The digital currency revolution is upon us. Only the global economy is at stake
- Digital money can vastly increase efficiency through greater speed and reductions in transaction costs, and since it’s not issued by the government but rather ruled by an algorithm, it may be more inclusive and less affected by political considerations.
- Governments are eager to position themselves for the next stage of the digital revolution in financial services by issuing central bank digital currencies. The stakes are especially high in the case of global currencies, such as the dollar, the euro and pound sterling, which do not want to lose status to other fiat currencies, such as the renminbi.
- Beware of countries intent on increasing their influence over global financial matters; China is planning to make a digital yuan accessible to its trading partners—thus disintermediating the U.S. dollar.
“Let me issue and control a nation's money and I care not who writes the laws.”
This apocryphal quote, often attributed to Mayer Amschel Rothschild, the founder of the legendary banking house, suffices to convey how important money is to the economy and life in general. Money has existed in the form of coinage for nearly three millennia. It’s important to distinguish from the outset two key characteristics of money: namely, who issues it, and what format it takes.
The issuer provides money with a certain degree of trust in it. Thus, money issued by a sovereign national government tends to be more trustworthy than money issued by a municipality, a company or a digital platform. Trust is boosted not just by financial credibility but also by effective protections against forgery and the double-spend problem. The format of money, by contrast, mainly affects the efficiency of using it. It is more expensive, for example, to mint and transport coinage than paper money.
Digital forms of money can vastly increase efficiency through greater speed and reductions in transaction costs. In addition, many people find that digital money not issued by the government but ruled by an algorithm may be more inclusive and less affected by political considerations.
The digital currency landscape
Contrary to the popular imagination, we’ve been using digital forms of money for several decades. “Commercial bank money” is created when a bank lends money, thereby increasing the money supply beyond the amount the central bank issues as “base money.” This type of money has existed in digitized form since the 1960s, when banks in the UK and later in the United States created interconnected systems to move money between accounts, thus enabling account holders to transfer money digitally, albeit with high fees, especially across national banks and national borders. Debit and credit cards added further functionality to digital payments. Nowadays, we are also holding non-bank digital money on payment apps like PayPal or CashApp, although the balances are not insured by the government.
Cryptocurrencies are the newest form of non-bank digital money, and there are thousands of them. They tend to be decentralized, peer-to-peer transactional tokens with the aspiration of becoming a widely-used means of payment and store of value, but without being backed by any real asset or by an issuing authority such as a government. Even the largest one, Bitcoin, has an annualized volatility approaching 100% (4 or 5% daily) making it a speculative cryptoasset rather than a medium of exchange or a store of value—very few merchants accept it as a form of payment.
Other cryptocurrencies were originally designed to serve a purpose, like ethereum, the second largest, or Ripple, which facilitate cross-currency transactions. They are called utility cryptocurrencies, and their value should be less volatile given that they exist for a specific reason. Stablecoins are a third type designed to address volatility by pegging its value to that of a fiat currency (for example, the dollar), a commodity or a financial instrument. The issuers, accordingly, maintain reserve assets as collateral. The fact that they promise stability by holding reserves has drawn the attention of regulators and legislators, who have called for periodic audits of reserve levels so that there is transparency as to whether they are adequate or not.
While regulation of cryptocurrencies may erode some of their allure in the eyes of users who distrust the government, it would help legitimize and stabilize them. All countries in the world save for a handful (China among them), have declared them legal, but only two have taken the bold step of making a cryptocurrency legal tender—El Salvador and the Central African Republic. Both countries rely heavily on remittances, and thus saw potential benefits in facilitating financial inclusion and lowering fees.
Will central banks enter the fray?
There is nothing preventing central banks (governments), from issuing a digital version of their own fiat currency, such as a central bank digital currency (CBDC). Unlike cryptocurrencies, a digital dollar, for instance, would be a liability of the central bank (the Fed), just as the physical version (coin or paper). It would accordingly be virtually risk-free for the owner, though not necessarily anonymous like bitcoin or physical cash unless it is implemented as a token with a crypto key instead of an account with an identifiable holder. The central banks of nearly one hundred countries are at the very least doing research on this possibility. Looming large in the background of these efforts is the fact that cash is losing relevance as a means of payment. Governments are eager to position themselves for the next stage of the digital revolution in financial services. The stakes are especially high in the case of global currencies, such as the dollar, the euro and pound sterling, which do not want to lose status or be threatened by other fiat currencies, such as the renminbi. Thus, the respective central banks have published position papers and started to conduct pilot implementation projects. To that end, the Federal Reserve of the United States issued a report earlier this year saying CBDCs could fundamentally change the structure of the U.S. financial system.
A CBDC could be implemented at the wholesale level alone: Financial institutions open accounts with the central bank to hold reserves and settle interbank transfers. This would not be, in practice, much different from the current system. A more radical step would be to implement the CBDC at the retail level with individuals and companies being allowed to hold and use it. Note that a retail CBDC would be as frictionlessly mobile as a cryptocurrency, but with much smaller risk and volatility, and it could be used in a store, online or in peer-to-peer transactions.
If supported by a well-fuctioning digital ledger, perhaps a blockchain operated by the central bank, it would dramatically lower transaction costs. The Bank for International Settlements has proposed an agreement to create “interoperating” CBDCs as a solution to extremely high international money transfer fees. Emerging economies are especially interested in this possibility because they tend not to be well served by correspondent banking arrangements. They are also attracted to the idea of fostering financial inclusion, given that between a third and half—and in some cases more—of their population may lack a bank account.
Potential pitfalls of digital currency
The most vexing issue concerning a potential CBDC is whether it would pay interest or not. Physical cash does not earn interest unless it is deposited in a bank account that pays interest and is thus transformed into digital commercial bank money. An interest-bearing CBDC would be a close or near-perfect substitute for commercial bank money, treasury bills, and money-market mutual funds. Thus, it would make it harder for commercial banks to attract deposits, reducing their ability to give credit, and potentially leading to complete disintermediation in correspondent banking networks.
This could result in a credit crunch and the need for central banks to provide the capital to lend, making them even more powerful than today. The Bank of England has proposed not to pay interest, while the European Central Bank favors it, though at varying rates depending on the circumstances. The Fed has left the door open to further discussion, noting the negative impact on financial stability. All three banks suggest limits on how much CBDC individual account holders may possess, and how much they can accumulate over a certain period of time.
Emerging economies are especially interested in this possibility because they tend not to be well served by correspondent banking arrangements. They are also attracted to the idea of fostering financial inclusion, given that between a third and half — and in some cases more — of their population may lack a bank account.
A system for fintech to thrive
The idea of a CBDC is proving attractive to entrepreneurs if central banks are open to a public/private platform model, whereby fintechs would be interface providers. Users would access the central ledger indirectly with a pass-through wallet on smartphones or smartcards. The Bank of England favors this approach, while the European Central Bank leans toward direct access. In a risk-free digital fiat currency system, fintechs would compete on the basis of price, product differentiation, and customer service. Another model is the deal announced by Samsung and the Bank of Korea in May 2023 to conduct research with a view to launching a digital won on Samsung’s Galaxy ecosystem.
CBDCs have both ostensible advantages over decentralized cryptocurrencies like bitcoin (for example, only as much risk and volatility as the conventional fiat currency) and drawbacks (privacy, disintermediation, and systemic risk concerns). It is hard to envision a future scenario in which the likes of bitcoin and ethereum remain the largest digital currencies, if the most important central banks in the world manage to set up a platform that exploits the advantages and minimizes the concerns. But that’s a big “if.”
As of summer 2023, there were three active CBDCs in the world, launched by the Bahamas, Nigeria, and the seven-country Eastern Caribbean Union. Constraints on the amount issued have minimized the systemic risks while providing some insights into the beneficial effects in terms of financial inclusion. For example, the Bahamian digital “Sand Dollar” was launched in 2021 on an extremely limited basis; it accounts for less than 1% of total money in circulation (the equivalent of less than half a million U.S. dollars). As of March 2023, the Nigerian Central Bank had issued about 10 billion digital nairas (enairas), approximately $22 million, a tiny amount compared to the size of Africa’s largest economy. China’s retail pilot of the digital yuan is restricted to less than 2% of all cash in circulation, and less than 1% of all cash plus bank deposits.
The future of digital money
The launching of further CBDCs will be contingent on how effectively systemic risks are addressed, and whether they offer lower costs and/or more value to the user than existing digital cash services like Paypal and CashApp or their equivalents in various countries around the world. Serious doubts also remain as to their scalability, which will in turn depend on the central bank’s degree of comfort in issuing large amounts of digital currency given the systemic risks at play. But beware of what countries intent on increasing their influence over global financial matters might do. China is planning to make a digital yuan accessible to its trading partners in the Belt and Road Initiative and beyond. In that case, the dollar, not commercial banks, would be distintermediated. Bypassing the U.S. dollar would require interoperability between the digital yuan and the CBDCs of China’s trading partners. That’s a big task, but the incentives are similarly huge because cross-border money transactions involve large amounts and are presently very cumbersome, costly and inefficient. Thus, it is far more likely than not that central banks will come up with a design that will make it worthwhile for them to issue a digital currency, and that governments will support the decision politically so as to remain relevant in the brave new world of digital money.
As of summer 2023, there were three active central bank digital currencies in the world, launched by the Bahamas, Nigeria, and the seven-country Eastern Caribbean Union.