Are central bank digital currencies the future of money?

By Jonathan Thun


With rising interest in cryptocurrencies and declining usage of cash, central banks are intensely investigating a new means of payment: central bank digital currency (CBDC). This new currency will have the same value and main functions as traditional bank notes, coins and fiat currency in general, such as being a storage of value, a medium for exchange and a unit of account. But CBDC will also bring new functionally, such as making money programmable using smart contracts – which makes it possible to automate payments based on a set of conditions – constrain moneys’ validity and add interest rates.

What is a CBDC?

CBDC is digital money, issued by the central bank. It works as either a token- or account-based solution.

Token-based CBDCs resemble cash. People have digital wallets that hold the tokens, or ‘digital cash’, and when they make a payment, the amount of cash in the wallet reduces accordingly. The token represents the value of the money, and the key concern is to ensure the validity of each token.

Account-based CBDCs work like digital bank accounts, but the central bank holds the account rather than a commercial bank. The value is equivalent to the balance of the account, and the key concern is identification, which will correctly link payers and payees, and check that the payer has sufficient funds to make the transaction.

How is a CBDC different to a cryptocurrency

Conceptually, it’s easy to see similarities between cryptocurrencies and CBDC. The common traits of cryptocurrencies are decentralised clearing without the need for a trusted counterparty, ownership-based on cryptographic keys rather than accounts, and the possibility to alter validity using smart contracts. It’s possible to design a CBDC with all these traits, making the two very similar.

Yet there are differences.

The value of CBDCs is commonly pegged to the value of a currency – the Swedish e-krona has the same value as the regular krona, for example – so, the central bank controls the value and supply of the CBDC. Cryptocurrencies, on the other hand, determine their value through supply and demand, leading to high volatility.

The mining we see with cryptocurrencies also won’t be part of CBDCs. The solving of complex mathematical equations is essential to generating and distributing cryptocurrency tokens and enabling transactions. But central banks can settle CBDC transactions and distribute the currency to the public, for example by exchanging physical money for digital money.

Even so, central banks are likely to collaborate with banks and other intermediaries. They lack, and probably don’t want to take on, customer and account management roles and responsibilities, such as Anti-Money Laundering/Combatting the Financing of Terrorism and Know Your Customer.

Recent developments in El Salvador is especially interesting, seeing as they are the first country to accept Bitcoin as legal tender alongside the dollar. The Salvadorean state guarantees that you can buy whatever you want in El Salvador using it, just like a fiat currency. However, this does not mean that Bitcoin will be the long-term winner as a digital currency for emerging markets.

CBDCs could ultimately be more attractive than private cryptocurrencies as digital currencies for emerging markets, but only if they are widely circulating genuine cryptocurrencies. Adopting Bitcoin, like adopting the dollar, allows El Salvador to access a potentially more attractive form of money without a credible central bank, but it also means ceding monetary policy currency control. Although it can be argued that adopting Bitcoin will reduce El Salvador’s dependence on the Federal Reserve, the country will now be subject to both US interest rate policy and global Bitcoin fluctuations.

What’s in it for the central banks?

The reasons central banks would want to issue a CBDC are diverse, but they start with the principle that a non-private option for payments is essential to the economy and national resilience. Currently, cash serves this purpose. However, the use of cash is declining in several countries – in Norway and Sweden, for example, the number of cash payments is tending towards zero. The combination of a payment system failure and no other payment options could have serious consequences. Having CBDC as an alternative means of payment could mitigate the impact.

Central banks also emphasise the potential operational benefits of CBDC, such as more efficient cross border payments, better financial inclusion and reduced financial crime. China, for example, is pioneering a CBDC through its digital renminbi initiative, which more than 100 million people are currently testing. According to the Chinese authorities, the motive for this is mainly the fight against

corruption, as a CBDC provides transparency through traceable transactions. The flip side to such positive impacts are questions and concerns related to government control, privacy, freedom and security at an individual, domestic and international level.

How could CBDCs impact countries?

We recently mapped the possible implications of CBDCs for a European authority, finding there are risks and rewards across privacy, monetary sovereignty, financial inclusion and geopolitics.

A central bank-operated ledger of digital currency, for example, could seriously hinder privacy. The central bank would need to know who is storing or transacting in the CBDC, revealing the behaviours of citizens.

But a CBDC could be essential to maintaining monetary sovereignty. If citizens drive a shift to digital currencies through cryptocurrencies, governments risk losing control over their monetary policies. The tools that central banks use to maintain financial stability and control inflation won’t work if no one is using regular money. A CBDC would facilitate the citizen-driven shift while keeping the central bank in control.

And in developing countries, a CBDC could boost financial inclusion. In countries with less developed financial systems, high commissions and no deposit insurance mean some people choose to stay excluded from financial services. As CBDC deposits are risk free, and most likely with low to no fees, more people might choose to use financial services.

Finally, CBDCs could change the face of geopolitics. The US controls the SWITFT international payment system, often using it for its own geopolitical agenda. But the rise of digital currencies, such as the digital yuan, can remove the power of US sanctions. China’s first mover advantage in the launch of a virtual currency could be a step towards unseating the US dollar from decades of financial dominance.

What are central banks around the world doing?

While China was the first major economy to issue a CBDC, many are looking into it. A survey by the Bank of International Settlements found 86 per cent of central banks are researching or experimenting with CBDCs, and a fifth of the world’s population may be using CBDCs in as little as three years. The European Central Bank expects to launch a digital euro by 2025, if there’s agreement to move forward. And on 19 April 2021, the Bank of England and the British Treasury launched a task force to ensure a strategic approach and coordination between UK authorities as they explore CBDC.

Still, some central banks have chosen to abandon CBDCs completely. Ecuador cut its CBDC due to low prevalence and transaction volumes. And the Danish central bank stated in2017 that the advantages of CBDCs didn’t outweigh the disadvantages – strong levels of cash transactions and a currency pegged to the euro reduce the potential upside.

On the other hand, Sweden has started testing their e-krona as a supplementing means of payment. While Norway is still in a more explorative phase, with The Norwegian Central Bank recently deciding to investigate CBDC further, including testing technical solutions and running consequence analyses.

Central bank digital currencies will be part of future financial systems

CBDC is still in its infancy. While central banks and the authorities analyse and carefully consider all the societal implications of a comprehensive solution, private actors continue to develop and launch innovative payment solutions, including crypto-based ones, at breakneck speed. Central banks will never be able to beat them at the speed of innovation, but there are societal considerations these players won’t necessarily have incentives to deal with. In these cases, the authorities will be able to play the regulatory trump card, as the EU is doing with its proposed regulation of cryptocurrencies to reduce risks to investors.

As central banks take their time getting digital currencies right for their populations, they must also keep an eye on the private cryptocurrency market. While there are concerns about a digital future for money, they won’t prevent it coming.

About the authors

Jonathan Thun PA financial services expert

Explore more

Contact the team

We look forward to hearing from you.

Get actionable insight straight to your inbox via our monthly newsletter.