Central bank digital currencies (CBDCs), also sometimes called govcoins, have suddenly become a subject of public discussion. Until recently the topic was mainly the preserve of a coterie of technical experts working for central banks and niche technology firms. But now there seems to be immense excitement about their potential to transform finance. There are even some who suggest the new technology could allow the renminbi to overtake the dollar as the world’s leading cross-border currency.

  • CBDCs are a particular form of digital money backed by governments and are legal tender
  • They already exist in some small territories but China and Sweden are ahead in the race to introduce them
  • Wholesale CBDCs are still experimental but they could help improve the efficiency of both settlement in the capital markets and cross-border payments

Their significance is not so clear, however. Central banks and financial markets have engaged in digital transactions for decades. And cryptocurrencies, such as bitcoin and ethereum, are already well-known. 

So what makes CBDCs distinct from digital money in general? And what impact are they likely to have on financial markets? 

What are CBDCs?
There is no universally agreed definition of what CBDCs are, although some of their distinct features are clear.

In technical terms, ‘currency’ is a particular form of money. Currencies are nowadays normally forms of fiat money – that is, their value is backed by a government promise. That is in contrast to the past when they were sometimes exchangeable for a specific amount of gold or silver. They are also legal tender in that someone who pays of a debt in that form of money cannot be sued for failing to repay – although El Salvador has recently made bitcoin legal tender. CBDCs are direct liabilities of central banks and they are backed by foreign exchange reserves  

Different types of money

What kinds of digital money do not count as CBDCs?
CBDCs differ from first-generation cryptocurrencies in at least three key respects. First, the value of CBDCs is fixed in relation to a currency rather than potentially fluctuating widely in the case of cryptocurrencies. 

Second, CBDCs are issued by governments rather than the private sector. 

Finally, CBDCs exist on a centralised system, whereas first-generation cryptocurrencies exist on a decentralised and distributed ledger, so any transaction has to be validated by several independent nodes.

So-called stablecoins are second-generation cryptocurrencies. They include Tether and prospectively Facebook’s Diem (formerly Libra) project. These are similar to CBDCs in that they have a relatively stable value and they are run on centralised networks. Their value tends to be pegged either to fiat money or a portfolio of metals. Stablecoins are a private initiative whereas CBDCs are public.

What are the forces promoting the adoption of CBDCs?
The growing move towards cryptocurrencies has focused central banks’ attention on digital currencies. A particular concern is maintaining control over the money supply. If cryptocurrencies take off, it means a higher proportion of money will be outside of government control. The role of traditional commercial banks in holding cash could also diminish. In particular, Diem, which could tap into Facebook’s 2.8bn users worldwide and act in some respects as an alternative to currency. The rapid advance of China in relation to CBCDs is also putting pressure on western central banks to develop the technology. 

In other words, the initiative to launch CBDCs is coming mainly from central banks themselves, rather than as a response to demand from consumers or private financial institutions. 

What kind of technology do CBDCs use?
CBDCs, like cryptocurrencies, are likely to be based on blockchain but they could, in principle, be based on conventional centralised technology. Unlike traditional cryptocurrencies, the identities of the parties involved are not anonymised. 

When are they likely to come into existence?
They already do. At least in some relatively marginal countries. The Central Bank of the Bahamas, for example, has rolled out the sand dollar, a digital version of the Bahamian dollar. Users have an e-wallet which can be accessed by mobile devices or computers. The system makes cash payments easier among a small population spread across hundreds of islands. 

Cambodia has also launched a CBDC. The Bakong can support transactions in both riel and dollars. 

Where do the world’s main central banks stand in relation to the development of CBDCs?
According to a January 2021 survey of more than 60 central banks by the Bank for International Settlements (BIS), the central bankers’ central bank, 86% were exploring the benefits and drawbacks of CBDCs.

The People’s Bank of China (PBOC) is ahead of its main peers in relation to CBDCs. It has been working in this area since 2014 and is already at the stage of trialling digital wallets for the e-renminbi. This is arguably a response to the huge success of private-sector payments systems such as Alipay and WeChat Pay. The PBOC has been working on its digital renminbi project for over five years and there are reports it will be launched in time for next year’s Winter Olympics in Beijing. The PBOC is also working with the Hong Kong Monetary Authority and the central bank of Thailand in a joint project on cross-border foreign exchange payments.

Francesca Fornasari

Francesca Fornasari, head of currency solutions at Insight Investment, argues that, over time, this could lead to a greater international role for the renminbi. “One of the questions is that if it is easier to pay with renminbi, as it becomes digital, is that share going to change?” However, she says it is likely to be a slow process, as the PBOC fears the potentially destabilising consequences if its currency becomes more globalised.

In contrast, the European Central Bank (ECB), the Bank of England and the US Federal Reserve are all at exploratory stages in terms of introducing CBDCs. The ECB’s discussion of the digital euro, for example, remains tentative. It has not announced any specific conclusions on the form the architecture will take. Sweden’s Riksbank is understood to be relatively far advanced in plans to launch a pilot scheme for the e-krona.

It should also be noted that the exact features of the architecture are unclear in most jurisdictions. For example, it would be theoretically possible for individuals to have direct CBDC accounts with central banks, although this is unlikely. The exact role to be played by commercial banks is still undecided.

What implications would CBDCs have for institutional markets?
The development of wholesale CBDCs is behind the retail variant but they could have substantial benefits for the institutional markets. These include faster transactions, lower costs and the ability to fractionalise assets.

A key point to understand is that CBDCs provide only one way of helping to apply distributed ledger technology (DLT) to the institutional markets. There are other routes they could go down. More generally, the trend is towards tokenisation – that is creating a unique digital representation of assets. This could be achieved by using CBDC technology but it would also be possible to harness other forms of stablecoins. 

As a recent release from the Bundesbank noted, “it is possible to establish a technological bridge between blockchain technology and conventional payment systems to settle securities in central bank money with no need to create central bank digital currency”. 

However, Iota Kaousar Nassr, a policy analyst at the OECD, says there are potential advantages to going down the CBDC route. As she told a recent webinar run by the International Capital Markets Association: “there may be some benefits for the use of CBDCs versus stablecoins for the settlement of tokenised assets because for the users it reduces any counterparty risk and credit risk”. She says that, in her view, the introduction of CBDCs could be a strong catalyst for the development of tokenised assets.

The recent BIS survey identifies several possible motivations for the introduction of wholesale CBDCs. Cross-border payment efficiency is receiving a lot of attention. Another driver is the enhancement of cyber resilience.

What difference could CBDCs make to the implementation of monetary and fiscal policy?
CBDCs could have important implications in terms of policy. For a start they make it easier for the authorities to monitor the state of the monetary system than if physical currency plays a large role. They could also make the application of monetary policy easier. For example, if consumers held money in digital wallets, rather than in physical currency, it would be harder for them to evade official policy measures. “If the central bank decides to implement negative rates you have no place to hide,” says Fornasari. CBDCs also open the way for new policy tools such as injecting money into the economy more efficiently in the event of a crisis.

CBDCs could be used to promote financial inclusion. There were about 1.7bn adults in the world in 2017 without access to bank accounts, according to a World Bank estimate. CBDCs could help give them access to financial services. 

However, there are concerns that CBDCs could be destabilising if their advent involved a flight away from bank deposits.