Why do we need Central Bank Digital Currencies (CDBCs) when we have online banking and digital payments?##
Let’s explore the need for central bank digital currencies. What problem do CDBCs solve, and what are the alternatives that exist or are possible?
CBDCs stand for Central Bank Digital Currencies so let's start at the meaning of currencies. Currency is a way to exchange money. But what is money?
Money is a way to exchange goods or services. Anything that is considered money has to perform the following three functions.
- Be a unit to account
- Be a store of value
- Be a medium of exchange
Understanding these functions will be essential to understanding CDBCs, why they are important, and their alternatives.
Making a payment using currency notes##
Most modern economies use fiat money. This means that the value of money is determined and guaranteed by the countries’ monetary authority – e.g., the Federal Reserve in the United States, and not some asset like gold. Currency notes and coins are a physical representation of that money. Let’s say that you paid CNY 100 (100 yuan) for a coffee. We know that the value of that coffee is CNY 100, you transferred the same amount by whipping out a crisp 100 Yuan bill, and now the seller has an additional value of 100 CNY with them.
You have just made a payment using cash. Payments are a big part of economies – they enable the transfer of value from one party to another party, and that's how economies grow. Payments are also essential to understanding CDBCs and many other innovations in economics and fintech.
But most likely, in all countries, you'll make this payment by taking out your cell phone and making an online payment. Countries like the UK, Germany, Brazil, Japan, India, and Australia have modern payment systems that are instant. The US is a bit of an outlier here, but even in the United States, people can use Zelle, Venmo, Paypal, or Apple Pay to make digital transfers (payments). See the following table for a list of payment systems in some major global economies.
|Country||Central Bank||Retail Payments system|
|India||Reserve Bank of India||UPI (2016)|
|UK||Bank of England||Faster Payments System (FPS) 2008|
|Europe||European Central Bank||Single Euro Payment Area|
|US||Federal Reserve||Zelle / Venmo (private)|
|China||People's Bank of China||Alipay (private) / Wechat Pay|
|Australia||Reserve Bank of Australia||NPP (2018)|
|Brazil||Central Bank of Japan||PIX mobile payments|
|Japan||Bank of Japan||PayPay or Suica|
These digital payment systems have gained popularity in the last ten years and allow paying another person or merchant from your phone. They offer near-instant settlements, work across banks and have low fees (compared to traditional credit cards).
Most of the larger world economies have digital payments. Using cash is getting rarer. Lack of adoption and privacy concerns, rather than technical issues, prevent further digital payment adoption. It is appropriate to ask why we need anything else. If the country wants, they can work to increase the adoption of their countries' digital payment systems or remove social barriers to adoption. Why invent new solutions to problems that already have answers?
In other words, why do we need CDBCs?
What problems do CBDCs solve?##
The problem that CDBCs solve is a technical one. If and when CDBCs are implemented, your behavior as an end user or even a merchant will likely not change from how you use digital payments and online banking.
Current digital payment systems are a liability on private banks. The word liability is used in the sense of an accounting (or economic) liability and does not mean "baggage." When you pay from your bank account to your friend's bank account in a different bank, the two banks cooperate, and the amount is transferred from your bank account to your friend's bank account. The liability for that amount is shifted from your bank to your friend's bank. The fact that your bank accounts are different is of no consequence since your country's payment system is what makes the banks talk to each other.
So why is this amount you have in your bank considered a liability? That's because the money in your bank account is yours, and they hold it on your behalf. It's not their money, so it's not their asset. Double-entry accounting ensures that these liabilities are matched by assets (a mix of cash and other things). If the bank ever ceases operations, you will lose that amount. Historically governments have protected against bank losses, but it is still a theoretical possibility.
It is good to remember that almost everything that the bank has is digital (both assets and liabilities). Banks have cash, but it is a tiny part of their assets due to fractional banking and because when banks make loans, those are digitally transferred, and they are the bank's assets.
How is CDBC different from a bank's digital money?##
Now that we have gone through some background material, let's delve into how CDBCs is different from what we have right now.
CDBCs are the liability of the central bank, not your retail bank.
Let's contrast the money you have in a bank account and cash. As we discussed above, the money you have in a bank creates a liability on the bank towards you to make good that amount. Their ability to pay you or anyone you want is dependent on their financial solvency. Suppose you hold €100 in cash. That’s a liability on the country's central bank not a private bank. It does not matter whether any bank is solvent or not. The central bank guarantees your asset of €100. CDBCs are similar – they are digital money that does not depend on any bank's solvency. Even if the bank goes under, the money is still yours because your country's central bank guarantees it.
The following table summarizes the key differences between online banking and electronic payments with CDBC.
|Medium of exchange (payments)|
|Store of value||Unit of Accounting||Domestic||International|
|Cash||Backed by the central bank||Yes||Yes||Based on exchange rates|
|Online banking and electronic transfers||Dependent on solvency of the bank that has the account||Yes||Yes||Currently very restricted|
|CDBC||Backed by the central bank||Dependent on convertibility to the national currency||Yes||Future plans exist but unknown at this time|
In future articles, we'll explore other topics related to CDBCs and fintech, like
- Comparison of different payment systems of other countries
- Promises and pitfalls of CDBCs
- Differences and similarities between CDBCs and cryptocurrencies
- Token vs coin-based CDBCs
- Different types of blockchains
- Smart contracts