T. ROWE PRICE INSIGHTS ON GLOBAL ECONOMICS Why Central Bank Digital Currencies Will Revolutionize Banking CBDCs should boost financial inclusion and improve efficiency. May 2021 KEY INSIGHTS ■ Central banks across the world are exploring the introduction of digital currencies to address long‑standing issues with the fiat money system. Tomasz Wieladek ■ In advanced economies, central bank digital currencies (CBDCs) will likely have International Economist a revolutionary impact on the payment system by fostering greater financial resilience, promoting efficiency, and reducing costs. ■ In emerging markets, greater financial inclusion through CBDCs may help mitigate business cycle volatility and reduce interest rate risk premia. Aadish Kumar International Economist rivate sector cryptocurrencies— In this first article in a series, we discuss digital assets used as a medium the technology behind cryptocurrencies Pof exchange—have received a and explore the economic consequences lot of public attention in recent years. of this monetary evolution. Now, central banks across the world are exploring the introduction of central Long-Standing Problems Solved bank digital currencies (CBDCs) to With New Technology address long‑standing issues with Fiat money has three main economic the fiat money system and to boost purposes: first, to facilitate economic financial inclusion. transactions by providing a universal means of exchange; second, to store the CBDCs will likely lead to structural value of savings; and third, to provide a changes in the way that individuals unit of account for all goods and services and businesses access the banking in the economy. The money provided system, potentially improving financial by central banks and facilitated by resilience and reducing business cycle commercial banks into the wider economy volatility. These changes will have already fulfills these purposes well, as had investment implications, particularly in been the case for most of the 20th century. emerging markets where we believe CBDCs will bring the biggest There are several flaws with the current benefits. The differing pace of CBDC system, however. One is that the fast implementation, and the potential retail payment system in most advanced benefits for each economy, will also economies involves temporary create relative value opportunities. counterparty risks. Another is that payment system inefficiencies can lead FOR INVESTMENT PROFESSIONALS ONLY. NOT FOR FURTHER DISTRIBUTION. 1 to retail banks charging excessively support greater financial inclusion and high fees for clearing payments. A third make a significant contribution to greater flaw in the current system is that payment system stability. individual citizens and businesses can be financially excluded because We believe that major private sector a retail bank account is necessary to currencies like bitcoin or Ethereum participate in the system. By adopting are not useful for these purposes as CBDCs, central banks hope that their high price volatility makes them these long‑standing issues can finally less suitable as a means of exchange. be addressed. However, asset‑backed currencies such as stablecoins, some of which A CBDC is a digital form of money are directly anchored to fiat currencies issued by the central bank denominated and are intended to be stable in value, in the national unit of account and has satisfy the medium of exchange and the same underlying value as existing store of value definition of money. If fiat money. Like fiat money, it is a stablecoins become a widely accepted liability on the central bank’s balance medium for transactions, this will sheet and can be used as a medium of effectively lead to private sector exchange and store of value. However, competition for the central bank’s unlike fiat money, a CBDC can utilize monopoly on the money supply. distributed ledger technology (DLT) for intermediation rather than relying on the For all these reasons, central banks traditional banking system. are acting rapidly to introduce the new technology into their payment and DLT allows transactions to be settled in financial systems. A survey of 65 central real time through direct access to the banks conducted by the Bank for central bank’s balance sheet rather than International Settlements shows that commercial bank money. An example 86% are engaged in some form of of DLT is blockchain technology, which CBDC research, with 60% conducting has a specific set of rules and is used as experiments or proof of concept while the platform for bitcoin. Different rules 14% are in the development and pilot can be applied to distributed ledgers arrangement stage.1 Wholesale CBDCs to suit the needs of the users. In the would be exclusively available to case of central banking, direct access financial institutions that hold deposits to the central bank’s balance sheet can with the central bank, whereas retail Financial Inclusion Is a Key Reason for CBDCs in Emerging Economies (Fig. 1) Payment safety is the main reason in OECD countries Advanced Economies (1) = Not so important (3) = Important Emerging Market and Developing Economies (2) = Somewhat important (4) = Very important 4.0 3.5 3.0 2.5 2.0 1.5 1.0 Average ImportanceAverage 0.5 0.0 Financial Financial Monetary Policy Payments Efficiency Payments Efficiency Payments Safety/ Other Inclusion Stability Implementation (Cross-border) (Domestic) Robustness As of December 31, 2020. Source: Bank for International Settlements. 1 As of December 31, 2020. 2 CBDCs would be issued for use by the Another important potential impact public. In this article, we are focusing of CBDCs will be to lower the cost of on retail CBDCs as they are the main transfers, which is particularly relevant focus for central banks. for individuals and businesses in emerging markets. Current digital CBDCs Will Likely Revolutionize the payment systems can be expensive for Payment System small and medium‑sized businesses as CBDCs will likely have a revolutionary costs often involve a flat transaction fee impact on the payment system by and, depending on volume, a percentage fostering greater financial resilience, of the value of the transaction. promoting efficiency, and reducing costs. Current payment systems often involve Greater financial inclusion in emerging transfers of commercial bank money, market (EM) economies will likely which are then settled on the central bank translate to increased access to credit for CBDCs will likely balance sheet. Although the payment is individuals and businesses in the short cleared instantly, the settlement between term. Since the demand for borrowing will have a revolutionary banks on the central bank balance sheet likely exceed the rise in savings, interest impact on the is not instant. Credit exposures between rates may initially rise. In the medium banks accumulate due to the delay, term, however, greater financial inclusion payment system which leads to credit and liquidity risk. should allow firms and households to It is only when the transfers are made build buffers in the form of saving and by fostering greater in the central banks’ accounts that all borrowing in response to shocks, which claims are finalized. in turn will likely reduce business cycle financial resilience... volatility. Lower growth volatility would — Aadish Kumar Transfers in CBDCs eliminate credit result in lower interest rate volatility— International Economist risk as they involve transferring the potentially reducing the risk premium direct claims on the central bank embedded in EM sovereign yields. from one bank to another rather than holding funds at an intermediary. Greater Financial Inclusion May The transactions would be settled in real Reduce EM Risk Premia time using central bank money rather For central banks operating in than commercial bank money. While developing economies, where fewer this difference appears to be just a detail people have bank accounts than in normal times, we believe that the in advanced economies within the payment system would be significantly Organisation for Economic Cooperation more resilient in a banking crisis or and Development (OECD) “financial during a cyberattack, when counterparty inclusion” is cited as the most important risks are significantly higher. motivation for introducing CBDCs Bank Account Ownership Is Lower in Emerging Markets (Fig. 2) In OECD countries, more than 90% have bank accounts Sub-Saharan Africa East Asia/Pacific Latin America & Caribbean OECD Members 100 80 60 40 20 Population Ages 15+ (%) Ages Population 0 2011 2014 2017 As of June 30, 2018. Most recent data available. Source: World Bank. 3 (see Figures 1 and 2). Financial inclusion document a steady income and use means that individuals and businesses this information in the loan application have access to useful and affordable process, reducing or eliminating financial productions and services to the dependence on peer pressure. meet their needs. This includes the CBDCs could therefore help ability to make payments, to save, and to supercharge micro‑credit to financially access credit and insurance. excluded people without collateral. A CBDC can help to promote financial CBDCs Are Not Without Risks inclusion by providing a form of money, Despite these potential benefits, issued by the central bank, that can the introduction of CBDCs is not without be accessed using a smartphone risks for the banking system. Unlimited For central or a digital card and is accessible direct access by retail clients could to individuals without