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The Future Of Banking: Central Bank Digital Currency May Replace Cash, Not Banks

Discussions around Central Bank Digital Currencies (CBDCs) have undoubtedly shifted gears in the past few months. While the fundamental features of these instruments are still unclear, as is the timing of any launch, S&P Global Ratings believes that central banks will have a clear preference for a CBDC model where banks and other financial institutions continue to play a strong role. Based on this assumption, we believe that CBDCs could ultimately have a moderate impact on banks' business models. However, they could exacerbate pressure on the revenue profile of certain activities (such as payments).

Depending on the model selected, CBDCs could meaningfully influence how intermediation occurs with a banking system, particularly in relation to bank deposits and funding. Based on our current assumptions, we don't believe that CBDCs will supplant financial institutions in their financial intermediation function. However, some central banks have acknowledged the potential disruption to the financial system due to CBDCs. In the same vein, we will closely monitor developments that could affect banking systems' competitive dynamics or other integral factors impeding country- or bank-specific rating factors.

There are many reasons why central banks and governments may consider the adoption of CBDCs. For example, to improve payment infrastructure and process, enhance financial inclusions, and spur innovation. However, central banks' key mandate--to ensure financial stability--remains unchanged.

Central banks around the world are exploring digital currencies, and some of them are more advanced than others in their plans. For example, The People's Bank of China (PBOC) conducted a trial in October 2020, in which it distributed Chinese renminbi 10 million (about US$1.5 million) in tokens of Digital Currency Electronic Payment to users in the city of Shenzhen. Other central banks (such as those of the G-7 economies and the Bank for International Settlements) are still in the design phase of a CBDC and are trying to agree on its core features. Chief among these is that a CBDC would not, for the foreseeable future, replace cash, but will act as an additional tool for its provision to the public.

Core Features Of A CBDC

The central banks of the G-7 economies, with the Bank for International Settlements, have identified a set of common principles around the creation of a CBDC (see table for a summary of these characteristics and our view on each).

Core Features Of A CBDC* S&P Global Ratings’ View
Liability: A CBDC would represent a liability of the issuing central bank. In our view, this feature gives the CBDC legitimacy from its first issuance, unlike cryptocurrencies or stable coins that have to build their reputation. This could encourage wide adoption by the most risk-averse consumers and corporates. In some cases, however, this could result in the opposite effect as the CBDC might be viewed as an additional tool used by governments to monitor users’ activities.
Convertibility: A CBDC would be convertible at par with cash and not viewed as a parallel currency. In our view, this feature resolves the issue related to potential volatility of a CBDC’s value that occurs with private sector cryptocurrencies (for example bitcoin) and even with stable coins (in the event that the value of the pool of underlying assets varies).
Accessibility: A CBDC would be widely and easily accessible. There are three potential models: (i) A disintermediated model: where the issuing central bank would authorize users to open accounts that it would manage directly; (ii) An intermediated model: where banks or other financial intermediaries would open and manage these accounts; and (iii) A hybrid model: where accounts are opened with the central bank, but managed by banks or other financial intermediaries. The first and last options could destabilize the financial system over time. In both cases, financial intermediaries might lose their deposit-taking monopoly. The first option (which is very unlikely in its most extreme form) could also be difficult to implement as a central bank would need to build its capabilities to manage a significant number of users. In any case, to ensure accessibility, banks and central banks would need significant new investment to enhance their technological infrastructure. We believe there will be a clear preference for the second model to avoid any risk of destabilizing the financial system and placing additional operational burden on the central bank (for example, in terms of know-your-customer requirements, managing a much bigger balance sheet etc.)
Trust: A CBDC helps to build trust with its end users. While CBDC brings legitimacy from the first time of its issuance, building trust across the ecosystem that accompanies it might take time. Specifically, the technology used should encourage that trust while at the same time remain accessible for the least sophisticated users. Unlike cryptocurrencies, we don’t expect CBDC to use cryptography and/or distributed ledgers. Under a scenario where the latter is used, we expect that transactions will be validated centrally and not by other users. Among other things, ensuring that proper back-up systems are in place would be key to its future success. Another example relates to the risk of counterfeiting CBDC. While we understand that this risk is minimal (as the central bank would control supply and the amount of CBDC in circulation), we cannot rule out risks related to fake wallets or CBDC accounts.
Availability: A CBDC would permit offline payments at predetermined thresholds. This feature would ensure that the CBDC remains available, even in the event of technological disruptions. In our view, the threshold of offline transactions should be managed to curb the risk of instability in the event of large discrepancies in transactions records, both on- and offline.
Market neutrality: CBDC would not crowd out private solutions. While a CBDC would offer legitimacy that private cryptocurrencies may not achieve, it could prompt private sector innovation relating to the use or transfer of CBDC. Like cash, CBDC could also pose issues for payment solutions providers. This could be the case if, for example, sellers of goods and services offer discounts for payment with CBDC as they could end up paying less commission on CBDC to the payment networks than other payment methods.
Economic policy enhancement: A CBDC could help the transmission of monetary policy. It could also lead to smoother fiscal policy implementation. If the CBDC is remunerated, we believe it could incrementally help the transmission of monetary policy (and even the use of negative rates in a physical cashless world, which we don’t expect for the foreseeable future). We see some risks related to the differential in remuneration between CBDC and other savings products. If these are not aligned, we might see some shifting from one instrument to another depending on remuneration movements. CBDC could also help the implementation of fiscal policy in some countries. For example, during the COVID-19 pandemic and its related lockdowns, some governments distributed money directly to the population (by sending cheques by mail or, in some countries, via other electronic channels). CBDC could help governments to reach these recipients directly and tailor support to their specific needs.
International usage: A CBDC could be used as a reserve currency or for international payments. In our view, the use of CBDC could spur significant cost savings with regard to international payments or the use of the specific currency as a reserve currency, assuming that users would have access to the necessary technological infrastructure. However, this could increase the central bank’s exposure to operational risks, such as fraud, and necessitate some investment in staff or systems. The risk is somewhat reduced by the full traceability of the CBDC’s trail since its inception.
Alignment with environmental, social, and governance factors: A CBDC could help to reduce the currency’s environmental footprint. In our view, this could be achieved by reducing the amount of paper cash in circulation and phasing out ATMs and other less efficient payment solutions.
*Based on a report by the following: Bank of Canada, European Central Bank, Bank of Japan, Sveriges Riksbank, Swiss National bank, Bank of England, Board of Governors of the Federal Reserve System, and the Bank for International Settlements.

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 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 and other financial intermediaries. More generally, CBDCs can make it easier and quicker for customers to switch from one financial services provider to another (for example, in the hybrid model), 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.

We consider that a shift to CBDCs would necessitate material investment in compatible payment infrastructure and depend on financial intermediaries' ability to switch to the digital currency. It will also require cross-border coordination of all stakeholders for international payments.

We observe various degrees of technology and stakeholder readiness for CBDCs globally, even in the countries where central banks are currently exploring them. We believe that considerations around data privacy will delay a global implementation of various CBDCs, at least in some regions, including Europe. Furthermore, we expect client preferences and willingness to adapt digitally, even amid the global COVID-19 pandemic, will continue to vary by region.

Overall, although the process would be lengthy, the current increased efforts to establish CBDCs may accelerate the agenda to dematerialize money eventually.

Related Research

This report does not constitute a rating action.

Primary Credit Analyst:Mohamed Damak, Dubai + 97143727153;
Secondary Contacts:Markus W Schmaus, Frankfurt + 49 693 399 9155;
Alexandre Birry, London + 44 20 7176 7108;
Sylvain Broyer, Frankfurt + 0049 69 33 999 1;
Emmanuel F Volland, Paris + 33 14 420 6696;
Ryoji Yoshizawa, Tokyo + 81 3 4550 8453;
Harry Hu, CFA, Hong Kong + 852 2533 3571;
Gavin J Gunning, Melbourne + 61 3 9631 2092;

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