As cryptocurrencies continue to gather momentum, governments across the globe have considered the practicality of entering this monetary and technological space through digital currency backed by a central bank, aka Central Bank Digital Currencies (CBDCs). The planned goal is to issue these assets with the full backing of a central bank and link their value to an existing fiat currency. Holders of these CBDCs will not have to go through a traditional banking institution to create a digital wallet or conduct transactions; rather, the issuing central bank will assume all of the liabilities and responsibilities.
“Currently, the public can hold only money issued by the central bank in the form of banknotes, whilst commercial banks can hold central bank money in the form of reserves held at the central bank.”
Lower transaction and storage costs, increased transparency, improved financial infrastructure, and process efficiency are a few of the key benefits of embracing a global CBDC system. The elimination of a bank account as an entry barrier will incorporate millions of currently ‘un-banked’ individuals across the world into the modern financial system, effectively creating a new marketplace for consumer and financial products. However, these benefits are also accompanied by several concerns, including the disintermediation effect that poses severe risks to commercial banks.
“Funds can potentially be switched out of conventional deposits at commercial banks into deposits at central banks in the form of CBDCs. This could lead to a reduction in the commercial banks’ funding and subsequently to cuts in the number of loans banks could provide, potentially harming the entire economy. Any such development could substantially increase the commercial banks’ funding costs as they would be required to find alternative funding sources—both domestically and overseas—in the absence of bank deposits, which could lead to a banking crisis.”
In summation, CBDCs are an exciting prospect for all stakeholders in the financial industry, due to the multitude of benefits. However, the realization of these benefits will only occur if the entirety of the CBDC infrastructure, from the technological to the financial aspects, is secured through a combination of key investments, future-proof planning, and the inclusion of industry stakeholders. Central banks must not freely issue these assets without considering the larger market imbalances such an action would trigger, and further research is critical to quantify the financial rewards of a CBDC system in the U.S. and across the globe.
Overview by Shreyas Shaktikumar, Research Analyst at Mercator Advisory Group