Whatever your view of the world, some things are indisputable realities.
One such reality is that the last year or so has seen unprecedented worldwide government and central bank intervention. While governments have used the idea of safety to inflate the role of the state, central banks have simultaneously used the consequences of these interventions to inflate the supply of traditional fiat currencies. Even in the face of world war, we have never seen interventions of this scale before.
These two parallel roads have complex moral, ideological, psychological, economic and public health implications. It is not, as some may wish for you to believe, a simple debate.
But perhaps an important question we should be asking now is whether these two roads have a moment of convergence ahead. Is there a point of unification where both roads merge into a high-speed highway?
Of all the changes ahead, Central Bank Digital Currencies (CBDCs) may represent the most likely candidate for this convergence of government and monetary policy.
CBDCs are not a conspiracy theory. They are not a fictitious dystopian fantasy. They are literally in development and in use right now.
The purpose of this article is to explore the future role of CBDCs in our economies and lives. We’ll start by explaining what CBDCs are and how they might work in practice. Then we’ll turn to where this highway could take us as a society and more importantly, how we can carve out an alternative route.
What Is a Central Bank Digital Currency (CBDC)?
A central bank digital currency (CBDC) is a form of electronic money issued by central banks, which represents a digital token of the national currency. CBDCs could be used by households and businesses to make and receive electronic payments of currency issued by the central bank, as well as offering a range of use cases for monetary and fiscal policy.
The concept of CBDCs is seen as an offshoot from the emergence of cryptocurrencies. Indeed, CBDCs may rely on similar underlying cryptography and distributed ledger technology (DLT) to achieve optimal levels of trust and efficiency. From a “tokenomics” standpoint, however, cryptocurrencies and CBDCs couldn’t be further apart in their degrees of centralisation and supply limits.
Key Concept: Tokenomics. A combination of “token” and “economics”, this term refers to the economics of a crypto token. The term encompasses considerations like token supply limits, token release schedules and transactional uses for tokens.
Wholesale CBDCs vs. Retail CBDCs
CBDCs could take various forms but they are broadly categorised into two categories: wholesale CBDCs and retail CBDCs.
A wholesale CBDC would be exclusively issued for financial institutions that hold reserve deposits with a central bank. Wholesale CBDCs would streamline transactional flows, eliminating unnecessary intermediaries and in turn reducing counterparty risk.
In contrast, a retail CBDC would be issued by the central bank for the general public. A retail CBDC would provide a new level of efficiency and traceability for monetary flows in the economy, as well as presenting a range of new monetary policy tools for central bankers.
The narrative from central banks so far has been quite cautious. While the concept of retail CBDCs would potentially pose an existential threat to traditional banking systems, central bank project papers have so far presented a hybrid model. That suggests the initial implementation of retail CBDCs would operate in parallel with physical money and in parallel with the traditional banking system.
With that said, if the well-practiced techniques of landscape amnesia apply, a pure central bank-to-citizen model may be closer than most think.
Advantages of CBDCs
Before we explore some of the most worrying aspects of CBDCs, we should explore the purported benefits. Many of these arguments will be used to justify implementation across the western world over the next few years, so it’s important that we understand them.
#1: Simplification of monetary policy. One of the challenges with traditional monetary policy is that it relies on intermediaries in the banking system. While wholesale CBDCs would streamline transactional flows of currency in the banking system, retail CBDCs would allow central banks to establish a direct connection with citizens. This direct financial connection opens up a range of policy options for expansionary (and contractionary) monetary policy. This could include instant transfers of helicopter money, as well as a range of bespoke monetary policy approaches (more on that later).
#2: Financial inclusion. CBDCs will simplify the process of distributing funds. In some countries this will play an important role in providing financial access without the need to establish expensive banking infrastructure. CBDCs will also help to facilitate government transactions, such as the issuance of benefits like universal basic income (UBI) and the collection of taxes.
#3: Efficient cross-border transactions. CBDCs would enable more efficient remittances from one country to another. This would significantly reduce the costs of sending and receiving currency, as well as increasing competition in the financial sector.
#4: Reduced illegal financial activity. A transparent ledger will make it easier for a central bank to track transactions and prevent fraud. In turn, the central bank can support in reducing illegal activity.
#5: Support for the fintech sector. A CBDC might support and facilitate the emergence of the fintech industry, helping to legitimize and streamline the new technological landscape.
Disadvantages of CBDCs
That all sounds rather interesting, doesn’t it? But if you haven’t detected it yet, there are some worrying disadvantages.
#1: Traceability: You will no longer transact anonymously
Physical cash will not be delegalised immediately. CBDCs will initially be a convenient add-on to the existing system, helping drive transactional efficiency and improve cross-border transactions. But make no mistake, the disappearance of cash is inevitable.
This is significant because it eliminates our ability to transact in a fully anonymous manner. CBDCs will likely use some form of private ledger, offering “controllable anonymity” but traceability and transparency for central banks. In short, that means that in the same way your debit card transactions are visible to your bank, your financial activity will be visible to your central bank. We’ll come to why that may be a bigger problem than it first sounds shortly.
#2: Negative Rates: There will be no option to hold physical cash
In CBDC world, you cannot withdraw your digital tokens and hold them under the mattress. Eventually there is no option for physical cash.
This gives central banks greater flexibility to implement negative interest rates. In doing so, people will be encouraged to use the money or lose the money, increasing consumer spending.
There can be little doubt that with interest rates bound to the floor since the 2008 financial crisis, central banks will not hesitate to drive them through to the basement given the tool in their arsenal.
#3: Programmability: New weapons for serial economy killers
Here’s where things get more worrying. With the centralisation of our relationship with the financial system, CBDCs give central banks a unique opportunity to make money “programmable”.
The major problem central banks encounter with monetary stimulus is that they control the price of money (interest rates) but not the velocity of money. CBDCs change that, offering the opportunity to implement policy to increase or decrease velocity according to their perspective.
Let me give you some examples of how that might affect policy in practice:
- Expiration: With a direct relationship with your central bank, CBDCs could permit a currency expiration policy. Your money could be programmed so that if you don’t spend the $5000 in your CBDC account by next Saturday, it will expire. Think this sounds absurd? According to this Wall Street Journal article, China has tested expiry policies with its own CBDC.
- Helicopter money: CBDCs are a means of delivering helicopter currency quickly and efficiently to the pockets of citizens. With the push of a button, your newly printed fiat currency can arrive straight in your CBDC account. This is in stark contrast to traditional quantitative easing (QE), where the flow of currency relies to a greater extent on financial institutions.
- Lending: With a diminishing role for commercial banks, it’s probable that central banks will begin to play a role in lending decisions. Want a mortgage or business loan? Complete the application on your Freedom App and the central bank will be in touch.
#4: Customisability: Personalised monetary policy
Taken collectively, the issues of traceability, absence of physical cash and programmability raise important ethical questions. By extension, they also raise the likelihood of personalised monetary policy. With a bank of Big Data on individual spending, saving and investing habits, coupled with digital identification infrastructure, the central bank will have enough information to tailor its monetary policy.
Remember: CBDCs provide dual control over price and velocity. We are stretching into scarcely imaginable territory here, but this means stimulus tools might be used where they will have the most impact on velocity, and not necessarily universally.
For example, if it is known that lower earners have a higher propensity to consume, stimulus can be directly delivered to those people. Worse, while central banks are labelled “independent”, personalised monetary policy could become politicised. A government could segment its voters, identify communities where it is behind in polls, and deliver stimulus to these groups.
How to Prepare for CBDCs
Granted, this situation isn’t going to happen overnight. Governments will not push a button and instantly introduce programmable, personalised monetary policy. It may take five years. It may take several decades. Incrementalism will be the key to successful implementation. And while ideas may sound insane now, they are legitimate possibilities later.
The critical point here is that CBDCs are not a trendy extension of the cryptocurrency space. They are in fact an opposing force. They are a trap. Traditional fiat currency on steroids. They are a mechanism for levels of central control hard to imagine for anyone who has grown up in free countries. And sadly, they are close to inevitable. Work is advanced across major economies, and so we need to plan accordingly.
The question is how?
With layers of uncertainty and technological change, this isn’t an easy question to answer. The below are three broad categories of approach, but I’d love to hear your thoughts. You can get in touch here.
#1: Physical Assets
As we transition to CBDCs, the first and most obvious route is to reduce your fiat currency portfolio allocation. In particular, physical asset ownership is going to become even more important. Whether it is productive real estate or perhaps even precious metals, alternatives will be sought which do not offer central banks the same level of controllability and traceability.
#2: Alternative Currencies
CBDCs will encourage more across to the cryptocurrency space. Broadly, there are two distinguishing factors that alternative currencies can offer: (1) finite supply and (2) anonymity.
The majority of the thousands of cryptocurrencies in existence come with finite supply. A very small proportion of these cryptocurrencies likely represent excellent investments in the long run. But is finite supply enough to offer rival utility as currencies?
In this respect, the problem with the majority of cryptocurrencies is that they are transparent. Everybody can see one another’s balance and transactions on a given address. Transactions are public and traceable, and therefore do not resolve the problem of anonymity. Privacy coins (e.g. Monero) may therefore offer the most compelling case where core utility is as a cash alternative.
#3: Playing the CBDC Ecosystem
This is not to say that the cryptocurrency infrastructure does not have value. On the contrary, some of these technologies will be the most important developments of the 21st century. What’s more, they may even serve as a base layer infrastructure for the international CBDC ecosystem. That could (emphasis on could) present a strong opportunity.
There are a few angles here to play the emergence of CBDC infrastructure. CBDCs will need to be interoperable between countries, facilitate efficient cross-border payments, and permit scalable, secure and rapid domestic transactions. There are a few utility tokens that could enable these characteristics. Indeed, it’s well reported that central banks are already working with some of the key players in the cryptocurrency space.
Let’s sum things up:
- A central bank digital currency (CBDC) is a form of electronic money issued by central banks. It is digital token of the national currency.
- Advocates of CBDCs argue that they will help to simplify monetary policy, promote financial inclusion, improve cross-border remittances, reduce illegal activity, and support the fintech sector.
- But CBDCs have some worrying drawbacks. These include the loss of privacy due to traceability, an open goal for negative interest rates, programmable money, and customisable monetary policy by individual.
- We may be able to protect ourselves from these risks through physical asset ownership, alternative currencies with anonymity features, and through capitalising on investment opportunities in CBDC infrastructure.
Time will tell where we end up with CBDCs. For now, I strongly encourage readers to do their own research and reach their own conclusions. Work is happening right now, whether we like it or not, and the initial implementation is closer than most think. It will pay to research and prepare accordingly.