Central banks and digital currencies: What are they, and what do investors need to know?

Bitcoin and other cryptocurrencies have entered the public consciousness in a big way, and not only because of the incredible volatility and the fortunes that have been made and lost on them. The revolutionary aspect of this new form of money also excites many people as it brushes aside the need for governments and central banks.

The most well-known types of cryptocurrency are decentralised – unregulated tokens like Bitcoin, Ethereum, Ripple and Dogecoin that can be exchanged for goods or services like traditional currencies. Most use distributed ledger technology, such as blockchain, to confirm tokens are valid and log transactions, and are issued by a network rather than a central authority or government. Stablecoins are another type of cryptocurrency that also uses distributed ledger technology but is pegged to an existing entity, like the US dollar or a commodity like gold. This should, in theory, reduce their volatility. Examples include Tether and Facebook's Libra project, now known as Diem.

But here we are going to look at the newest cryptos on the block – central bank digital currencies (CBDCs).

What are CBDCs?

CBDCs are issued by governments and are basically digital versions of an existing national currency. They use the same underlying distributed ledger technology of cryptocurrencies, but governments recognise them as legal tender in the issuing central bank's jurisdiction, meaning anyone can use them for payments and every merchant must accept them. 

Why are CBDCs being created?

But why should a government issue a CBDC when fiat currency exists? In short, central banks have been rattled by the growth in digital currencies and are worried that Bitcoin and others, particularly stablecoins, could eventually undermine traditional fiat currencies, including the world’s reserve currency: the US dollar.

How does a CBDC differ from other electronic payments?

We already use electronic money such as credit cards, as well as through online banking. With a CBDC it is the government that is the counterparty and accepts liability for the money. That contrasts with a commercial bank cash deposit where the bank takes responsibility, and your deposit sits in the bank’s own ledger. With the government as counterparty, this raises the possibility of more efficient clearing which would lead to faster processing and transfers.

CBDCs could also improve the efficiency of cross-border payments if countries work together. But it also means that the government could control how your money is spent. For instance, there may be governments that allow you to buy food, clothing, and medical supplies, but not cigarettes or alcohol.

Which countries are using CBDCs?

Several central banks are running feasibility studies including the European Central Bank, Sweden, the Bahamas, the US, and the Bank of England.

Perhaps it’s unsurprising that China is leading the way with its digital yuan. It has already been used in transactions worth $5 billion in a trial version, and would be the ultimate way for China to control citizens in terms of how much they get paid and for what, and what they spend this money on. This sense of control as well as privacy issues are the greatest concerns.

Some have said that the US has been slow off the mark when it comes to CBDCs. Perhaps not for long, especially if a digital yuan were to threaten the dollar’s reserve status. To avoid a backlash about privacy and control, the US could develop a CDBC without any limits about how the money is used. It would also be more acceptable if the CBDC lived alongside existing forms of money, including physical cash, bank deposits and other cryptos.

The trouble is that there have been far too many calls for cryptocurrency regulation in the US and elsewhere. While some oversight may boost confidence in cryptos, too much would kill what is an exciting and beneficial technology. Why not build on that and encourage development in this area? There is plenty of room for unregulated and volatile cryptos, some light-touch regulation on stablecoins, and fully regulated CBDCs. Let the developers and entrepreneurs do their thing and all could flourish together.

How could CBDCs affect investors?

Perhaps it’s too early to speculate on how the adoption of CBDCs could affect investors. After all, we’ve currently got little idea about how they would operate. In an ideal world they would exist alongside other currencies, cryptos and no doubt the International Monetary Fund’s Special Drawing Rights. Certainly, it would be highly disruptive if they were introduced to replace, say, the US dollar. Such a move would potentially upend FX markets.
 
However, it seems possible that over time, trust will build in one form of money over another and we’ll then see a gradual take-up of the most trusted and convenient variety. But it’s just as likely that we’ll have a number of different forms of money which act as both mediums of exchange and stores of value. Hopefully these will be allowed to exist, rather than the authorities of the day forcing people to accept a currency that people distrust. After all, the euro experiment is still far from over.