Why Central Banks Want to Create Their Own Digital Currencies Like Bitcoin

Even the Federal Reserve, which has long said it doesn’t have plans to launch a digital currency, plans to build and test a hypothetical design. Fed Chairman

Jerome Powell

cautioned Monday that a “great deal of work” needs to be done before the central bank would decide to launch a digital dollar.

Here is what you need to know about this new form of money.

Why do central banks want to introduce digital currencies?

The pandemic is accelerating a shift away from the use of physical cash in most developed economies, with alternative payment methods or private cryptocurrencies potentially taking its place.

Central banks are exploring ways to create a digital version of cash: money that is trusted, convenient to use and widely available to people, for making payments and getting paid. Digital currencies have the potential to make it easier, cheaper and faster to move money around.

If foreign countries issue their own digital currencies, or if private cryptocurrencies were to gain popularity, they could eat into use of the traditional forms of money issued by central banks, and pose a threat to policy makers’ ability to transmit monetary policy.

Are any digital currencies currently available?

Bitcoin is called a digital currency, but it is nothing like the money you carry. It is a computer program that allows two people anywhere in the world to exchange value across the internet in minutes.

Unlike traditional money, bitcoin and other cryptocurrencies aren’t issued by countries or central banks. On the contrary, one of the hallmarks of these products is the lack of regulation and oversight by a central authority.

Individuals and companies use powerful specialized computers to solve a computational puzzle and “extract” or “mine” new bitcoin. Users of the currency verify transactions with a permanent, inalterable public ledger, which anybody can view and analyze at any time.

No major central bank in the world has yet introduced its own digital currency.

Why has bitcoin not become a popular payment method?

Most retailers don’t allow the cryptocurrency to be used for general transactions, such as buying groceries, because there is no guarantee that bitcoin can be easily exchanged for more traditional forms of money at a predictable price.

Buyers and sellers also haven’t embraced bitcoin as a way to pay because the price is volatile. At present, one bitcoin is worth about $12,175. Just this year, its value has ranged from as low as $4,945 apiece to as high as $12,399, according to CoinDesk.

Bitcoin has also gained an unsavory reputation, because it is effectively anonymous. Anyone with a computer and an internet connection can download the software. Unlike opening up a bank account, users don’t have to provide any identifying information to start a cryptocurrency account. That is also making it challenging for authorities to track, trace and crackdown on malicious actors using cryptocurrencies.

With the backing of central banks, digital currencies are likely to be more palatable to both merchants and the general population than bitcoin and other private cryptocurrencies, said

Carlo Cocuzzo,

an economist at ING Bank.

What is bitcoin used for?

Instead of being used as money, to make payments or exchange value, bitcoin is considered a financial asset by most of its users. They are betting that the value will climb as the cryptocurrency remains scarce, with the underlying blockchain technology allowing for new uses of bitcoin over time.

Why are central banks exploring new electronic payment systems?

Traditional American banks have been slow to introduce apps and software that allow peer-to-peer payments for things like splitting the bill on a meal, or paying someone for a coffee.

That has allowed apps like

PayPal Holdings Inc.’s

Venmo to gain popularity. They provide a secure means to move money between bank accounts, ensuring there are sufficient funds to meet the claim. These services typically charge a fee, and can still require days for funds to be transferred.

Behind the scenes, most financial transactions—whether using a credit card, sending money to a relative, or buying something online—involve settling payments over a patchwork of systems.

Middlemen include payment processing companies such as PayPal or Stripe Inc., as well as card networks owned by

Visa Inc.

or

Mastercard Inc.

The payment is ultimately routed through banks, who sort and settle the transactions, and typically collect fees from merchants for offering the service.

That means money can take two or three days to move between accounts.

Why would making payments become faster and cheaper?

Central banks could directly issue their digital currencies into users’ online wallets without involving banks and other middlemen, under some of the proposals being considered.

Americans could also potentially hold accounts at the Fed for making transactions using a digital dollar, simplifying the process and lowering the cost of exchanging payments.

Such a system could possibly have helped the government send stimulus money to American households, or aid to small businesses, faster in recent months.

What other benefits could digital currencies offer?

Digital currencies are likely to give central banks more insight into the movement of money in the economy. The widespread use of electronic payment systems may also aid authorities crack down on money-laundering and terrorist-financing efforts.

People who don’t have bank accounts may gain access to more financial services through this new form of money. Many hundreds of millions in poorer nations are completely untethered to the modern financial system, making financial inclusion an urgent target for central banks in emerging markets.

Digital currencies issued by central banks could also help improve the effectiveness of monetary policy by allowing a central bank to change rates directly on accounts holding the product, bypassing financial markets.

What are the risks?

One of the key questions that central banks are trying to address is how to avoid destabilizing their economy and financial markets.

If a new monetary structure designed around digital currencies allows Americans to maintain their savings and current accounts directly with the Fed, commercial banks could lose retail deposits, which are their most stable source of funding. Because of this, central banks are talking about limiting the scope of central bank digital currencies, perhaps by imposing a cap on how much money could be kept in a central bank account.

There are also growing concerns about privacy and digital surveillance, as the government would be able to track payments made using these new currencies. In addition, some people worry that central banks could impose subzero rates on ordinary people’s deposits.

Mr. Powell also cautioned on Monday that the Fed must consider the risk of cyberattacks, counterfeiting and fraud, as well as the impact on monetary policy and financial stability.

“We do think it is more important to get it right than to be the first,” he said.

Write to Caitlin Ostroff at caitlin.ostroff@wsj.com