Central Bank Digital Currencies (CBDCs)
What are Central Banks and what do they do?
Central banks are the institutions of the state that issue a country’s currency. Typically, the central bank controls the country’s banking system, while private banks operating in the country interact with the consumers and companies which they provide services to.
Central banks have traditionally issued their own paper currency such as the US Dollar (USD) or Great British Pound (GBP). These are also known as Fiat Currencies. Cryptocurrencies, on the other hand, are digital currencies that are not owned or controlled by a central bank.
How is Money Moved Around the World?
Transferring money internationally is more complex than using cash to buy food at the store. International payments typically have currency exchange and transaction fees associated with them, because each country has a centralised banking system which operates independently from others.
Therefore, intermediary or ‘’middlemen’’ institutions have to step in, exchange the currency and transfer it overseas for a fee. These payment providers are there to help facilitate transactions, enabling money to be sent from one account to another even if the bank accounts belong to different countries.
Due to the number of institutions involved and the complexity of these systems, the process can sometimes take days to complete.
What Are The Limitations of Paper Money?
Paper currencies are still used by billions around the world, despite facing several challenges as a means of payment. Although paper money is cheap to produce, convenient to make small payments with and can be created at will, it is far from perfect.
- One of the main challenges is that paper currencies are centralized, meaning the political and economic situation in the country impacts the value of the currency.
- Consequently, the value of a currency can reduce significantly due to economic or political problems.
- High inflation can erode public confidence in the currency. If the people stop trusting the currency and government and no longer use the paper money, goods and services will only be traded in kind – leading to hyperinflation (Two examples are Germany in the 1920s or more recently Zimbabwe around 2008).
- Cash is inconvenient to carry in large amounts and creates a security risk.
- The currency of one country might not be a valid payment method in another.
- Paper money can be easily stolen, damaged, burnt, or lost.
Paper currencies are therefore becoming less popular as a means of payment and consumers in many western economies have already transitioned to using predominantly digital or contactless payments. The development and adoption of contactless payments have further emphasised a consumer preference for fast, convenient, and safe digital payments over carrying cash at all times.
Furthermore, financial institutions now offer digital bank accounts intended to let us pay, save, and exchange money without conventional banking. As the popularity of cash payments declines and payment technology becomes more available, the use of digital currencies is now emerging as a possible substitute that meets the needs of tomorrow’s economy.
Hence, both governments and institutions are recognising that paper currencies are slowly becoming outdated, and with the emergence of cryptocurrencies, the utility of paper money is decreasing.
What Could Be Better Than Paper Money?
Communicating (sending and receiving information) with someone on the other side of the planet used to be a complex process. Now through the internet we can send huge amounts of data to people instantly and practically for free. De-centralised finance and digital currencies aim to bring the same type of convenience to the exchange of value.
Digital currencies have the potential to tackle some of the limitations of paper money. They also offer greater convenience to users than fiat currencies, by allowing people to participate in the economy without exchanging fiat currencies.
Until now, digital currencies had a limited use case – they’ve been used primarily for making online payments or buying digital goods. Central bank digital currencies could change all of this.
Central Banks around the world have started to acknowledge the benefits of issuing their own digital currencies. These include:
- Ease and speed of making small transactions
- Lower transaction costs
- Increased privacy
- Boost economic growth
- Improved access and ease of distribution
Who benefits the most from CBDCs?
- Central banks of emerging markets and developing nations will be more concerned about being left behind than richer countries, because banks in developing countries are often technologically disadvantaged and remain dependent on foreign banks for digital currency solutions.
- By issuing CBDCs, these central banks could develop their own solutions and avoid lagging behind technologically, all the while continuing to provide access to international finance and better payments options to their citizens.