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Central Bank Digital Currencies - Part 1
In a recent report, the Bank of England stated that “A Central Bank Digital Currency (“CBDC”) would allow households and businesses to directly make electronic payments using money issued by the Bank of England”.
Currently, only the commercial banks have privileged access to their central bank, while businesses and consumers do not. A CBDC would change this, and there are far-reaching implications for the global economy and the reach of the state.
Most people think they already have digital money because there’s an app on their phone that links to their bank, but they don’t. They have deposits with their bank rather than the central bank, which they can administer electronically. Until now, the only way people could access central bank money has been via cash.
I liken bank deposits to pigeons, which want to come home, and digital cash to doves, which are free. Bank deposits might move from HSBC to Citi to Credit Agricole before returning back to HSBC. Bank deposits seem to revolve around the system, periodically passing where they came from. By contrast, cash is free to go wherever it wants.
This is FIAT, not crypto
The broad definition states that a CBDC utilises blockchain distributed ledger technology to create digital forms of central bank issued FIAT currency, which are governed by a central body.
The technology that enables digital cash comes from blockchain or distributed ledger technology (“DLT”), which all started with Bitcoin. The main difference is that the economic outcome is simply a dollar, yuan, pound or euro that will have exactly the same value as the existing FIAT currency it represents. In that sense, there is no exciting investment opportunity, merely a technological improvement on how a currency can interact.
The crypto world has already created multiple private “stablecoins”, which see billions of dollars change hands each day over the blockchain. These are FIAT currencies, which benefit from global accessibility through utilising infrastructure created by the crypto space.
Stablecoins are a private sector solution to digital FIAT that have grown to nearly $200bn in a short space of time and have the potential to dominate payments in the future. This is why the central banks are interested as they worry about missing out.
Some believe, as we do, that the central banks should let the private sector carry on and let the innovation thrive. Others see stablecoins, such as Tether, as risky because they lack transparency and have questionable governance. They would prefer the “real thing” in the form of a CBDC.
A private company issuing a stablecoin guarantees their digital dollars are fully backed by real dollars, but things can go wrong. Whether it be due to deception, incompetence, or just bad luck, a stablecoin will never have the guarantees of a CBDC. But neither will a money market fund, and they have been hugely successful and are an integral part of the financial system.
In short, a stablecoin is a money market fund that uses crypto payments infrastructure. While a CBDC is not dissimilar, it is directly backed by the central bank.
The underlying mega-trend is that money is being digitised whoever happens to be doing it. That said, most central banks have firmly stated that CBDCs should work alongside cash and not aim to replace it.
But even if you have the best form of cash, digital or otherwise, it is still FIAT money that inflates away over time. There is no change here. Investors who want to fight inflation are wise to own hard assets, whether they be shares, bitcoins, gold bars or houses.
Good for the consumer, bad for the banks
The world could carry on with digital deposits for years to come. Still, when an opportunity for new technology comes along, it is right to research it and understand the implications. A CBDC would potentially give businesses and consumers access to instantaneous cross border payments at a lower cost, which would be a welcome development.
CBDCs would be adopted and interfaced by tech companies. No doubt they’d do a great job in providing easy-to-use and innovative services, but at what cost for the legacy commercial banks? Few will shed tears as they fight for survival, but they are an integral part of our financial system. For example, if the banks lose deposits as the world moves to digital money, mortgage lending will need to find a new funding model.
Outside of the developed world, many currencies still pay interest on bank deposits, but not on cash. That begs the question of whether a CBDC should be interest-bearing? The tech certainly allows for that, but unsurprisingly, the banks don’t want interest to be paid, as it would make them less relevant and see deposits flee.
That leads to another discussion about CBDCs having different designs for the financial players and retail. The clever bankers could have one that works for them, enjoying faster settlement times and paying interest while the public gets a simplified version with no interest, which is useful for holidays and shopping.
Mainstream adoption of CBDCs has the potential to turn the financial system on its head and is fraught with unknown risks. Since there is no rush, the prudent course is to introduce these changes gradually rather than suddenly.
The Swiss National Bank, an institution that seems to understand money more than most, and is one of the most cautious, wrote that: “any introduction [of CBDCs] should support wider policy objectives and do no harm to monetary and financial stability.”
A policy tool
While we tend to embrace tech, there are endless possibilities for programmable money, some of which are frightening. A CBDC will give central banks, and therefore the government, a degree of power that is fundamentally at odds with personal freedoms. Currently, when a central bank wants to stimulate the economy, they lower interest rates or engage in quantitative easing. The former reduces the cost of borrowing for all, whereas the latter, as we have seen since 2009, drives up asset prices. It clearly does more for asset owners than working people.
With the widespread use of digital wallets, a central bank could make targeted payments much more quickly and easily than, say, increasing benefits and allowances, which take time to enact. They could also add conditions to the newly issued money, such as; spend it within 30 days, but only on food and children’s clothing, and not on wine or gambling.
They could also implement monetary policy tools such as negative interest rates. In this case, you pay interest on your deposit as if it were a loan. Your balance slowly shrinks over time.
Data, privacy and security
Blockchains and DLTs are rich in data. For the national statisticians, it would be fabulous. Economic statistics would flash away on their screens in real-time, enabling policymakers to make more informed, or at least more frequent, decisions.
Sir John Cowperthwaite, the architect of Hong Kong’s economic miracle, would thoroughly disapprove. Part of the success he claimed was by denying London economic statistics that would cause them to intervene. Let the economy run free, he cried.
Another downside of too much information is that it can find its way to bad actors, be they governments or otherwise. Our spending decisions, with times and locations, paint a detailed picture of our lives. Under the wrong regime, CBDCs would be a vehicle for additional government control. Totalitarians should take note.
In a free society, there need to be safeguards on access to this data, and a successful CBDC would embrace the freedoms currently enjoyed by cash, both now and in the future
If a central banker designing a CBDC is unsure about freedoms, here is a simple test; can your CBDC be sent to an unregulated crypto exchange to buy Bitcoin? If no, your CBDC has failed.
This conversation is not going away, and those that think money is already digital should think again. The app on your phone is a pigeon, which in time, might be replaced by doves. In other words, this will unleash economic potential never previously seen.
The debate around digital currencies, particularly CBDCs, is far more complex from a legal, moral, economic and political standpoint than many realise. There is an inevitability about this movement, and if traditional investors think they don’t need to understand digital assets, they best think again.
In part 2, we’ll look at where the G20 central banks are and their different opinions and approaches. In part 3, we’ll examine the pros and cons of stablecoins, and other private currencies, against CBDCs.