New Paper Explores Pros and Cons of Central Bank Digital Currencies

New Paper Explores Pros and Cons of Central Bank Digital Currencies

by April 14, 2023

Central bank digital currencies (CBDCs), a digital form of a government-issued currency that’s pegged to a physical commodity, have gained notable traction over the past couple of years, prompted by technological advances and a decline in the use of cash.

Central banks from all around the world are now exploring their potential benefits, investigating the merits of a government-issued digital currency to improve process efficiencies, increase convenience, reduce risks, and enhance financial inclusion.

According to the International Monetary Fund, nearly 100 CBDCs were in research or development stages in July 2022, with two being fully launched.

The number of central bank digital currencies under research and development around the world, Source: International Monetary Fund, Sep 2022

The number of central bank digital currencies under research and development around the world, Source: International Monetary Fund, Sep 2022

In a new paper, Patrick Schueffel, adjunct professor at the Institute of Finance of Fribourg’s School of Management, gives a comprehensive overview of the advantages and disadvantages of CBDCs compared to currently existing monetary system, arguing that while CBDCs promise a great deal of benefits, these technologies also introduce a number of risks and come with several drawbacks.

Benefits of CBDCs

According to the paper, the main benefits brought by CBDCs revolve around their ability to address issues related to efficiency, costs and access.

Because CBDCs are legal tenders that are electronically issued, CBDCs can be directly credited to digital wallets. This make CBDCs accessible via mobile phones and other digital devices, facilitating thus access to financial services for individuals and businesses, especially those in remote or underserved area, the paper says.

CBDCs could also held reduce crime, in particular financial fraud, by supporting know-your-customer (KYC) protocols. CBDC enables customers to use unique digital fingerprints to identify themselves to financial institutions, and allows for easy verification of identity. This would ultimately lead to reduced financial fraud since all transactions are traceable and thus adhere to higher anti-money laundering (AML) and KYC standards then current cash.

Another advantage of CBDCs outlined in the report is that they do not entail any credit risk for payment system participants. Since CBDCs are issued by the central bank, transactions are settled directly with the central bank. This eliminates the risk of default or counterparty risk that exists in traditional banking systems, which would subsequently increase the security and stability of a financial system.

Another key attribute of CBDCs is their programmability. This characteristic allows for more opportunities to implement efficient monetary policies, allowing central banks to bypass intermediaries and directly target sectors or groups.

Finally, the last advantage outlined in the paper is the potential of CBDCs to improve data privacy. Digital payments today are provided by private enterprises that use the troves of data they garnered from their customers for commercial purposes. Public digital money has a comparative advantage at providing privacy because, unlike private sector alternatives, it is not bound by profit-maximization incentives.

Disadvantages of CBDCs

Despite the many benefits and opportunities brought about digital currencies, the paper warns of major drawbacks and pitfalls of CBDCs, especially regarding their potential impact on privacy and freedom.

With CBDCs, governments would gain access to a vast database containing any transaction that any individual or legal entity has ever made. This could lead to increased surveillance of financial transactions.

The programmability of CBDCs would also give the administration the possibility to impose spending caps and restrictions on certain individuals or groups of citizens, limiting their financial freedom and ability to transact. Limits could also be imposed on what citizens can buy or consume, whether by targeting specific industries or goods and services.

With CBDCs, spending blocks and transfer blocks can be easily implemented. The government could use CBDCs to freeze or block the accounts of individuals or organizations that are deemed to be engaging in suspicious or illegal activities, thereby restricting their financial resources and ability to transact.

CBDCs can also be used to restrict capital outflows and currency exports. For the individual consumer, this could mean tangible foreign exchange limits by restricting the amounts of currency that can be converted into foreign currency and the amount of money that could be brought abroad.

Besides privacy concerns and monetary controls, the paper notes that CBDCs could potentially negatively impact financial stability. Since CBDCs are issued directly by central banks, this could lead to a decrease in the volume of traditional bank deposits, prompting a decline in the profitability and stability of commercial banks, the paper says.

Finally, just like any other digital payment systems, CBDCs are vulnerable to cybersecurity attacks, account and data breaches, and theft. A successful hack could result in electronic counterfeiting of money, the theft of funds, or even to a disruption of the financial system and ultimately loss of confidence in the currency, the paper says. Additionally, CBDCs are dependent on electricity, meaning that outages and disruptions in these services could lead to a loss of access to funds, potentially disrupting the entire financial system.

Pros and cons of central bank digital currencies on societal and individual levels, Source: CBDCs: Pros and Con, Patrick Schueffel, Institute of Finance of Fribourg’s School of Management, March 2023

Pros and cons of central bank digital currencies on societal and individual levels, Source: CBDCs: Pros and Con, Patrick Schueffel, Institute of Finance of Fribourg’s School of Management, March 2023