Digital Euro, cryptos, and how could we benefit from the new currencies?

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In the last months we have heard experts, politicians and legislators talk a lot about central bank digital currencies, and how they could represent an advantage for central banks, some claim these could be a game changer for monetary policy since we could explore new ways to implement monetary policy; this being triggered by the current outlook in which we live. Central Banks have often struggled with increasing interest rates and leave the ZLB (Zero Lower Bound), but this might be about to change thanks to central bank digital currencies, also known as CBDCs. Despite all the discussion that has been taking place, there is still some confusion around this new-coined term, and we will try to point out the differences and potential similarities that CDBCs and cryptos might share.

We will start off by defining what a cryptocurrency is. A cryptocurrency according to Oxford: “a digital currency in which transactions are verified and records maintained by a decentralized system using cryptography, rather than by a centralized authority” (Oxford Languages). But this might be too sophisticated to understand, so we will simplify it a bit. Cryptocurrencies base their existence on four basic principles which are decentralization, immutability, anonymity, and scarcity. Let’s explain one of them, taking Bitcoin as an example. Bitcoin is a cryptocurrency which exploits the advantages of the blockchain to create a decentralized network in which no single human voice has power over the transactions made within the network, nor can alter them.

The term blockchain refers to a database which is distributed and shared among the nodes of the network, with all the participants. When a transaction takes place, this change is approved and recorded by all the nodes, this democratizes the writing of information and prevents fraud. The second characteristic is immutability, each and every bitcoin is unique, so are transactions. Transactions can be audited at any time and since they are being stored by all the individuals who make part of the network, we would need most of them to vote in favor of changing the common ledger. This feature makes the Bitcoin system fraud-proof. Anonymity comes from the fact that Bitcoin exchanges public keys when a transaction is performed, these keys do not include any personal information. The last point to address is scarcity, Bitcoin is a scarce currency, just as gold is, it has a limited supply and around the year 2140, no more bitcoins will be created, and Bitcoin mining will cease. Given the cryptographic characteristics of their system and blockchain, it will be technically impossible to increase its supply in the future.

On the other hand, CBDCs work in different ways as cryptocurrencies. Their architecture has not already been constructed for most of the fiat currencies, central banks have just recently started to conduct some research on the different types of approaches that could be taken. CBDC would most probably not use a blockchain framework, using Blockchain would mean they would be constrained to be decentralized which goes completely contrary to the nature of fiat currencies and the nature of a central bank. Nevertheless, immutability and anonymity are some characteristics that will be tried to be preserved. Some scholars have pointed out the privacy issues that CBDCs might give rise to, especially in authoritarian regimes, in which the storage of data could be concerning for citizens or how the management of it could represent violations to their inherent rights.

After this brief but clear comparison we can instantly note the differences and similarities that these two new technologies might or not share, and these are not many. CBDCs do not offer, at the time this article is being written, the advantages that crypto maniacs seek in an alternative currency. Central bank digital currencies could offer new possibilities, but certainly very different from the ones we all might be thinking about. One of these could be the savings in terms both of time and money for customers and small/medium businesses. CBDCs allow for a rapid and intermediary-free exchange. In the current financial system, one payment is processed by the merchant bank, the issuer bank, the network, and the associations, such as Visa, MasterCard or Discover; these actors materialize themselves in the form of commissions that are charged to consumers but also on the business owners. These commissions might represent an obstacle for the exchange of goods, and this is one of the main reasons why Central Banks take a chance on CBDC.

Another way in which we could increase our financial landscape would be increasing financial inclusion, which CBDCs certainly do. In the last few years we have seen an increase in e-commerce sales, and this trend will certainly not fade in the coming years. Many people lack a bank account around the world as reported by the World Bank. In 2017 roughly 1.7 billion adults did not have access to these financial services, this implies these 1.7 adults do not have access to e-commerce opportunities. Here we might see a great share of the market, which is not being served as of now, but if addressed, could increase online sales revenues. CBDCs being a liability of the central bank would not require an affiliation with a commercial bank to enjoy its benefits. Of course, it is important that central banks are careful in their design in a way in which privacy is regarded in a lawful manner and data can be safely stored, so as to avoid data leakages or even system malfunctioning.

Talks about the design of these innovations are underway and various pilot tests are being carried out, such as the digital yuan in China, which comprises a digital wallet in which e-yuans are stored and a QR based system through which payments are easily carried out. It is planned to also work offline to increase its usability, but I think it is a matter of time to see these ideas evolve and come to their implementation. In the same manner working papers are being issued by the European Central Bank in which they discuss the setbacks that such a currency could impose in the actual monetary system. One of the main challenges they walk us through in the paper (January 2020, Nº 2351) is the risk of the total disintermediation of commercial banks and how they would be constrained to offer new financial products which are attractive to customers. This risk could be eliminated though, through the introduction of a two-tier remuneration system, in which citizens are disincentivized to hold CBDCs for a long time through a direct negative interest rate on their digital tokens. This would drive people to spend and avoid the utilization of CBDCs wallets as medium of storage of value.

As we have mentioned before CBDCs could offer a new range of possibilities in terms of monetary policy. As of now we have 2 main non-conventional monetary instruments which could be implemented through CBDCs, so as to accelerate the transmission of monetary policy. These are helicopter money and negative interest rates directly applied onto deposits. On one hand we have helicopter money, which is a term first coined by Milton Friedman in 1969, which refers to the concept of a direct payment to individuals made by the central bank, this to incentivize spending and increase inflation to its desired target rate. On the other hand, we have the introduction of negative interest rates, which could be implemented either by imposing a nominal interest rate or an expiry date on the tokens. These policies would have as an objective, to incentivize spending during low economic growth. Nevertheless, it remains uncertain if we will see their implementation soon and on the whole, it remains a question if these policies are compatible with the legal frameworks in place, not only in the Eurozone but also in other countries.

Certainly we are facing a whole new world of possibilities in the matters of financial services, non-conventional monetary policy and financial inclusion. The question is not who will be the first one to develop a functional CBDC, but who will make a design that can healthily benefit for the economy, in a way that can truly revolutionize inclusion while at the same time not representing a threat to commercial banks.