Will digital currencies change the finance sector?

Cryptocurrency has been around since the 1980s, and popularised with the launch of Bitcoin in 2009. Since then, many other altcoins have appeared including Ether and Litecoin. Now that the use of cryptocurrencies has become fairly mainstream, central banks are considering creating their own digital money referred to as central bank digital currencies (CBDC).

Originally, banks and governments were not supportive of cryptocurrencies due to the perception that they offer anonymity and could be used for criminal activities like money laundering. Bitcoin was created to decentralise currency and utilises blockchains because they are immutable. This means that data entered is irreversible, therefore transactions are permanently recorded although it is encrypted. In the case of Bitcoin and Ether, they are certainly not untraceable. The public ledgers upon which they are founded can be analysed by anyone, including law enforcement agencies.

The  financial sector  has recognised that cryptocurrencies might help to strengthen markets and because so much activity now takes place online, official digital currency may be advantageous. It is also to the customer’s advantage as digital transactions with CBDC allow cross-border payments without the usual fees and time constraints. The Bahamas has fully launched a CBDC called Sand Dollar which is for domestic use only and prohibited from acceptance by non-domestic payees. Nigeria became the first African country to issue a CBDC in the form of eNaira in October 2021.

Which countries are considering CBDCs?

China’s e-CNY had more than a hundred million wallets registered for individual domestic users and saw billions of yuan in transactions in pilot runs before its international debut for global users during the Winter Olympics in February 2022. It is a CBDC, but it does not operate on blockchain. Sweden’s Riksbank has developed a concept and is now stress-testing the technology and understanding the implications on monetary policy.

The European Central Bank (ECB) announced in 2021 that it was progressing its digital euro project into a more detailed investigative phase. According to a paper for The Bank of International Settlements (BIS) entitled ‘Ready, steady, go? Results of the third BIS survey on central bank digital currency’, more than four-fifths of the world’s central banks are also engaged in similar pilots or the early stages of other CBDC activities.

In February 2022, at the Atlantic Council in Washington, IMF Managing Director Kristalina Georgieva stated that there was no universal case for CBDCs because each economy is different. She also outlined three lessons that had been learnt through discussions with the central banks of China, Sweden, Canada, Uruguay, the Bahamas, and ECCU (Eastern Caribbean Currency Union):

• No one-size-fits-all: in some cases, a CBDC may be a vital route to financial inclusion, in others, a CBDC could provide an essential backup in the event that other payment instruments fail.
• Financial stability and privacy considerations are paramount to the design of CBDCs.
• Balance between developments on the design front and on the policy front.

Georgieva’s speech came in the wake of the Federal Reserve issuing a report which took into consideration that “a CBDC could fundamentally change the structure of the U.S. financial system.” The report is called Money and Payments: The U.S. Dollar in the Age of Digital Transformation and was commissioned by the Fed without favouring any particular policy outcome but to invite comment from the public.

With the rise of fintech, new forms of digital money are increasingly being used by consumers and businesses, particularly since the pandemic broke out and banknotes became less popular. However, those forms of money are liabilities of private sector entities such as commercial banks. A CBDC is a liability of a central bank such as the Federal Reserve or the Bank of England, which is why the introduction of a CBDC is a risky proposition for the policymakers of these financial institutions. Despite this, in 2021, the UK government created a task force between HM Treasury (HMT) and the Bank to explore a retail CBDC for the UK.

Why are cryptocurrencies so volatile?

Electronic money like Bitcoin experiences price fluctuations because it is influenced by supply and demand, how much people are investing in it or trading in other digital cash, and the effects of media hype, for example when Elon Musk mentions Bitcoin in his tweets. Some cryptocurrencies are known as stablecoins, which means that the price is pegged to cryptocurrencies or more stable assets such as fiat money and exchange-traded commodities like precious metals. These offer more financial stability, which is more attractive to the banking sector, especially since the financial crisis of 2008.

Stablecoins are not the same as CBDCs – they are still non-bank altcoins – but they do offer some safeguards which have influenced the approach to designing central bank money which is digital. The Bank of International Settlements lists the possible merits of stablecoins as enhancing anti-money laundering efforts, offering operational resilience, protecting customer data, and ensuring financial inclusion, tax compliance, and cybersecurity.

Issuance numbers also play a part in the value of altcoins and relative inflation. For example, Ether follows the same model as Bitcoin in that its rewards and distribution are regulated on an annual basis. Ether issuance is capped at 18 million a year, but Bitcoin has a hard total cap of 21 million. Since its conception in 2009, Bitcoin has not had much experience with rising interest rates, which is believed to be what has seen its value (and that of other altcoins) plummet recently.

The pros and cons of cryptocurrencies

In September of 2021, the government of China (which is the single largest market for cryptocurrency), declared that all cryptocurrency transactions were illegal. This completed a crackdown on cryptocurrency that had started with the banning of the operations of intermediaries and miners within China. The impact of this on Bitcoin was considerable as China accounted for 46% of Bitcoin mining in April 2021 (down from 75.5% in September 2019).

Although the Chinese government often states fears of illegal financial activities and money laundering as reasons for cracking down, the environmental impact of blockchain is also huge. The especially large carbon footprint has been known to increase to a consumption of 141 terawatt-hours (TWh) on an annualised basis. As a comparison, approximately 70 TWh is more than the consumption of the entire country of Venezuela.

Despite fears of blockchain-enabled digital cash being used by criminals for large digital payments, the interoperability of blockchain has made supply chains more transparent. It also offers the ability to send international payments directly and automatically to small-hold farmers or producers in remote areas, enabling truly fair trade.

In response to concerns over sanctions being easily evaded by electronic money, Sean Stein Smith of the City University of New York wrote in an article for Forbes called Bitcoin Is Showing the Power of Decentralized Money, that “as large as the cryptoasset space has become, the liquidity that is available simply would not be enough for widespread sanction evasion at the nation-state level.” 

Ultimately, government-backed digital fiat money has the potential to offer financial services at a lower cost to both providers and customers and investigations into its viability continue.

Ready to discover more about the cryptocurrency ecosystem?

Learn more about cryproassets such as stablecoins, NFTs, and CBDCs and how they are changing payment systems in the banking sector. 

With a 100% online MBA Finance from the University of the Commonwealth Caribbean (UCC), you can gain vital insights into how the banking landscape could be altered by CBDCs and equip yourself with the knowledge needed to navigate the new terrain.