When they burst into public view in 2009, the market for digital currencies was the Wild West. Bitcoin – and the many imitators that it spawned – was a fringe novelty that captured the attention of technologists and those looking for an alternative to mainstream financial services. In that early surge of activity and Utopian optimism, the digital currency market was certainly marked by innovation, but also by misunderstanding, volatility, fraud and minimal oversight.
Now, just over a decade later, 80% of central banks surveyed by the Bank for International Settlements are engaged in research, experimentation or development of a central bank digital currency (CBDC) and 20% said they would likely offer a digital currency by 2025.
While Bitcoin still has its supporters, in hindsight its real value may be as a catalyst that exposed the world to the ideas of tokenization, distributed trust, and multi-party systems.
So What Are CBDCs?
The term CBDC can broadly refer to any digital representation of central bank money, including the digital account balances that commercial banks hold in their Federal Reserve accounts. The innovation here is tokenization, which creates a unique digital representation of value that is portable and functions in the digital realm the same way “hard” currencies do in the physical world. With tokenization, a successful transaction depends on the token itself being valid rather than the account having enough funds for it to clear.
Tokenized digital currencies promise greater flexibility, with the ability to handle large transactions, including those in securities markets. Because they rely on decentralized tools, such as distributed ledger technology, they can reduce delays, errors and reconciliation costs.
Why Do Central Banks Care?
Central banks are working with digital currencies because they recognize that financial systems, for all the post-financial crisis work done to bolster them, still have vulnerabilities and flaws. Large financial firms concentrate risks and cross-border payments can be slow and expensive. At the opposite end of the spectrum, financial inclusion remains a problem in many countries, with the U.S. alone having tens of millions of unbanked or underbanked consumers who are overly reliant on cash, and emerging markets like Mexico with over 80% in cash transactions.
And then there’s China. The current world leader in deployment of CBDCs is the People’s Bank of China, which has rolled out a digital currency in four cities via over 100,000 personal and 9,000 corporate digital wallets that have already processed over $160 million worth of money transfers.
As recently as February, U.S. policy makers remained publicly skeptical about CBDCs. Just eight months later, regulators are rushing to play a far more activist role in shaping the future of digital currency. “It’s our obligation to understand it well and not wake up one day and realize the dollar is no longer the world’s reserve currency because we just missed a technological change,” said Fed Chairman Jerome Powell in testimony before the House Financial Services Committee
Banks’ Role Going Forward
While foreign CBDCs and private digital currencies aren’t yet a threat to the greenback’s status as the world’s reserve currency, it’s important to understand how tokenized central bank currencies could alter our world. As the Fed moves closer to adding a tokenized dollar to the physical money already in circulation, bank executives need to devote time to thinking through what a real digital currency would mean for their businesses and their clients.
For example, some legislators and academics have argued that a form of digital currency would make COVID-19 aid delivery more efficient by eliminating the need to print and mail millions of paper checks. For small businesses, CBDCs could also provide a way to control the disbursement of aid, helping to manage both who gets the funds and also how those funds are spent, ensuring that, for example, they are used for payroll support.
Digital currencies could also become an important tool to help people who are currently underserved by traditional banks gain access to the financial system. Digital wallets, provisioned by public or private entities, would be a low-cost on-ramp for financial services. The penetration of smart phones, the roll-out of 5G technology and advances in distributed ledger technology could help displace cash in many transactions, giving consumers access not only to a secure means of digital payment but also add-on features like insurance and short-term credit.
Having a tokenized CBDC will also provide a platform for accelerated private sector innovation. With CBDC as a foundation, features or benefits driven by consumer demands, such as privacy protections or loyalty rewards, can be built on top by taking advantage of the programmable nature of digital currency to restrict use or attach other data elements to the unit of currency.
The era of speculating about digital currencies is over. The era of implementing them has begun in earnest. The next few years will see them become a reality in many countries around the world and the ramifications for the banking industry will be profound. Now is the time to plan for the world of the digital euro, dollar and pound and figure out how they will reshape the world of banking.
Credit: Source link