How Central Bank Digital Currencies may impact the monetary system

Authors: Muralikrishnan Puthanveedu and Prashant Gandhi, Principal Consultants, Financial Services at Thoughtworks

Central Bank Digital Currencies (CBDCs) are set to be an integral part of the future of finance.

Ongoing digitalization of the economy is changing the way people pay. The use of cash, the only form of central bank money available to the public, is falling in many jurisdictions and the pandemic has accelerated this significantly.

With more than 6,000 cryptocurrencies now in use across the globe, and one in ten people invested in them, demand for digital currencies has become impossible for central banks to ignore. Faced with a parallel monetary system that’s completely out of their control, central banks around the world are stepping up to create their own digital currency options.

These CBDCs have far more in common with cash than most major cryptocurrencies and represent a natural digital evolution of traditional monetary systems. In comparison to other speculative crypto currencies and tokens, the CBDCs are created and offered directly by central banks and are typically backed in similar ways to cash; whether that’s by gold or by reserves, thereby creating the trust and ensuring consumer protection.

As the map below shows, Central banks everywhere are exploring or actively working on them right now and looking to first mover advantage. The Reserve Bank of India is set to start trial for Digital Rupee by early this year.

While CBDCs are sure to impact national and international monetary systems, let us look at a Future Wheel exercise that visualizes the growth of CBDCs and how they will likely affect major stakeholder groups in the Financial System. The future wheel diagram shows different levels of impacts that one needs to consider before embarking on a CBDC like strategic initiatives in a country.

Here’s a high-level overview of what we learned.

Stakeholder group #1: retail customers

CBDCs provide consumers with convenient digital payment options without exposing them to the volatility of cryptocurrencies. Designed as a medium for spending, they have the potential to make payments faster, cheaper, safe and frictionless, while addressing some of the dependencies in the current payment network and systems.

However, retail customers, who have already experienced real time payments and those concerned about data privacy, will remain one of the hardest groups to convince of CBDCs’ value. Also, the needs of non-tech-savvy consumers should be carefully considered as adoption may provide particularly challenging for them – leading to greater tech inequality across society.

Stakeholder group #2: corporate customers

Corporate customers understand the advantages and are excited about CBDCs’ potential to reduce costs, time and settlement risk involved in international payments. By enabling the use of smart contracts, CBDCs could be used to automatically pay taxes or make other payments to the government as a part of routine transactions. Plus, digital audit trails can simplify and streamline financial compliance.

However, the shift will cause far-reaching changes in how businesses operate and transact with one another. Corporate customers will have to navigate a period of transition, evolution and confusion at some levels of the business as they adapt to transacting with CBDCs.

Stakeholder group #3: domestic banks

For domestic banks, views of CBDCs aren’t quite as positive. When central banks issue a digital currency directly and provide interest on it, domestic banks’ roles as a deposit-taker and essential intermediary are undermined.

Less deposit-taking means fewer resources to work with, which in turn limits a domestic banks’ ability to provide credit to customers. In that sense, the growth of CBDCs represents a real threat to current domestic banking operating models.

Credit unions and co-operative banks in particular will likely struggle with this shift, as their customer base is very cash-oriented and will take a long time to warm up to using CBDCs as their primary currency.

Stakeholder group #4: international banks

CBDCs have the potential to completely transform the role of international banks, especially when it comes to international and cross currency trade. International banks need to step up and re-invent their role in a CBDC driven economy.

It’s a shift that will require those banks to participate in new networks, work with new digital ledger types and collaborate with fintechs. Creating the infrastructure needed to support international CBDC transfers at scale carries a significant resource and innovation burden in the short term.

Stakeholder group #5: fintechs

For fintechs, CBDCs are creating new opportunities to innovate at all levels. From building user-friendly transaction services for consumers to helping create a stable and scalable foundation for cross-currency transactions, the shift toward cashless digital finance represents the largest opportunity fintechs have seen to date.

Stakeholder group #6: financial network players

Domestic and international CBDC transactions demand new standards that have yet to be set. Banks will likely want to work alongside established innovators to determine the best standards for their currencies and establish a robust distributed ledger infrastructure.

If they want to remain key players in the CBDC-driven global economy, today’s major financial network organizations like Swift, Visa and Mastercard, will need to consider their position in this emerging space and ensure they have the skills, capabilities and technologies to provide that foundation.

Stakeholder group #7: central banks

For central banks themselves, CBDCs represent a huge shift in operations. They can significantly reduce the costs of printing, transporting and managing cash, freeing up resources to meet the new challenges of CBDC management. And they can fight fraud automatically, thanks to policies embedded within currency and transaction code.

Desire to move quickly and seize first-mover advantage, the creation of a new global reserve currency and addressing the increased threat of disruption by decentralized finance players could all fundamentally transform the global financial and political landscape.

CBDCs have implications for every data-driven element of finance. From managing Know Your Customer data to tracking illegal activity across billions of transactions, the detailed audit trail that comes with a digital currency can help tackle some of central banks’ biggest challenges.

However, those benefits demand a steep upfront cost. Securing buy-in from all stakeholders won’t be easy – especially at the consumer level. Retraining and re-education will be necessary, new infrastructure will need to be established and central banks will have to define and master a new era of digital finance in which cyber warfare and threats will be of top concern.

It’s a big journey, but it starts with the right preparation and partnerships. There’s no doubt that the move to CBDCs is a daunting undertaking for central banks. But, just like the move to cash, it’s a necessary step to support the evolution of our society and monetary system.

Below are some of the areas of impact that CBDC strategists need to be aware of and adopt a multi-disciplinary approach to address.

Using strong simulation models (agent based modeling), as well as hypothesis based field testing, central banks try to find answers for important questions like whether they should focus on retail or wholesale money first, should interest be offered on CBDCs, should anonymity be offered, should limits and threshold be set for transactions and whether cash and CBDC should co-exist or not.

Those tools and approaches might not provide definitive answers, especially for solutions that are built for scale, but they do give central banks strong indications that will help make the shift far less of a leap into the unknown.

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