In recent years, decentralized cryptocurrencies like Bitcoin, Ethereum, and others have become widely used as alternatives to fiat currencies produced by central banks. The blockchain and related technology upon which these cryptocurrencies are built are far more efficient than the current network of transaction banks and intermediary banks that are typically needed to settle digital payments. As such, the efficiency of the technology, its ease of usage, and the global shift towards digitization have made cryptocurrencies the likely future of money. However, popular cryptocurrencies like Bitcoin are decentralized which means central banks have no control over these currencies. As a result, with the growing popularity of these decentralized cryptocurrencies, central banks are faced with a future where money is no longer completely within their control and the response tothis is the Central Bank Digital Currency (CBDC). At its most basic level, a CBDC is simply another form of money that is completely digital; built on blockchain and related technology but controlled by the issuing central bank (sole issuer). By creating CBDCs, central banks have a foothold in what is likely the next step in digitizing money and the monetary system. In this article, we discuss CBDCs and conclude that the adoption of a CBDC supports not just central banks but everyday users and banks. Further, the potential that CBDCs bring to commercial banks, in particular, creates an opportunity for investors to benefit from banking innovations.
How far has the world gotten with CBDC adoption?
To date, 81 countries representing over 90% of global GDP are now exploring CBDCs, all with the ultimate aim of creating their own CBDC. Among the most advanced in the process, we have countries within the development stage (16 nations), the pilot stage (14 nations), and the launched stage (5 nations). The five countries that have launched thus far include the Bahamas, China, Eastern Caribbean Currency Union, Marshall Islands, and Sweden. China’s rollout is being closely monitored given China’s geopolitical and economic position globally. So far, China’s CBDC dubbed e-yuan, has reached some 10 million persons and is expected to continue growing as the Chinese remain steadfast in fully implementing the currency. Other world powers have been moving more slowly but in our view, the likelihood of worldwide adoption, over time, is elevated.
Direct CBDC architecture
Among those exploring CBDC, some countries are focussing on a direct (retail) CBDC architecture which essentially removes commercial banks as an intermediary while most countries are taking a hybrid approach which keeps commercial banks as intermediaries. With direct CBDC architecture, Central Banks have complete control which somewhat dismantles the current system. Specifically, within the current system, commercial banks have accounts at the central bank while individuals hold accounts at the commercial bank. With a direct CBDC architecture, everyone would have an account at the central bank directly which therefore makes commercial banks obsolete. The expectation is that this materially increases the speed of transactions since transactions would simply be done by shuffling money between CBDC accounts as opposed to between banks. Within this system, central banks would know how much money each person has in their CBDC account, who they send money to or receive money from. Further, central banks could enact targeted monetary policy, essentially targeting specific areas of the economy to raise or reduce interest rates. Given these enhanced levels of oversight, illegal activities like money laundering and tax evasion become far more difficult. It would also mean directing cash to the most vulnerable would be easier, something that nations are doing more often since the pandemic.
Hybrid CBDC Architecture
Within the Hybrid CBDC architecture, the CBDC functionality is a combination of the current system (central banks distribute currency or CBDCs to commercial banks who have accounts at the central bank) and the direct CBDC system. Since only a few countries are at the launch stage and broad adoption has not yet occurred, the specifics of the hybrid architecture can vary depending on the central bank. With that said, it’s best to look at Jamaica’s own hybrid CBDC which is expected to make its pilot implementation in August. According to the BoJ, its CBDC will not utilize the typical blockchain technology but will instead use the Real Time Gross Settlement System (RTGS) infrastructure. This infrastructure already exists within Jamaica’s financial system so it makes implementation easier. The BoJ’s CBDC will simply be an additional option for money and will be distributed not only to commercial banks but other Deposit Taking Institutions (DTIs) and authorized Payment Service Providers (PSP). The main benefit to everyday consumers is convenience and financial inclusion. Those who already have regular bank accounts will be able to obtain a CBDC account automatically. Those who are unbanked can open an account through a commercial bank with simplified Know Your Customer (KYC) requirements or alternatively, through authorized PSPs. By allowing PSPs the opportunity to create accounts for everyday individuals, this would be a big step towards financial inclusion as not all Jamaicans use banks but most persons use some form of payment service.
As the global economy moves forward, the complete digitization of money is potentially inevitable. Consequently, we believe central banks at the forefront of CBDC implementation are best positioned in the global marketplace to benefit from the efficiencies that stem from this technology. From an investment perspective, the adoption of CBDCs has positive implications for listed financial companies that will benefit from increased systemic efficiency as well as reduced costs related to cash distribution and storage. Moreover, significant opportunities exist within the financial industry to digitize using Financial Technology (FinTech) as the BoJ’s CBDC (and other CBDCs globally) could pave the way for such innovations, thus making the largest beneficiaries solid equity purchases.
Written by Awah Muirhead, Senior Investment Strategy Analyst
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