Digital payments are generally considered safer and more efficient than cash payments. Some researchers have found that greater usage of digital payments increases economic growth and reduces poverty. Over the past decade, banks—defined broadly as insured depository institutions—using open-loop networks (e.g. Visa) and non-banks using mostly closed-loop networks (e.g. M-Pesa) have offered account-based digital payments denominated in fiat currencies. More recently, cryptocurrencies have been introduced as digital payment alternatives (see Nakamoto’s white paper describing Bitcoin along with a previous blog in this series for more discussion). However, the usage of cryptocurrencies, not backed by a reference asset such as a fiat currency (unbacked cryptocurrencies), to make payments remains very low. However, cryptocurrencies that are backed by fiat currencies or some other reference asset (stablecoins), may be more attractive as payment instruments because of their price stability (for a discussion, see the last blog.
In this blog, I explore the role of retail central bank digital currencies (CBDCs) and their impact on payments and banking, more fundamentally. CBDCs are digital representations of fiat currencies issued by central banks, but their existence may have wider implications than just for payments. Today, central banks around the world, ranging from the Federal Reserve (Fed) to the Central Bank of Kenya, are considering if they should issue CBDCs. Project Hamilton, a joint project between MIT researchers and the Boston Fed, has started to design and test a U.S. CBDC technical framework. While many central banks have started to research CBDCs, only a few have issued or piloted CBDCs. For a summary these central banks, see the Soderberg et al. summary in a recent IMF Fintech Notes.
What Are the Benefits for CBDC Issuance?
With the increasing popularity of cryptocurrencies and account-based digital payments, central banks are asking if there are benefits for digital fiat currency to exist. Let’s consider different motivations for central banks to issue retail CBDCs.
First, CBDCs are likely to enhance the cryptocurrency ecosystem by providing safe and secure central bank liabilities that may reside directly or indirectly on various blockchains, decentralized digital ledgers where transactions and holdings of cryptocurrencies are recorded. Today, converting cryptocurrencies into and out of fiat currencies can be slow and costly. In addition, CBDCs may provide confidence for market participants in a more decentralized world by providing greater price stability.
Second, the use of physical fiat currency is decreasing rapidly in many countries because usage of account-based digital payments are increasing such as those that access payment card networks, automated clearing houses, fast payment schemes, and closed-loop mobile payment networks. For example, in Sweden and China (in the larger cities), account-based digital payments have replaced most cash transactions. In these countries, the ability to pay with cash is becoming more difficult. CBDCs may provide a digital alternative to those that have not adopted account-based payments to participate in the digital economy more easily. In the end, will readily accessible CBDC encourage cash users to convert to digital payments?
The infrastructure to access CBDC is still developing and remains challenging especially in areas where Internet connectivity is weak or absent. In some cases, CBDCs will likely piggyback on existing payment infrastructures. The key question for central banks to ask: Why are CBDCs needed when account-based payments continue to grow and evolve? Access, cost, and speed are popular reasons given to establish CBDCs. Furthermore, CBDCs may provide additional competitive pressures to account-based payment providers to improve their products.
Third, CBDCs may increase the speed and lower the cost of cross border payments. Traditionally, these transactions have been slow and costly primarily because of the coordination required between several intermediaries across different countries. Today, FinTech firms such as Wise are providing cheaper solutions for retail cross-border transactions. Cryptocurrency platforms such as Ripple are providing fast and efficient cross-border payments especially in certain remittance corridors. In addition, some central banks are coordinating to develop and pilot cross-border payment solutions based on CBDCs.
Fourth, central banks often consider issuing CBDCs to maintain monetary sovereignty. Even before the existence of CBDCs, some countries used another country’s currency. More recently, El Salvador went one step further and made bitcoin legal tender following many years of using the U.S. dollar. Part of the motivation to issue CBDCs or cryptocurrencies might be to remove reliance on another country’s currency. Some governments fear that geographic borders may be unable to provide barriers for CBDCs issued by other countries. To discourage foreign CBDCs from being used as a medium of exchange or a store of value, central banks may choose to issue their own CBDCs. However, such a move may not be sufficient and regulations banning foreign CBDC usage may not be effective or economically optimal. On the other hand, central banks issuing CBDCs that are widely used in other countries would enjoy greater seigniorage income along with potentially lower borrowing costs for their governments.
What Are the Potential Challenges?
The successful rollout of a CBDC leading to widespread use requires coordination among various market participants. The Fed has stated that it will not distribute retail CBDC directly to the public instead the USD CBDC will be “intermediated” if the U.S. Congress grants to the Fed the authority to issue CBDCs. Generally, central banks do not have the bandwidth to provide services directly to the public. Therefore, central banks will look to existing or new market participants to build or use existing infrastructures for CBDCs. For example, WeChat Pay and Alipay, the two dominant mobile payment providers in China, will accept the digital yuan, the People’s Bank of China’s CBDC, on their platforms. Ripple, a cryptocurrency platform, recently announced a partnership with the central bank of Bhutan to explore the issuance of a retail CBDC and membership in the Digital Pound Foundation, a think tank exploring the introduction of a digital pound.
Central banks should be cautious not to stifle innovation and crowd out private sector providers and innovators. It is unlikely that CBDCs will replace all cryptocurrencies. Most likely, cryptocurrencies and CBDCs will coexist (see Stellar Development Foundation and Catalini, Gortari and Shah (2021)). However, the use of CBDCs may allow for faster and less costly on and off ramps for crypto and fiat currencies. The design elements are still evolving and are critical in the evolution of the digital currency ecosystem.
Some banks have noted that CBDCs may lead to bank disintermediation, lower bank profits, and higher cost of bank credit (see Goldman Sachs (2021), Wells Fargo (2022), Morgan Stanley (2021) for discussion). Would the introduction of CBDCs lead to less traditional bank deposits, a low-cost source of funding for bank loans, resulting in higher borrowing costs for households and businesses? If the portfolio decision is between physical cash and digital cash, bank funding would not likely be impacted. However, if there is substitution between traditional bank deposits and CBDC holdings, the cost of credit might be impacted. In addition, to provide disincentives to hold excess CBDCs, government policies such as not paying interest on CBDCs could be implemented. On the other hand, CBDC may also increase bank discipline imposed by depositors.
From a financial stability perspective, will depositors exchange bank deposits for CBDC during a financial panic leading to bank runs? During times of panic, safety nets such as deposit insurance and access to central bank liquidity have limited runs on bank deposits. The dynamics of individuals and businesses switching to the domestic CBDC or potentially to a foreign CBDC during times of financial distress and policies that discourage or encourage such activity warrants further investigation.
Generally, financial innovations, such as money market mutual funds that have also reduced demand for bank deposits, have been positive for consumers and businesses on net. Predictably, banks expand their business lines to compete as the financial landscape evolves resulting from technological advances and regulatory change. Banks continue to become more engaged in the crypto ecosystem. Some banks have started to offer crypto products, invest in crypto infrastructure, or both. However, many banks remain hesitant because of regulatory uncertainty.
A key aspect of digital payments is access to the Internet and widespread adoption of mobile phone technology. However, there are instances when transactions cannot be completed because of internet or cellular outages. Offline payments are being piloted specifically for instances when digital wallets and acceptance infrastructures are unable to access the Internet or receive a cellular signal. For more details on such challenges, see Soderberg et al.
It is difficult to predict how money and financial services will evolve. However, past financial innovations may provide some clues. If CBDCs become commonplace, what will the supporting infrastructure look like? Similar to physical wallets today, digital wallets would store different types of payment instruments potentially including CBDCs, privately-issued cryptocurrencies, and account-based instruments. It is unlikely that any one payment instrument will dominate. Competition generally provides consumers and businesses with better products. It is likely that the providers of payment infrastructures will also evolve. What will be the role of today’s financial institutions and networks in the future? Many payment providers and networks are embracing these changes and partnering with central banks and financial technology firms. Big technology firms, e.g. Google, Meta, and WeChat Pay, with large numbers of active users may play a greater role in financial transactions given their network connectivity. Will central banks compete with one another to become the de facto global CBDC used to make payments? Certainly, the introduction of Diem did wake up central banks to a stablecoin becoming a global currency. How policymakers react to such changes will not only impact the accessibility and cost of payments but financial intermediation more broadly.