In conjunction with the technological advancements, economists and legislators are pragmatically searching for various ways to promote the financial system and conduct financial transactions in a more efficient way, which raised the idea of launching central banks digital currency (CBDC).
So, what is its purpose, benefits and challenges; what impact will it have on financial institutions, and how will it affect the economy as a whole?
Firstly, let's define and discuss what a CBDC is and how it differs from crypto currencies, as many people could be confused between the two concepts. A CBDC is a form of digital currency issued by a country's central bank with a value guaranteed by the central bank and is equivalent to the country's fiat currency.
While CBDC and cryptocurrencies share some characteristics, there are prominent differences in terms of design, purpose, and control. A fundamental difference is that a CBDC is considered money, whereas cryptocurrencies are not, as they lack the core characteristics of money, like a widely acceptable payment method and store of value.
A CBDC is designed for the purpose of supporting central bank objectives like financial inclusion and monetary control along with lowering the costs of current monetary systems and improving payment efficiency. Prior to going further into the benefits and risks, it is important to be aware that the financial system expects two different kinds of digital currencies: the retail CBDC and the wholesale CDBDC. While the former is intended to serve transactions conducted by individuals and businesses, the latter relates to bank and other financial institution transactions.
Lower transaction costs, financial accessibility, more monetary control, and the use of local currency are some of the advantages of using CBDC.
To begin, a CBDC improves international transactions by speeding them up and reducing the need for intermediary banks, which tend to be slow and expensive, particularly at the retail level, relying on long chains of intermediaries located in different time zones and adhering to different technical and legal standards. All of these factors will increase money velocity, liquidity, and, as a result, economic activity.
Furthermore, a CBDC facilitates financial inclusion as it holds no minimum balance requirements like some conventional banks, along with offering quick and cheaper transaction costs. Such a type of technology will stimulate financial accessibility, as globally around 1.4bn adults (24% of adults) still lack access to a financial account. Hence, achieving financial inclusion will boost the financial system's liquidity, which may encourage investment and lead to higher production levels.
Nevertheless, it is important to remember that the unbanked population makes up a relatively small share of the world's wealth and saves at a significantly lower rate than middle-class and upper-class individuals. As a consequence, the impact of financial inclusion on the unbanked population will not immensely increase liquidity in the financial system; rather, the transition towards a cashless society will have a greater impact improving monetary control, economic metric calculations, and inhibiting tax evasion practices.
Another distinguishing feature of CBDC is that it abolishes the implementation costs of a financial structure within a country to bring financial access to the unbanked population, which may explain why states, particularly developing countries like the Bahamas, Jamaica, and Nigeria, have already introduced CBDCs.
Additionally, CBDC could reinforce the use of local currency in both domestic and international contexts by making it a more attractive means of payment through lower transaction costs, which in turn can mitigate currency fluctuations.
Recalling the aforementioned benefits, it's unsurprising why Qatar’s central bank is planning to introduce its digital currency before the end of 2024, with more than 100 other countries in the exploration stage.
On the other hand, there are various challenges and unfavourable outcomes that countries may encounter as a result of adopting CBDC.
To start with, while a CBDC's marginal operating costs are likely to be minimal, introducing and maintaining it would definitely involve significant fixed costs. The effect that CBDC may have on the banking industry by increasing competition for bank deposit funding represents another important constraint. This is mainly because by offering a reliable, efficient means of payment and a safe store of value, deposits may leave banks in favour of the CBDC, leading to a decrease in deposit funding available to banks.
In turn, banks may respond to such movement through wholesale funding to offset the loss in deposits to sustain their capability of loan provisions. However, this could imply higher financing costs, which may undermine banks’ profitability to the extent that higher costs cannot be entirely passed through to higher lending rates.
Alternatively, banks could also choose to compete with CBDC through raising interest on deposits, yet they would pass these higher rates to borrowers on mortgage, auto, corporate, and all other loans, which may come at the expense of economic activity as it can discourage investment, consumption level, and capital tied up in bank deposits or money market funds. The magnitude of this issue will depend on the extent to which CBDC is an attractive substitute for bank deposits.
While CBDC would entitle central banks to directly get involved in managing cross-border transactions, which could help in tracking capital movements, the exceptional features of CBDC, like lower transaction costs and faster speed of transfers, could lead to larger and more volatile gross capital flows across borders and, thus, quicker transmission of global shocks as countries facing economic stress may see faster withdrawals or inflows of capital, amplifying volatility and making countries more vulnerable to unforeseen economic crises.
Despite all the potential downsides of using a CBDC, there are a series of measures that need to be addressed and co-ordinated by the relevant authorities to ensure a smooth implementation of a digitalised system that avoids any potential issues. In terms of the rivalry that could arise from launching a CBDC, I do suggest several frameworks and policies.
For instance, central banks may not pay interest on retail deposits to discourage large inflows towards CBDC. Additionally, central banks can lessen the threat to the banking system by setting caps on individual CBDC holdings or imposing fees on large deposits exceeding a specific amount. Also, central banks could lend the funds diverted from deposits back to banks at a minimal interest rate, or alternatively, central banks could retrieve these funds while holding a small portion of these amounts, which would not incur significant costs to commercial banks; simultaneously, the central bank can use this interest income to cover its digital currency operational costs. All of the discussed proposals may help overcome the challenges a CBDC may trigger in the banking sector.
Additionally, regardless of potential issues with capital flow management (CFM) and the faster transmission of economic shocks, such issues can be avoided by developing an effective CBDC capital movement tracking program that works in parallel with conventional systems, ensuring a well-managed capital flow system. Thus, this issue is highly dependent on the level at which a central bank will regulate its surveillance systems.
Finally, banks can capitalise on these advancements by providing services such as CBDC wallet management and digital payment facilitation, thereby increasing their earnings. To clarify, traditional banks can handle CBDC operations such as account administration and customer support. This may encompass all parts of client service, such as account opening, deposit and withdrawal processing, and dealing with CBDC transaction issues.
One example could be a system in which the central bank provides banks with a central platform for CBDC management. These banks can then handle accounts and transactions through their existing banking infrastructure. This entitles banks to earn from fees for transaction processing, account management, and other associated services.
Banks can also introduce point-of-sale systems to capitalise on CBDC transactions. As previously indicated, the funds held by central banks from deposit flows will be used to cover these charges, as the rate of deposits to be retained must be adjusted proportionally to operational costs incurred, ensuring that CBDC transactions remain cost-effective.
To sum up, after considering the numerous benefits and challenges of digital currency utilisation, we can conclude that the success of such innovation depends substantially on the framework that governs how digital currency activity is co-ordinated among the relevant authorities. A poor regulatory framework would have an adverse effect, which explains why a detailed execution and co-ordination plan must be investigated prior to the execution phase.
Mohammed Fahad Hussain Kamal Alemadi is senior student at Qatar University studying Finance and Economics
Mohammed Fahad Hussain Kamal Alemadi
