Why are central bank digital currencies (CBDCs) now and what they might mean for climate change? (1/2)

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This is the first of two articles. You can find the second article here.

Mike Novogratz, founder of Galaxy Digital, recently joked: “Bitcoin is a report on how central banks are doing.” Could one of the central bank’s emerging digital currencies (CBDCs) trump Bitcoin’s card? With central banks’ mandate on climate change looming, what could the CBDC mean for climate change?

Major central banks around the world are in a tight race to deliver the first credible version of digital currency. China is testing a digital version of the renminbi, through which customers can make payments on their mobile phones. Europe has announced the launch of a digital euro as part of the five-year plan. The Fed has announced that it will release a discussion paper this summer regarding digital payments, including the respective calls and threats of a central bank digital currency.

The following are some considerations before the Fed Discussion Paper.

How would CBDC be different from Bitcoin?

From a taxonomic standpoint, digital currency is currency that is not held in physical form. It can be a (digital) token or an account. Crypto currency, like Bitcoin, is digital money in token format, which is supported by blockchain technology. This technology is based on a distributed database managed by several stakeholders. In addition, it uses cryptography to satisfy a consensus protocol and validate the underlying transactions. This combination enables peer-to-peer transfers over a network.

Cryptocurrency does not represent a claim on an issuing entity; as such, its status as an offer is based on an adoption dynamic, influenced by human behavior and psychology. And finally, (private) cryptocurrency is fully decentralized, far from a central governance structure. The main reason cryptocurrency came into being was to make payments without trust (avoiding counterparty risk), in the face of the 2008 financial crisis, outside the traditional banking network and its payment rails. who as a result.

On the other hand, CBDC is digital currency issued by a central bank, without first resorting to distributed ledger technology (DLT). Given the decentralized and distributed nature of database management, this technology is not equipped to protect privacy, especially if the CBDC is account-based. The CBDC is legal tender and private citizens would hold a direct claim on public money, alongside their claims on private money through the banking system. The CBDC could be implemented in two ways, through the existing banking system as an intermediary or directly through mobile phones.

Stablecoins, such as Tether or Facebook’s Diem, are private cryptocurrencies (so far) issued by entities whose underlying value is tied to some form of collateral.

But why CBDC in the first place?

Innovation and modernization are necessary due to several shortcomings of the current analog and digital infrastructure. Cashing a check involves a float (the time it takes for your account to be credited with the payment amount) of three days. With international remittances, this float can be extended to four full days, sometimes a week. With pricing at 3% on average, ignoring the drop in the exchange rate, such utility becomes prohibitive.

Alipay currently executes 120,000 transactions per second in terms of execution speed benchmarks, while Visa trails at 65,000 transactions per second. Bitcoin, weakened by its intensive and energy-intensive consensus supported by the blockchain protocol, processes approximately 4.6 transactions per second.

The Fed, separate from any CBDC initiative, will shortly be launching the FedNow service, a new 24x7x365 real-time gross settlement (RTGS) interbank service with built-in clearing functionality. Starting in 2023, this service will allow individuals and businesses to send instant payments through their depository institution accounts.

A CBDC, depending on one of the options, should however be able to provide instant settlement with 24/7 continuous availability, directly to the end customer, the retail customer. In addition, the CBDC should have the capacity to resist, absorb and recover or adapt to adverse conditions. And if the CBDC was offered directly to retail clients, strong anti-money laundering and know-your-customer procedures would have to be implemented.

A CBDC should also be designed to interoperate and facilitate cross-border payments as well as foreign currency payments. Interoperability between different payment systems and alternative blockchain platforms will be a crucial part of the design. DAML and Darrell Duffie of Stanford University published an article in April examining the fundamentals when choosing and implementing (interoperable) technology to support CBDC.

Regarding inclusion, Governor Lael Brainard revealed at the May 2021 Coindesk conference that 5.4% of U.S. households do not have access to bank accounts and associated payment options, while 18.7 Additional% were underbanked in 2017.

These statistics struck even more when the cash stimulus payments, issued by the government to ease the hardships of the Covid pandemic in 2020, were severely hampered by missing IRS data and incomplete banking data sets.

Thus, a CBDC could minimize payment fees, increase expediency, provide transparent cross-border and inter-currency payment service, and promote inclusiveness.

What about the CBDC and monetary policy?

The CBDC’s public money function could also extend monetary policy tools beyond the current twenty-four primary market brokers. In the future, PayPal and members of shadow banking (hedge funds, private equity firms, etc.) could potentially gain direct access to the discount window and monetary policy intervention mechanisms. This privilege would undoubtedly be associated with regulatory liquidity and solvency policies.

What could be some of the unintended consequences of the CBDC?

The total amount of currency in circulation is valued by the M2 monetary aggregate and currently stands at around $ 20.4 trillion in the United States, an increase of 33.3% since January 2020. Not always fully understood intuitively, the commercial banking sector initiates much of the currency. creation. These banks create money, roughly $ 10.4 trillion, through a process called fractional reserve banking. Banks continually lend money to economic agents, but these loans are only backed by a fraction of their reserves. In addition, the banks’ hypothesis is based on the fact that depositors do not jointly request cash withdrawals at the same time.

Central banks, on the other hand, create money in two ways. First, thanks to the issuance of banknotes and coins, there are currently about $ 2 trillion in circulation, about half of which is believed to be held abroad, sometimes with nefarious intent.

Second, quantitative easing stands at around $ 8 trillion, according to the Fed’s record. Finally, quantitative easing is facilitated by a digital line of credit advanced by the Treasury to the benefit of the Central Bank, through which it can inject money into the financial system in exchange for securities or to benefit from helicopter money.

The issuance of CBDC would be the third channel of money creation. The latter could create deposit competition with the private banking sector in regular periods, but exacerbate bank runs in times of financial crisis. In addition, customers would speed up the withdrawal of deposits from commercial banks for more secure deposits with central banks.

A different but crucial unintended consequence could be the violation of data integrity and confidentiality rights. CBDC payments, if transferred directly to private customers’ cell phone wallets, could now become fully traceable by the government with respect to the type of goods and services purchased, including their location and timing. This potential privacy breach could spark more interest in the trustless payment execution function offered by cryptocurrencies, unless compelling CBDC breakthroughs are made on the data protection front. .

This is the end of the first article. You can find the second article here.


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