Will Digital Money Really Be a Game-Changer?

Stéphane Déo, the People’s Bank of China’s digital yuan project is at an advanced stage, and the European Central Bank (ECB) has recently completed a consultation on a digital euro. What benefits could central bank digital currencies (CBDCs) like these deliver?

They have the potential to significantly shake up the financial infrastructure of any jurisdiction where they are introduced. Transaction costs and settlement times for payments could be slashed, resulting in efficiency savings across whole national – and in the case of the ECB, transnational – economies.

We believe they can cut costs for the production and distribution of physical cash, encourage competition between payments providers, and break down barriers between walled-off payments environments and the wider payments system – for example, the proprietary ecosystems presided over by several Chinese online retail platforms.

«Central banks could offer emergency liquidity support far faster than is possible now»

Also, CBDCs could potentially offer significantly more direct transmission of monetary policy than is currently possible. Central banks could offer emergency liquidity support far faster than is possible now, helping prevent chain reactions in any future financial crisis.

The real-time processing of transaction data would provide a wealth of information to any regulator or monetary authority. The processing of this data is one key aspect of the People’s Bank of China (PBOC) project, raising important questions about privacy. Finally, there is the «tone-setting» implicit in adoption – there are hard to predict second-order effects, where innovation spurs further innovation in a virtuous cycle.

What would they mean for banking?

Theoretically, the implications could be enormous.

If you deposit a euro in your bank account, that’s a de facto liability for your bank. You have lent your euro to the bank, which can then use it on their balance sheet as they determine the extent they can reuse it as they make loans, deliver mortgages, invest it in equities and so on. Your euro is in practice a funding source for the rest of the bank’s activities.

«This would have serious consequences for the banks»

With a CBDC, in theory, your wealth is booked directly with the central bank – in our example, the ECB. This would have serious consequences for the banks, as the deposits that fund their other activities could dry up or even disappear. Any big shift in the balance sheets of major banks would have major disruptive impacts throughout the real economy.

Obviously, this is an extreme picture, and any disruption on this order will surely attract the attention of regulators and lobbying efforts from the banks, but it should give a picture of how big any changes could potentially be.

For example, if we again consider the PBOC’s digital yuan project, the digital money issued by the central bank would be retained in custody by commercial banks. These would be akin to deposits, so the banks would in practice retain this funding source – offering a valuable sense of continuity between the two operating models.

If we think about where the complimentary opportunities may lie – where do cybersecurity, KYC and AML sit in this picture?

If there is to be reorganization in the banking system in the long term, it seems logical that the banks themselves will shift into something more along the lines of IT providers. It won’t be as substantial a change as that sounds, although it’s clear that cybersecurity will be ever more central as the risk transfers from the banks themselves to the payment chain.

«That’s just the first step»

If we look at KYC and AML and other anti-fraud practices, we see a huge opportunity. Even a small institution can potentially raise thousands of suspicious transactions every day: the kind of data that a digital currency embeds in every transaction means that triage can be accelerated significantly.

What kind of innovation could digital currencies unlock in the wider economy?

In the short term, digital currencies can deliver faster, cheaper and more efficient payments both within and between countries – but that’s just the first step.

We move here to speculation, but what could their impact on lending be, for example? There are likely to be several layers of disruption, but they are hard to predict because each builds on the previous disruption in a chain that grows in impact over time. We can think of them as foundational technologies that can spur and facilitate innovation throughout the wider economy.

The currencies themselves are not the end of the story – they are the beginning.

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