As new technology interacts with demographic shifts and changing consumer behavior, digitization is rapidly changing payment markets worldwide. Prompted by these trends, many governments are exploring the possibility of central bank digital currency (CBDC).
At this stage, CBDCs are experimental, but they are noticeably picking up steam. The implications of CBDC for the role and profitability of commercial banks could be profound. If CBDC’s potential is realized, it could revolutionize how money is exchanged and even redefine the relationship between the state, financial institutions and technology companies.
A CBDC is simply the digital form of a country’s fiat currency — electronic tokens, whose value is backed by the central bank. Most CBDCs are designed to run on a blockchain or distributed ledger. However, unlike decentralized cryptocurrencies — such as bitcoin — that rely on a public blockchain, central banks will initially issue their token on a permissioned or private blockchain network.
The first iteration of digital currencies, introduced roughly a decade ago, were not interoperable and had limited programmability. CBDCs will address these issues and likely work on a national or supranational level. CBDC brings with it stability and confidence and could replace the need for multiple digital currencies intended for specific use cases, such as lending or trade finance.
According to the IMF, a key reason that advanced economies are moving toward digital currency is to counter the growth of private forms of digital money. Major discussions are currently underway in the financial industry about the status of this new technology.
The potential benefits of CBDCs
A CBDC makes the transfer of money across banks and national boundaries more straightforward, removing the need for bank systems to interact with each other. As a fast, low-cost medium of exchange, CBDC can improve liquidity and payment systems’ efficiency.
Other potential benefits include:
- Increased traceability to combat money laundering & fraud
- Greater consumer protection & security
- Support for financial inclusion efforts, especially in emerging economies
- Contestability in transactional financial services
At a macroeconomic level, researchers at the Bank of England have estimated that the productivity gains from adopting digital currency would be like those of a substantial reduction in distortionary taxes. Interest-bearing CBDCs could also increase an economy’s response to interest rate changes and be used to charge negative interest rates in an economic crisis.
Toward a cashless society
CBDCs have generated significant buzz in the last few years. At a conference earlier this year, the Swiss National Bank presented data from the survey showing that over 80 percent of central banks are engaged in work on either a wholesale or general CBDC or both.
In 2019, the People’s Bank of China announced that it would soon replace its cash in circulation with a digital currency. In Sweden, the central bank recently announced the launch of a year-long pilot project of its proposed e-krona. In the US, a non-profit think tank has been formed to explore digitizing the dollar. Meanwhile, Lithuania has gone a step further by launching the world’s first state-backed digital coin.
This is all evidence of a larger trend: money is becoming inseparable from technology. Although Facebook is shifting its Libra global currency plan to satisfy regulators, the threat of encroachment from big tech is not over. The disruption caused by the Covid-19 pandemic has added a further call to action for central banks to move forward.
The role of banks
Until recently, many commercial banks were working with the assumption that central banks would focus on wholesale rather than retail CBDCs. While a wholesale CBDC might not present a direct challenge, a retail version could pose a bigger threat. The principle suggests that basic functions such as account maintenance can be done outside of a bank. Even if a CBDC network did not belong solely to the central bank or there was regulatory intervention, institutions could find themselves with new-found competition for deposits.
An account-based directly issued retail CBDC would be particularly challenging for commercial banks, but this is unlikely. What is more likely is that CBDCs will be distributed through banks and other institutions. This would create a hybrid model where the private sector could concentrate on innovation, interface design and client management, and the central bank could focus on regulation and trust. This is one possibility, but big questions remain; and even in this hybrid scenario, CBDCs could represent a serious threat to a bank’s profitability in the long run.
There are two primary responses. A cautious one could be approaching CBDCs as nothing more than a tool for reducing costs, offering extra digital services and more security. With this response, a bank positions itself to design services within the CBDC system. For instance, on the consumer side, the consolidation of classic accounts and tokens, a simpler way to exchange tokens; and on the merchant side, digital services, smoother and more secure payments.
A second more open response suggests radical changes. Some services will naturally be supported by the network and, therefore, by the banks. This would allow a broad inclusion of the population and access to sophisticated financial services. In this scenario, banks embrace their role as a trusted third party — a guarantor for individuals or companies. In doing so, they can double down on their strong points, i.e. insight into their customers’ needs.
A bank can also distinguish itself through services, such as a particularly useful mobile banking platform, new payment methods, investment advice or an excellent trading platform. Assuming CBDCs accelerate the growth of DeFi, the banks would have a role to play in terms of advice, choice, support and even as a kind of specific wealth manager to each customer.
A final possibility: focus on features that will not be affected by CDBC, such as credit cards or multi-currency cards. Banks can invest in domestic instant payments or RTGS systems that will offer payment solutions able to compete with CBDC schemes.
Time to act
In the space of a few months, the subject of CBDC has leapfrogged from a theoretical abstraction to an urgent question at central banks around the world. Surging interest in CBDCs will likely push central banks to act more quickly than they might have previously.
When these experimental constructs exit the sandbox, the consequences — good and bad — will be profound. Their emergence raises some deep strategic questions for the future of the commercial banks, at a time when their profitability is already challenged.
Participants in the banking system should spend this time analyzing potential implications, anticipating possible disruptions and exploring what role they want to play to maximize the value of digital currencies and benefit from their development.