China, the world’s second largest economy by gross domestic product, soft-launched its digital yuan in January, and the CBDC already boasts over a hundred million users. In total, about 100 countries are studying CBDC at one level or another, said Kristalina Georgieva, managing director of the International Monetary Fund, during a speech at the Atlantic Council think tank last month.
“We have gone beyond the conceptual discussions of CBDC and are now in the experimental phase,” said Georgieva. “Central banks are rolling up their sleeves and getting to know the bits and bytes of digital money.”
David Yermak, head of finance at New York University’s Stern School of Business, told CNN Business that it is now “inevitable that the whole world will be issuing money this way.” In the United States, the pandemic has spurred demand for cashless payment options, and many Main Street investors have switched to cryptocurrencies like Bitcoin and Ethereum, putting pressure on the government to keep up with the trend.
Now that the Biden administration is putting new weight on Americans’ innovative money, here’s what to know about a potential CBDC.
What is a Central Bank Digital Currency and how will it work?
The Federal Reserve defines CBDC as “a digital form of central bank money that is widely available to the general public.” The key difference from current forms of digital money in a bank account or payment application is that the money will be a liability of the Fed, not commercial banks – hence “central bank money.” This means it will be a real US dollar in digital form, not a cryptocurrency investment or a deposit in your PayPal.
There are different opinions on how this will work and what it will look like, but in theory it could reduce the need for third-party processors when transferring money.
“At a very high level, a CBDC is just digital money that will be issued by a central bank,” Sarah Hammer, managing director of the Stevens Center for Innovation in Finance at the University of Pennsylvania’s Wharton School, told CNN Business. . “It will be based on the fiat currency of that country, so it will be based on the money supply and then implemented using a government database or approved private sector entities working with the government.”
Yermak, who has studied the growth of digital currencies for years, added that CBDC “will actually work in the same way as Bitcoin or other cryptocurrencies.”
“You would have a network of wallets, probably owned by members of the public, where people could pay each other directly, bypassing third parties,” Yermak said.
An important technology decision for policymakers is whether the U.S. central bank digital currency will run on blockchain, the technology behind cryptocurrencies such as Bitcoin, Hammer said, as it will increase the federal government’s influence over this new technology.
“It can be managed through a central database or through distributed ledger technology, blockchain,” Hammer said.
The Federal Reserve Bank of Boston and the Massachusetts Institute of Technology published last month a joint study of a CBDC experiment dubbed the Hamilton Project. The work used blockchain technology and “created one codebase capable of processing 1.7 million transactions per second,” according to a statement from the Federal Reserve Bank of Boston. This far exceeded the benchmark of 100,000 transactions per second that the researchers had originally aimed to achieve. The statement added that Project Hamilton “focuses on technology experimentation and does not aim to create a usable CBDC for the United States.”
Yermak, however, said that “probably whatever they’re working on is going to be something the Fed will grab onto and try to increase.”
However, China’s digital yuan, in particular, is not powered by blockchain technology. The digital yuan is intended to replace cash payments and can be accessed through a government-backed mobile app as well as through Tencent’s WeChat. It uses the existing technology infrastructure used by China’s approved commercial and online banking and payment platforms and is issued by the People’s Bank of China.
What are the potential benefits and risks?
CBDC has the potential to offer consumers a more convenient, safer and cheaper alternative to the options currently available. It could also reduce the need for cash and stop fraudulent transactions, as well as make it more efficient to collect taxes or disperse earmarked public funds, Hammer said.
“There are some financial inclusion benefits to central bank digital currency,” she added, touting their ability to reach Americans who don’t have bank accounts.
Yermak noted that there are several potential risks, including technical barriers and security issues, as well as privacy threats. Its ability to take over some of the work done by commercial banks and the credit markets is also a source of concern for some.
The Fed specifically warned of potential cybersecurity risks in a January report, stating, “Any dedicated infrastructure for a CBDC must be extremely resilient to such threats, and CBDC infrastructure operators must remain vigilant as attackers use more and more sophisticated methods and tactics.”
Moreover, the CBDC could potentially jeopardize the Fed’s independence and raise a host of new policy questions.
“The risk of political abuse is huge,” Yermak said. “If you give the central bank that kind of power, political guarantees should probably be much higher than what the Federal Reserve currently has.”
While Yermak says the CBDC will likely require some “thoughtful political overhaul” and transition as countries experiment with it over the next decade, he still sees “a lot of good reasons to do so.”
“Add to that the fact that people really don’t like using cash – public preferences are also pushing governments in that direction,” Yermak said.