Disclosure of central bank digital currencies: Purpose, benefits, challenges and economic impact

In conjunction with the technological advances, economists and legislators are pragmatically looking for various ways to promote the financial system and carry out financial transactions in a more efficient way, which gave rise to the idea of ​​central banks’ digital currency (CBDC ) to introduce.

So, what is its purpose, benefits and challenges; what impact will this have on financial institutions, and how will it affect the economy as a whole?

First, let’s define and discuss what a CBDC is and how it differs from cryptocurrencies, as many people may be confused between the two concepts. A CBDC is a form of digital currency issued by a country’s central bank with a value guaranteed by the central bank and equivalent to the country’s fiat currency.

While CBDC and cryptocurrencies share certain characteristics, there are prominent differences in terms of design, purpose and control. A fundamental difference is that a CBDC is considered money, while cryptocurrencies are not, as they lack the core characteristics of money, such as a widely accepted payment method and store of value.

A CBDC is designed with the goal of supporting central banking goals such as financial inclusion and monetary control, along with lowering the cost of current monetary systems and improving payment efficiency. Before going further into the benefits and risks, it is important to be aware that the financial system expects two different types of digital currencies: the retail CBDC and the wholesale CBDC. While the former is intended to serve transactions carried out by individuals and businesses, the latter relates to banking and other financial institution transactions.

Lower transaction costs, financial accessibility, more monetary control and the use of local currency are some of the benefits of using CBDC.

For starters, a CBDC improves international transactions by speeding them up and reducing the need for intermediary banks, which tend to be slow and expensive, especially at the retail level, relying on long chains of intermediaries located in different time zones and at different technical and legal standards. All these factors will increase money velocity, liquidity and, as a result, economic activity.

Furthermore, a CBDC facilitates financial inclusion as it has no minimum balance requirements like some conventional banks, along with fast and cheaper transaction costs. Such type of technology will stimulate financial accessibility, as approximately 1.4 billion adults (24% of adults) worldwide still do not have access to a financial account. Achieving financial inclusion will therefore boost the financial system’s liquidity, which can encourage investment and lead to higher production levels.

Nevertheless, it is important to remember that the unmanned population makes up a relatively small portion of the world’s wealth and saves at a significantly lower rate than middle- and upper-class individuals. Consequently, the impact of financial inclusion on the unmanned population will not greatly increase liquidity in the financial system; rather, the transition to a cashless society will have a greater impact improving monetary control, economic metrics and inhibiting tax evasion practices.

Another distinguishing feature of CBDC is that it eliminates the implementation costs of a financial structure within a country to bring financial access to the unmanned population, which may explain why states, especially developing countries such as the Bahamas, Jamaica and Nigeria, are already introduced CBDCs. .

Moreover, CBDC can strengthen the use of local currency in both domestic and international contexts by making it a more attractive means of payment through lower transaction costs, which in turn can mitigate currency fluctuations.

If we remember the above advantages, it is not surprising why Qatar’s central bank intends to launch its digital currency before the end of 2024, with more than 100 other countries in the exploration stage.

On the other hand, there are several challenges and adverse outcomes that countries may face as a result of adopting CBDC.

To begin with, while a CBDC’s marginal operating costs are likely to be minimal, launching and maintaining them will certainly involve significant fixed costs. The effect that CBDC could have on the banking industry by increasing competition for bank deposit funding represents another important limitation. This is mainly because deposits can leave banks in favor of the CBDC by offering a reliable, efficient means of payment and a safe store of value, leading to a decrease in deposit funding available to banks.

In turn, banks may respond to such movement through wholesale funding to offset the loss in deposits to maintain their ability to provide loans. However, this may imply higher financing costs, which may undermine banks’ profitability to the extent that higher costs cannot be completely passed on to higher lending rates.

Alternatively, banks may also choose to compete with CBDC by raising interest on deposits, but they will pass these higher rates on to borrowers on mortgage, car, corporate and all other loans, which may come at the expense of economic activity, as it can discourage investment, consumption level and capital tied up in bank deposits or money market funds. The extent of this issue will depend on the extent to which CBDC is an attractive substitute for bank deposits.

While CBDC will give central banks the right to become directly involved in managing cross-border transactions, which can help track capital movements, the unique features of CBDC, such as lower transaction costs and faster speed of transfers, could lead to larger and more volatile gross capital flows across borders and thus faster transmission of global shocks as countries facing economic stress may see faster withdrawals or inflows of capital, amplifying volatility and making countries more vulnerable to unforeseen economic crises.

Despite all the potential disadvantages of using a CBDC, there are a series of measures that must be addressed and coordinated by the relevant authorities to ensure a smooth implementation of a digitized system that avoids any potential problems. In terms of the rivalry that may arise from the introduction of a CBDC, I propose several frameworks and policies.

For example, central banks may not pay interest on retail deposits to discourage large inflows into CBDC. Additionally, central banks can reduce the threat to the banking system by setting limits on individual CBDC holdings or charging fees on large deposits that exceed a specific amount. Central banks can also lend the funds diverted from deposits back to banks at a minimal interest rate, or alternatively, central banks can recover these funds while keeping a small portion of these amounts, which will not incur significant costs for commercial banks ; at the same time, the central bank can use this interest income to cover its digital currency operating costs. All the discussed proposals can help to overcome the challenges that a CBDC can cause in the banking sector.

Moreover, regardless of potential issues with capital flow management (CFM) and the faster transmission of economic shocks, such issues can be avoided by developing an effective CBDC capital movement tracking program that works in parallel with conventional systems, ensuring a well-managed capital flow. system. This issue is therefore highly dependent on the level at which a central bank will regulate its supervisory systems.

Finally, banks can capitalize on these advances by providing services such as CBDC wallet management and digital payment facilitation, thereby increasing their earnings. To clarify, traditional banks can handle CBDC operations such as account administration and customer service. This can include all areas of customer service, such as account opening, deposit and withdrawal processing, and dealing with CBDC transaction issues.

One example could be a system in which the central bank provides banks with a central platform for CBDC management. These banks can then handle accounts and transactions through their existing banking infrastructure. It gives banks the right to earn from fees for transaction processing, account management and other related services.

Banks can also set up point-of-sale systems to capitalize on CBDC transactions. As previously indicated, the funds held by central banks from deposit flows will be used to cover these charges, as the rate of deposits to be retained should be proportionally adjusted to operating costs incurred, to ensure that CBDC- transactions remain cost-effective.

To sum up, after considering the many benefits and challenges of digital currency utilization, we can conclude that the success of such innovation essentially depends on the framework that determines how digital currency activity is coordinated between the relevant authorities. A weak regulatory framework will have a detrimental effect, which explains why a detailed implementation and coordination plan should be explored before the implementation phase.

Mohammed Fahad Hussain Kamal Alemadi is a senior student at Qatar University studying finance and economics