Date first published: 19/10/2021
Key sectors: finance
Key risks: bank runs, monetary policy
81 countries representing over 90 per cent of global gross domestic product (GDP) are either researching or looking to launch their own central bank digital currencies (CBDCs). 15 countries, including China, South Korea, and Sweden are running pilot CBDC projects, while five Caribbean countries have launched full projects. There exists a series of motivations for introducing CBDC – ranging from improved financial inclusion, reducing transaction costs through the elimination of middlemen, combating the rise of cryptocurrency and evading US sanctions. Yet introducing CBDC carries huge risks. Privacy advocates worry that it would allow central banks and governments to track every single financial transaction. Others are concerned that it raises the risk of money laundering and illicit transactions. But the largest is the CBDCs’ potential to upend the entire commercial banking sector.
Why it matters
Commercial banks are at the centre of the financial system. Traditionally, banks have made a large proportion of their revenues from acting as middlemen in virtual transactions – with McKinsey estimating that those services generated as much as US$2tn in 2019 alone. A more efficient payment system would thus eliminate literally trillions of dollars in global bank revenue. Furthermore, banks rely on deposits from the public and from non-financial corporations. CBDC has the potential to significantly affect the banking sector by cutting revenues and reducing deposit funding.
The monetary system has developed over thousands of years. Commodities, primarily gold, were initially treated as money. While those who held gold faced no counterparty risk, gold was inconvenient to carry around for transactions and difficult to divide. Over the centuries it was replaced by paper money, with central banks holding gold and creating paper notes backed by gold and then by government bonds. In the modern economy, the majority of what we think of as money is a digital liability of a commercial bank. In other words, retail deposits are commercial bank liabilities, and only paper money is directly a central bank liability. Commercial banks receive wholesale funding from central banks, and deposits from everyday retail consumers – using those funds to distribute loans and purchase other assets.
CBDCs could change the entire financing model. A retail CBDC could allow consumers to hold private accounts at the central bank. A private account at the central bank would be more secure than an account at a commercial bank – as the central bank is less likely to default than commercial ones. For a commercial bank to attract deposits it would need to offer higher interest rates. Alternatively, commercial banks could rely on wholesale markets – likely leading to higher rates. Potentially more worryingly, there would be strong incentives for individuals to convert their commercial bank deposits to CBDC during times of financial stress – increasing the risk of a bank run.
Central banks have raised concerns over CBDCs’ effect on the composition and cost of bank funding. Thus, they have attempted to design and implement CBDC in a way that makes the demand for CBDC, vis-à-vis bank deposits, manageable. Yet alternative models significantly reduce the potential benefits of CBDC. While some countries may implement CBDC models that do not significantly affect demand for commercial bank deposits, its highly likely that others will move ahead with a more disruptive and higher risk system.