Even ‘bank-friendly’ CBDCs could prove disruptive

An announcement by Facebook in September 2019 to create a stablecoin called Libra collateralised by a basket of fiat currencies sent shockwaves through the central banking community fearing it could erode their control over critical functions such as monetary policy. Regulatory pressure forced Facebook to modify its stablecoin, opting for more modest ambitions, such as only basing it on a single fiat currency, and rebranded it as Diem. The wake up call sent central banks scrambling to their drawing boards to potentially create digitise cash to avoid others doing it for them. 

On May 14, a deputy governor of the Bank of England, Jon Cunliffe, said it is “probable” that countries would need to issue digital cash to sustain public confidence in the availability of public money. Though Sweden’s Riksbank, a central bank digital currencies (CBDC) pioneer, thinks digital fiat currencies may not happen before 2026. 

“I view CBDC as a net positive. Its landing, which will probably occur in the next few years in developed economies – despite a late and tentative start by their central banks – should not threaten the existence of banking sectors,” wrote Sam Theodore, a senior consultant at Scope Ratings, in a note on May 16. 

Opportunity beckons

“The deployment of CBDCs will create opportunities to strengthen financial system inclusion, innovation, resilience and efficiency, but may also give rise to new risks,” wrote Monsur Hussain, senior director, financial institutions EMEA at Fitch Ratings, in a report on May 17.

According to the rating agencies they have the potential to enhance authority-backed cashless payments innovating in parallel with the digitalisation of society and the declining use of physical cash. It would enable the authorities to track financial transactions and to crack down on crime, but also raises questions from privacy to financial stability. Given that CBDCs could be programmable, central banks could impose expiry dates on them or direct negative interest rates to stimulate consumption. Some experts believe this would ratchet up public interest in crypto currencies, which are designed to be free of centralised control. 

However, rating agencies warn that CBDCs could disrupt the financial system depending on their design. If the public were to hold digital wallets with central banks, depositors could rapidly move money from commercial banks to central banks, and unleash destabilising bank runs. However, central banks want to avoid such risks, but even commercial bank ‘friendly’ CBDCs could still be disruptive. 

Mr Theodore sees the threat as mainly for firms heavily reliant on mass-retail activities, which will fall behind with digitalisation. Second tier banks, such as savings banks or co-operative groups, are particularly vulnerable given their heavy reliance on small savers for their funding, with limited capacity to boost fee revenues. The winners would be banks with market scale and digital leadership. Using technologies such as blockchain, CBDCs would enable banks to optimise often loss making retail payment services and would make the provision of products such as mortgages far more efficient.

Mr Hussain adds that CBDCs could make payment systems more resilient providing cyber risks are contained. Depending on their design and access permissions, Mr Hussain wrote that CBDCs could also allow banks and credit reference bureaus to strengthen their artificial intelligence and machine-learning capabilities, using payments data. Most banks are investing heavily in AI to drive efficiency and to enhance the user experience. 

China’s experience

Among the large countries, China is clearly a leader and is pursuing a retail CBDC, whilst developed countries are currently more focused on wholesale CBDCs, which would be far less disruptive for banks. 

Mr Theordore believes China’s push into CBDCs is nudging the West to respond with its own projects fearing an e-renminbi becomes completely dominant in international digital payments. Though the international e-renminbi’s adoption could be stymied as China is an authoritarian country and would see CBDCs as a tool for social and economic control. 

Nonetheless, China’s experience is likely to influence how others develop their CBDC projects. The People’s Bank of China launched pilot projects in a number of cities in early 2020 and reached half a million users by the first quarter of 2021. 

The Fitch Ratings note explained the PBoC distributed Digital Currency and Electronic Payment (DC/EP) to commercial banks and payment service providers adding that these have no deposit or money-multiplier effects. Also, the PBoC does not pay interest on DC/EP account holdings.

Longer-term, CBDCs could be  a threat to payment providers such as Alipay and Weixen Pay, particularly if the authorities levelled the playing field by enabling more entities, such as banks, to access payment transaction data.  

However, a more worrying development for US policy-makers in particular is that China wants to internationalise its CBDC. In February 2021, the PBoC teamed up with its counterparts in Hong Kong, the United Arab Emirates and Thailand to build a cross-border payments project. 

If this project became widespread, it would enable China to bypass the US dollar and its payments infrastructure internationally thereby reducing its vulnerability to US regulatory actions. This would also boost the use of the renminbi and its role as a reserve currency. However, Fitch Ratings noted that this challenge faces considerable headwinds highlighting that even the EU’s effort to bypass the dollar system in 2018 to allow trade with Iran struggled. It said this reflects the strong network effects enjoyed by the dollar and the complexity of establishing interoperability between jurisdictions.