Central bank digital currencies could transform global financial system

The world is on the cusp of a new revolution in the international financial system – this time it is the regulators that are driving innovation. This new revolution centres on the emergence of smart cash in the form of central bank digital currencies (CBDCs) for use in international payment settlements.

Nigeria has just launched its own CBDC, the eNaira, the first of its kind in Africa.

The Basel-based Bank for International Settlements (BIS), the gatekeeper of the global banking system often dubbed the ‘Central Banks’ bank’, defines a CBDC as “a purely digital banknote that could be used by individuals to pay businesses, shops or each other (called a ‘Retail CBDC’), or between financial institutions to settle trades in financial markets (called a ‘Wholesale CBDC’).”

Banking regulators including central banks, monetary authorities and reserve banks all over the world are currently assessing the potential benefits and drawbacks of introducing a CBDC.

Already 60% of central banks, according to BIS, are “experimenting” with CBDCs, trying to understand the potential impact of their introduction on everything from monetary policy to financial inclusion.

The difference between cash and a CBDC is that we can physically hold cash, whereas a CBDC is available exclusively in digital format. This makes them potentially more user-friendly for consumers and merchants in that payments and remittances can be made remotely. They are safer and more secure and allow transactions to be traced without infringing on privacy rights. 

A CBDC is also guaranteed by the issuing central bank and would be as safe as cash and would have minimal or no counterparty risk. It is a liability on the central bank balance sheet, similar to cash. 

But it should not be confused with money held in a commercial bank account in a digital form such as an online account, which represents an amount owed to you by that bank. It is a claim that you have against the bank. It can be withdrawn in its physical form, but only if the bank is solvent. 

In contrast, a CBDC with legal tender status would not be a commercial bank’s liability, so the holder of the currency would not have to rely on a particular bank’s solvency to be able to maintain a balance.

CBDCs should also not be confused with the spate of cryptocurrencies and digital assets around, most of which are privately issued and unregulated and therefore illegal – or partially regulated, largely because they are nascent, or their regulatory frameworks are being developed in tandem. 

Major step forward

The introduction of a wholesale CBDC took a major step forward in September 2021, when BIS, through its Singapore office, teamed up with four “of the world’s most stable central banks”, the South African Reserve Bank (SARB), Bank Negara Malaysia, the Monetary Authority of Singapore, and the Reserve Bank of Australia, to test the efficacy of CBDCs in international payments in a pilot project. 

“The aim,” says BIS’s Andrew McCormack, “is to develop prototype shared platforms for cross-border transactions using multiple CBDC platforms, which will allow financial institutions to transact with each other in digital currencies issued by participating central banks, eliminating the need for intermediaries, and cutting the time and cost of transactions and laying the foundation for global payments connectivity.”

It is also to explore different governance and operating designs for CBDC infrastructures. 

SARB, according to Deputy Governor Rashad Cassim, has been doing years of domestic research and exploration on CBDC payments and interoperability. It would be poised to lead such a regional wholesale CBDC settlement system in the Southern African Development Community. 

Cross-border payments are essential for the settlement of global trade, remittances, e-commerce, tourism receipts and even sovereign debt obligations.

Multi-currency and cross-border payments are more complex, adding to risks and costs. Most are settled through correspondent banking arrangements, traditionally through banks in New York for dollar transactions, in London for sterling transactions and Frankfurt for euro transactions.

As such, CBDCs have enormous transformative potential for the global financial system. But the approach is a work in progress. Its development and testing raise as many questions as they answer. These include what impact CBDCs could have on capital flows and global financial stability if the associated risks are not properly managed.   

CBDC research and testing has gained in strength since the Covid-19 outbreak. If carefully implemented, they could produce large economic gains by increasing financial inclusion and reducing friction within the system.