising

Controversy about the benefits and drawbacks of CBDCs notwithstanding, governments around the world are increasingly exploring, researching, or testing the implementation of digital, programmable fiat. All eight central banks of the top currencies from the IMF report are either considering, researching, or actively developing a CBDC.

CBDCs based on transparency-enhancing blockchain are a promising way to achieve three objectives: liberating the payments’ system from rentiers, guaranteeing unprecedented transparency regarding how much money is plucked from the money tree, and democratising access to the tree’s fruit.

At the retail level, a CBDC would offer some obvious advantages. It would help the poor and others who are currently underserved by the banking system. It would also make it much easier for governments to administer social transfers like the household cash disbursements made during the pandemic. And a well-functioning international system of digital currencies would sharply reduce cross-border transaction costs.

However, in addition to various privacy concerns, CBDCs have complications of their own. One crucial question is where CBDC accounts would be held. If it is in the central bank, how will privacy for transactions be preserved? Equally unclear is what role would be left for private banks, which are currently the predominant source of credit in most market economies. If banks no longer receive deposits, how will they issue loans?

For such an arrangement to function well, the CBDC would need to strike a difficult balance between anonymity (privacy) and control of the system. Otherwise, all the concerns regarding the government’s unrestricted access to account holders’ information will start looking legitimate.

The viable alternative for the central bank is to allocate deposits to member banks, which would then continue to function as sources of credit. In this case, there would need to be strong fractional reserve requirements.

Regarding concerns about privacy, it is possible to anonymize central-bank accounts with digital tags that only an independent regulatory institution can trace to physical persons. After all, lest we forget, our current payments system (with the strict “KYC” rules) is managing well with illusionary privacy.

There are also complications at the international level. Would central banks be willing to accept payments in other central banks’ CBDCs? Could countries retain control of their money supply once it has taken a digital form?

At present, it is very difficult to imagine a future scenario where the major central banks would be willing to underwrite the international financial system without a high degree of cooperation, coordination, and control.

The Road Ahead

These international questions are of particular importance for the United States because the dollar has served as an international reserve currency, a unit of account, and a means of payment for the past 75 years. For better or worse, the dollar’s key role in the system has enabled the US to impose reasonably effective financial sanctions on countries such as Russia and Iran, and the US is in no mood to surrender this tool willingly.

No monetary system has ever functioned perfectly. But it is generally agreed that the current one has performed well over the past so many years, especially when compared to earlier systems such as the gold standard.

Although a CBDC could improve financial inclusion, most experts caution that it should not be inaugurated until there are assurances that credit allocation, payments systems, financial-stability safeguards, and other aspects of the new system would function at least as smoothly as they do under the current one. There is no doubt that the central bank digital currency will happen sooner rather than later. The question, then, is whether all the issues (both the identified and emerging ones) will be resolved before the transition is made.

(The writer is an economist, former IRS officer, and author of the upcoming book “The Current Perspective on Indian Economy”)

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