The potential benefits and risks of central bank digital currencies

The buzz around a digital euro is growing. After two years of examination how a central bank-controlled digital currency might work, the European Central Bank is tentatively planning its implementation, although it refuses to admit that the concept is more than just a proposal.

The ECB is one of a number of central banks around the world exploring the potential of a digital currency, with the People’s Bank of China perhaps the most advanced amongst major nations. But why might a digital currency be needed in the first place?

The Bahamas, Jamaica and Nigeria have already introduced central bank digital currencies. The International Monetary Fund reports that more than 100 countries are exploring their potential, with Brazil, India and the UK at a similar stage to European financial policymakers.

Governments and their central banks hope that digital currencies could improve payment systems, making them more secure and efficient. There is also an issue of control with an increasing proportion of transactions being conducted via digital platforms such as Apple Pay, Google Pay or Alipay.

A significant share of transactions is thus currently dependent on private companies, whose raison d’être is profit rather than the stability of the financial system. A digital currency operated by a central bank would reduce some of the risks involved in the shift over to alternative forms of payment, giving consumers the choice of a trusted digital option.

Central banks can also monitor how cash is being used, which could help prevent criminal activity.

There are also advantages for central banks. Issuing digital cash is cheaper than minting, printing and administering physical money. Central banks can also monitor how cash is being used, which could help prevent criminal activity. Throughout history, both physical and digital currencies have been exploited by criminals. The advent of CBDCs (Central Bank Digital Currencies) presents a potential solution, offering enhanced security features and improved traceability to counter illicit financial activities more effectively.

Will users benefit?

For potential users of digital currencies, the advantages are less clear-cut. Digital currencies issued by central banks will, in essence, be just a digital form of cash. They will almost certainly look and feel like existing digital platforms, but money deposited with a central bank platform is a deposit with a central bank and is therefore backed by the government – which might be more secure than putting one’s money in the hands of a privately-owned company.

Digital currencies will not be used speculatively – at least no more so than currently happens on currency markets. Unlike a so-called crypto-currency such as Bitcoin, which is essentially a vehicle for speculative trading and attracts purchasers looking to make a quick profit, central bank digital currencies would be just a medium of exchange, which is expected to limit their volatility.

Central banks hope that digital currencies may also be a tool for financial inclusion, which is why they are popular with forward-thinking governments in emerging countries.

Central banks hope that digital currencies may also be a tool for financial inclusion, which is why they are popular with forward-thinking governments in emerging countries. In its March 2023 report, Central Bank Digital Currency and Financial Inclusion, the IMF says digital currencies could encourage “previously unbanked households to open bank accounts to access CBDC wallets for payment. Second, households can build a credit history by using CBDC for payments.”

Cashless transactions should be faster and may be more reliable, like existing cleric electronics payment channels. Central bank digital currencies may also be more difficult to steal, providing optimum security is in place.

Digital currencies as policy instrument

While experts do not currently expect that digital currencies will have a significant impact on monetary policy, they could affect the efficiency with which monetary policy decisions are transmitted through a country’s economy. The effects may be more significant in an environment characterised by low interest rates or affected by financial market stress.

For example, in the wake of the 2007-09 global financial crisis, central banks found that they were unable to implement negative interest rates because people and businesses could simply hold their savings in cash. In a digital currency environment, it would be easier to implement negative rates. While this appears a remote possibility in today’s monetary policy environment in which central banks are battling to get inflation back under control, crises can erupt without much warning.

Digital currencies may also facilitate the more efficient distribution of cash injections into the economy. If a government wanted to distribute aid payments quickly in the event of a flood or earthquake, they could send money via mobile wallets rather than through local agencies or administrators.

What are the risks?

Central banks will have greater oversight of how cash is being used. While they argue that this will curb or deter crime, not everyone is comfortable with this new capacity for scrutiny of their personal actions. While digital currencies may transmit monetary policy more effectively, this is an abstract concept for most users, few of whom would be happy with the imposition of negative interest rates. However, this would require the wholesale withdrawal of cash, and there are no immediate signs of this happening, although cash use is falling – even drastically in some Scandinavian countries.

Inevitably it will take time for people to build up trust in digital currency systems. The ECB has already sought to reassure savers that they will not be at risk of losing their deposits. Some policymakers have expressed concern about the impact of so-called digital bank runs, which could occur if people converted their savings to CBDCs in the event of a crisis, which could drain the banks of liquidity.

Banks fear that to some extent they could find themselves disintermediated by digital currencies. Individuals might prefer the relative security of a government-guaranteed deposit to a bank owned by shareholders. It could compel institutions to pay more competitive interest rates on savings. In a recent public comment, titled “Digital euro: debunking banks’ fears about losing deposits”, the ECB insists that individuals’ digital euro holdings would be restricted in order to preserve the corporate deposit base of the banking system.

These are extremely early days, and there is currently no one-size-fits-all path for the introduction of central bank digital currencies. Governments and their central banks will take different approaches, depending on their economic and monetary priorities, the relative level of digitalisation of their economies, and their existing legal and regulatory frameworks. In Europe at least, the digital euro may not be for tomorrow, but it is coming over the horizon.