Is the future of finance in central bank-backed digital currencies?
Earlier this month the Bank of England announced that its investigation into the merits of the UK’s own digital currency – dubbed Britcoin – would enter its consultation phase next year.
Unlike crypto currencies, the digital pound is a central bank digital currency (CBDC) backed by physical cash and issued by the BoE, remaining as stable in value and regulation as its physical counterpart.
The consultation, carried out in partnership with the UK’s finance ministry the Treasury, will ask stakeholders for views on the role that digital pound might play, and will focus on design, benefits and implications that users and businesses could face.
Like the US’ Federal Reserve, and the European Central Bank, the BoE has said that it was at the exploratory stage in terms of CBDC development, estimating in a press statement that the earliest launch of a UK CBDC would be ‘in the second half of the decade’.
If a case for a digital coin is made, a development phase would follow next, to nail the technical spec and proposed conceptual architecture, followed by further in depth testing.
Some financial institutions don’t think that major economies are moving fast enough with their development of CBDC however.
According to a survey produced by The Bank for International Settlements (BIS) – a Swiss-based body that supports monetary and financial stability for central banks – around 80% of the world’s central banks it spoke with were engaging in some form of CBDC, but only half of these had progressed beyond the conceptual stage.
During his speech at this year’s Eurofi Financial Forum, BIS Innovation Hub head Benoit Coeure urged central banks to “roll up their sleeves” and “accelerate work on the nitty-gritty of CBDC design”.
Coeure’s concerns focused on the risks posed to financial stability in an increasingly cashless economy.
From PayPal to Apple Pay, more payments are now conducted electronically without any notes or coins changing hands. Because cash is still the only state-guaranteed means of payment and is in decline, so is the role of central banks in the payment market.
Meanwhile, the booming rise in speculative crypto currencies – from Bitcoin to Ether – has attracted a new generation of speculators who see digital currency, based on blockchain technology, as the cash of the future.
Central banks now want some skin in the game, while they also hope to offer a more stable alternative to crypto and not to lose out to Big Tech.
As Coeure warned in his speech, “CBDCs will take years to be rolled out, while stablecoins and crypto assets are already here. This makes it even more urgent to start.”
Many observers have linked Facebook’s announcement that it is creating its own international digital currency Diem (formerly Libra) with the move by the European Central Bank to launch a two-year investigative phase into a digital euro, which kicked off this summer.
Sweden and Bahamas advance
A rapid decline in cash in Sweden’s economy spurred on this tech-savvy nation to become the first major Western economy to officially launch a CBDC, the eKrona, backed by the country’s central bank, Riksbank.
Powered by Distributed Ledger Technology (DLT) – a form of blockchain – the currency has been available on a trial basis to external investors since early September, via a website created by the Swedish government, enabling citizens to buy and sell within the country or in stores abroad.
The pioneer of digital currency, however, is the Bahamas, which, in October 2020 launched its aptly named sand dollar, hoping to bring greater financial inclusion to underserved communities the archipelago, whose complex geography of 700 islands and remote keys throws up challenges in securely distributing cash.
The sand dollar is issued by the Central Bank of The Bahamas to digital wallets held by an initial tranche of six licensed money-transfer and payment firms. Through them, people and businesses are able to access, hold and spend the virtual dollars via a mobile phone app.
The digital yuan
China is in advanced stages of trials for its own central bank backed digital currency, which it hopes to release before the 2022 Winter Olympics.
The Chinese government is thought to have started exploratory work into CBDCs as early as 2014 and, to date, has filed 120 patent applications for its official currency – more than any other country.
Digital yuan trials have involved a number of use cases, including making travel subsidy payments to civil servants in once province, while in another around 20 firms, including foreign brands like McDonald’s, Starbucks, and Subway were invited to test the currency.
By last summer, trial users were reported to have created more than 20 million digital yuan wallets and executed over £3.6 billion worth of transactions using China’s new CBDC.
China gives similar reasons to other nations for wanting its own currency: to counter the growing popularity of crypto assets, to help enhance the efficiency of payment systems and to increase financial inclusion.
Yet some claim that the introduction of the digital yuan is a tool for increased surveillance, giving the CCP a window into every transaction made in the country.
Whether or not this is the case, it does expose some of the data and security issues that central banks and governments need to explore.
According to BIS, more than 88 of CBDC projects at pilot or production phase are using blockchain as the underlying technology. Unlike crypto currencies, which use blockchain as a way of maintaining anonymity and decentralisation in the system, CBDCs rely on a centralised ledger.
This means that Central Banks are able to access an exceptional amount of data about the financial transactions of their populations.
While transparency in the payment system might have its uses in terms of controlling illicit payments and tax evasion or in combating money laundering or terror financing, it also requires banks, governments and stakeholders to think carefully about their policy and design decisions in terms of the legality of data storage and confidentiality.
From a cyber security perspective, systems also need to be secure against attacks: threats faced by a CBDC could be potentially much greater than the those faced by crypto assets with assailants possessing different motivations, including destabilising the economy, and may be equipped with more resources in the case of state-sponsored attacks.
Given the additional infrastructure issues of resilience, scalability, processing and interoperability with other CBDCs – not to mention the time and resources needed for stakeholders to experiment and innovate with CBDC payments, the Bank of England’s 2025 timescale for the digital pound, if it decides to press ahead with it, appears realistic.
But nations who have not yet explored the merits of CBDC would do well to heed Coeure’s sleeve rolling warning, because while cash may be around for a while yet, the use of digital currency, whether state-backed or private, is only going to increase throughout the world’s economies and world’s central banks, governments and industries need to be ready to cope.
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