Why Central Bankers Got Serious About Digital Cash

(Bloomberg) -- What central banks once sneered at, they’re now scrambling to master. Back when Bitcoin, the world’s first cryptocurrency, was seen as the province of anarchists and drug dealers, it was easy for the world’s central bankers to keep their distance. That changed in a hurry after Facebook Inc. proposed creating its own digital currency, Libra. Suddenly, the concept was seen as both practical and as a potential threat to existing monetary regimes. The central banks of China, the euro area, the Bahamas and others have been experimenting in the field, while others, including the U.S. Federal Reserve and Bank of England, are conducting research but not plunging in, at least for now.

1. What was so alarming about Libra?

The prospect of a coin usable for everyday transactions being put into the hands of Facebook’s more-than-two-billion strong user base. Most cryptocurrencies, such as Bitcoin and Ethereum, regularly experience wild price swings that make them unsuitable as a medium of exchange. Libra was conceived as a stablecoin, a flavor of virtual currencies that seeks to track the of some low-volatility asset; the most popular stablecoin, Tether, aims to follow the U.S. dollar. Facebook’s proposal faces many hurdles, but the notion of an alternative currency used on a global scale was quickly seen by regulators as posing a threat to national sovereignty, privacy, financial stability and central banks’ ability to carry out monetary policy. Billionaire hedge-fund founder Ray Dalio has said that if he were a central bank, he wouldn’t allow any private digital currencies.

2. What would a central bank coin be like?

More like Libra than Bitcoin, which was founded on a belief in the superiority of a financial system outside the control of a central party. Even so, central banks from Saudi Arabia to Thailand envisage using the same technology developed to underpin Bitcoin, the distributed ledgers known as blockchain. But instead of shaping them to promote anonymity -- Bitcoin represented a rebellion against central financial authorities -- the banks envisage using blockchain in such a way as to ensure oversight.

3. What do the central banks have in mind?

There are two main tracks: wholesale and retail. In wholesale projects, access to the digital currency would be limited to banks and other financial institutions and the goal would be to make payment flows within the existing financial system faster and cheaper. In retail projects, central bank digital currencies, or CBDCs, would be issued through would what might effectively be accounts at a central bank for the general public -- or accounts at commercial banks working with the central bank. In the latter, central banks could have to assume responsibility for performing customer due diligence, having to ensure the fulfillment of anti-money laundering and counter-terrorism financing requirements, as well as providing tax information.

4. Who’s trying this?

Some of the islands in the Eastern Caribbean, including Grenada and St. Kitts and Nevis, that share a central bank have already launched their own digital currency, which is now being tested by consumers and merchants. But the first major central bank to roll this is out on a big scale is likely to be the People’s Bank of China. After years of researching the topic, the PBOC in April gave the green light for some commercial lenders to conduct internal, hypothetical-use tests of the digital yuan. In some areas, consumer-facing pilot tests have begun -- for example at McDonald’s in Xiong’an, according to the Global Times newspaper. The European Central Bank has announced its own experimentation phase -- as well as a public consultation -- after officials have recently stressed the need to stay on top of the technological trends, in part because of risks posed by protectionism and pandemics. Sweden, Uruguay, South Africa, and Switzerland are other countries that are actively exploring digital possibilities.

5. Who’s not?

The Fed, for one, has been slow to warm to the idea of a digital currency, but its interest picked up more recently as it launched experiments with a hypothetical digital dollar for research purposes. Still, it hasn’t committed to exploring the legality and feasibility of digital currency with the government and stakeholders. The Bank of Japan has also made it clear it has no plan to issue a digital currency at this point, but important personnel changes this year suggest that officials want to at least study the matter more in depth.

6. What would the advantages be?

If central banks can surmount the technical difficulties, digital currencies could allow for faster and cheaper money transfers across borders, and could improve access to legal tender in countries where cash supplies are dwindling. A World Economic Forum paper suggested that the new currencies could offer retail investors safer places to save, if it allows them to create accounts with their central bank, and could reduce the cost barriers that currently leave some 1.7 billion people without banking services. Some economists even argue they could make monetary policy more efficient by allowing direct pass-through of interest rates. ECB President Christine Lagarde has argued that a digital euro could become particularly important amid a rise in protectionist policies if these led to a disruption of Europe’s predominantly foreign payment services. For China, a digital currency offers a possible way to keep up with and control a rapidly digitizing economy. On the other hand, it could also give the government an extra tool for surveillance.

7. What’s the downside?

The risks of getting this wrong are significant, which is why most central bankers have to date trod with caution. Depending on the model of CBDC, central banks risk either cutting out commercial banks, a vital funding source for the real economy, or assuming the direct risks and complications of banking the masses. Problems in managing a business that’s new to them could undermine the public trust that central banks count on to let them pursue occasionally unpopular actions like interest-rate hikes. Also, some researchers have expressed doubts about whether current blockchain technology would be able to support a large volume of simultaneous transactions. A People’s Bank of China official said its research showed that Bitcoin’s blockchain capacity fell well below peak demand, on China’s 2018 Singles’ Day shopping gala, of 92,771 transactions per second. Other studies have found that Ethereum handles an average of 15 transactions per second, while Visa Inc.’s network can handle 24,000 per second.

8. Is this just a financial fad?

It seemed like that to many in the field but no longer. Agustin Carstens, the former Governor of Banco de Mexico turned general manager of the Bank of International Settlements, the so-called central bank for central banks, said in March 2019 that “research and experimentation have so far failed to put forward a convincing case” for central bank digital currencies. But the week after the Libra announcement, Carstens said digital currencies could appear “sooner than we think.” The Bank of England has recently said it’s reviewing whether it should create a central bank-backed digital currency, and according to governor Andrew Bailey, the country “will be heading toward some sort of digital currency” in a few years time.

The Reference Shelf

Bloomberg QuickTakes on stablecoins and Libra, and on China’s digital currency experiments.
The Bank of International Settlements published a roundup of central banks and digital currency plans.
A review of the subject on the IMF’s blog.
Tyler Cowen’s column on central banks and digital currencies for Bloomberg Opinion.
A Bloomberg News article on the ECB’s new plans to move in this area.
How central bankers responded to Facebook’s proposal on Libra.
Resources from the Bank of England the Bank of Canada on central bank digital currencies.