Why it's time to take central banks' digital currencies seriously

The decline of cash use in western economies has accelerated due to COVID-19. Meanwhile, central bank digital currencies are emerging, potentially upending the existing global economic hierarchy.

Lockdowns limit physical interactions and naturally reduce physical cash use. But there also credible concerns that paper money can transmit the virus. Research has shown that the average European banknote plays host to around 26,000 colonies of bacteria. The human influenza virus can survive on a banknote for up to 17 days; with one-dollar and five-dollar bills changing hands more than 100 times per year on average, the risk during a global pandemic is considerable.

Who then can blame the People’s Bank of China (PBOC) when it announced in February that it would be destroying cash collected in high-risk environments, such as public transport, markets or in hospitals?

In concert with this decision, the PBOC also ramped up its plans to replace cash with a central bank digital currency (CBDC) - the e-RMB. In April, testing began for the e-RMB in several major cities, including Shenzhen, Suzhou, Chengdu, and a new area south of Beijing called Xiong’an. According to state media, the e-RMB has been formally adopted in these cities, with some government employees receiving salaries in the digital currency as early as May. The expectation is that these pilots will extend to the venue for the 2022 Beijing Winter Olympics.

China is not alone. Deutsche Bank Research has tracked almost 20 digital currency projects led by central banks across all regions globally. Meanwhile, the private banking sector has also launched multiple initiatives, such as the R3 consortium, or in India, the Blockchain Infrastructure Company.

The aim for most of these initiatives is efficiency and effectiveness. Digital currencies could remove the cumbersome operational and security apparatus which surround conventional forms of money transmission. Reducing the ‘cost of friction’ can help financial inclusion of individuals, while also making global trade more efficient and less risky. Increasing transparency and traceability can protect against money laundering and other forms of financial crime.

For central banks, the most important benefit is the ability to improve regulatory compliance and the effectiveness of monetary policy. This is particularly important now. It’s difficult, if not impossible, to know if or when monetary policy is having the intended effect on the economy. If such stimuli were executed through a central bank digital currency, its flow through the economy could be monitored precisely, informing future monetary actions.

There are political and social benefits as well. As research by Deutsche Bank shows, first movers in this space could win long-term geopolitical advantage. The potential for China here is immense. If the e-RMB is adopted broadly as a system to streamline trade and reduce risk, China could become the world’s trade banker, as well as its factory. Yet the bigger goal for China is actually more local, and relates to financial inclusion. Digitising the RMB will grant access to financial services to hundreds of millions of citizens, including some of the most disadvantaged. This benefit is something that can be applied to any country across the world.

That said, significant technical and structural barriers must be overcome before any CBDC becomes reality. Described as a 'tri-lemma', the challenge is that the underlying blockchain architecture of many cryptocurrencies can be designed to be highly decentralized, secure or scalable – but not all three at the same time. Scalability and security are crucial to the effectiveness of any CBDC, but losing decentralization risks creating other bottlenecks and inefficiencies.

These technical challenges are being addressed by companies such as Infosys, along with many partners in the financial and technology industry. What is clear is that any solution needs to be at once fast, cheap, energy efficient and unbreakable. Privacy and identity must be dealt in a way that is acceptable to governments, citizens and corporations. We need enough transparency to enable the hoped-for leaps forward in efficiency and effectiveness, while still protecting individual and corporate rights to privacy.

This is a tall order – but in a world where digitalization is already transforming our lives, it is by no means impossible. If the last century has taught us anything, it’s not to underestimate the transformative potential of technological innovation.

Important questions remain. How do we manage the disruption a CBDC could create by replicating, and potentially cannibalising, the current banking structure? What if some countries migrate to a CBDC and others don’t? What new power imbalances may result?

The answers are not straightforward, yet the opportunities to strengthen fiscal management, transparency, and efficiency are significant. What is clear is that the crisis of COVID-19 presents many challenges – but also a unique opportunity to rethink how money is managed and used in our society.