Checking deposits account for more than 97% of all money in circulation today, with dollars deposited online and converted into a string of digital code by a commercial bank. The digitization of credit and debit card transactions, as well as the development of banking apps, has moved many previously cash-based transactions online.
So far, the digital shift has left the banking industry relatively unscathed, at least in the West, where new players like Paypal continue to rely on customers linking the service to their bank debit and credit cards. A few online-only banks have emerged, such as Chime and Nubank, but these, too, operate on existing rails. The Chinese financial sector has seen more disruption, as evidenced by the emergence of Alibaba's Ant Financial and Tencent's WeBank, which have dominated consumer payments and have also entered retail and small business banking by leveraging looser data privacy protection and smart data analytics. Traditional banks, on the other hand, have generally adjusted well to the digitization of money.
The impetus for more radical change comes from China, whose central bank has been testing a type of cash called Central Bank Digital Currency (CBDC), which it envisions as the cash of the future, eventually eliminating the need for paper money.
In a CBDC world, the digital code for each virtual currency unit will be stored in a digital wallet and transferred seamlessly by the wallet-holder to other people's digital wallets, similar to how fintech and Big Tech digital wallets (think Venmo and ApplePay) and traditional bank wallets work today (such as Zelle, a cooperative of six-banks including Chase, Bank of America, and Wells Fargo). In China, four state banks and three telecommunications companies will be licensed to provide these services, acting as wallet distributors rather than cash depositories. Users will use their phones to scan barcodes to make in-store payments or send money to other mobile wallets. The People’s Bank of China (PBOC) will periodically receive copies of customer transactions, stored on a mixed central and blockchain database.
The Chinese pilot began with the distribution of 100 million digital Yuan via lotteries in nine cities, including Shenzhen, Suzhou, Chengdu, Xiong'an, and the Beijing Office Area for the 2022 Winter Olympics. The digital currency pilot had recorded approximately 500 million transactions with 140 million users by the end of September 2021. E-Yuan will be fully implemented during the 2022 Winter Olympics, and if bilateral agreements with foreign monetary authorities are reached, tourists and business travelers in China will be able to obtain a Chinese e-wallet on their own phones.
Part of China's motivation for launching a CBDC is to reduce the country's reliance on Alipay and WeChat, which currently account for 94 percent of online transactions worth $16 trillion. It also helps to mitigate the threat posed by independent digital currencies such as Bitcoin, which could potentially jeopardize governments' ability to manage their economies, which is not a prospect that the Chinese government would welcome.
CBDCs will ultimately be powered by the technology of Blockchain, the same technology that powers Bitcoin. It is made up of time-stamped record blocks containing encrypted transaction activity that is constantly audited by all verified network participants. The blockchain decentralizes the storage and transmission of money. Although Blockchain is still slow and cannot support large-scale applications, the technology is expected to mature over the next three to five years and overcome its limitations. As a result, at some point, the existing digital infrastructure will be replaced, removing new entrants' reliance on the resources and capabilities controlled by incumbent financial institutions.
Individuals or institutions receive money (from investments or pay) that they deposit with banks, which then use the money to make loans, setting aside (i.e., reserving) a percentage mandated by regulators (typically 10%) available for depositors to withdraw and convert into cash. Banks profit from the difference between the (primarily short-term) interest they pay to depositors and the (primarily long-term) interest they receive on loans to business customers or investments in comparable financial securities (such as corporate or government bonds).
While regulation ensures that individual banks lend no more than their total deposits less reserves, it has bloated the overall banking system's credit level. When a bank makes a loan, the borrower deposits the proceeds in their account, which is then treated as a new deposit and lent out again, minus the reserve. This process is repeated several times over and means that the $16 trillion of deposits in the US results in banks allocating $50 trillion in funding for direct loans and backing for bond issues. This process is repeated several times, resulting in banks allocating $50 trillion in funding for direct loans and bond issuance from the $16 trillion in deposits in the United States. This multiplier effect drives economic growth, but the new money supply created is risky credit. Defaults are high, amounting to $200 billion per year in normal times but up to three times that in times of crisis. And, as the 2008 financial crisis demonstrated, the cost of these defaults is ultimately borne by consumers.
The banking industry is fraught with dangers: borrowers may default, and short-term interest rates may be higher than long-term rates, and depositors may seek to withdraw more cash than is available for withdrawal. The risks are mitigated by equity capital, the possibility of government assistance (typically in the form of last-resort loans from a central bank), and retail deposit insurance schemes – all of which come at a cost.
CBDC differs from regular digital cash issued by commercial banks in that each CBDC unit of cash will have a unique, immutable digital identity. It will also be a direct liability of the central bank, similar to how paper dollars or yuan are now. This is a significant distinction from today's digital currency, which is a liability of the issuing bank despite the fact that it is theoretically convertible into paper cash on demand – a feature predicated on that cash being available to the bank in physical form. It is this differentiation that largely explains why the CBDC is likely to disrupt the basic model of the banking system, which has always been based on paper cash (or convertibility into it).
Consider the following key implications of a CBDC-based banking model:
Paper cash is essentially a bearer IOU issued by a central bank that the bearer can spend (or stuff under the mattress) at any time. Today's digital currencies are based on the ability of commercial banks to convert the digital codes they issue into paper money, which is dependent on the commercial bank having paper money on hand to use for the conversion. That connection to paper money gives digital currency issued by commercial banks value and makes it safe to use.
Central bank digital currencies, on the other hand, are direct liabilities of the central bank, just like paper cash, making them a safer form of digital money than commercial bank-issued digital money. The situation is analogous to every citizen having, in essence, a checking account with the Central Bank. Their pay and investment payouts are deposited into their central bank accounts, where they can keep cash and earn interest if the central bank so desires. However, unlike a traditional deposit or checking account at a commercial bank, the depositor bears no risk because a central bank is a sovereign credit, backed by the government's ability to tax rather than a cushion of reserves and equity capital. There are no "runs" on the central bank, which eliminates the need for insurance plans to protect depositors from bank runs. Furthermore, at the level of the overall banking system, all liquidity (and credit) risks are spread across the entire population, not just the depositor base of each individual bank.
Banks would no longer compete for retail or business cash depositors, which currently underpins much of their market value, if the central bank effectively became the sole intermediary for financial transactions. Instead, they will all essentially borrow wholesale from the central bank to fund their lending activities, transforming the central bank into a lender of first rather than last resort. With funding secured, inter-bank competition will be entirely based on the ability to recognize and price good loans, as well as efficiently bridge short-term and long-term interest rates, lowering margins in that business to the benefit of good borrowers, engaging in value-creating projects. Competition for customer deposits will be replaced by competition for the most innovative and user-friendly solutions for distributing their electronic wallets.
CBDC will also make it easier for new fintech players to enter the market, because established banks' brand reputation as safe custodians of people's money – as well as their networks of branches and paper cash outlets – will no longer be a barrier to entry. The central bank will now be the custodian of everyone's cash and the clearer of all transactions, and there will be no need for paper money into which digital money can be converted, because a CBDC unit is a direct central bank liability and exactly equivalent to paper money rather than merely convertible into it, rendering paper cash obsolete. People will no longer require cash outlets, and there will be fewer places to deposit cash or other valuables.
In a CBDC world, all transactions could theoretically be monitored using data analytics and AI to identify banks that are struggling or engaging in questionable transactions more quickly. At the moment, financial regulators must rely on reports provided by banks, which means that corrective action is delayed and frequently comes at a higher cost. Furthermore, in a CBDC world where digital bank codes are visible to the clearing institution, it becomes much easier for authorities to identify the parties to a transaction, greatly simplifying the detection of criminal activity and eliminating the black markets common in countries that deal primarily in physical money. The annual cost of fraud to US financial services firms is estimated to be 1.5 percent of revenues, or around $15 billion.
The switch also makes monetary policy execution easier because the central bank can immediately change supply by issuing or canceling codes in its own accounts. In addition, by paying interest on CBDC holdings, the central bank can directly transmit monetary policy to households rather than influencing commercial deposit rates through the rates it offers banks on reserve accounts with the central bank. With money in commercial banks today, policymakers can only have an indirect influence on consumer and business behavior.
Transacting with CBDC doesn’t require a bank account – important in developing countries, where typically a third of the population lack access to traditional finance and yet have access to mobile internet. (In the U.S., approximately 5% of people are unbanked.) An unbanked Indian consumer with an Aadhar number and a smartphone could easily transact over a mobile app. This means that countries in the developed world will fairly easily be able to integrate people into the financial system who were traditionally outside of it.
These changes have the potential to eliminate many of the costs and risks inherent in the traditional system, which was designed at a time when customers required secure branches to deposit bags of cash. This has resulted in a trillion-dollar, 85,000-branch, operations, and payments infrastructure in the United States that employs 1.2 million people – roughly one-third of all truck drivers in the country. This infrastructure, which costs around 600 billion per year to operate, is assumed to be required for handling all deposits and payments (this figure is based on US banks' approximately 60% cost/income ratio applied to related revenues of around $1 trillion, half of which comes from commercial banking and the rest from payment processing).
But if customers no longer need to physically deposit cash, then the $600 billion annual spending on physical infrastructure is a complete waste of money – equivalent to paying one out of three truck drivers to drive around with an empty truck for a year. Aside from the waste of physical infrastructure, the system is slow and expensive: payments take an average of 1-3 days to settle, and card processing fees consume half of retail profit margins. Cross-border transfers are exorbitant – a migrant worker can pay up to $50 to wire a few hundred dollars home via a commercial bank.
With CBDC and central banks holding deposits, banks will be unable to overstretch customer deposits as they currently do, significantly reducing the risk to the banking system. Furthermore, with CBDC's instantaneous transactions, money circulates faster, reducing the need for short-term credit, lowering overall debt levels by 25%, or $13 trillion. The reduction in default rates as a result of the precision of CBDC transaction data in monitoring credit use could have an even greater impact. When we combine lower debt levels with lower credit default rates seen in countries that have historically relied on transaction data, we get (two-thirds lower than in the US), I estimate that the overall US credit default could conceivably fall from $200 billion to only $50 billion.
Overall, switching to a CBDC-based banking system could save the US economy $750 billion per year – roughly the amount that US households spend on food during the same time period.
CBDC is not without issues. One obvious danger is to one's privacy. Several US lawmakers believe China will use digital yuans for domestic surveillance. "Central banks gain control over money issuance and gain insight into how people spend their money, but they deprive users of their privacy," says Congressman Tom Emmer (R-MN), adding that "CBDCs would only be beneficial if they are open, permissionless, and private."
Other concerns revolve around a central bank's role as a wholesale lender of last resort. State-controlled credit could be vulnerable to political pressure for sector-specific lending. Would there be formal criteria in place to determine which banks would be eligible for central bank funding? How simple would it be to manipulate these in some way?
Perhaps the most serious concern is security, particularly cyber security. You could argue that the current system, with multiple banks responsible for their own security, is vulnerable to more frequent but possibly more localized security breaches.According to this logic, if the central bank is hacked, the entire system could be fatally compromised, though the risk of a breach occurring is possibly reduced – given that a central bank would have access to its government's cyber expertise. Essentially, the choice would be between recurring but manageable breaches and extremely rare but catastrophic breaches. A central bank would undoubtedly be too large to fail.
However, because blockchain technology is highly secure and transactions are highly compartmentalized, the central bank could potentially operate a highly distributed and compartmentalized system, thereby spreading the risk and consequences of any possible cyber-security breach more widely. Indeed, the technology of blockchain for cybersecurity is expected to improve in the present situation.
The transition to low or no-cash economies based on CBDCs, whose sovereign monetary bodies compete on software-like features and costs, is, in my opinion, unavoidable. Its arrival will undoubtedly disrupt the banking industry, exposing the industry's large, powerful incumbents to nimble, asset-light, and tech-savvy fintech competitors focused on creating value within ecosystems rather than building monopolistic empires. The new banking model will reach out to more people with better, faster services and provide credit to businesses on better terms, all while maintaining liquidity and efficiency in the capital markets. Overall risk exposure will most likely be reduced, and while some privacy may be sacrificed, the benefits of protection against fraud and other crimes will more than compensate.