Are central bank digital currencies the future of finance?

May 19th, 2021

Are central bank digital currencies the future of finance?

There's been a lot of news about digital currencies lately. Companies like Tesla, Square and PayPal have been getting into cryptocurrencies in a big way with billion-dollar bets on Bitcoin specifically. Whether all this turns Bitcoin into a viable currency instead of a speculative investment, or indeed a store value, remains to be seen. But there are a growing number of governments around the world who aren't going to wait around to find out.

The Bank of England is looking into its own digital currency, Sweden's central bank is testing an e-krona and emerging economies have introduced pilot programs. In 2020, 60% of the world's sixty-five central banks surveyed[1] said they are running experiments on digital currencies. This is up 18% compared to 2019.

Advocates say digital money can make cross-border payments easier, promote financial inclusion and payment system stability – but there is also a host of serious risks. Chief among these are the surveillance and privacy issues that could arise if a central bank is able to monitor every transaction.

Why go digital?

According to ‘When digital currencies become mainstream’[2], a recent paper by Deutsche Bank, the primary motivation among advanced economies is to improve payment security. Emerging economies, meanwhile, “generally have a wider array of motivations, especially when a digital currency is designed to complement or substitute cash.”

In the US, the entry of big-name investors and big-name companies into the digital currency space is forcing the Federal Reserve to get more serious about the digital dollar. The US also faces pressure from competitors like China, who are leading the world on digital currency development.

Deutsche Bank’s paper suggests that cultural factors in China related to convenience, usage and privacy will influence adoption rates. They conclude: “China’s central bank digital currency (CBDC) will take off at a faster pace than in most other countries. Beyond replacing cash and improving financial inclusion, the long-term goal of their digital currency is to improve the efficiency of transactions across the nation’s financial system.”

It’s true that China has already moved beyond the pilot testing stage. On February 4th this year their central bank launched a joint venture with Swift, the global system for financial messaging and cross-border payments.

“I think the US has lagged China on state-led initiatives around fintech generally and digital currencies are just one component of this,” says Kevin Kilty, CEO and Founder of Hubpay, a cross-border digital wallet and the first Money Services start-up to be licensed in the UAE.

“US entrepreneurship has clashed on many occasions with the power of US corporate lobbying. Companies such as Plaid, an open banking platform, were fined heavily for their bank-linking technology. Legacy banks saw them as a threat. But, in the end, the industry worked with them and they’re one of the reasons we have open banking in Europe.”

Hubpay leverages remittance flows from the Gulf to drive financial inclusion in emerging markets such as Pakistan, India and Egypt. According to Kilty, the rapid rise of challenger banks and e-payment start-ups has changed the nature of how regulators engage with the industry. Previously, regulators were there to say what banks could or could not do, not to foster a regulatory landscape that would create new competition. “The global financial crisis and the success of entrepreneurship in other sectors changed this,” he says.

Source: R Auer, G Cornelli and J Frost, “The rise of central bank digital currencies: drivers, approaches and technologies”,
BIS Working Paper, no. 880, Deutsche Bank

How will they work

The prevailing view around CBDCs is that the digital pounds, dollars and euros will be issued by a central bank and then held directly in a citizen’s digital wallet, accessible through smartphones.

China’s commercial digital payments operators such as Alipay and WeChat pay already work in this way. Users download digital wallets on their phones where they can store their funds. This generates a QR code which can be scanned by payment terminals and shops to pay for things like food and retail items.

Lowering the cost of cross-border payments is likely to be one of the value propositions when CBDCs are eventually rolled out. Currently, it can cost up to 4% or more to send money from one country to another due to our antiquated correspondent banking system and the inefficiencies in our payments infrastructure. This especially affects people on the economic margins who are working overseas and sending money back home to their families.

Kilty explains that while e-currencies can provide an inclusionary benefit, “there are already many pillars in place working to support broader financial inclusion.” He cites the ubiquity of smart devices, other tech advancements like point of sale, near-field communication and QR codes, plus the expansion of digital ID verification. Nadra in Pakistan and Aadhar in India – areas served by Hubpay – have digitalised users’ identities, enabling companies to complete identity verification and onboard users rapidly.

In the wider conversation, risks remain. If we solely rely on digital currencies and there is a power outage or a hack, it could jeopardise the entire system. There is also the debate around civil liberties. Will we be required to produce ID and proof of address to access a CBDC, for example. Privacy could become a huge issue depending on how each digital currency is designed.

Kilty says: “The digital world naturally creates more issues around surveillance and privacy.  No matter how tight the level of encryption or physical security is, the world is far closer together now and that brings benefits as well as unwelcome intrusions into our lives.

“The broader issue of inter-connectivity and the risk of a wider scale cyber-attack, whether aimed at our elections or financial systems, needs to be constantly reviewed.  It’s the reason cyber security is one of the fastest growing sectors in tech.  And as the systems become more complex, there is a manifold increase in risk.”

Is digital money the future?

In February 2021, Fed Chairman Jerome Powell said the US central bank will engage with the public on the digital dollar this year. Speaking to the House Committee on Financial Services, he commented: “We have a functioning financial and banking system. We need to be careful with our design of the digital dollar so that we don't create something that will undermine that healthy, market-based function.”

For advocates, CBDCs are a way to harness the cryptocurrency movement and contend with the competitive challenge from China. But developing the technology to compete is one thing; delivering a currency infrastructure that wins buy-in from sceptics and advocates alike is another thing altogether. This is perhaps where the biggest challenge lies.

If the US and Europe are to match China’s payments innovation and, what’s more, maintain the hegemony of the dollar-dominated global financial system, long-term political leadership will be key.

“China’s digital currency decision was made years ago as a direct result of their Digital Silk Road initiative,” says Kilty. “China has watched the US assert geopolitical power via its financial system.  The digitalisation of financial systems is the logical next step and getting there before competing nations will tip the scales in China’s direction.”



[1] https://www.bis.org/publ/bppdf/bispap114.pdf

[2] https://bit.ly/3eEfzuE

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