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10 June, 2022

Why is there a global race towards central bank digital currencies (and what does this mean for businesses)?

What do central bank digital currencies mean for businesses and what do they need to know at this stage of their development?

By Lara Williams

Central bank digital currencies (CBDCs) are a digital version of fiat currency issued by central banks. More than 80% of the world’s central banks are either planning to or have already launched their own CBDC, according to the Bank for International Settlements (BIS) – which acts as a central bank for the world’s central banks.

If implemented in the right way, CBDCs should facilitate more efficient, lower-cost, real-time cross-border payments – but what does this mean for businesses and how should they be preparing for this innovation in payment systems?

What actually is digital money?

Digital money first entered public consciousness with cryptocurrency, which was designed for peer-to-peer payments over a public blockchain network. However, the original intention for cryptocurrency to become a payments network free from government control has not been realised. Instead, cryptocurrencies such as Bitcoin have become more of an asset class, albeit highly volatile in value. Cryptocurrencies remain largely unregulated and free from any central bank control.

Stablecoins are another kind of digital currency that act as a bridge between fiat and cryptocurrencies. Stablecoins are less volatile than cryptocurrencies as they are usually algorithmically pegged to fiat currency or commodities. However, US stablecoin Terra’s spectacular implosion in May 2022 and controversy around another US stablecoin, Tether, and its disputed claim of maintaining $1 of reserves for each coin issued, has weakened confidence in this form of digital currency.

CBDCs are a new type of identity-linked fiat currency issued by central banks. Unlike physical fiat money, which is fungible, CBDCs can be traced and tracked as well as moved in real time.

Why is there a need for CBDCs?

The digital properties of CBDCs allow fractions of currency to be spent without the costly overheads. Perhaps even more importantly, for an industry whose very existence relies on trust in the system, every fraction of that digital currency can be forensically traced and tracked, giving a central bank full visibility of currency flows. This could represent a huge leap in tackling money laundering, tax evasion and other types of financial fraud.

Financial inclusion is another net benefit of CBDCs. Digital wallets issued by central banks and accessed via smartphones could give large swathes of the world’s unbanked populations access to financial services.

Which countries are ahead in the CBDC race?

According to the BIS, there are three live retail CBDCs and at least 28 pilot projects globally. In addition, at least 68 central banks have publicly stated that they are in the process of launching a CBDC. The Bahamas, Nigeria and the Eastern Caribbean already have legal digital currency in use, with Jamaica expected to follow soon, according to PwC’s Global CBDC Index 2022. Nigeria hopes its CBDC will raise levels of financial inclusion from 64% to 95%. Countries with large unbanked populations, including India and the Philippines, have also announced CBDC projects.

It is not only countries with ‘unbanked’ populations that are making CBDCs a priority, however. In March 2022, a US executive order placed “the highest urgency” for research and development to be carried out towards the design and implementation of a digital dollar. For the US it is a matter of global leadership, particularly as China is the most economically powerful country to lead CBDC implementation.

The People’s Bank of China is conducting large-scale public trials of its digital yuan across 11 cities, including at the 2022 Winter Olympics in Beijing, where the digital yuan was available to foreign visitors. China’s main impetus for leading the CBDC race is to reduce the country’s dependence on Alibaba’s Ant Financial and Tencent’s WeBank, which currently account for 94% of the country’s online transactions. A government-controlled digital yuan also reduces the threat posed by Bitcoin and other cryptocurrencies, which the Chinese government has now outlawed.

Not all financial jurisdictions are as eager to enter the CBDC global race, however. The UK’s plan for a ‘Britcoin’ was reviewed by the country’s Economic Affairs Committee of the House of Lords, which concluded that a retail CBDC presented significant challenges for financial stability and privacy concerns. A new Bank of England and HM Treasury consultation began in 2022 to further investigate the introduction of CBDCs. By contrast, in February 2022, the European Commission announced it was planning to propose a bill in early 2023 as a legal foundation for the European Central Bank’s ongoing research and development of a digital euro. Member states including Germany and France have urged speed on the project to maintain Europe’s global leadership in this field.

What form will digital money take in future?

Cryptocurrencies have triggered innovation within the payments ecosystem, pushing financial services providers to modernise. CBDCs are one of these innovations, according to Carlos Leon, financial market infrastructures and digital currencies solutions director at financial network analytics technology company FNA. “The central and commercial banks were sleeping for the past 60 years,” he says. “The last great advance was the credit card and that was a 1960s invention.”

Among cryptocurrencies, stablecoins and CBDCs, which digital currency will become widespread? “It is more a matter of coexisting,” says Leon, who believes there will be no sole survivor in the digital currency space. Instead, there will be a complex system of interoperable payment systems. “What we are all doing at the moment is trying to understand how different systems interconnect, how people pay each other, looking at the safety and efficiency of network topologies,” he says.

What about cash? Physical money might be viewed by many as old-fashioned and dirty, but it serves a purpose to the system when card and payment systems are down, for instance. Some features of cash are being conserved in CBDCs, such as anonymity for small payments, says Leon. Larger payments may need proof of identity as banks will have to maintain anti-money laundering and security features.

How will businesses access CBDCs and what do they need to know?

Different ways of issuing CBDCs are being piloted across the world. The Eastern Caribbean has implemented a system where consumers hold CBDC deposit accounts directly with the central bank. By contrast, China’s CBDC involves private sector banks distributing and maintaining digital yuan accounts for their customers. The European Central Bank is exploring a plan for licensed financial institutions to each operate a permissioned node of the blockchain network to distribute a digital euro.

Most central banks are designing their CBDCs to be intermediated, says Leon. This way the CBDC works under a two-tier system: in the first tier, the central bank issues the CBDC to authorised intermediaries, including commercial banks; in the second tier, those intermediaries exchange and circulate the CBDC, undertaking the usual consumer-facing activities, including anti-money laundering and compliance. “China’s pilot for the digital yuan is a good example of such a two-tier system, with Tencent’s and Alibaba’s apps, WeChat Pay and Alipay, working as intermediaries between the People’s Bank of China and the public,” adds Leon.

Under the intermediated CBDC framework – which Leon says is the most likely to be widespread – companies should expect minor changes to their business as usual. “CBDCs would operate through the same channels that commercial banks and other non-banking payment institutions use today,” he says. However, as with any new system, adds Leon, education is the key to learning how CBDCs would work alongside the existing forms of money used every day.

Haydn Jones, a director and senior blockchain market specialist at PwC, echoes Leon’s point that it is important for businesses to educate themselves about the changes afoot in the digital currency space. Businesses must first look at where their customers and suppliers are to examine the implications of a CBDC requirement, he says. “It wouldn’t take a lot for a Chinese company to suddenly start asking trading partners to use its CBDC to start paying suppliers; for example, a UK-based company would then have to work out ‘how do we get this digital yuan from somewhere?’,” adds Jones.

This is where it gets interesting, according to Jones. Foreign settlement banks may start offering this as a service, with the introduction of a digital euro or digital dollar, because there may well be a requirement for companies to pay using a CBDC. “But awareness is the first step, then obviously being aware of what is happening in different jurisdictions and which countries are likely to launch a CBDC,” he says.

There are very different scenarios regarding CBDCs depending on the country, according to Jones. For example, the UK already has an effective retail and wholesale payments ecosystem. “Would you decommission our infrastructure, when it works perfectly well, with all of the inherent complexity and risk associated with doing that? I would argue not at this stage,” he says. The UK already has sophisticated payment rails including Swift, BACS and Chaps. “Adding CBDCs would be more a question of incorporating innovation such as attaching conditions and coding money rather than a wholesale replacement of the payments infrastructure,” adds Jones.

GlobalData senior analyst Lil Read says that among these innovative advantages for businesses, CBDCs could offer greater supply chain visibility. “If designed well, CBDCs could have the potential to help businesses track payments up or down the supply chain, from multiple suppliers and vendors,” she adds.

In addition, much is made of cryptocurrency’s energy consumption, but Read points out that the existing financial services system is also a culprit when it comes to carbon emissions. “If designed well, either using blockchain protocol with minimal gas consumption or else not using blockchain but [protocols that are] well-designed programmatically, CBDCs should have the potential for reduced energy consumption and this will help companies with their ESG credentials,” she adds.

As a business issue, it is still early days in the evolution of digital money, according to Read. If interoperability between different central banks is achieved and digital money is implemented with a coordinated global approach – notionally overseen by the BIS – CBDCs have the potential to revolutionise the global payments system.

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