March 17, 2021 | Why Central Bank Digital Currencies (CBDCs) Matter
CBDCs influence on the global financial system will be subtle in the short-term, but within a few years it will be hard to imagine monetary policy without them
Why Central Bank Digital Currencies (CBDCs) Matter
On the surface, it’s not obvious why central bank digital currencies (CBDC) matter.
There’s nothing functionally different between China’s digital yuan (DCEP) and the traditional fiat yuan (CNY/RMB). They’re both issued by the People’s Bank of China (PBOC), they’re directly convertible at a 1:1 ratio, their values are both informally pegged to the dollar, they’re both subject to China’s closed capital account, and they’re functionally the same from an end-user's perspective.
So why does it matter when China announces domestic/international test phases or completes its first B2B payment settlement?
Central bank digital currencies like DCEP matter because they can drastically expand the monetary policy tools available to central banks like the PBOC.
Keep in mind that digital currencies issued by central banks have very little in common with de-centralized cryptocurrencies like Bitcoin. CBDCs are not mined via a proof-of-work (PoW) system. Instead, CBDCs like DCEP are issued digitally and introduced into China’s money supply through China’s commercial banks.
Central bank digital currencies are antithetical to cryptocurrencies like Bitcoin. Where Bitcoin is rooted in an Austrian school, libertarian ethos of decentralization, and the elimination of centralized financial intermediaries — central bank digital currencies are the complete opposite.
Where Bitcoin loosens central banks’ grip on monetary policy dominance, CBDCs tighten central bank control. Central bank digital currencies not only strengthen the authority of central banks like the Federal Reserve and PBOC but in the long run, they’ll allow central banks to expand their macroprudential policy tool kit in ways that are impossible with traditional or non-digital fiat currencies.
For example, the PBOC will have the ability to utilize a completely centralized permissioned blockchain leger to monitor all DCEP transactions, both within China and internationally. The centralization of such transaction data could provide central banks and governments with the ability to monitor and control financial activity to an unprecedented level.
In the short-term, enhanced central bank capacity to monitor transactions within its monetary jurisdiction will greatly inhibit money-laundering, tax evasion, and other similar illegal practices. This is only the beginning. In the future (10-30 years), the PBOC will likely have the ability to not only comprehensively monitor transactions but directly influence monetary and macroprudential policy within the currency itself.
Central bank digital currencies can theoretically be ‘programmed’ to dramatically alter the currency's basic functionality. For example, central authorities can implement an ‘expiration date’ on sovereign currencies so that government institutions, corporations, and individuals are effectively barred from saving and forced to spend their cash before it expires and disappears from their digital wallets.
Central banks could also have unprecedented control over what individual consumers are allowed or not allowed to buy. As a crude example, central authorities could block retail investors from investing in certain securities or asset classes at the flip of a switch. Or on a more granular level, a monetary authority will have the ability to directly influence the consumer behavior of individuals and families as well.
The world described in the previous paragraph is a genuine possibility, especially in a monetary jurisdiction like China, where monetary and macroprudential policies are already highly centralized. Also, China’s digital payments ecosystem is the most advanced globally, and the dominant digital payment platforms Alipay and WeChat Pay are already heavily integrated with the routine spending habits of nearly the entire country. However, we’re still several years or even decades away from central bank digital currencies replacing traditional fiat ones.
China’s digital currency (DCEP) is the clear frontrunner ahead of initiatives launched more recently by the Federal Reserve and European Central Bank. However, DCEP is still in the early testing phases, and no timetable exists for a full rollout to replace the traditional fiat yuan. The impact of central bank digital currencies on the global financial system will be limited and subtle in the short-term. But in the coming years and decades, digital currencies issued by central banks will dominate the global economy and will permanently change central bank monetary policy.
Additional Reading on CBDCs and DCEP:
International Trade Law Concerns With China’s Digital Currency (Georgetown University; Harrison Dent)
China, the United States, and Central Bank Digital Currencies: How Important Is It to Be First? (SSRN; Martin Chorzempa - Peterson Institute of International Economics)
Related Notes:
The Future of China’s Digital Currency: Expanding Central Control of Monetary Policy
How will the Chinese government benefit from issuing its own digital currency?
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