It’s time for central banks to start issuing their own digital currencies. Yes, even the Fed.
To be clear, these calls are not for the government sponsored versions of PayPal or Venmo, which ultimately transfer balances from one bank account to another, but for fully digital currencies that can be viewed and stored. regardless of the current banking system. .
If central banks do not adapt to a rapidly digitizing economy, they will be left behind, as will the economies they support. The question is no longer whether to introduce central bank digital currencies (CBDCs) at all, but when and how to introduce them without compromising the stability of the banking system and slowing down innovation in payment technologies.
In light of Chinese competition, the European Central Bank (ECB) and the US Federal Reserve (Fed) need to improve their game.
The technology is already here
Cryptocurrencies such as Bitcoin and Ethereum were the first to show what is possible with blockchains and distributed ledger technology.
Bitcoin, launched in 2009, was originally designed as a “peer-to-peer electronic payment system” by its pseudonymous creator Satoshi Nakamoto. It works on an open-source cryptographic protocol, a blockchain, and allows you to send online payments directly from one electronic wallet to another electronic wallet without going through a financial intermediary.
These features have many advantages over traditional payment systems: electronic wallets are protected by public-to-private key encryption, which makes them extremely private, and they are accessible via the Internet from anywhere in the world, which makes them just as practical for international payments as for domestic payments. Bitcoin transfers are mostly done free of charge and usually settle in a few hours, unlike bank transfers, which often have a fee and can take several days.
Ethereum, the next-generation blockchain launched in 2015, adds a programming layer and enables the automation of payments through “smart contracts” and decentralized applications. This system, in which a token transfer is recorded on the Ethereum blockchain, is compatible with a programmable, autonomous and automated flow of goods and services – exactly what is needed to support machine-to-machine or pay. -per-use in the future “Internet of things”.
In recent years, private companies have introduced “stablecoins,” which combine the benefits of a blockchain-based public payment infrastructure with the stability of a fiat currency like the US dollar.
Take USDC, a stablecoin launched in 2018 by a consortium called Center, which includes Coinbase, the crypto exchange, and Circle. The USDC smart contract only creates USDC tokens if equivalent US dollar amounts have been transferred to the issuer’s bank account. It runs on the Ethereum blockchain. And USDC is regulated: all issuers are required to report their holdings monthly through Grant Thornton LLP, the audit firm. Recently, Visa announced that it will accept USDC for transaction settlement – a step that puts stablecoins on the verge of becoming mainstream.
Banks are following suit. The Office of the Comptroller of the Currency (OCC) recently authorized U.S. banks to use stablecoins and mine computer nodes in blockchain networks. JP Morgan, America’s largest bank, even created its own unlicensed public blockchain called Quorum to issue its own JPM Coin, a stable coin backed by USD deposits with JP Morgan.
And then there’s the Diem Project (formerly Libra), which was announced by Facebook, although it hasn’t been launched yet. Diem is designed to run on a private and authorized blockchain that runs on independent nodes managed by a limited number of member organizations of the Diem Foundation. Diems will be issued in the electronic wallets of Facebook customers against USD deposits with the Diem Foundation. The Diem Foundation will then manage the Diem reserves as a fund through investments in short-term bank deposits, as well as in sovereign bonds. With 2.8 billion monthly active users on average, Facebook is the largest social media network in the world: if even a fraction of its users or merchants adopted this stablecoin, the impact on the global financial system could be substantial.
Central banks still have a role to play
Still, it’s important to recognize that neither cryptocurrencies nor stablecoins like USDC or Diem could ever replace fiat currencies backed by the central bank – at least not a desirable substitute.
For example, only 7 transactions can be processed on the Bitcoin network per second – a tiny fraction of the 24,000 transactions per second processed by Visa. While Bitcoin is in principle a low-to-no-fee alternative for otherwise very expensive cross-border remittances, the volatility of Bitcoin, the low number of traders who accept it, and the limited number of exchanges that can convert Bitcoins. in local currencies make it a poor alternative to, say, a wire transfer.
Ethereum’s ability to execute smart contracts and process token transfers from one e-wallet to another is also limited as long as it relies on the same computation-intensive consensus mechanism (or means of authorizing and synchronize a transaction) than Bitcoin. Even though the capacity of the Ethereum blockchain is ultimately increased through the shift to a less computationally intensive consensus mechanism, there are still a significant number of cryptocurrency-specific technological, legal, regulatory and reputational risks.
While stablecoins like USDC bring fiat currency stability to the cryptocurrency space and allow cryptocurrency investors to realize their speculative gains by instantly swapping them for stablecoins instead of spending through the tedious process of selling them for cash, they also present new risks. Who is overseeing the USDC strike and fire? What if there is a race on USDC? Do USDC holders have the same deposit insurance and lender of last resort guarantees as bank depositors? What happens if the Center or its supporters declare bankruptcy?
And even Diem, although he has fully subscribed to the concept of a centralized, regulated, single-currency stable currency arrangement running on an authorized private blockchain, with strong protections built into the reserve management system, still raises questions. many questions regarding the protection of management and financial stability: how can consumers be sure that Facebook will not use transaction data for advertising purposes? Where is the reserve actually held and invested? And what does it mean for financial markets if much of the reserve has to be liquidated to meet demands for liquidity if holders suddenly lose faith in Diem?
It’s time to compete
There is, however, a larger problem at play. Even if all of these issues have been satisfactorily resolved, central banks can hardly stay above the fray and leave their citizens alone in the sea of centralized and decentralized private payments. They must realize that unless they wish to cede huge control over their own currencies and national economies, they must actively compete with privately distributed cryptocurrencies and stablecoins.
Central banks in less developed countries with weaker currencies will need to issue CBDCs if they are to offer their citizens an efficient payment system without sacrificing the sovereignty of their currencies. Central banks in developed countries are generally less concerned about financial inclusion. But they have yet to introduce a CBDC option to ensure their citizens have access to fiat currency better suited to the digital age. And their sophisticated makers and traders wouldn’t want to miss a fiat currency anchor as they begin the transition to a more programmable, automated economy and the Internet of Things.
Therefore, it’s hardly surprising that most central banks are at least exploring CBDCs – and some are more than exploring.
The Bahamas became a pioneer with the launch of the first retail CBDC, the digital B $ or sand dollar, whose value is pegged to the US dollar. A system of authorized financial institutions has been established to provide identification, portfolio and custody services.
When it comes to large central banks, the People’s Bank of China (PBOC) appears to be the most advanced. In 2020, the PBOC confirmed that it had tested a digital yuan in four cities, involving the largest state-owned banks as providers of mobile wallets.
In the Western world, the Swedish Riksbank has been at the forefront. Last year, Riksbank launched an e-Krona pilot to test payment, deposit and transfer functionality in a distributed ledger environment. Meanwhile, the ECB has been experimenting with virtual currencies for some time and recently released a report on the digital euro. He should finally embark on a digital euro project this summer.
In the United States, the Fed has started researching CDBC and recently announced a multi-year research collaboration with the Massachusetts Institute of Technology. Despite investing heavily in understanding technology and policy issues, the Fed does not appear to be in any rush to issue a digital dollar anytime soon.
Prepare for a world with CBDC
Still, it’s conceivable that we’ll see the ECB, Fed, and other major central banks follow the lead of the PBOC and issue CBDCs during this decade. This will require national governments to create the appropriate legal frameworks for the issuance and use of CBDCs. This will also require international cooperation, as real efficiency gains in payments can only be achieved if CBDCs are interoperable. International cooperation will also be needed to protect CBDCs from cyber attacks.
The journey will not be easy. Central banks around the world will need to navigate new technologies, rethink the role of financial intermediaries such as banks in the payments system, and also be prepared to engage with critics who question whether they “should” issue CBDCs in the payment system. first – as opposed to relying on continuous private sector innovation and simple regulation of payment providers. They will also need to determine how to approach the protection of consumer privacy in a cashless world.
Central banks finally recognize that a new era of digitization is upon us. The ECB and the Fed in particular would be smart to push themselves to act faster than they would otherwise – without compromising due diligence and prudence. Meanwhile, banks and private payment service providers are expected to prepare their infrastructure and service offerings for a world with CBDC. And we should all be following these developments very closely, as our economic future depends on the successful completion of this transition.