By Chetan Ahya, Morgan Stanley's Chief Economist and Global Head of Economics
Central Bank Digital Currencies – The Next Disruption
We do not usually associate disruption with central banks. But a major move to introduce central bank digital currencies (CBDCs) could actually disrupt the financial system.
CBDCs are a new form of digital cash intended to serve as a substitute for physical cash. They will be a liability of the central bank, which will maintain them in a centralized ledger. CBDCs should not be confused with cryptocurrencies, which either are pegged to an underlying asset or backed by a public blockchain. Cryptocurrencies are not a viable form of digital cash for payments on a large scale, given the high computational and energy intensity of the validation process using distributed ledger technologies. However, they will continue to perform other functions. For instance, investors may perceive that cryptocurrencies can be a store of value (akin to precious metals) to hedge against the effects of central banks’ aggressive monetary easing.
Efforts to introduce CBDCs are gaining momentum, with as many as 86% of the world’s central banks exploring digital currencies. China has launched pilot trials in a number of cities, the ECB recently concluded a public consultation on a digital euro and will make a decision this summer, and the Boston Fed is set to release its initial research in the fall.
What explains this sudden concerted interest? We see three main reasons:
- Monetary sovereignty: Private payment networks have proliferated rapidly. As they gain market share, these networks can become the primary means of transaction for many users. The central banks’ concern is that money will circulate almost exclusively within the networks, posing a threat to central bank control of the monetary system.
- Financial stability: Any potential failure by a private provider of digital money could disrupt the payment system and lead to financial stability risks. While regulators have taken steps to mitigate these risks, they cannot eliminate them. In contrast, the central bank both creates and holds a CBDC, hence will be able to guarantee its reliability as a medium of exchange for transactions.
- Financial inclusion: The rise of private, narrow money networks risks excluding segments of the general public, e.g., the unbanked population. A CBDC, just like physical cash, can be made broadly available and may even foster greater financial inclusion.
With these objectives in mind, we think that central banks will implement consumer-facing retail digital currencies, accessible to the public through financial intermediaries and running on a centralized ledger system controlled by monetary authorities.
Nevertheless, when something as fundamental as what you use to make payments changes, the effects can be far-reaching.
Commercial banks will face the risk of disintermediation. Once CBDC accounts are launched, consumers will be able to transfer their bank deposits there, subject to limits imposed by the central banks. Moreover, the technological infrastructure of CBDCs will make it easier for new non-bank entities to enter the payments space and accelerate the transition towards digital payments. These factors will increase competitive pressures on commercial banks.
In a digital economy, data provide a competitive edge. We see a tug-of-war playing out between consumers who are privacy-conscious and want to keep their transactions anonymous and fintech companies that will innovate and incentivize consumers to get onto their platforms in order to acquire transaction data. If the fintechs’ efforts succeed, network effects could proliferate, allowing fintechs to take market share from banks.
CBDCs also have the potential to disrupt the international payments system. If a country’s CBDC gains acceptance for international transactions, significant advantages could accrue to the issuer country in financing costs and control over financial transactions, similar to the US dollar’s privileged role today. Some central banks like the ECB and the PBOC see the move towards digital currency as an opportunity to raise the international status of their currencies and increase their use in cross-border payments. On the other hand, emerging markets want to limit the use of foreign digital currencies in their economies (e-dollarization).
Innovations are typically viewed with caution and their disruptive potential is usually underestimated. While central banks’ CBDC initiatives are not intended to disrupt the banking system, they will likely have unintended disruptive consequences. The pace of disruption will hinge on how quickly network effects take hold in a CBDC system. The more widely digital currencies are accepted, the more opportunity for innovation and the greater the scope for disruption to the financial system.