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Role of CBDCs in Achieving Global Financial Stability

CBDC

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Central Bank Digital Currencies (CBDCs) are a plausible solution to the global financial system’s issues. CBDCs are digital versions of traditional fiat currency, issued and backed by central banks and governed under their oversight. They offer numerous advantages over traditional payment systems.

CBDCs could achieve global financial stability through increased transparency and control over monetary policy. 

Background of CBDCs

Introducing a central bank digital currency (CBDC) has become a serious topic of discussion among governments and financial institutions.

Proponents of this new form of digital cash cite its potential convenience and security, but there are substantial concerns over its ramifications on financial stability.

Opponents have hypothesized that having access to CBDC could lead to more frequent or severe runs on banks and other similar entities.

To better understand this possibility, researchers showed two countervailing effects when introducing CBDC into their equation. On the one hand, issuing CBDC would increase liquidity in times of crisis, but on the other hand, increased use of CBDC could also lead to a decrease in confidence in the banking sector, leading to more runs. The paradox suggests that there may be different outcomes depending on how and why users switch from traditional forms of money to CBDCs in these periods.

Office of Financial Research (OFR) opinion on CBDCs and financial stability

OFR is a US-based research organization answerable to the department of treasury. Its role is to promote financial stability by studying economic systems to measure and analyze risks, perform essential research, and collect and standardize financial data.

Banks lower maturity mismatch reducing their exposure to depositor runs thanks to CBDCs

Banks fulfill an essential role in modern economies: they provide depositors with liquidity services and access to credit via loans. However, the mismatch between their liquid assets and longer-term liabilities makes them vulnerable to a bank run, where too many depositors demand immediate payments at once. 

The development of Central Bank Digital Currency (CBDC) alleviates this liquidity risk by providing a digital means for individuals and businesses to access funds quickly. 

According to the OFR model, a CBDC would reduce the demand for banking services by fulfilling much of it directly on its platform – providing more stability for banks. Banks can then respond by reducing the maturity mismatch on their balance sheets, making them less susceptible to a run and better able to weather systemic shocks within the financial system.

CBDC provides policymakers with a new source of real-time information

By enabling policymakers to observe the flow of funds into a CBDC in real time, they can gain insight into the state of the financial system and depositors’ confidence in their banks. 

Transaction transparency is beneficial during moments of financial stress. For instance, when individuals withdraw their funds from banks out of fear for their solvency or due to personal liquidity needs, monitoring flows into a CBDC will allow officials to identify a potential run on the bank sooner and act swiftly by placing it into resolution. In addition, this would reassure depositors that safe money management practices are being observed, thereby decreasing further incentive for them to participate in the run. 

In other words, this information effect adds another layer of stability to the financial system – one that governments could accomplish with a CBDC.

CBDC risks to financial intermediation

One of the biggest criticisms facing Central Bank Digital Currencies (CBDCs) is the potential impact they could have on the finance industry. A widespread view is that these digital assets could steal potential deposits and payments from traditional banking activities, potentially leading to decreased lending and financial instability. 

Many governments, as a result, have been understandably hesitant to introduce a CBDC. However, recent research suggests this issue could be clearer-cut and that introducing a CBDC could prove manageable for banks regarding intermediary activities and lending. In light of this evidence, more nations are considering issuing their version of a central bank digital currency.

Central banks play a defining role in determining the risk associated with CBDCs. Through their choices, central banks can trust financial entities to distribute CBDCs and leverage their skills to provide front-end services. Central bank decision-makers also wield power over design features that greatly influence the potential demand for CBDCs. For example, if central banks play their cards right, safeguards such as tiered remuneration or holding limits can successfully limit these risks. Central banks may also provide favorable funding to mitigate money market fluctuations should changes occur in the composition of bank funding.

Central Bank Digital Currencies (CBDCs) can positively impact the financial system beyond reducing the demand for cash. Issuing CBDCs could support confidence in payments and provide a reference value for private money. Moreover, it could foster competition by lowering the bank’s market monopoly, improving capital allocation by decreasing transaction costs, and making payment opportunities more innovative and accessible to everyone.

CBDCs can increase financial intermediation. Providing a remuneration on CBDC transactions could force banks to raise the interest rate on their deposits, leading to more CBDC and deposit balances in addition to increased lending. Even when this is absent, a ‘crowd-in effect” still exists. As cash usage decreases, a CBDC serves as a substitute for deposits and sets a floor on rates which helps limit banks’ dominance.

CBDCs in times of financial crisis

New research shows that the introduction of CBDCs could help contain digital runs. A key benefit of CBDCs compared to cash is that they can be held in large volumes and at no cost, which could lead to increased risk of bank runs if other lines of defense, such as deposit insurance, supervision, and the lender of last resort, fail.

CBDCs, through smart contracts, can mitigate these risks. In addition, concerned parties can obtain real-time information about depositor flows from CBDCs; this would stabilize expectations and increase depositor confidence.

CBDCs’ impact on monetary policy

CBDC is a relatively new technology, and researchers are studying its implications for monetary policy. However, though this research is still in its early stages, its significance should not be underestimated. Studies have highlighted how CBDCs without safeguards could weaken monetary policy transmission and impact banks’ funding structures and financing conditions.

The studies focus on how convenient it is and if it offers competitive remuneration rates. Researchers need to consider all of these factors when researching the implications of CBDCs for monetary policy.

Many investors have recently looked to CBDCs as safe and high-yield assets, but large deposit outflows threaten their usefulness as a payment instrument. While capping the amount of CBDC a person can own could help control this issue; it also reduces CBDCs payment potential.

A practical solution might be to link citizens’ CBDC accounts with private money accounts, enabling larger payments without affecting the scale of the currency. An alternate idea is a tiered remuneration, disincentivizing excessive CBDC holdings above a certain threshold by making them less attractive. Finding lasting solutions like these will ensure that digital currencies remain useful in achieving global financial stability.

How regulators can ensure that CBDCs don’t destabilize the global financial system

Regulators should ensure that CBDCs do not undermine their currencies’ sovereignty and financial systems’ stability. They should:

  1. Examine whether central banks can issue digital currency, manage different associated risks, prevent money laundering and other illegal activities, and protect user privacy.
  2. Assess the impact of CBDCs on monetary policy and examine how the central bank can issue CBDCs in a way that does not create new destabilizing incentives for global markets or regional economies. 
  3. Consider how these digital assets will interact with existing payment infrastructures and how they can help facilitate smoother domestic payments across borders.
  4. Ensure that CBDCs are designed and implemented in a way that does not create systemic risk. They can achieve this through sound regulatory frameworks, policies, and robust cyber-security measures. 
  5. International cooperation is also crucial to developing shared standards for digital currency systems that enable greater interoperability between domestic payment networks. 

With all these elements in place, regulators have an essential role in mitigating the risks associated with CBDCs while allowing them to achieve their full potential.

An opportunity for global cooperation

The emerging landscape of CBDCs is diverse, with more than 100 explored and developed worldwide. 

Each country has its motivations for CBDC plans, and geopolitical uncertainty and financial instability drive even more significant consideration of this move. 

Regional roundtables are essential to ensure that they build these new digital currencies in a way that helps to support global economic stability and in discussing the best practices for creating an integrated and interoperable system to support CBDC use.

FAQs

What is a monetary policy?

Monetary policy is the process by which a central bank controls the money supply, interest rates, and other elements of economic activity to promote financial stability and growth.

What is a 'bank run'?

A bank run is a situation in which many customers withdraw their deposits from a financial institution for fear that it may be unable to honor its obligations.

Is CBDC a cryptocurrency?

No, CBDCs are not cryptocurrencies. Cryptocurrencies are decentralized digital currencies that use cryptography for security and have no central issuing authority. Central Bank Digital Currency (CBDC) is an electronic form of money issued by a central bank and controlled by the same authority.

Will CBDC replace cash?

No, CBDCs do not replace cash. Instead, they are digital forms of the same currencies used in cash transactions.

Disclaimer. The information provided is not trading advice. Cryptopolitan.com holds no liability for any investments made based on the information provided on this page. We strongly recommend independent research and/or consultation with a qualified professional before making any investment decisions.

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Micah Abiodun

Micah is a crypto enthusiast with a strong understanding of the crypto industry and its potential for shaping the future. A result-driven Chemical Engineer (with a specialization in the field of process engineering and piping design), Micah visualizes and articulates the intricate details of blockchain ecosystems. In his free time, he explores various interests, including sports and music.

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