How Will Digital Currencies Change Wallets?
APRIL 13, 2021
Faster and more trackable than cash, newly minted, state-managed digital currencies are poised to revolutionize how the world buys, sells, and invests.
WHAT ARE CENTRAL BANK DIGITAL CURRENCIES?
Central bank digital currencies (CBDCs) are essentially the digital version of cash. Like cash, they are issued by and have their value guaranteed by central banks. For example, an Indian CBDC would be denominated in rupees, with one digital rupee having the same value as a one-rupee coin.
These digital currencies are the latest innovation in payments technology and could change the way financial transactions are done. Whether the task is sending money abroad in a jiffy or making digital financial transactions without using the internet, CBDCs can help solve many of today’s payment issues like long transaction times and high fees.
If and when CBDCs become widely used, people will be able to exchange currency with each other digitally in real-time using mobile phones, computers, smartwatches, bar code scanning, and so on. In China
, the digital yuan—which is already circulating on a trial basis—can be exchanged with authentication procedures using facial recognition.
Rajesh Bansal was a senior adviser at Carnegie India. His research focuses on financial technologies, particularly electronic payment systems, electronic cash transfers, and digital financial services to enable inclusive development. He leads the center’s technology and society program.
While no major country has fully launched its own digital currency yet, China has already taken the lead, and several other countries are scrambling to catch up. (The Bahamas
is the only country that has fully launched
HOW IS USING DIGITAL CURRENCY DIFFERENT FROM TRADITIONAL PAYMENT OPTIONS?
Digital payment systems like credit cards, debit cards, or mobile payment methods (digital wallets like Amazon Pay, Apple Pay, and Venmo) operate quite differently from digital currencies. Traditional digital payment methods are carried out by exchanging a certain amount of money held in an account for goods or services. Such exchanges of traditional forms of money do not happen in real-time; instead, such transactions are tallied and settled after a period ranging from a few minutes to a few days. (Just think about how it usually takes a few days for a credit card charge to appear on your statement after you buy something.) In contrast, exchanging digital currency involves a near real-time settlement
process, as CBDCs are not a mere representation of physical money stored elsewhere but a complete replacement for currency notes.
HOW ARE STATE-MANAGED DIGITAL CURRENCIES DIFFERENT FROM PRIVATE CRYPTOCURRENCIES AND STABLECOINS?
Central banks are not the first to pursue the potential of digital currencies. Private cryptocurrencies were made famous by the likes of Bitcoin
, which was first launched in 2009. Since then, these private digital currencies have grown immensely popular. Private cryptocurrencies are issued by private players and are not backed by a central bank, so unlike CBDCs, there are no tangible assets backing their value. Bitcoin and its peer currencies are only available in fixed quantities
, so their price depends solely on supply and demand. This makes private cryptocurrencies an extremely volatile asset. In contrast, the supply and value of a CBDC is carefully decided and managed by a trusted entity like a central bank, which takes into consideration financial and monetary stability. This makes CBDCs a safer and less volatile asset.
Yet there is also a certain subset of private digital currencies known as stablecoins, which (as their name suggests) are designed to have less price volatility. Like other private cryptocurrencies, stablecoins are issued by private players, but their values are determined differently. Instead of being determined solely by supply and demand, the value of stablecoins is tied to fiat money
or other assets or are pegged to a basket of currencies and assets
. Some popular stablecoins are Tether, USD Coin, and Facebook’s Diem, which is still in the works.
One of the big draws of private cryptocurrencies is that they can be traded anonymously. This means they are not registered on a ledger that is part of the official banking system or visible to regulators.
HOW WILL STATE-MANAGED DIGITAL CURRENCIES DOCUMENT FINANCIAL TRANSACTIONS?
All digital currencies, whether backed by private players or central banks, need a reliable way to make sure each transaction is authorized and settled safely and securely. One new way of doing that is distributed ledger technology (DLT), which is essentially a decentralized online database. The blockchain used by Bitcoin is one prominent example.
Unlike traditional financial databases, DLT offers decentralized databases in which transactions and data are replicated, stored, and synchronized over a distributed network consisting of several computers (also referred to as nodes). Because there is no central authority to check the data and to commit new transactions, DLT databases rely on what are called consensus algorithms that ensure the data is valid. Once the participating nodes reach a consensus, a new transaction is added to the ledger.
Blockchains, a term often confused with and used interchangeably with DLT, are actually a type of DLT database. In a blockchain, each transaction (block) is linked together in a list (chain) with a cryptographic hash. Blockchains are popularly used for recording transactions made with cryptocurrencies, such as Bitcoin, but they also have a variety of other applications. The most well-known blockchain, the Bitcoin one, is a distributed, decentralized, public and permissionless ledger. Blockchains are also considered highly robust, reliable, and secure. But because they are also decentralized, public, and permissionless, blockchains are not feasible for CBDCs due to concerns about control, scalability, and cost.
Somya Singh is a research assistant at Carnegie India.
There is another problem with DLT databases from the perspective of central banks. Currently, central banks maintain a centralized ledger and have the sole authorization to adjust claims on their own balance sheets and adjust the quantity of money circulating in an economy. But in the case of a DLT-based CBDC, external validators would be able to adjust claims on the central bank’s balance sheet. While this decentralization has many advantages for efficiency, the lack of total control over processing transactions and maintaining balance sheets might be a deal breaker for central banks that have so far operated in a centralized way.
A blockchain ledger is also less likely to be used for CBDCs because blockchains consume a lot more energy than is feasible for a state-authorized CBDC. According to the Bitcoin Energy Consumption Index
, the annual carbon footprint of bitcoin transactions is equivalent to nearly 37 megatons of carbon dioxide, comparable to the emissions footprint of New Zealand, while Bitcoin’s annual electrical energy consumption is estimated to be higher
than that of Argentina, the Netherlands, and the United Arab Emirates.
WHICH COUNTRIES’ CENTRAL BANKS ARE PLANNING TO LAUNCH DIGITAL CURRENCIES?
A January 2021 report
by the Bank of International Settlements declares that 86 percent of central banks worldwide are actively engaging in some form of CBDC work, and half of them have moved past initial research toward experimenting and running digital currency pilots. The Bahamas has launched the sand dollar
as a CBDC recently.
Of the major economies, China has made the most progress on CBDCs. After six years of research, the People’s Bank of China launched
mass domestic CBDC pilots in April 2020, and it has since completed two mass pilots. In these pilots, citizens were allotted CBDCs based on a lottery system. It is said that China’s CBDC already has been used for about 3.1 million transactions totalling 1.1 billion yuan ($162 million)
. With this trial phase already under its belt, China is on track to become the first major country to fully launch a CBDC.
The central banks of several other countries including Canada, Japan, Sweden, Switzerland, the UK, and the United States (as well as the EU) have been collaborating with the Bank of International Settlements on research
on CBDCs including possible design plans. In addition to designs for the domestic usage of CBDCs, they have also discussed plans for cross-border remittances using CBDCs and the implications of CBDCs on international trade. The digital currencies could boost international trade by enabling faster and cheaper cross-border transactions.
The coronavirus pandemic and its associated economic shutdowns in particular have highlighted the importance
of digital payments and the need for dependable official digital currencies as cashless transactions become more prevalent.
WHY ARE CENTRAL BANKS WORLDWIDE SO INTERESTED IN DIGITAL CURRENCIES?
Four major benefits to digital currencies stand out. The first is efficiency
, as CBDCs could enable low-cost, instantaneous payments. CBDCs could help process transactions and exchanges more quickly, boosting a country’s productivity and technological progress.
The second is financial inclusion
. CBDCs could conceivably provide better access to financial services as people may not need to have a bank account to use them. CBDCs can also be used offline without any internet connection. Transactions can be done with various means
. These include radio frequency identification (RFID) using cell phones, smartphones, smartwatches, smart cards
, tap-and-go technology
(which involves physically tapping two devices to process a transaction), and other kinds of wearable technology. This feature could make CBDCs extremely useful for people living in remote areas.
The third benefit of state-managed digital currencies is preventing corruption and illicit activities
. CBDCs could allow governments to keep track of every unit of its currency in circulation. If successful, that would reduce money laundering, tax evasion, black market transactions, and embezzlement.
The final benefit relates to monetary policy
. CBDCs could be considered programmable money. In theory, central banks would be able to algorithmically adjust the supply of CBDCs based on interest rates and other key macroeconomic indicators. So CBDCs could give central banks direct control of the money supply, thereby making the economy more responsive to changes in interest rates. Patents filed by the People’s Bank of China
indicate that the central bank plans to make use of some of these advantages.
WHAT ARE THE POTENTIAL RISKS AND LIMITATIONS OF USING STATE-MANAGED DIGITAL CURRENCIES?
The introduction of CBDCs could significantly alter and disrupt existing domestic and international payment systems. Given the advantages of low costs, faster transactions, and offline capabilities CBDCs offer, it is likely that consumers will prefer CBDCs to existing digital payment options like credit and debit cards and mobile wallets. The business models of current market leaders like Visa, Mastercard, PayPal, and others could be affected.
It is crucial for countries to first gauge the impact of CBDCs carefully and create an enabling ecosystem before launching them. Established payment players like credit card companies should be involved in the distribution and exchange process. Countries will also need to consider factors like whether cash can be easily converted into digital form and make sure citizens and businesses have the necessary technology and infrastructure needed to accept and process transactions involving CBDCs.
While CBDCs are meant to act as a replacement for cash, it is unlikely that CBDCs will be able to replicate the anonymous nature of cash transactions. Due to money laundering concerns that arise from anonymous transactions, it is unlikely that any government-managed CBDC will be completely anonymous. In fact, a central bank would know who holds a given unit of such a digital currency and would be able to access its entire transaction history. Such a trove of information may help officials do a better job of managing monetary and fiscal policies. But concerns may arise regarding privacy, surveillance, and a lack of anonymity, especially in countries where trust in the government is low.
WHAT STANCE DOES INDIA’S CENTRAL BANK TAKE ON DIGITAL CURRENCIES?
The Reserve Bank of India has yet to publish any research or launch a pilot for CBDCs. The Indian central bank’s webpage on digital payments
mentions that the central bank is currently “exploring” CBDCs. The underlying technology for CBDCs is still in the works, and no ideal model for a fully operational CBDC exists yet.
The governor of India’s central bank, Shaktikanta Das
, has been cautious, stating that “we need to be watchful of the risks associated with certain technological innovations. While we are working on introducing a digital version of the fiat currency, the [Reserve Bank] is also assessing the financial stability implications of introducing such a Central Bank Digital Currency.”
The recent 2021 Cryptocurrency and Regulation of Official Digital Currency Bill is a step toward developing India's CBDC. However, it only establishes a basic legislative framework for digital currencies—there are no details about the design plans and implementation process, and the bill also plans to ban all cryptocurrencies and other unregulated digital currencies.
As the Reserve Bank of India and other central banks around the world grapple with the emergence of digital currencies, they must carefully determine the impact and functionality of CBDCs in their countries to develop a safe and efficient model.
To learn more, here are some external links for further reading on central bank digital currencies.
Carnegie does not take institutional positions on public policy issues; the views represented herein are those of the author(s) and do not necessarily reflect the views of Carnegie, its staff, or its trustees.
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