Central bank money is the safest and most liquid settlement asset in our financial system. With the rise of cryptocurrencies, interest on the application of a Central Bank Digital Currency (CBDC), a form of digital money issued by central banks, has gained significant momentum. A CBDC can offer numerous advantages, including settlement finality, liquidity, and integrity, making it a valuable tool for the digital economy.
Broadly speaking, Central bank digital currencies can be divided in two categories: wholesale (for interbank transactions) or retail (for use by companies and the general public).
A wholesale Central Bank Digital Currency is issued as an electronic version of central bank money, which is already digital but, in most countries, not yet issued on blockchain. The primary aim of a wholesale CBDC is to enhance the reliability and efficiency of the existing financial system.
Wholesale CBDCs can be used for large-value transactions between banks, such as interbank lending or securities settlement, in a secure and fast way. A wholesale CBDC can also improve international payments between banks and other financial entities, by eliminating intermediaries that are required at present, reducing both the cost and complexity of such transactions. Besides enhancing settlement speed and reliability, these digital currencies can serve as collateral in financial dealings, which introduces a novel approach to risk management.
A central bank can also use a wholesale CBDC to provide liquidity to financial institutions in times of stress, helping to maintain financial stability and supporting the correct functioning of the financial system. In this sense, central banks can use a CBDC as a tool for monetary policy via the real time control of currency supply.
With a wholesale CBDC, companies and individuals would continue to use existing forms of digital money for their transactions, such as fiat currencies like the euro stored in their bank accounts, meaning that payments between individuals would still go through the traditional banking system where accounts are debited and credited as required. The role of the wholesale CBDC would, for the most part, take place behind the scenes, used for settling transactions between banks and other financial institutions via the central bank's ledger.
A retail CBDC is a type of Central Bank Digital Currency that is designed for use by the general public, serving as a digital equivalent of physical cash, issued and backed by the central bank. Retail CBDCs aim to give the general public direct access to central bank money, which is considered risk-free and is state-guaranteed.
Retail CBDCs can be used for any type of everyday transactions, including purchasing goods and services or transferring money between individuals. A central bank can inject liquidity into the market using a retail CBDC, thereby fostering financial stability and facilitating the efficient operation of the financial sector. Similarly to their wholesale counterparts, retail CBDCs can be employed by central banks as an instrument for executing monetary policy, such as modifying interest rates.
As outlined above, a CBDC serves as a technological advancement capable of enhancing the features of central bank transactions and the execution of monetary policy. These benefits may seem incremental and not game changing at first glance, but they represent a substantial evolution of the financial system.
Today, when someone makes a payment to another person or a company, the funds must actually be transferred from one account to another. The funds travel electronically, but they do have to make the journey from one bank to the other, using multiple intermediaries. This process is costly, slow, and not without risks, since one of the banks involved in the transaction could default before settlement is completed.
By contrast, a CBDC that settles transactions originating from tokenized deposits is, so to speak, "super safe" money that wouldn't have to travel from one account to another. Instead, the two banks would share a common blockchain ledger and settle payments in Central Bank Digital Currency. The banks would also update the account balance of the parties accordingly (the payor's balance is decreased and the payee's is increased). No funds would have to actually be sent and received. It's a faster, safer, cheaper way to transact.
The CBDC implementation described requires that funds used in transactions are tokenized. since they could not originate from deposits in regular digital form if they are to facilitate CBDC settlement. Banks create deposits for many different reasons, such as issuing personal or institutional credits, holding customer deposits, or excess reserves. Their role would be as today, only in tokenized form and supporting settlement on CBDC.
For singleness to exist, all forms of a currency must act as perfect substitutes for one another. Singleness of money refers to the absence of fluctuation in the exchange value between different forms of money in circulation (whether privately issued, such as bank deposits, or publicly issued, such as a CBDC). Monetary exchange is not subject to changing exchange rates that could introduce uncertainty or frictions.
At par settlement means that transactions are settled at their face value, without any premium or discount being applied. If different forms of money always settle at par, without the exchange rates between them deviating, then this ensures their purchasing power remains exactly equal. So at par settlement is crucial for achieving and maintaining the singleness of money in practice. As long as all monies settle at par value through the payments process, their exchangeability is guaranteed and singleness is preserved.
According to the Bank for International Settlements, the singleness of money is better preserved by the described system than by potentially using a stablecoin to settle transactions, due to the risk of the stablecoin depegging, which is when a stablecoin loses its parity with the value of the fiat currency it is pegged to. This has happened several times already, with varying degrees of severity. While MiCA regulation introduces many safety measures, the security provided by a CBDC is unmatched.
The Bank for International Settlements (BIS) has released several papers on CBDCs that are influencing regulators around the world. In particular, on the concept of a Unified Ledger using a CBDC and tokenized deposits to settle transactions, described above.
Central Banks from around the world, in every continent, are researching and piloting CBDC implementations. The European Union is currently focusing on a wholesale CBDC for securities settlement, gearing up to test three potential technical implementations in 2024. At the same time, the European Central Bank has declared itself ready to start developing a retail digital Euro with support of EU institutions.
At a national level, France is the most active among EU member states, researching and piloting several CBDC implementations for different purposes. Outside the EU, Singapore stands out in its dynamism researching and piloting CBDC projects, closely followed by the US. Both Russia and China, for their part, are piloting CBDCs.
For the time being, however, the eNaira Nigeria remains the only official CBDC launch in the world.
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