Why Central Bank Digital Currencies (CBDC) Now And What They Could Mean For Climate Change? (1/2)

Why Central Bank Digital Currencies (CBDC) Now And What They Could Mean For Climate Change? (1/2)

This is the first of two articles. You can find the second article here, which focuses more on how Central Bank Digital Currencies could abate climate change outcomes.

Mike Novogratz, founder of Galaxy Digital, recently quipped, “bitcoin is a report card on how central banks are doing.” Could one of the emerging Central Bank Digital Currencies (CBDC) trump Bitcoin’s card? With the impending climate change remit for Central Banks, what could CBDC mean for climate change?

Major Central Banks across the world are in a tight race to deliver the first credible version of digital money. China is testing a digital renminbi version, whereby customers can transact payments over their mobile phones. Europe announced the launch of a digital Euro as part of the five-year plan. The Fed announced it would release a discussion paper this summer regarding digital payments, including respective appeals and threats of a central bank digital currency.

What follows are some considerations ahead of the Fed’s discussion paper.

In what way would CBDC differ from Bitcoin?

From a taxonomy point of view, digital money is a currency not held in physical form. It can either be token- (digital) or account-based. Crypto currency, like Bitcoin, is digital money in token format, which is supported by blockchain technology. This technology hinges on a distributed database managed by several participants. Furthermore, it uses cryptography to satisfy a consensus protocol and validate underlying transactions. This combination allows for peer-to-peer transfers over a network.

Crypto currency doesn’t represent a claim on an issuing entity; as such, its tender status relies on adoption dynamics, influenced by human behavior and psychology. And lastly, (private) crypto currency is fully decentralized, away from a central governing structure. The main reason crypto currency came into existence was to effect payments in a trustless manner (avoiding counterparty risk), in the face of the 2008 financial crisis, outside of the traditional bank network and its ensuing payment rails.

On the other hand, CBDC is digital money issued by a Central Bank, without, in the first instance, falling back on Distributed Ledger Technology (DLT). Given its decentralized and distributed nature of managing databases, this technology is not equipped towards safeguarding privacy, especially if the CBDC would be account-based. CBDC has legal tender status, and private citizens would hold a direct claim on public money, next to their claims on private money via the banking system. CBDC could be implemented in two ways, via the existing banking system as an intermediary or directly via mobile phones.

Stablecoins, such as Tether or Facebook’s Diem, are private (so far) entity-issued crypto-currencies whose underlying value is pegged to some form of collateral.

But why CBDC in the first place?

Innovation and modernization are needed because of several flaws in the current analog and digital infrastructure. Cashing a cheque involves a float (the time it takes for your account to be credited with the payment amount) of three days. With international remittances, that float can get extended to a full four days, sometimes a week. With a fee structure at 3% on average, making abstraction of the exchange rate cut, such utility becomes prohibitive.

Alipay currently executes 120,000 transactions per second regarding execution speed benchmarks, while Visa trails at 65,000 transactions per second. Bitcoin, impaired by its intensive, energy-consuming blockchain-supported consensus protocol, processes about 4.6 transactions per second.

The Fed, separate from any CBDC initiative, will shortly be introducing the FedNow service, a new interbank 24x7x365 real-time gross settlement (RTGS) service with integrated clearing functionality. As of 2023, this service will enable individuals and businesses to send instant payments through their depository institution accounts.

A CBDC, under one of the options, should, however, be able to furnish instant settlement with continuous 24x7x365 availability directly to the end customer, the retail client. Furthermore, the CBDC would need to have the ability to resist, absorb, and recover from or adapt to adverse conditions. And if CBDC would be offered directly to retail clients, robust Anti-Money Laundering and Know-Your-Customer procedures would have to be implemented.

A CBDC would also have to be designed to interoperate and facilitate cross-border as well as cross-currency payments. Interoperability across different payment systems and alternative blockchain platforms will be a crucial design component. DAML and Darrell Duffie from Stanford University released a paper in April reviewing foundational principles when choosing and implementing an (interoperational) technology to support CBDC.

Regarding inclusion, Governor Lael Brainard disclosed at the May 2021 Coindesk conference that 5.4 percent of American households lack access to bank accounts and the associated payment options, while a further 18.7 percent were underbanked as of 2017.

These statistics even hit harder when cash stimulus payments, issued by the government to mitigate the Covid pandemic hardship in 2020, were severely hampered by missing IRS data and incomplete banking data sets.

So, a CBDC could minimize payment fees, augment expediency, offer seamless cross-border and cross-currency payment service, and foster inclusiveness.

What about CBDC and monetary policy?

The public money feature of CBDC could also extend monetary policy tools beyond the current twenty-four primary market dealers. In the future, PayPal and shadow banking members (hedge funds, private equity firms, etc.) could possibly obtain direct access to discount window and monetary policy intervention facilities. This privilege would undoubtedly be paired with liquidity and solvency level playing regulatory policies.

What might be some of the unintended consequences of CBDC?

The total amount of money in circulation is assessed by the monetary aggregate M2 and currently stands at about $20.4 trillion in the US, a 33.3% increase since January 2020. Not always entirely intuitively understood, the commercial banking sector initiates a large portion of the money creation. These banks create money, approximately $10.4 trillion, by a process called fractional reserve banking. Banks continuously lend money to economic agents, but such lending is only backed by a fraction of its reserves. Moreover, the banks’ assumption hinges on depositors not jointly asking for cash withdrawals concurrently.

Central Banks on the other hand create money in two ways. Firstly, through banknote and coin issuance, currently, there are about $2 Trillion in circulation, of which around half is presumably held abroad, sometimes with nefarious intent.

Secondly, quantitative easing stands at approximately $8 trillion, per the Fed’s balance sheet. Finally, quantitative easing is facilitated by a digital line of credit advanced by the Treasury to the benefit of the Central Bank, by which it can inject money into the financial system in exchange of securities or to avail helicopter money.

CBDC issuance would be the third channel of money creation. The latter could create deposit competition with the private banking sector during regular times but exacerbate bank runs in times of financial crises. In addition, customers would accelerate the withdrawal of commercial bank deposits for safer central bank deposits.

A different yet crucial unintended consequence could be the infringement of data integrity and data privacy rights. CBDC payments, if transferred directly to wallets on mobile phones of private clients, could now become fully traceable by the government in relation to the type of goods and services purchased, including location and timing thereof. This potential privacy infringement might trigger more interest in the trustless payment execution function offered by crypto currencies unless convincing CBDC breakthroughs are achieved on the data protection front.

This is the end of the first article. You can find the second article here.

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