Central bank digital currencies have reached the point of no return. Over the next few years, financial institutions will turn to these novel instruments into a principal payment device. And, as they do, society will follow — until eventually, physical cash is phased out altogether.

Per a survey by the Bank of International Settlements (BIS), approximately 80% of central banks are actively considering CBDCs and their broader implications. Of that 80%, roughly a fifth have progressed past the conceptual stage and onto construction.

Sky Guo, Cypherium

The majority of those in development are retail iterations rather than the comparatively mundane wholesale variants. Retail CBDCs are what we typically think of when we consider digital currency — that is, spendable, transferable and valuable digital cash. Wholesale CBDCs, meanwhile, essentially act as instruments for interbank settlement, which never see the light of day outside of the internal banking system. In contrast to their retail brethren, wholesale CBDCs bear minimal impact on society besides streamlining banking. 

By far, the most realized retail version of a CBDC is in the hands of China. Progress on the digital yuan — or DCEP (“Digital Currency, Electronic Payment”), as it’s known — has been extraordinary. DCEP is almost fully formed and currently knee-deep in a pilot program. After months of segmented trials, within both business and retail sectors, the People’s Bank of China (PBOC) extended DCEP’s testing range to include the Beijing-Tianjin-Hebei region, Yangtze River Delta, and the Guangdong-Hong Kong-Macau Greater Bay Area.

For PBOC, the race to market is integral. In a recent commentary, the bank remarked on the importance of being the first to launch a CBDC, stating that a rapid release would not only help post-Covid recovery, but break the U.S. dollar’s monopoly as well.

The China-US battle for global financial supremacy

For China, launching the first retail CBDC isn’t merely about bragging rights; it potentially offers a way to pre-empt U.S. sanctions, reduce dollarization, and take back economic control, all while boosting the influence of the RMB.

China’s overt stance on financial supremacy will undoubtedly act as a catalyst for the world’s central banks — and this applies to America more than most. The U.S. has enjoyed the dollar’s status as a de facto global reserve currency for decades, only to have that status potentially imperiled — or at the very least, diminished — by the digital yuan.

However, with DCEP acting as the competitive impetus for a digital dollar, there is the risk of the U.S., and indeed other countries, rushing development and neglecting essential innovations, chief among them being interoperability.

The importance of adaptability shouldn’t be underplayed. If cross-chain compatibility isn’t baked into sovereign CBDCs, they could risk hosting a range of difficulties, including bottlenecking and financial disintermediation.

A collaborative approach, by contrast, extends the advantages of CBDCs by ensuring there are no pain points when exchanging with another national CBDC of a separate design. Without this integral element, CBDCs will be little more than digital replicas of the current fiat cash system, which is rife with inefficiencies — namely, with costly intermediaries and legacy cross-border remittance systems, such as SWIFT.

Opportunities to innovate

Should banks take their time and strike a balance between control and compatibility, the benefits could be limitless.

Retail-focused, cross-compatible CBDCs could improve remittance transfers tenfold, both increasing efficiency and minimizing associated costs. This could also aid financial inclusion by making cross-border transfers cheaper — something that many occupants of emerging economies rely on. Moreover, CBDCs will also drive the remodeling of the current banking infrastructure, which could cater to the unbanked.

However, chief among the advantages of interoperable CBDCs is the ability to eliminate unnecessary intermediate links and rent-seekers, such as SWIFT and various foreign exchange bureaus who capitalize on the current incompatibility between currencies.

Additionally, much like China’s rationale for DCEP, CBDCs could enhance the transmission of monetary policy, potentially expediting recovery from the Covid pandemic. Banks could also lean on the decentralized finance (DeFi) sector, a division of the cryptocurrency industry centered around lending and borrowing. By leaning on the DeFi model and instilling interest-bearing functions into CBDCs, central banks could help deliver the economy from recession, or worse, depression.

With borrowing and lending executed via automated smart contracts, and interest automatically being paid through the smart contracts, the need for expensive intermediaries is extirpated. By enabling qualified parties to issue digital assets backed by real-world assets, such as real estate and stocks, they can be used as collateral to secure loans in CBDCs, bringing immense liquidity into the economy.

With China’s DCEP set for an imminent launch, other central banks will soon pick up the pace. But rather than rush to market, these institutions need to think long and hard about what they’re hoping to achieve.

Will the future of finance be as rigid and segmented as the current system, or will central banks heed the lessons of physical cash and innovate with everything at their disposal?