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The Future Of Banking: When Central Banks Go Crypto

The central banks of Sweden, Canada, Switzerland, the U.K., and Japan, plus the European Central Bank, have recently formed a working group with the Bank of International Settlement to share findings as each investigates potential cases for central bank digital currencies (CBDC). They will not only assess the potential benefit of CBDCs but also work with other stakeholders, notably the Committee on Payments and Market Infrastructure and the Financial Stability Board. Other central banks are also eagerly looking into CBDCs. China for example intends to replace cash with a CBDC to support the yuan's circulation and for use as an international currency. India is also exploring the introduction of an official digital currency with the status of legal tender under the control of the Reserve Bank of India. Several policymakers in the U.S. believe that the Federal Reserve should also move in this direction, but the Fed has not yet taken a position on this.

In our view, some features of the proposed CBDCs are fundamentally different from those in private-sector-promoted cryptocurrencies or crypto-instruments, some of which fail to fulfil the basic characteristics of currencies (see "The Future Of Banking: Cryptocurrencies Will Need Some Rules To Change The Game," published Feb. 19, 2018, on RatingsDirect). What's more, the readiness of the technology, potential disruption of traditional financial systems, and cross-border coordination are risk areas that should be considered carefully.

How A CBDC Might Differ From Other Cryptocurrencies

Established private-sector sponsored cryptocurrencies (such as bitcoin) fail to fulfil the two basic features of money: general acceptance and an effective store of value. Their use as a means of payment is restricted, and there's been significant volatility in their value. The consortium that was planning to launch the Libra intended for it to become a widely accepted payment medium, using a basket of stable assets as an anchor to support its value (see "The Future Of Banking: Regulators To Decide If The Crypto Stars Align For Libra," published June 25, 2019). Still, less than a year after the Libra project was announced, several of its original members have dropped out, and U.S. regulators and politicians have voiced concerns about Libra in general. This highlights the steep challenges of launching any private-sector cryptocurrency.

More importantly, to succeed, crypto- or digital currencies have to pass regulatory tests and demonstrate that they pose no threat to financial stability. A publicly sponsored and regulated CBDC could potentially resolve such problems from inception. A digital euro or pound would come with the de facto approval of the regulator, its issuer, and not require asset backing. It would therefore meet the two basic prerequisites of a currency, assuming the necessary payment infrastructure is in place and there's acceptance by most end users. We think the latter may entail providing users with an incentive, such as lower costs or some remuneration. The central bank's sponsorship should suffice, in theory, to facilitate broad acceptance of any CBDC, as is the case for traditional paper money. A recent Ipsos survey for the Official Monetary and Financial Institutions Forum shows that central banks have the highest confidence ranking for digital money issuance (see chart).

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Could CBDCs Succeed Where Private-Sector Cryptocurrencies Failed?

We still believe that a number of considerations will lead regulators to prevent or slow down the emergence of privately sponsored cryptocurrencies. However, CBDCs could reduce or eliminate most of those concerns, which include:

  • The implications for monetary policy and financial stability. For instance, if a cryptocurrency backed by a global tech company takes a large share of deposits, monetary policy transmission to the real economy via banks could be undermined.
  • Consumer protection and data privacy, with the potential for very different legal and regulatory stances across the globe.
  • The possibility for stable private-sector digital coins to be seen as securities given their link to a basket of assets, which could lead to oversight by regulators.
  • How and where to tax related activities.
  • The risk of money laundering and financial crime, especially in the context of this rising risk for banks.

At the same time, we believe the central banks' objective is to maximize the uptake of financial services in each country. Although digital channels may offer a broader range of services or encourage previously nonbanking individuals to join the banking system, some less tech savvy segments of the population could be left out.

CBDCs Could Have A Significant Impact On The Economy

In addition to fueling the transition toward a cashless society, CBDCs could make payment services more efficient, reduce tax evasion, and even improve monetary policy transmission. If a CBDC is widely accessible and interest bearing, for example, institutional investors might prefer to use it during periods of market volatility. The conduct of monetary policy might also become more fluid, with a higher pass-through effect even when interest rates are negative. A CBDC could also improve the efficiency of cross-border payments if adopted internationally, for example in the form of a unique CBDC or several CBDCs. On the flip side, a CBDC might be difficult to manage if central banks that issue it don't also authorize financial intermediaries to administer it, as they do for fiat currency. Under such a scenario, the role of banks will be reduced, which regulators would likely wish to avoid.

Because digital currencies are inherently technology driven, the choice of technology and provider is also a determinant of a CBDC's success. Blockchain and distributed ledger technology allow for traceability, transparency, and other benefits. However, they could result in lower performance of the CBDC, given the likely need for new payment infrastructure, particularly regarding the volume of transactions that can be processed simultaneously, energy efficiency, and the replacement of legacy systems. Therefore, central banks would need to ensure that all stakeholders are working in tandem to achieve greater digitalization of their respective financial systems and be prepared to meet the cost.

Moreover, using existing technologies could expose the financial system to the same risks we see today, such as cybersecurity. A potentially disruptive amount of money could disappear from the system if it were subjected to a cyberattack. Other similar risk areas related to CBDCs include money laundering, tax evasion, and the financing of terrorism, which can emerge if central banks allow anonymous dealing in CBDCs. That said, the technology behind CBDCs could increase the traceability of economic activity (unlike cash) and therefore taxation, especially if anonymous dealing is banned.

CBDCs could be more vulnerable than traditional money to natural disasters and climate change, given the potentially disruptive impact on the availability of power and connectivity. Reducing this risk would require strong backup systems capable of bridging gaps if needed. For CBDCs to work, a large portion of the financial system would need to be digitized, making long-term technology risks more relevant.

Market Preparedness Is Key

The extent and timing of a financial market disruption due to CBDCs will depend on several factors, and may be far off given the exploratory nature of the talks between the central banks. If CBDCs were to replace cash, this could lead to the reintegration of all cash-based economic activities into the financial system, which might generate new business opportunities for banks. CBDCs could also aid financial inclusion through deposits at digital banks or loans from non-bank financial institutions such as micro-lending agencies or crowdfunding platforms.

More generally, CBDCs can make it easier and quicker for customers to switch from one financial services provider to another, which could create some volatility in banks' deposit bases or loan books. Ultimately, CBDCs could affect the profitability of traditional banks, which will have to invest in infrastructure to become CBDC ready, while funding other ongoing investments to meet customers' needs.

It is clear that a shift to CBDCs necessitates compatible payment infrastructure and depends on financial intermediaries' ability to switch to the digital currency. It will also require cross-border coordination for international payments. Currently, however, we observe various degrees of readiness for CBDCs globally, even in the six countries whose central banks are currently discussing them. Overall, although the process would be lengthy, it may accelerate the agenda to dematerialize money.

Related Research

  • The Future Of Banking: Regulators To Decide If The Crypto Stars Align For Libra, Feb. 10, 2020
  • The Future Of Banking: Cryptocurrencies Will Need Some Rules To Change The Game, Feb. 19, 2018

This report does not constitute a rating action.

Primary Credit Analyst:Mohamed Damak, Dubai (971) 4-372-7153;
mohamed.damak@spglobal.com
Secondary Contact:Markus W Schmaus, Frankfurt (49) 69-33-999-155;
markus.schmaus@spglobal.com

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