Central Bank Digital Currency | Part 2

In the first part of this 3-part blog series, we laid the foundation for the discussion on Central Bank Digital Currency by seeking to understand what is money and what is currency. We also pondered upon the simple meaning and purpose of is digital currency and why at all it is relevant. Having done this ground work, let’s try to figure out Central Bank Digital currency in this second part.

Central Bank Digital Currency

Today we send and receive money electronically, through our mobile banking, internet banking and other apps. Are those monies digital money? The answer is yes. It is important to note that the physical cash in circulation is between 5% to 8% of all money in use. This ratio is shrinking at a rapid pace as more and more transactions move to electronic mode.

The mobile banking, internet banking and other apps, act as the mechanisms that transfers value between transacting parties electronically fast replacing the physical movement of value through cash.

Whereas, Central Bank Digital Currency is a digital currency which is issued, managed and regulated by the central bank of a nation. It is not a digital representation of cash. It has its own token just like each currency is uniquely numbered. It is money in its own right. It exists only in digital form.

Why do we need Central Bank Digital Currency (CBDC)?

Physical cash became de-facto mode of transaction by replacing barter system. This is because barter system was cumbersome, lacked divisibility, and credit functions were not reliable. Physical cash sufficiently addressed these issues and it was extremely convenient compared to barter. However, cash comes with a huge overhead of the effort and cost of minting, logistics of circulating and needs constant vigil against counterfeiting.

The concept of CBDC has evolved as a result of evolution of digital technology. Wallets, crypto technology and distributed ledger technologies have demonstrated that it is safe and reliable to store and exchange value entirely electronically. Private wallet providers such as PayTM, PhonePe in India, ApplePay, GooglePay and WhatsappPay globally, have demonstrated that digital transactions can be more convenient than even cash transactions. Bitcoin has demonstrated that it is possible to authenticate a transaction without compromising on the need for anonymity of the transacting parties.

Digital technology has finally proved that it can provide all the advantages of physical currency without the overhead of minting and circulation. Besides, cash slows down the rate of transactions as it has to be physically carried and delivered. Digital transactions can happen in an instant from anywhere to anywhere removing all frictions from financial transaction, thus pacing economic activity. This is why quite a few central banks across the world are now exploring the feasibility of issuing digital currency under their authority.

US Federal Reserve, the Bank of Japan, the European Central Bank, BIS (Bank for International Settlements), the Swiss National Bank, Bank of Canada, Sveriges Riksbank in Sweden, and the Bank of England have all indicated an intention to assess the feasibility of implementing publicly available CBDCs.

Other countries such as India, China, Russia, South Africa, Uruguay, Barbados, Switzerland, Thailand and Iran are considering or beginning to implement CBDCs.

Types of Central Bank Digital Currencies

There are two main types of digital currencies possible. 1. General Purpose Digital Currencies 2. Wholesale digital currencies.

General Purpose Digital Currencies

General Purpose Digital Currency is digital currency rolled out for day to day transactions of the people in the country. The general-purpose digital currency can be administered by the central bank with the common people directly, or via the banking system. If banks are used as intermediaries, it will work very similar to the present currency operations except in pure electronic form. It can be argued that using the banking system for roll out and managing digital currencies nullifies the very purpose of it.

If the central bank directly administers the digital currency without involving the banks, the settlement of transactions between retail parties can be instant as the need for settlement between banks – which is the case today for each electronic transaction – is eliminated. However, the load on the central bank infrastructure will be humongous. Besides the central bank systems become the single point of attack for cyber hackers which can bring down the financial system of the nation totally.

Wholesale Digital Currencies

Wholesale digital currencies are digital currencies used exclusively to settle institutional (corporate) payment transactions across banks. This settlement could be on behalf of corporate entities, retail entities, Government or even cross border entities. However, the digital currency is used exclusively to settle between banks in the banking system. Common people will continue to use the physical currency and its electronic means to deal with their financial transactions as always.

Wholesale digital currencies are limited in scope and therefore have limited impact on the monetary ecosystem of the country / jurisdiction. Nevertheless, the impact can still be significant as large value transactions can be settled instantly, authenticated thoroughly, subjected to strict enforcement of rules and policies.

Both with general purpose digital currencies and wholesale digital currencies, enforcement of anti-money laundering practices can be made with rigor.

In our next and last part, let us discuss factors that can possibly influence the success of digital currencies and whether banks will become redundant in the world of Central Bank Digital Currencies.