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Get Ready for Central Bank Digital Currencies

You can’t possibly miss how human life on Planet Earth is becoming increasingly “digital”. I believe there are now more active smart phone accounts than there are people, at least above the age of 5. Techies started talking about “the internet of things” years ago and now we are seeing objects like refrigerators connected to the World Wide Web.

Money has not escaped this trend. Unfortunately, in this area, the initial forays into digital money have been disastrous for many people at the same time they produced incredible windfall profits for a few. I’m referring here to Bitcoin and other “cryptocurrencies” that claimed to be better than dollars and yen and other normal, official, everyday currencies.

The big difference between cryptocurrencies and official currencies is that the former are produced by private owners seeking to make personal profits. The latter are produced by government agencies (Finance Ministries and Central Banks) that carry the full “faith and credit” of their governments.

Official currencies are “legal tender”, which means that by law they MUST be accepted for the payment of taxes, for the purchase of merchandise, and all other legal monetary transactions in the country of issue. A small number of countries have given legal tender status to one or more cryptocurrency, but there is no evidence that these experiments will lead to wider and eventually global adoption. I don’t expect cryptocurrencies to disappear. It’s more likely that they will get regulated by governments and eventually become collector items, like stamps and coins.

Cryptocurrencies have two advantages today over official currencies. Their main attraction, until recently, was secrecy: transactions in cryptocurrencies were outside of government control and therefore were a wonderful way of laundering dirty money (from gambling and selling drugs, for example). The other advantage was being “universal”, meaning that people living in countries with different currencies could carry out transactions without regard to the exchange rates between their country currencies, or capital controls restricting cross-border payments.

A huge disappointment for crypto fans was discovering in recent years that some government agencies are able to crack the codes and identify the participants in crypto transactions. Other factors that have contributed to skepticism about the future of crypto are: extreme price volatility on the (private) exchanges where cryptocurrencies are bought and sold, steep fees levied by most of these exchanges, and the incredible amount of electrical energy required to “mine” (create) some of the cryptocurrencies.

Inevitably, central banks and finance ministries around the world began to study these alternative currencies and consider producing their own digital currency to avoid losing control of their country’s money supply. Hence: central bank digital currency or CBDC.

It’s not easy to visualize CBDC, even for me. A starting point is to pull out one of the dollar bills (or Euro, peso, etc.) in your wallet or purse. Each piece of this paper currency has a unique serial number. This identification is essential to making paper currency work as legal tender. It enables governments to control the amount of currency issued, to track its movement, and to discourage counterfeiting.

The main feature of a CBDC is that every unit issued has a digital “cryptographic stamp” comparable to the identification number on paper currency.

The main operational difference from paper currency, for the holder/owner, is that a CBDC can only be accessed via an app on your smart phone or other wired device. It also means that banks and stores and all other “intermediaries” in the economy having a CBDC need to install devices that can read your app, allowing you to buy and sell, and save and invest, with your CBDC.

Conceptually, a CBDC can be adopted in a “pure” form or a “hybrid” form. In the case of a pure CBDC, every user has an account in the central bank of his or her country. Nigeria is the only country that has introduced a CBDC in this form, but it had to convert it to a hybrid form in response to strong public objections.

In a hybrid CBDC system, commercial banks (and other financial institutions) function as intermediaries between the issuing central bank and CBDC users. Thus, instead of having a CBDC account in their central bank, users have a CBDC account in the bank (or institution) of their choice.

Now we get to the policy nitty gritty. The overwhelming public concern with both forms of CBDC is privacy. The administrators of any CBDC system have the technical ability to monitor every single transaction. This potential invasion of privacy is stopping the United States and every other country that values privacy from rushing to launch a CBDC.

The biggest CBDC system in the world today was launched by China in April 2020 in four cities. It is a hybrid system that was expanded in stages to include 23 cities by September 2022, using seven commercial banks and two online banks as intermediaries. The Peoples Bank of China issues the “e-CNY”to these banks and users must open an e-CNY account in one of them.

A hybrid CBDC system can mitigate the privacy problem by making the intermediaries (commercial banks and other financial institutions) responsible for safeguarding privacy. Specifically, a national law prohibits participating intermediaries from disclosing to third parties any transactions by their account holders. This law is then enforced through government regulations and close monitoring. A problem with the Chinese CBDC is that its design allows surveillance of activities deemed by the Chinese government to be undesirable even if they are technically lawful. So far, millions of Chinese users of e-CNY have decided that its benefits are greater than its risks to themselves personally.

The benefits of CBDC are potentially large. The most obvious benefit is not needing paper money when you go shopping and not worrying about losing your money if your wallet is stolen or your house burns down. The cost of maintaining a CBDC system will presumably be smaller than the cost of printing and distributing and disposing of worn-out paper money, although it is likely that paper money will continue to be legal tender for a decade or more after a CBDC is issued. Perhaps the biggest social benefit of CBDC is to facilitate meeting a systemic demand for money, arising from a natural disaster or a Covid-like epidemic. It could also bring countries a step closer to adopting a Universal Basic Income (see my February 7 post on UBI).

So, how soon will the USA have a CBDC? No sooner than five years from now, is my best guess. One of the first countries to introduce a hybrid CBDC was Jamaica. As many as half-a-dozen small countries have introduced or have announced the introduction of a CBDC. There will have to be solid evidence that a particular, relatively large, CBDC model is working well before the USA commits to introducing one.

A story published by Bloomberg at the beginning of February provides a good overview of this subject and how far the UK government has gone in getting ready to introduce a digital pound. (If you can’t get past the paywall, let me know and I’ll send you the full text.)


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