What was the last time you paid for something with cash? It has become blindingly apparent that people are globally shifting away from physical cash, thus banks are re-evaluating their role in monetary systems. CBDCs (Central bank digital currency) are government-backed digital versions of national currencies, combining the efficiency of digital technology with the trustworthiness and reliability of central banks.
How will CBDC distribution and creation work?
In some ways, CBDCs are similar to cryptocurrencies; unlike cryptocurrencies, they are digitally and officially “minted” by the central bank using safe software platforms. Simply put, instead of printing paper notes, Central banks will generate tokens.
CBDCs are a digital form of a country’s fiat currency1. Here, the central bank will issue currency in a digital form instead of printing banknotes. Commercial banks will buy CBDCs from the central bank by exchanging the reserves which they hold at the central bank. Then, through an intermediary system (Bank apps) users will convert their deposits directly to CBDCs of equal value.
Benefits uses of CBDCs
Firstly, retail payments and public uses. Today, cash is the only central bank money available to the public, whereas debit and credit card payments are based on bank deposits.
CBDCs will give the public digital access to central bank money, combined with the efficiency of digital payment methods. CBDCs will reduce merchant fees for businesses because consumers will choose CBDC payment methods rather than card – without this option, businesses would have to pay to accept electronic payments through card processing fees, interchange fees or maintenance fees.
On the consumer end, international transaction charges are reduced as CBDCs remove reliance on intermediaries like correspondent banks or currency conversions, including exchange rate markups. Because CBDCs enable instant transfers between central bank systems, this could mean that CBDCs may also implement foreign exchange conversion at market rates using bank rates, with lower markup rates.
Effect on macroeconomic policy
As noted by the IMF, CBDC issuance in future may “strengthen or weaken the transmission channels2 of monetary policy” – There are four main channels of monetary policy transmission:
Interest rate channel
Within this channel, the central bank changes interest rates, influencing the demand for credit and the available income from borrowers. By changing the marginal cost of borrowing, the central bank can motivate households to consume, spend or invest more or less.
The presence of CBDCS will strengthen this channel, making it more effective for government use. The financial inclusion promoted by the accessibility of CBDCs to the population would mean that more households have bank accounts and are economically active, and therefore will be more responsive to changes in interest rates.
Bank Lending Channel
Monetary transmission through this channel occurs when changes in the policy rate3 will affect the bank’s willingness to lend and their cost of funds.
The introduction of CBDCs could reduce banks’ deposit funding, as households and firms may substitute traditional deposits with central bank-issued digital currencies. In response, banks may increase their reliance on wholesale funding4 sources, which are typically more sensitive to changes in policy rates. This heightened sensitivity strengthens the interest rate pass-through mechanism, thereby amplifying the effectiveness of the monetary transmission process through the bank lending channel.
Asset Price Channel
This channel operates when changes in interest rate will impact asset prices (equity values or collateral value) – should there be a money tightening process, borrowers’ balance sheet looks less favourable and may reduce their credit-worthiness, directly influencing consumption through changes in the availability of investment funds.
CBDCs will increase financial inclusion, strengthening this channel since credit is accessible to more people, and so more people will be privy to changes in interest rates, meaning that changes in interest rates (which impact asset prices) more directly and more significantly impact consumer or borrower behaviour.
Exchange rate channel
This channel shows how interest rates will affect exchange rates and by extension net exports. When interest rates rise, domestic deposits are more attractive than foreign ones – this encourages capital inflows and in the short run currency may appreciate. This sums in a reducing of a trade deficit as the country exports more.
CBDCs will have a limited impact here; however, if CBDCs reduce reliance on global reserve currencies, then the widespread use of a given currency means the central bank can conduct transactions more easily and conduct monetary policy more effectively.
- A Fiat currency is a national currency whose value is not backed by a physical asset like gold or oil; instead, it relies on the public’s confidence that the central bank will maintain economic stability, manage inflation and honour the currency’s worth ↩︎
- Transmission policies refer to mechanisms through which changes in policy measures affect key economic variables. Strengthening these channels means that changes in policy have a larger effect on macroeconomic variables, and weakening them dampens the effect of policy on the macroeconomic environment ↩︎
- Interest rate set by a country’s central bank ↩︎
- When the banks don’t have enough funding, they will: Borrow from other banks, issue bonds to investors or borrow from central banks. this is called wholesale funding.
The above sources of funds are all very responsive to interest rate changes, affecting banks in terms of their funding costs and capacity to lend. ↩︎