How and why central banks create digital currency?

Experts are already identifying central bank digital currencies (CBDCs) as one of the most important trends that will shape the future of money in the coming decade. According to a report by the Bank for International Settlements, at the beginning of 2019, 70% of central banks were engaged in CBDC research. Due to the coronavirus pandemic, the work to create digital currencies in various countries will only accelerate.

On August 19, The Block published a report on the current development of the CBDC. It details why governments around the world are betting on CBDCs, how digital currencies differ from traditional fiat, and what central banks have learned from research and experimentation.

>> Here is the main <<

▪Few central banks plan to issue a digital currency within five years, but several institutions have already conducted or are in the process of conducting in-depth pilot tests.

▪The first experiments with CBDC showed that to ensure competitiveness and adaptability to technological changes, the participation of the private sector is necessary in the process.

▪Most proposals for issuing CBDCs involve the creation of a two-tier monetary system: the central bank issues and controls circulation, while licensed intermediaries (banks and other financial institutions) distribute and provide transactions.

▪Claims that CBDC will remove anonymity are unfounded. The ECB recently explored the possibility of anonymizing transactions using "anonymous vouchers" on the blockchain. With blockchain transfers, such transactions could be private.

▪Private stablecoins and CBDC are not mutually exclusive, but complementary.

>> Incentives for Issuing CBDC <<

Today, central banks already practice virtual currency issuance, and a significant part of payments and transfers takes place in cashless form. The differences between CBDC and the existing system are as follows:

▪CBDC will simultaneously increase competition and stability in the financial sector as banks push back against tech companies and cryptocurrencies.

▪CBDC can increase financial inclusion as it can offer a new payment infrastructure with lower transfer costs. In addition, it will be easier for central banks to operate in a digitized economy.

▪Digital currencies will expand the fiscal policy tools available to regulators, such as avoiding the “zero rate trap”. The programmability and transparency of the CBDC makes it easier for regulators to control the operation of deposits and loans at negative rates. More transparent data on payment flows will improve the quality of macroeconomic statistics.

▪CBDCs also encourage the use of local currency to pay for goods and services, especially in countries subject to “dollarization”.

▪The “commercial” version of the CBDC (where the digital currency is only available to banks) will reduce settlement risks, provide banks with 24/7 availability of liquidity, reduce the cost of cross-border transfers, etc.

>> Retail CBDC <<

Although "commercial" CBDC is perceived as a safer option for the stability of the financial system, it is "retail" CBDC that is of interest to mass users - a full-fledged substitute for the usual currency that can be used to pay for goods and services, stored in a bank account, etc.

One of the first countries whose authorities considered CBDC was Sweden. The reason for this is the extremely low use of cash (it accounted for only 5% of all household payments, while 60% were paid by bank cards).

Uruguay, one of the most economically prosperous countries in Latin America, piloted its own CBDC (e-peso) from September 2017 to April 2018 among ordinary consumers and businesses.

Another European country that is actively developing "retail" CBDCs is Ukraine, according to the study.

The National Bank of Ukraine (NBU) successfully tested the "digital hryvnia" for four months in 2018.

The Central Bank of Ukraine is now studying both centralized and decentralized models of the digital hryvnia system.

Similar projects have also been launched by the Central Bank of the Bahamas (Sand Dollar) and the Central Bank of the Eastern Caribbean (DXCD).

>> Commercial CBDC <<

Another type of digital currency is the so-called commercial CBDC (Wholesale CBDC).

This currency is intended for limited use by specialized organizations. According to the proposal, only banks have access to the W-CBDC. The scope of W-CBDC is limited to the areas of interbank transactions, transfer settlements, clearing operations and international trade (where banks often act as guarantors of transactions).

Commercial CBDC is another development of the current practice, where the central bank issues currency to a virtual account and provides access to it to banks, who then spread the currency through the economy.

Compared to the current system, however, W-CBDC has a number of advantages. First is the 24/7 availability of funds, with the central bank now approving applications manually. Second, all transfers are recorded in a more reliable distributed ledger, which increases the efficiency of settlement, and the central bank acts as a source of funds and therefore a guarantor of obligations, thus avoiding credit risks.

Among the main W-CBDC experiments, the researchers noted the project of the ECB and the Bank of Japan (Project Stella), the Bank of Canada (Project Jasper), the Monetary Authority of Singapore (Project Ubin), as well as Hong Kong. and Thailand.

In all cases, W-CBDC was tested using popular enterprise blockchain platforms: R3 Corda, Quorum or Hyperledger Fabric. Although some consider blockchain as the technology of choice for CBDC.

It was in the European-Japanese Stella project that "anonymous vouchers" were involved. These are special electronic certificates that could be obtained by a participant of the platform. Transactions with attached "anonymity vouchers" could take place without confirmation from the ECB: the sender only had to indicate the amount, the recipient's identifier and activate the anonymization function (the voucher used was "burned" in this case). In this scenario, the identities of the translation participants were not verified.

>> Chinese Digital Yuan <<

Perhaps most attention is now focused on what the digital currency of the second world economy will be.