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central banks and cryptocurrencies

Why central banks flirt with digital currencies

Cryptocurrencies have a reputation to be adventurous and unstable as the value is not supported by any central banks but varies widely by market-moving news or statements. But digital-only currencies have an attraction and central banks around the world are increasingly discussing the option.

The central banks’ idea is that digital currencies are less expensive to administrate, safer and open up for easy use also in countries where a limited number of citizens are connected to the banking system.

The cryptocurrencies, like bitcoins, are based on distributed-ledger technology, meaning that multiple devices all over the world are constantly verifying the accuracy, not one central hub.

What central banks discuss is instead called Central Bank Digital Currency (CBDC) which means a digital currency that is backed by a government’s central bank.

China has been the first major economy to test a digital currency. The People’s Bank of China has said it is aiming for increased domestic use of the digital yuan by the 2022 Winter Olympics in Beijing.

The Swedish central bank has studied a digital currency and has submitted a first report.

The International Monetary Fund (IMF) has mentioned that the advantage of CBDC is that it is less expensive to manage and transfer. Financial inclusion means those who are not having access to the banking system can easier and safer get access to money on their phone.

Among risks are that it could be too easy for citizens to pull much money out of banks at once and purchase CBDCs, triggering a run on banks. Cybersecurity is also an obvious worry with a centralized system for digital currency. Cross border flow of money could also be more difficult to follow with increased risks for money laundering.

International Monetary Fund (IMF) is cooperating with the Bank for International Settlements, the Committee on Payments and Market Infrastructures, and the Financial Stability Board to establish relevant guidelines for how CBCDs could be used.

IMF’s Tobias Adrian, Financial Counsellor and Director of the Monetary and Capital Markets Department, in a speech recently informed about the planning for CBDC saying that “a profound transformation is already under way.”

“From private-sector-led innovations like cryptoassets and stablecoins — to public-sector-designed programs like the Bahamas’ issuance of the “Sand Dollar” and China’s experiment with the “digital yuan” — digitalization is changing our understanding of what a “currency” is and how it operates.”

Discussing the risks with CBDC, he said that in most cases, these can be restrained through appropriate design. For instance:

  • CBDC holdings could offer a lower rate of interest — if they provide any interest at all — than the policy rate. Or, holdings could be capped, with surplus funds swept into bank accounts every night.
  • Transaction limits could be imposed, helping reduce the risk of the disintermediation of banks.
  • CBDC could also be distributed through existing financial institutions, using the customer onboarding processes that are already in place.
  • In addition, countries whose central banks issue CBDC could restrain “currency substitution” by limiting the holdings by non-citizens. 

The Swedish central bank has studied a digital currency based on blockchain technology. The bank in a report said the digital currency opens up for new options but that it is also untested on a larger scale and needs to be further investigated. The tests made so far have been most technology-based and aimed at describing how a digital currency could be used as a complement to cash.

Summarising the study, the central bank said that the technology to create unique identified e-krona is here but that it is untested when it comes to huge amounts of payments and with security.

One basic question concerning functionality is if the currency should be able to handle also without internet access, offline functionality, which was not included in the study. Could you have the e-krona on your phone or would it only be available via an online connection to the platform?

As IMF’s Tobias Adrian said in his overview of the possibilities with CBDC:

“We’re at an exciting moment in the evolution of currencies — and indeed, in the evolution of our very concept of what “money” is, and what benefits “money” should deliver. If we design digital currencies with caution and with precision — and if we frame their adoption within legal and regulatory systems that maximize their benefits and minimize their risks — we could be on the verge of an era that fulfills the promise of transformation.”

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