Central Bank Digital Currencies: catalyst for financial inclusion?

Evolution of Money

Traditionally, money is a metal token or a slip of paper symbolising a value of credit based upon people’s trust in it. Its three primary functions (store of value, means of exchange, and unit of measurement) have been served by constantly evolving means for 3000 years. The latest in this evolution is the digital currency. Unlike any type of currency to precede it, digital currencies are intangible – accessible only in electronic form. 10 years after the launch of the first digital currency and 2000 cryptocurrencies later, Facebook sent central banks reeling with the announcement of Libra. A stablecoin, Libra was pegged to a fiat currency (the US dollar) backed by reserves for stability. Its bold declaration forced central banks to engage in the digital currency conversation via the Central Bank Digital Currency (CBDC).

What is a Central Bank Digital Currency ?

The Bank of England defines Central Bank Digital Currency as “an electronic form of central bank money that could be used by households and businesses to make payments and store a value”. A CBDC is the digital equivalent of a banknote: centralised and regulated by a central bank, yet typically blockchain-based.

As aforementioned, Facebook’s 2019 Libra announcement piqued the interest of central banks in Central Bank Digital Currency. Recent data suggests that 86% of central banks are engaged in some form of development.

By virtue of its design, CBDC could foster the best of both worlds. It implements the cryptographic protection of cryptocurrencies while replicating the stability and legal-tender status of a central bank-backed currency.

What are the advantages over a traditional fiat currency?

CBDCs score over traditional currencies in a number of key areas:

1) CBDCs are significantly more cost-effective and efficient as a payment system, especially in countries where the cost of cash management is high.

2) CBDCs are a tool for governments to counter privately-owned, volatile cryptocurrencies e.g., Bitcoin (or stablecoins such as Facebook’s Libra). If such digital currencies were widely adopted, they could pose security and regulatory concerns, unlike CBDCs.

3) CBDCs enable fast, secure cross-border payments, especially regarding the members of financially vulnerable families as remittance.

Another major benefit of CBDC is its unique ability to aid universal financial inclusion – widely considered to be the most relevant use-case of CBDC.

Financial Inclusion

One of the most compelling uses of CBDCs, especially in Emerging Markets and Developing Economies (EMDE), is to combat the prevalent issue of financial exclusion. An individual or business is financially excluded if they lack access to basic financial services, such as insurance, loans or a savings/current account, effectively preventing them from any meaningful engagement in the financial sector.

Globally, 1.7 billion people are un-banked (“not having access to the services of a bank or similar financial organization”: financially excluded) which can having detrimental effects to their quality of life and future prospects. For example, a schoolchild being denied an educational loan due to their financial exclusion could deny them the chance to pursue higher education and break free of poverty: the financially excluded are indefinitely suspended in a vicious cycle of poverty and inequality. 

That is where digital currencies, especially CBDCs, offer a solution by bypassing the traditional banking system. According to the IMF, “digital currency offers great promise” in pursuit of financial inclusion. Why is this? Many of the 1.7 billion un-banked people worldwide (especially in EMDEs) are financially excluded for a lack of formal identification. This data enables commercial banks to implement- as the jargon goes- KYC (Know Your Customer) and AML (Anti-Money Laundering) protocols, such as proof of address or reliable income statements. On the other hand, CBDCs require merely a smartphone with internet access which broadens horizons due to its ease of identification. CBDCs can be the platform through which millions of new economic participants build a credible financial identity and credit history, enabling them to engage in a formal financial ecosystem and build a path out of poverty.

In this respect, CBDCs, although they cannot counteract the fundamental causes of financial exclusion, are a foundational keystone in the quest for universal financial inclusion. They empower the un-banked population to digitally access formal financial services and thus encourage greater economic participation and freedom.    

The “Digital Helicopter”

The concept of helicopter money, coined by economist Milton Friedman in 1969 and revitalised by Chairman of the US Federal Reserve Ben Bernanke in 2002, is a theoretical, unconventional expansionary policy proposed as an alternative to Quantitative Easing (QE). As the name suggests, it invokes metaphorical images of a helicopter “dropping” money to the public in extreme circumstances. A mass government-to-household cash injection like this (such as COVID relief stimulus checks) would undoubtedly be enhanced by the introduction of CBDCs. In a digitized economy, a direct CBDC transfer would be far more efficient for all parties (both financially and logistically) over a “trickle-down” QE approach.

Potential Challenges

Infrastructure

Currently, internet access globally stands at 59% – fewer still have access to a smartphone. Feasible, widespread internet and mobile infrastructure must come before any digital currency.

Privacy concerns

Additionally, CBDC poses the potential challenge of privacy. These concerns were highlighted during Russia’s announcement of the crypto-ruble. In 2018, emerging doubts in the international community were confirmed via reports on Putin’s economic advisor, “This instrument suits us very well. We can settle accounts with our counter-parties all over the world with no regard for sanctions.”

Destabilisation

The introduction and universal adoption of CBDCs could destabilise traditional financial institutions, as expressed by Swedish bankers over the e-krona CBDC. Masih Yazdi, CFO of Swedish corporate bank SEB, claimed, “a rational household would hold its money with the Riksbank (Central Bank of Sweden)”. Admittedly, due to its favourable security and interest rates, the majority of Swedes are likely to hold a direct account with the Riksbank if/when given the opportunity, bypassing commercial banks in the process. As a consequence, commercial banks would be deprived of funding via their previous customers, thrusting the system into debt and financial instability. Yazdi adds, “If you have a bank account but you can – at the click of a button – move your money to the central bank…that could risk instability in the system.”

Conclusion

CBDCs are more than a currency; they are a separate a monetary system. They broaden the reach of the financial system into the undocumented, un-banked population and enables them to access essential financial services. CBDCs hold tremendous potential as a policy tool, but come with their own set of challenges. Most central banks are likely to experiment with their own digital currency design in the coming decade, which could result in an overall increase in global financial inclusion, among other breakthroughs in the financial ecosystem.

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