Central bank digital currency
Central bank digital currency (CBDC, also called digital fiat currency or digital base money) is the digital form of fiat money (a currency established as money by government regulation or law).
Central bank digital currency is different from virtual currency and cryptocurrency, which are not issued by the state and lack the legal tender status declared by the government. As such, public digital currencies could compete with commercial bank deposits and challenge the status quo of the current fractional reserve banking system.
The Bank of England was one of the first to initiate a global discussion on the prospects for the introduction of a CBDC. The central bank of Sweden is however the closest to consider its implementation. In November 2017, the central bank of Uruguay announced to begin a test to issue digital Uruguayan pesos.
In the Eurozone, the Bank of Spain's former governor Miguel Angel Fernandez Ordoñez has called for the introduction of a digital euro, but the ECB has so far denied such possibility. Nevertheless, in December 2019, the ECB stated that "The ECB will also continue to assess the costs and benefits of issuing a central bank digital currency (CBDC) that could ensure that the general public will remain able to use central bank money even if the use of physical cash eventually declines".
A central bank digital currency would likely be implemented using a database run by the central bank, government, or approved private-sector entities. The database would keep a record (with appropriate privacy protections) of the amount of money held by every entity (e.g. people or corporations).
CBDC is a high security digital instrument; like paper bank notes, it is a means of payment, a unit of account, and a store of value. And like paper currency, each unit is uniquely identifiable to prevent counterfeit.
Digital fiat currency is part of the base money supply, together with other forms of the currency. As such, DFC is a liability of the central bank just as physical currency is. It's a digital bearer instrument that can be stored, transferred and transmitted by all kinds of digital payment systems and services. The validity of the digital fiat currency is independent of the digital payment systems storing and transferring the digital fiat currency.
Benefits and impacts
Digital fiat currency is currently being studied and tested by governments and central banks in order to realize the many positive implications it contributes to financial inclusion, economic growth, technology innovation and increased transaction efficiencies. Here is a list of potential advantages:
- Technological efficiency: instead of relying on intermediaries such as banks and clearing houses, money transfers and payments could be made in real time, directly from the payer to the payee.
- Financial inclusion: safe money accounts at the central banks could constitute a strong instrument of financial inclusion, allowing any legal resident or citizen to be provided with a free or low-cost basic bank account.
- Preventing illicit activity: A CBDC makes it feasible for a central bank to keep track of the exact location of every unit of the currency (assuming the more probable centralized, database form); tracking can be extended to cash by requiring that the banknote serial numbers used in each transaction be reported to the central bank. This tracking has a couple of major advantages:
- Tax Collection: It makes tax avoidance and tax evasion much more difficult, since it would become impossible to use methods such as offshore banking and unreported employment to hide financial activity from the central bank or government.
- Combating crime: It makes it much easier to spot criminal activity (by observing financial activity), and thus put an end to it. Furthermore, in cases where criminal activity has already occurred, tracking makes it much harder to successfully launder money, and it would often be straightforward to instantly reverse a transaction and return money to the victim of the crime.
- Protection of money as a public utility: digital currencies issued by central banks would provide a modern alternative to physical cash – whose abolition is currently being envisaged.
- Safety of payments systems: A secure and standard interoperable digital payment instrument issued and governed by a Central Bank and used as the national digital payment instruments boosts confidence in privately controlled money systems and increases trust in the entire national payment system while also boosting competition in payment systems.
- Preservation of seigniorage income: public digital currency issuance would avoid a predictable reduction of seigniorage income for governments in the event of a disappearance of physical cash.
- Banking competition: the provision of free bank accounts at the central bank offering complete safety of money deposits could strengthen competition between banks to attract bank deposits, for example by offering once again remunerated sight deposits.
- Monetary policy transmission: the issuance of central bank base money through transfers to the public could constitute a new channel for monetary policy transmission (ie. helicopter money), which would allow more direct control of the money supply than indirect tools such as quantitative easing and interest rates, and possibly lead the way towards a full reserve banking system.
- Financial safety: CBDC would limit the practice of fractional reserve banking and potentially render deposit guarantee schemes less needed.
A general concern is that the introduction of a CBDC would precipitate potential bank runs and thus make banks' funding position weaker. However, the Central Bank of England found that if the introduction of CBDC follows a set of core principles the risk of a system-wide run from bank deposits to CBDC is addressed.
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