What are Retail CBDCs and why do banks need to be careful when introducing them?

You would be hard pressed to find a central bank that has not already rolled out, or is not currently researching, CBDCs. Central banks have responded to the success and popularity of the decentralised finance space (DeFi), and the deployment of a digital currency is what we expect to see as a rival to cryptocurrencies in the financial space. The major problem is that jurisdictions are unsure how issuing a retail CBDC will impact the wider financial ecosystem.

As showcased through its use during the Winter Olympics, China’s digital RMB was the first digital currency to be rolled out by a major world economy. In October 2021, Nigeria became the first African country to officially launch a CBDC, the eNaira. Before China and Nigeria, in October 2020, The Central Bank of The Bahamas made a digital version of its local currency available nationwide. Furthermore, Jamaica is set to launch its Jam-Dex this year after a successful pilot.

Chile and Tajikistan–among several countries–have also taken major steps in their plans for central bank digital currencies. What we are seeing here is developing countries becoming more willing to push through the issuance of a CBDC. The long-term impact of the Covid-19 pandemic has led to nations with large percentages of unbanked citizens looking to solve this crisis through a CBDC. The Central Bank of England and the US Federal Reserve are far more cautious with their approach. So much so that a House of Lords Committee in the UK has stated there is no ‘convincing case’ for a UK CBDC.

The use of banknotes – the most accessible form of money – is declining, and use of privately issued money continues to increase, with technological changes driving innovation. These developments provide the public with new ways to pay for goods and services, which support and enable the digital economy, but also present new risks. Of course, CBDCs have lots of potential benefits, such as reducing the need for central banks to print cash, and for individuals, firms and financial institutions the handling of physical money; increasing financial inclusion; preserving monetary sovereignty against new forms of private money; facilitating the distribution of subsidies and benefits; gaining a better understanding of people’s aggregate behaviour; and making transactions traceable for taxation and crime prevention purposes. Yet they also come with their challenges. 

The worries with digital currencies  

One of the biggest challenges with CBDCs is security. Cybersecurity is one of the largest threats to the future of money, so ensuring the economy is prepared for any scenarios that might happen is of paramount importance. For financial institutions, central and commercial banks, national security is a consistent talking point particularly as there are regular reports into attacks made against critical national infrastructure and assets. If cyber criminals, or state-sponsors seized control, they could literally hold an entire country’s economy to ransom.  

CBDC as a means for financial steadiness  

A well‑designed CBDC could have the potential to enhance financial stability by supporting a resilient payment system and enabling financial authorities to better understand agents’ aggregate behaviour. Yet, agents’ demands for CBDC would oblige banks to purchase more collateral to borrow CBDC from the central bank. This would not only reduce the availability of credit to households and firms, but also disintermediate and compress banks’ interest margins; for instance, banks would change households’ deposits for central bank lending and lending to firms for holding sovereign securities. While over time the banking system would be expected to balance out, it is likely that a rapid flow into CBDC from bank deposits could be destabilizing.

However, the disintermediation could affect the availability of funds to commercial banks and to firms and households in the long run. Therefore, the design of the CBDC, amid the features of each economy, will play a key role in preserving financial stability; design features, such as caps on balances and transactional limits, could mitigate some of these effects.  

How will banks promote the use of their CBDC?  

A safe payment system is only beneficial if people use it. The people need an efficient, user‑friendly and inclusive service to be able to use it. On the other hand, if everyone adopts it and starts using it instead of their existing cards and accounts, it could disintermediate the payment system. Also, cash has certain unique characteristics that would be lost if it were to fall out of general use, including its major role in financial inclusion and users’ anonymity. In a world where cash becomes less widely used, there is no guarantee that the current private sector provision of the retail payment systems may meet the needs of all users, leaving underbanked groups of society particularly at risk. Further, as the digitisation of money increases, the redundancy granted by the availability of cash diminishes whereas the reliance on technology and critical infrastructure increases.

It is undeniable that CBDCs can deliver major benefits on not only the payment network of a nation, but also the average person. Supporting a resilient and inclusive payment system in developing nations; reducing the costs related to handling physical money; avoiding the risks of new forms of private money creation; meeting future payment needs in a digital economy; and gaining a clearer understanding of people’s aggregate behaviour, are all exciting benefits CBDCs can offer. Yet, the biggest challenge is understanding how CBDCs will affect the economic landscape of each jurisdiction when issued. Over everything else, each nation has their own unique payment network. This is very much not a ‘one size fits all’ proposition.  

Using simulation technology and financial analytics can help banks to understand the short- and long-term impacts of issuing their retail CBDC. In doing so, they can mitigate risk, and analyse the subsequent changes to financial ecosystems and the interdependence between the banking infrastructures of nations. Although we are seeing a slow and cautious approach from many of the world’s largest economies, CBDCs should be welcomed as it is internationally understood that a mistake in this context has the capabilities to bring around another GFC (Global Financial Crash).