Why governments have powerful incentives to develop digital currencies

Over the past two decades, there have been sweeping changes in how we manage and spend money — witness the rise of contactless payment, mobile banking and cryptocurrencies, to name a few. However, fiat currencies are still anachronistic in many ways — for example, they’re still underpinned by cash held by central banks and sanctioned financial institutions. Despite the fact that many governments now have the technology to digitize their currencies, most haven’t yet done so, even though most of us already receive paychecks or Social Security and make payments digitally through direct deposit. 

But governments are increasingly taking a serious look at developing their own central bank digital currencies. The purpose of CBDCs, which can function alongside physical currencies, is to provide a regulated and secure way for people to exchange, store and use money digitally. The interest in CBDCs among governments is partly a reaction to the surging popularity of cryptocurrencies, which aren’t subject to monetary policy and are something countries have a clear interest in controlling.

While the establishment of CBDCs among major countries isn’t going to happen overnight, governments have every incentive to keep moving in that direction. This is why we should expect to see a greater emphasis on the development and implementation of CBDCs in the coming years — a shift that could fundamentally alter global commerce. 

Why are CBDCs useful for governments and consumers?

The use of physical currency has been steadily declining. According to a report published by the Federal Reserve Bank of San Francisco, cash accounted for less than one-fifth of all payments in 2020 — a decrease of 7 percentage points from 2019. The transition to digital payments has been hastened by the Covid-19 pandemic — 72% of U.S. consumers said they made an in-person payment over a three-day reporting period, down from 91% in 2019. 

CBDCs have a wide range of advantages. They can eliminate third-party risk by connecting consumers directly with central banks. The adoption of CBDCs would be beneficial for developing countries with large unbanked populations or in the case of failed nation-states. It’s difficult for these countries to build the infrastructure of a modern banking system, so the ability to give citizens immediate digital access to money is crucial. Airdropped CBDCs could help stabilize regions affected by war, natural disasters and economic depression.

There are other benefits, too, from expanding payment options for consumers to making monetary policy more streamlined and responsive. Cash is also the preferred mode of payment for illegal activity, which means CBDCs could have a powerful role in combating crime. Finally, CBDCs allow governments to counterbalance the influence of emerging private digital currencies such as Diem, the blockchain-based payment system that was backed by Facebook, now renamed Meta.

Tracking the status of CBDC development

Countries investigating CBDCs have to navigate a vast array of challenges, from technical issues to labyrinthine legal and regulatory implications. But this hasn’t stopped governments from prioritizing CBDCs on a broad scale. According to a December 2021 Atlantic Council report, 87 countries are exploring CBDCs, 14 are in the pilot stage, and nine have actually launched a digital currency. 

There’s significant variation in the conception and implementation of CBDCs across countries, owing to different economic demands, technological capacities, and so on. Sweden is among the leaders in CBDC development, and the Swedish government has been working with the consulting firm Accenture to conduct practical research on its e-krona project. In 2021, Sweden investigated the economic effects of CBDC deployment in the country, tested its technical solution along with several alternatives, and examined the potential consequences for public policy. 

Last week, the U.S. Federal Reserve released a paper intended to “foster a broad and transparent public dialogue about CBDCs in general, and about the potential benefits and risks of a U.S. CBDC.” An American CBDC would need to be particularly resilient, as the dollar remains the world’s reserve currency. But it would also facilitate universal financial inclusion, enable cheaper and faster transactions, and sustain the United States’ economic influence by providing its own competitor to other CBDCs around the world. While a U.S. CBDC could face threats from hackers, they would be attempting to compromise a system capable of tracking and tracing every transaction as well as freezing or simply deleting stolen money.

The future of CBDCs

Although the Federal Reserve is approaching the development of CBDCs carefully, there has been substantial recent progress. For example, a collaboration between the Boston Fed and the Massachusetts Institute of Technology on the technology that could underpin the establishment of a CBDC entered its final phase several months ago. Like Sweden, the United States is also assessing the potential economic and public policy implications of digital currencies. According to the Fed paper, the U.S. could end up working with commercial partners such as banks and other financial institutions to create wallets and help manage its CBDC.

Meanwhile, China’s e-CNY, its new state-backed digital currency, has entered a robust pilot phase. China’s central bank — the People’s Bank of China — and other financial institutions oversaw the testing of the digital yuan across the country last year. According to Deutsche Bank, China’s e-CNY initiative is designed to “create a digital currency that can compete with other digital currencies such as bitcoins, stablecoins, and other [CBDCs]” and provide consumers with a universally accessible and affordable method of digital payment. China is planning to officially launch e-CNY in 2022, a reminder that CBDCs are in the process of permanently altering global commerce and a development that will create a sense of urgency among other governments. 

With the rapid emergence of digital currencies in the private sector, it was always inevitable that governments would get involved with their own regulated alternatives. This transition will lower transaction costs, prevent criminal activity, bring more people into the financial system, and provide governments with more flexibility in the development of monetary policy. Physical currencies were already in the process of being phased out, and governments have every reason to hasten this process with the establishment of their own CBDCs.