Central banks are rushing to build digital currencies. What are they, and what do they mean for you?

As bitcoin and other cryptocurrencies roared back to life in 2020 and threatened the longstanding “cash is king” rhetoric, many central banks have been carving out a similar yet completely distinct concept: central bank digital currencies (CBDCs), their own solution to a cashless global financial system.

China became the first major economy this week to create a blockchain-based digital version of its currency, the cyber yuan. This is good news on one hand for the country’s citizens who rely heavily on electronic payments, but it also gives the government greater oversight into the spending habits of its citizens.

Sweden’s central bank, the Riksbank – the world’s oldest and often touted as the most advanced in exploring digital currencies – revealed this week that its current pilot project will take at least one more year to be ready, years later than the once suggested target date of 2018. The Riksbank has even given itself until 2026 to continue exploring the e-krona.

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But central banks across the globe are still rushing to get involved. So, what are CBDCs and what’s driving interest in the sector?

What are CBDCs and how are they different from cryptocurrencies?

A CBDC is considered to be a variant of cryptocurrencies, although stark differences exist. In reality CBDCs contradict the core principles of cryptocurrencies –after all, bitcoin was introduced in 2009 to be free of control by central banks.

A CBDC is a blockchain based digital currency launched by a central bank. They have no investment value –so unlike bitcoin’s claim to be “digital gold” – and will serve the purpose of transferring value via digital transactions. Cryptocurrencies normally use a decentralised blockchain, meanwhile CBDCs are centralised in nature and will use “permissioned” blockchain networks, paving the way for central banks to monitor the activities of network participants on the blockchain.

This would involve the central bank partnering with other banks and financial institutions who would execute transactions for clients. Many virtual currencies being explored by central banks also are not anonymous. So users have to often go through the standard Know-Your-Client (KYC) processes.

Why are CBDCs being launched and who is involved?

CBDCs have been discussed for years as an alternative to cash as many economies have witnessed a slump in physical money being used in transactions. Cash accounted for only 20% of payments in China – the world’s second largest economy – in 2018, according to research published by the Bundesbank in 2019. This has halved since 2016.

But the covid pandemic has accelerated some central banks’ plans to pilot CBDCs, simply because CBDCs are safer as they do not need to be physically handled. But hygiene is not the only driving force pushing central banks to embrace CBDCs.

In the Bahamas, the country’s central bank is piloting the “Bahamas dollar”. The need for CBDCs has risen after Hurricane Dorian devastated the island in 2019. As Ledger Insights notes, it is quicker to “repair the antennae needed for digital payments”, than to build cash machines or rebuild bank branches, which can often take months or years. Digital currencies were , however, already being discussed in the Bahamas as there are concerns that the island is under-served after a number of banks scaled back their operations there over recent years.

A spate of other countries’ central banks are also exploring CBDCs, including Japan, Turkey, Switzerland, the Philippines, France, Canada, Singapore and the UK to name a few. The Bank of England recently said now is the “right time” for the central bank to be considering the future of money and “the type of money” it provides to the public. But China was the first country to announce a pilot for a CBDC earlier this year, having set up a special task force in 2014.

The US – the world’s largest economy – is carrying out a joint project between the Boston Fed and MIT, but its digital currency exploration is still at the very early stages. Fed chair Jay Powell has ruled out enacting any measures without support of Congress.

Why CBDCs are a threat to privacy

So why were countries exploring CBDCs well before the pandemic? This is because there are clear advantages of introducing digital currencies.

According to PwC, they provide a better economic picture. A digital currency “could provide a real time picture of economic activity in a country or region as well as provide more accurate and timely economic data for GDP estimates than are available today,” it said in a report released in November 2019.

CBDCs can also help fight against corruption. Cryptocurrency critics often cite the risk of financial crime as one of the biggest disadvantages of using them. CBDCs can perhaps be a “best of both worlds” solution which provides virtual currencies but has some oversight.

But will CBDCs become another financial tool used by the government to exert greater social control on citizens’ financial affairs? The social concerns extend far beyond just the discomfort of knowing there is government surveillance. CBDCs in an extreme case could also prompt the government to also control consumer behaviour including various spending habits and different aspects of citizens’ financial decision-making, or even compel consumers to purchase certain financial assets.

If that were to happen it could strengthen the case for decentralised currencies like bitcoin and push its price even higher.

But as Cuy Sheffield, head of cryptocurrency projects at global payments company Visa points out: “Central bank digital currency... is one of the most important trends for the future of money and payments over the next decade. Regardless of anyone’s personal views of whether it’s good or bad, the reality is that global interest in it is not going away. [CBDC’s will have] major implications for privacy, monetary sovereignty, geopolitics, and financial inclusion, as well as global adoption of crypto dollars and bitcoin.”

So ignoring digital currencies altogether is likely to be a mistake for central banks at a time where economies are becoming cashless and the pandemic has created a clear bias towards digitised payments.

Another impact of CBDCs could be the US dollar losing its crown as the world’s reserve currency now that China has launched its digital yuan, analysts at investment bank JPMorgan say in a note.

“There is no country with more to lose from the disruptive potential of digital currency than the United States. This revolves primarily around US dollar hegemony. Issuing the global reserve currency and the medium of exchange for international trade in commodities, goods, and services conveys immense advantages”, the analysts say.

Ultimately, it remains to be seen how many countries actually launch CBDCs and how public confidence fares once they are adopted. But it may very well be the case that CBDCs are a game-changer for the global financial system.