At least 114 central banks—representing 58% of all countries, which generate 95% of global GDP—are now exploring central bank digital currencies (CBDCs), up from 35 in May 2020. And a team of cryptocurrency analysts from Bank of America is unabashedly bullish on the tech.
“Digital currencies appear inevitable,” a new research report from BofA concludes. “We view distributed ledgers and digital currencies, such as CBDCs and stablecoins, as a natural evolution of today’s monetary and payment systems.”
The report includes analyses of CBDCs' potential benefits and risks—both in their issuance and non-issuance—as well as potential approaches to their distribution. As part of the study, there are also several case studies into CBDC development and challenges within specific economic blocs and nations.
Some key observations from the analysts revolve around the current financial system's antiquated infrastructure and numerous inefficiencies—issues that properly developed CBDCs might solve instantly.
CBDCs' benefits for banks and the unbanked
CBDCs' potential to remove intermediaries—once the technology makes them redundant—could bring about real-time settlement, complete transparency, and lower costs, the report states.
The analysts point to an estimated $4 trillion of capital that banks are required to deposit in corresponding banks in order to remove settlement risk. The study argues that this is an inefficient capital allocation that could otherwise be generating yield elsewhere.
Furthermore, less capitalized banks and payment service providers cannot expand into cross-border payments, the research report argues, due in part to the requirement to pre-fund accounts at correspondent banks:
"In reality, cross-border payments are routed through 2.6 different correspondent banks on average, increasing time to settlement,” the report notes. “However, 20% of euro-denominated cross-border payments require the involvement of 5+ correspondent banks."
The result? Cross-border payments cost ten times more than domestic payments.
The researchers also predict that CBDC adoption will positively impact the unbanked population, which is 1.4 billion people worldwide, and 6.5% of the U.S. population, according to 2021 figures from the U.S. Federal Reserve.
The unbanked cannot access standard financial services nor have pathways to building their credit history. As a result, they face increased separation from their wealth—e.g., reliance on payday-loan services that offer only subpar terms and conditions.
If a CBDC wallet was developed to fulfill basic financial services such as being able to hold, send, and receive funds, as well as establishing credit histories and providing credit scores, this disparity could be almost entirely eliminated.
"A CBDC that is accessible to those with bank accounts and smartphones would increase the banked population from 93.5% of households to 96.7% in the U.S.,” the report claims. “Removing the need for a smartphone would increase the banked population to 98%."
CBDCs vs. stablecoins—fight!
The report also includes a few words about the role stablecoins could play in CBDC adoption. Noting the significant growth in stablecoin transaction volumes over the past two years—which reached $7.9 trillion in 2022.
"The proliferation of stablecoins for cross-border and domestic payments and transfers could inhibit a central bank’s ability to implement monetary policy if growth remains unchecked and unregulated, as well as increase systemic risk,” the report’s authors state. “In some cases, loss of monetary control could lead to inflation significantly above current central bank targets."
Because their controls still perform favorably compared to some traditional financial systems, the analysts say they "expect stablecoin adoption and use for payments to increase in the absence of CBDCs as financial institutions explore digital asset custody and trading solutions."
Should issuing a CBDC take too long, however, the researchers worry that stablecoins could proliferate even further into cross-border and even domestic payments. Allowing stablecoins to become entrenched will "increase systemic risk in the traditional market and impede a central bank’s ability to implement monetary policy."
The report does entertain a future in which both stablecoins and CBDCs can coexist. According to the analysts, stablecoins will likely continue to excel in certain use cases, especially when smart contracts are involved. However, just a few lines later, the researchers suggest that stablecoins are not long for this world.
"CBDCs’ design and programmability will likely determine the level of future stablecoin adoption and usage,” the report states. “We also note that the potential for CBDCs to displace stablecoins largely depends on the former being interoperable with blockchains and blockchain-based applications."
Look out, Tether, here they come.
CBDCs' risks for banks and privacy
After six pages exploring the potential benefits of CBDCs, the Bank of America analysts turn to the potential risks of issuing and not issuing CBDCs.
Topping the list of risks: the potential competition between commercial banks, such as Bank of America, and the central bank. According to the analysts, "CBDCs are in some ways superior to bank accounts as stores of value, particularly during times of crisis."
Though commercial banks and central banks currently exist in a two-tier system, CBDCs could blur the demarcation lines, according to the report. If commercial banks' customers are able to swiftly and easily transfer their savings out of a commercial bank and into the central bank,, how would the commercial bank be able to continue borrowing and lending their customers' funds?
Indeed, the analysts' second-ranked risk is that bank runs could occur more frequently if safeguards are not included in the CBDC's design.
"During times of stress in the banking system, people could withdraw deposits and exchange them for CBDCs, given that there is no credit or liquidity risk if distributed with the direct and hybrid approaches, increasing financial stability risks," they write.
Apart from the potential collapse of the commercial banking industry, the researchers grapple with two important questions: How will governments convince their citizens to use its CBDC? And what will governments be capable of if and when they do?
Large-scale policy rollouts will almost certainly be piecemeal, the analysts concede, prone to gaffes and marred by controversy.
Eleven countries have already issued CBDCs, and the largest central banks around the world are either exploring designs or launching pilots. According to the analysts, the first CBDCs were designed mainly for retail banking use and were issued by the central banks of developing economies in an attempt to broaden financial inclusion in the absence of a commercial banking sector.
The Eastern Caribbean Central Bank's CBDC, one of the 11 first-generation attempts, faced a crippling setback after the platform crashed in January 2022 and was unable to facilitate transactions for two months. Adoption and usage of the ECCB's CBDC have been "largely uninspiring so far," according to the analysts.
"Issuance and adoption are not synonymous, and adoption is not guaranteed," they wrote.
Central banks are no doubt paying attention to the successes and failures of this inaugural class of CBDCs. Meanwhile, as central banks and governments are preparing for the launch of next-gen CBDCs, the Bank of America analysts worry that mainstream adoption of CBDCs could face backlash over privacy concerns.
Potential headwinds to CBDC adoption could result from the loss of privacy and anonymity that the public enjoys with physical cash, the authors concede. For this, the analysis suggests a policy-based compromise.
"Payments using CBDCs can remain anonymous if a legal framework exists providing a central bank or government the right to trace transactions if there are indications of criminal activity, tax evasion, money laundering or terrorism financing,” they write. “But purely anonymous payments are anathema to central banks."
However, the researchers go on to emphasize that any perceived or legitimate invasions of privacy might push the public to reevaluate the policy initiative and possibly result in higher demand for CBDCs with stronger legal protections.