The concept of a central bank digital currency (CBDC) was first introduced to a wider public in 2016 by Ben Boardbent, who was then the Deputy Governor for Monetary Policy at the Bank of England. Since then, many central banks, notably China, have been working on their own digital currency projects, with the IMF reporting almost 100 CBDCs in development. The discussions surrounding the use of distributed ledger technology (DLT) are, with supporters touting benefits while critics pointing the risks associated with governmental use of the technology. Nevertheless, the creation of CBDCs is a significant piece of technology that directly impacts all financial sectors, whether one supports it or not.
Stablecoins: Risks and Mitigations
Cryptocurrencies were once welcomed as a technology that could revolutionize the financial industry. They also promote financial inclusion thanks to its underlying DLT technology. Early on, we recognized the potential to simplify the financial system and increase access to financial services, but cryptocurrencies soon shifted their focus from being a means of financial exchange to becoming a store of value or an investment instrument.
Despite their potential, the nascent crypto-asset market required liquidity injection mechanisms. Stablecoins were created as a way to address this shortcoming. Essentially, stablecoins are privately issued coins that peg themselves to underlying assets, typically fiat currencies. Private entities issue stablecoins and maintain their peg by holding a set of assets as collateral to the digital tokens. However, since private entities issue stablecoins, they pose risks similar to commercial banks. If these entities do not have sufficient assets, they could break the peg, causing the issuing entity to become insolvent. This is exactly what happened to with LunaTerra in 2022, which led to a liquidity crisis in the crypto-asset market.
In essence, stablecoins are an addition to the conventional monetary system. Their existence relies on private entities’ ability to convert digital tokens into fiat. This creates a system akin to a foreign exchange. Unfortunately, a collapse in the entity issuing the stablecoin can trigger monetary instability, similar to a bank run. This introduces fragility to the monetary system. Therefore, the development of CBDCs aims to mitigate these types of risks associated with stablecoins by introducing a digital monetary token.
CBDC: A Remedy for Insolvency
In order to understand CBDCs, it is necessary to understand how Central Banks function outside of the crypto-asset market. Central Banks are the highest authority of a country’s financial system. It influences the stability of markets by ensuring its safety, integrity, efficiency, and access. As an accountable public institutions, they accomplish the objective of maintaining the macroeconomic goals by fulfilling four different roles:
- Sole issuer of the unit account in the monetary system.
- Trusted intermediary of banks
- Lender of last resort
- Overseer of the payment system’s integrity
Through various instruments, Central Banks are able to directly affect inflation rates, money supply, foreign exchange, and payment system. These banks also serve to process cross-border payments, facilitating international trade from occurring between countries. In essence, Central Banks are an indispensable institution for the international trade to proceed in a satisfactory form.
However, despite the competent system, the procedures are still largely inefficient with high costs, low speed, limited access, and insufficient payments. For example, traditionally, a cross-border payment, with high fees, could take weeks before a payee receives the funds, part of the reason is the different country regulations that may impede on a more instantaneous transmission of funds and make the process expensive. The creation of a wholesale CBDC would provide the system with much needed speed and transparency.
The Many On-Going Projects
Currently, the institution at the forefront of the development of wholesale CBDC is the Bank of International Settlement. With its various Innovation Hubs around the world, the Bank of International Settlement has opened partnership with many different banking institutions, national and commercial. These partnerships were established to test groups for various architectural and functional capabilities. Among the various research projects conducted, the most advanced architecture presented comes from Project mBridge.
In Project mBridge, the Bank of International Settlements Innovation Hub Hong Kong in collaboration with the Hong Kong Monetary Authority, the Bank of Thailand, the Digital Currency Institute of the People’s Bank of China and the Central Bank of the United Arab Emirates developed a new blockchain ledger. The mBridge Ledger developed in the project is custom-built by central banks by central banks to act as a specialized and flexible platform for multi-currency cross-border payments of CBDCs.
The ledger was able to perform transactions among twenty different banks from four different jurisdictions. This pilot allowed banks to settle real value directly on the platform and on behalf of corporate customers. In total, over $12 Million (USD) was issued on the platform, facilitating over 160 payments and Forex transactions. The transactions themselves occurred at faster speeds and crossed time zones with ease. This largely increased the efficiency of transactions and trade.
Future of CBDCs
The introduction of Central Bank Digital Currencies (CBDCs) is expected to significantly impact the global economy. People often cite two major benefits: enhanced stability in monetary exchange and greater efficiency in settlements.
Firstly, CBDCs can potentially improve the stability of the financial system by ensuring the solvency of the banks and preventing bank runs. Additionally, CBDCs may help curb illegal activities such as money laundering and terrorism financing.
Secondly, CBDCs can offer greater efficiency in settlement networks due to the use of blockchain technology. It eliminates the need for third-party intermediaries to verify transactions and allows CBDCs to be programmed to engage intermediaries only when specific conditions are met. This streamlined process has the potential to revolutionize international trade and facilitate future economic growth.
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