What Is Central Bank Digital Currency (CBDC)?
By: J SCOTT
With all the talk about banks over the past few banks, I’m starting to hear a lot more rumbling about Central Bank Digital Currency (CBDC), with many people in my circles talking about how the current situation will likely hasten the Fed’s rollout of such a technology.
So, with the expectation that we’re going to start hearing the term CBDC (or some variation) a lot in the near future, I wanted to provide a brief introduction to what CBDC is, what it isn’t, what’s good about it, what’s bad about it, and how it’s likely to impact us.
WHAT IS CBDC?
Central Bank Digital Currency is a digital form of fiat currency that is issued and backed by a central bank.
Let’s break that down a bit:
A fiat currency is simply a currency created (out of thin air) by a government to allow trading within a national or global economy. That’s a fancy way of saying just a regular currency. The US Dollar is a fiat currency. The Mexican Peso is a fiat currency. The Chinese Yuan/Yen is fiat currency. The Euro is fiat currency. Etc.
A central bank is a government institution responsible for monetary policy for that government’s currency – they control the money supply.
So, when we talk about a CBDC in the United States, what we’re talking about is a digital form of the US Dollar that is implemented and controlled by the Federal Reserve. And it’s not just the US who is working on implementing this technology; several prominent countries are talking about enhancing or replacing their fiat currencies with CBDC.
One thing to keep in mind – digital currency isn’t a new concept. Many countries – including the United States – already use forms of digital currency to facilitate transactions between the government, banks and even consumers.
When you buy a house, you probably never see even a physical dollar of the money that goes between you, the seller or the bank. When you use Uber, you don’t hand the driver cash. And when you Venmo dinner money to a friend, that’s done completely electronically.
So again, digital technologies around currency are not new. What’s new is the concept of doing away with physical currencies altogether. And that’s what is generally referred to these days as CBDC.
HOW DOES CBDC WORK?
Again, CBDC is just a digital representation of a country's existing fiat currency, which is issued and backed by the central bank. CBDC in the United States would be a digital representation of the US dollar created and controlled by The Fed. While we don’t know exactly what it would look like, eventually it could entail all consumers having an account with the Fed, just like they currently have accounts at a bank.
The Fed would serve as both the issuer of the currency, and the bank that distributes and manages it. Instead of printing money through the treasury, the Fed would create digital coins/currency that had the same guarantees and protections by the government as paper currency.
In theory, consumers would be able to access this digital currency through electronic wallets or accounts, using their digital dollars to transact and purchase just like they would with physical currency. When you get paid at work, the money would go into your "Fed account" and be available through your digital wallet. When you buy something, you'd pay using your digital wallet.
Not much different than now for many things -- if you work a W2 job, you probably already get direct deposit of your paycheck and when you buy many things (a house, an Uber ride, etc), you probably rarely use cash.
CBDC takes this to the next level, where ALL transactions are handled without physical currency and everyone is using the same “bank” so that transactions are immediate and seamless.
THE GOOD, THE BAD, THE UGLY
There are lots of reasons to like the idea of CBDC, there are lots of reasons not to like it, and there are a few reasons to be completely skeptical. Let’s take a look...
While many people are not big fans of the idea of fully digital currency (and we’ll talk about some reasons for that below), there are some advantages of a full CBDC implementation:
* If you’re like me, you probably rack up hundreds/thousands of dollars per year in fees from digital transactions. Whether it’s sending or receiving wire transactions, PayPal fees, or other fees from various electronic payment systems, it’s adds up quickly. Banks earn billions of dollars per year on these fees. And for those who live paycheck-to-paycheck, these fees can often put them into long-term debt that they can’t escape. With CBDC, fees on electronic transactions (which are ALL transactions) go away, because all transactions are going through a centralized system controlled by the Fed.
* When was the last time you sent a wire and had to wait hours (or days) for it to arrive. Crazy that we live in such a technologically advanced world, but we can’t send money from our bank account to a title company (or vice-versa) at the touch of a button. With CBDC, we get efficiency in transfers and won’t have to wait for banks to communicate with one-another to facilitate a payment.
* There are currently a lot of people without access to bank accounts. I was surprised to find this out a bunch of years ago when I purchased a multifamily property in a lower-income area. Many of my tenants were paid in cash, didn’t trust banks (or didn’t have transportation to get to the bank), and pretty much only had the option to pay me in cash. As a landlord using a property management team, I don’t like cash – there are simply too many ways for that money to disappear. With CBDC, these disenfranchised folks who don’t have ready access to banks are now able to more actively participate in important transactions like digital payment of rent.
* You might not care about this one, but you should: With an all-digital economy, the Fed has complete insight into how much money is moving through the system, and how. This means we wouldn’t have to wait weeks or months to get inflation reports, GDP reports or other financial data that helps the Fed control monetary policy. With CBDC, the Fed would have more direct insight into the economy and could tweak monetary policy in real time.
As you can see, there are definitely some important benefits, especially for those who are more marginalized and who aren't in a position to use banks in their favor.
But, it's easy to find some drawbacks as well...
* I think many of us can agree that the government often doesn't do things efficiently, and this initiative would effectively be an overhaul of our entire financial system. Would the Fed/government get it right? Would they cause more financial instability than they were creating? Would we have good integration with other payment systems that we were accustomed to using, and if not, what happens to all the money we have in those systems?
* Unless the government forces all vendors and merchants to start accepting CBDC as payment -- which is likely eventually -- it's quite possible that most merchants are going to be resistant to change, and we'll see slow adoption. If the government tries to force adoption early-on, it could lead to push back by both consumers and vendors, creating new challenges for the government to implement the technology.
* While this could be an entire separate article, the implementation of CBDC could spell bad news for banks, especially commercial banks. It's quite possible that we see many banks go away, and the products that we rely on from these banks (loans, for example) to dry up and become less consumer-friendly due to reduced competition.
* While this could be in the pro or con side of the list -- depending on where you fall in the socio-economic spectrum, Fed oversight of all transactions would give the government the ability to assess taxes directly. No longer would the IRS need you to communicate your annual tax situation, as they'd already have all the information at their fingertips.
Okay, so those are some not-so-good aspects of a CBDC rollout. But, then there are some downright scary scenarios that could play out, especially if you're distrusting of the government.
* First and foremost, there are obvious privacy concerns. The ability to use physical cash and private payment systems provides the ability to "hide" transactions as we see fit. Don't trust the government (or maybe your employer) knowing that you buy a 12-pack of beer every night, you may not have the option to pay for that in cash anymore. Don't trust the government (or maybe your health insurance company) to know that you eat a couple Big Macs every night for dinner, good luck keeping that information from them.
* Perhaps the biggest concern is how the government could use this centralized system of currency to unlevel the playing field even more. What happens when large corporations can go directly to the Fed for loans or bailouts, while the rest of us have to compete through banks. What's to stop the Fed from giving loans at one interest rate to some people/companies and other interest rates to other people/companies? How would we know?
Nobody knows exactly where CBDC is headed or how it will look 5, 10 or 20 years into the future. Remember, we already have a significant portion of our economy that operates fully electronically, so it’s possible that we could see a slow rollout that takes years or decades to change how we do things.
But, based on how things are currently progressing, it's probably safe to say that we're heading towards this technology faster than we have been before, and there's probably no stopping it now.