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The Future of Money – The Rise of Central Bank Digital Currencies

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Fiat currency provides the stable foundation of the world economy; it is a vernacular to exchange, goods, and services, and is a stable store of value. It is evidenced in some of the world’s largest economies such as the United States, China, and Japan – as fiat currency flows through the financial system daily. In the United States, the U.S. dollar is the primary currency and is used for most transactions. It is widely accepted by merchants and businesses and is also used as a benchmark currency for international trade and investment. The U.S. dollar is also considered a safe-haven currency, meaning that investors tend to flock to it during economic uncertainty.

As a result of technological advancement and a shift in interest, digital currency has now become an area of focus. Central Banks are now exploring the idea of introducing a Central Bank Digital Currency (CBDC – an advancement of our current traditional fiat currency). CBDC will be a digital version of our traditional fiat currency; issued and backed by Central Banks. CBDC will mirror the function of fiat currency which is considered a store of value; used for transactions, with the added advantage of being easily transferable, trackable, and programmable. Central banks are exploring the implementation of CBDC as it is believed that increased efficiency, security, and further financial inclusion can be achieved. It is further argued that CBDC can provide a novel form of liability for our banking industry; to achieve a more robust financial ecosystem.

Below is a high-level summary of the benefits of CBDC:

  • Increased financial inclusion: A key advantage that CBDC has is that it can potentially make it easier for people to have access to and use financial services where financial infrastructure is less developed; providing a huge benefit for small and medium business owners in less economically developed countries.
  • Reduced transaction costs:  CBDCs can provide users with cheaper transaction costs, allowing individuals and businesses to send and receive payments instantly without the burden of high transaction fees.
  • Increased efficiency: The rise of CBDC can provide an uplift in efficiency and productivity within the financial ecosystem. The use of CBDC can streamline payment processes removing the functional need for financial intermediaries; additionally increasing the rate of transactions.
  • Economic stability: CBDCs could potentially provide an alternative to traditional fiat currencies – which are subject to inflation and other economic risks. By using a digital currency that is backed by a central bank, it may be possible to increase stability and reduce volatility in the financial system.

CBDC is a digital representation of a country’s fiat currency, as aforementioned CBDC can be programmed for specific functions to include revolutionary features that aren’t possible with traditional fiat currency. A CBDC can be modified/programmed to include a smart contract functionality, allowing for the automatic execution of certain conditions or terms in a financial transaction. This could include things like automatically releasing funds to a particular recipient when certain conditions are met, or automatically triggering a payment when a certain date or time is reached.

Though CBDC can hugely benefit the realm of financial services, there are also some risks and challenges that the implementation of CBDC can pose such as:

  • Cyber security: A major concern for governments and central banks is that there is a huge threat that funds can be lost from people’s digital currency accounts because of a cyber-attack. Digital currencies are vulnerable to hacking, and this can negatively impact the economy. Given the likely importance of a CBDC to a jurisdiction’s financial system and broader economy; other security considerations include anti-money laundering (AML) and countering the financing of terrorism (CFT), consumer protection, and financial stability. It is important to consider the security risk CBDC poses to AML and CFT, as it has the potential ability to encourage illicit financial activity if sufficient AML and CFT controls and procedures aren’t in place. The industry needs to ensure adequate transaction monitoring systems and Know Your Customer (KYC) processes and procedures are in place to prevent the misuse of CBDC technology. From a regulatory focus, the FCA and PRA may want to heavily consider how the implementation of CBDC can potentially cause financial harm to its everyday user. Consumer protection should be a key consideration, therefore consumers should have access to a clear and comprehensive articulation that outlines the risks and benefits, as well as how to resolve queries if they were to materialize.

Concerns about financial stability

The implementation of CBDCs could potentially have an impact on financial stability. For example, if a large portion of the population begins using a CBDC instead of traditional bank deposits, it could potentially destabilize the banking system. CBDCs can provide an increase in financial inclusion; providing those in less economically developed countries to further access the use of financial services – reducing the costs of transactions and streamlining the process of payments by eliminating the need for financial intermediaries.

Progress on CBDCs has been relatively slow. But a flurry of tests near the end of the year suggests CBDC initiatives are improving their pace, as central banks try to determine the impact on traditional banking and payment systems. About a dozen CBDCs have launched, according to a tracker from the Atlantic Council, which also states that 17 are in pilot and 72 are in research and development. Eighty percent of central banks are considering a CBDC or have already launched one, according to PwC.

A prime example we can consider is the digital Yuan, explored by the People’s Bank of China (PBOC); the digital Yuan is being developed to further compliment China’s physical renminbi. The PBOC aims to achieve a more efficient and enhanced payment system, to eventually reduce the reliance of foreign payment providers that currently operate within the Chinese Market. The digital Yuan has been created to be a two–tiered approach; tier 1 is designed for the central bank to control quantity levels, and tier 2 has been designed for commercial banks to ensure the digital Yuan is distributed to the public.

The PBOC has conducted a few pilot programs to identify the feasibility of the digital currency, pilot programs have been conducted across; Shenzhen, Suzhou, Chengdu, and other cities in China; of which feedback from both consumers and businesses were gathered. A notable benefit that was of significance was the enhanced capability to transact in real-time, reducing the need for third-party payment processors; ultimately reducing the cost and improving the speed of payments.

Though CBDC can revolutionise the financial industry and distribute a plethora of benefits to the financial ecosystem, Central Banks need to consider the associated risks and challenges before implementation. Central banks need to assess the current state of the financial ecosystem to understand and put in place the appropriate risk deterrent controls to achieve a stable and secure deployment of CBDC within the financial system. For a smooth integration, Central Banks should consider the interoperability between CBDCs across different regions, and other countries financial systems. CBDCs need to be compatible with other digital and traditional payment systems; to enable seamless integration into our current financial infrastructure and the programmed functionalities can be used across different regions if needed.

We must remember that though CBDC can be hugely beneficial; it is still within its infancy stage and a lot of research and development is required. A full diagnosis is required to completely review the risks and respective challenges related to CBDC. Central Banks, Governments, and other market participants must collaborate to understand the scalability and viability of this novel technology.

How Delta Capita can help

Delta Capita has an experienced and dedicated team that provides expertise in digital assets and regulatory compliance to many financial institutions worldwide.

This experience gives us an expert view of industry best practices and financial regulations. For organisations impacted by, or interested in, smart contracts, we can provide valuable insights and ensure your firm is always aligned with the latest regulations and licenses.

Contact us to find out more and speak to one of our experts.