The global financial system is in transition with innovative technologies disrupting the status quo banking and financial services industry. After the advent and adoption of Bitcoin, Stable coins and other cryptocurrencies, Central Bank Digital Currencies (CBDC) are the latest fintech products spearheading the financial revolution towards digital tokens as the probable global currency standard replacing fiat money. Money, since ages has been used as medium of exchange supplanting barter system in various permutations and combinations from precious metals to gold, silver and copper coins to Gold Standard and since its abolition in 1971, fiat money. Paper currencies underwent quantum transformation in the last decades of the 20th century with the explosion of digital technologies, computerization, the Internet and World Wide Web. In the United States, by the 1990’s all interbank transfers between Federal Reserve and commercial banks were in electronic format and by the turn of the 21st century, all bank accounts were held as digital deposits in bank databases. CBDC’s are an evolution of digital currencies having striking similarities and stark differences in its form and function. CBDC could be defined as digital money 2.0 and is pegged to the currency value of the fiat money of respective countries.
Digital money in contemporary world is account-based where financial transactions are performed and services availed by corroborating and verifying individual identity through Know Your Customer (KYC) norms and protocols. CBDC’s are mostly token-based built on underlying blockchain technology or distributed ledger (DLT) that allows for peer-to-peer, disintermediated and decentralized financial transactions and this architectural framework is the bedrock of all cryptocurrencies and stablecoins. Legally, cryptocurrencies can be mined transcending geographies as in the case of Bitcoin, by contrast, CBDC’s are issued by the central banks that retain monopoly control of its quantity supply. The ownership of token-based CBDC’s are on the basis of proof unlike verification of identity in person or electronically in an account-format. Digital tokens are transferred ownership by verification and authentication of digital signatures that are secured by cryptography. Similar to Bitcoin and other cryptocurrency transfers, a CBDC transaction involves a private key that encrypts transaction and the corresponding public key (generated simultaneously with the private key) verifies the encrypted code and if the digital signature is ratified (cryptographic handshake), executes the transaction.
Programmability of CBDC is another feature that will re-order the world of finance that includes programmability of money and programmability of payments. The former pertains to wiring in definitive logic and in-built rules of usage like setting an expiry date, restricted to a certain category of goods or used only for specific purposes while the latter uses smart contract technology to customize payments based on predetermined criteria. An example would be to execute salary payments automatically to employees in a Decentralized Autonomous Organization (DAO) every month-end using dollar-backed stablecoins on a blockchain network, eliminating payroll processing costs to the company. JP Morgan has developed a state-of-the-art technological banking infrastructure based on its blockchain program, the Onyx for payments processing which is a world’s first and have tested on Siemens AG, as fully automated treasury operations solution.
CBDC’s can be classified on the basis of implementation model. If a central bank issues CBDC’s only to commercial banks that participate in the transmission of monetary policies with well-developed capital markets and interbank systems, then its limited to wholesale operations whereas in emerging markets like China, CBDC development and piloting are targeted at retail customers and businesses. Besides eliminating or reducing conventional transaction costs (intermediary service/processing fees) involved in retail financial payments and fund transfers through a debit, credit card or digital wallet, CBDC’s in developing economies have financial inclusion of the unbanked as a critical targeted outcome of social change. A key benefit is that financial inclusion could be materialized through CBDC without the requirement of a bank account. In the Indian context where millions do not have a bank account and outside the purview of welfare policies, a CBDC account will only need an Aadhar Card and a smart phone.
China had raced against time to pilot their CBDC called e-CNY at the Beijing Winter Olympics in February 2022 and e-CNY wallets were made available to Olympians and delegates during the event. China launching e-CNY was mission critical to thwart competition from Chinese behemoths Alibaba and Tencent with their digital wallet cum online payment portals Alipay and WeChat that currently accounts for 94% of all online transactions within China at estimated revenues of $16 trillion. The explosive growth of cryptocurrencies such as Bitcoin that could potentially destabilize economies and similar financial alternatives are a trigger and incentive for central banks across the world to develop their own CBDC’s. According to the Bank for International Settlements, more than 85% of global central banks are either researching, developing or piloting CBDC’s. In 13 countries, CBDC’s are in the piloting phase and prominent among them are Singapore, Sweden and South Korea. In the United States, The Federal Reserve Bank in Boston in collaboration with MIT is designing a prototype.
Distribution channel type is another basis for categorizing CBDC. In the Direct Model, all digital tokens are issued by the central bank where all checking accounts are maintained without any intermediaries like commercial banks or non-banking financial institutions (NBFC). The bank underwrites the liability to pay, which, also includes maintaining the Know Your Customer (KYC) databases and implementing Anti-Money Laundering (AML) protocols. In the Indirect Model, an intermediary bank, NBFC or a fin-tech issues the digital currency that will also handle KYC and AML requirements. The liability to pay is entrusted with the distributing entity, here the commercial bank. Yet another model most central-banks worldwide are designing is The Hybrid, where the digital tokens are distributed by commercial banks which also manages the KYC and AML protocols but the liability to pay is vested with the central bank.
Besides financial viability and economic feasibility of CBDC’s, it could set a new paradigm in global banking and finance. Apparently, benefits far outweigh the risks on assessment. CBDC could end the murky history of bank-runs forever since each digital token issued has a unique, unchanging identity and the liability to pay lies solely with the central bank unlike digital tokens issued by commercial banks. The market risks associated with commercial banks like borrower defaults and short-term interest rates on deposits outpacing long term interest rates on borrowings which adversely impacts the spread, which, is the bank profitability will no longer be applicable to CBDC accounts as central bank will become the sovereign credit, backed by governments ability to tax and not dependent on cash reserve ratios (CRR), equity capital and re-insurance of retail deposits which are commercial banks risk-mitigation measures.
CBDC’s will usher in a new era of paperless and cashless economies. CBDC’s will come under the direct liability of the central bank that are stamped with a bearer IOU similar to paper cash. It is not predicated on the convertibility to cash in the case of digital currencies issued by commercial banks, but CBDC’s are cash itself. The current banking and financial services industry are built on the requirements of transacting paper-based currencies or currencies based on the erstwhile Gold Standard, a fallout of the legacy of secure bank branches to deposit cash. A natural evolution of the cash-based economies entailed 85,000 bank branches, operations and payments valued at a trillion dollars employing 1.2 million people in the US alone and costing a staggering $600 billion a year in operating expenses. Commercial banks will have to vie for customer segments through innovations in digital wallet solutions and will be under pressure to originate profitable corporate loans after meticulous due-diligence if customer deposits are directly held with central banks.
CBDC’s instantaneous transactions that significantly reduce domestic and cross-border transaction costs, will render superfluous the need of short-term money market credit which could diminish debt levels by 25% or $13 trillion in US alone. CBDC’s will result in better compliance, regulatory and policy execution due to the transparency and accountability of the digital codes that enables a comprehensive identity check on the parties transacting. This has the potential to eliminate black markets, terrorist funding, tax evasions and financial frauds on a global scale. A study in the US estimated that switching to CBDC’s will facilitate cost reduction of $750 billion annually even though extant financial services infrastructure and customer touch points like ATM’s, brick-and-mortar bank branches and commercial real estate prices will largely suffer redundancy. Strategists and think-tanks around world are raising concerns over privacy of individual accounts, cybersecurity issues of exposing a centralized entity to the mercy of hackers are fiercely debated and deliberated. If the blistering pace of technological revolutions in the last 50 years have engendered massive socio-cultural changes in smart phones, connected cars, omnichannel retail, social media, cloud computing, electronic banking and mobile applications, CBDC seems to be a natural transition from paper currencies towards a cashless world. Its adoption will be relatively easy as humans are already attuned to the limitless possibilities of the Digital Age.