Central banks go digital, bit by bit

Creative Commons/Achilver

• Central bank digital currencies should be no more volatile than notes
• Most central banks are researching different types of digital currency
• They can make cross-border payments cheaper and faster  

The turmoil in cryptocurrency markets this year has been a wake-up call to investors and regulators, prompting questions about how viable many digital currencies really are.

According to CoinMarketCap, the total value of cryptocurrencies has slumped from almost $3 trillion in November 2021 to less than $1 trillion in September this year. 

But not all digital currencies are alike. The best-known ones such as bitcoin or ethereum are privately issued and tend to be volatile. At the other end of the scale are central bank digital currencies (CBDCs), which are issued by a central bank and should be no more volatile than the country’s coins and notes.

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Only a handful of countries have launched a CBDC, including the Bahamas, Jamaica and Nigeria, but momentum is building. 

A 2021 survey by the Switzerland-based Bank for International Settlements found that 90 percent of central banks were actively researching the potential for CBDCs and 26 percent were running pilot projects.

An Arab Monetary Fund survey in the same year found 76 percent of Arab central banks were weighing up plans to issue CBDCs and 60 percent expected to issue one within six years.

They can come in many different shapes and sizes. There are, for example, wholesale versions that can only be used by financial institutions and retail ones open to businesses and consumers.

Distribution models vary from currencies that can only be used via accounts at the central bank (known as the direct model) to ones where the currency is distributed by banks and fintech companies (the indirect model). 

Reaching the unbanked population

In most cases the aim of CBDCs is to make cross-border payments cheaper, faster and more efficient. But they have other possible uses, including reaching the unbanked population. 

In the Gulf, the Saudi Central Bank and the Central Bank of the UAE have been the most active, starting with Project Aber, which they launched in January 2019 to test a wholesale CBDC.

In a November 2020 report, the two banks said the project had confirmed a cross-border dual-issued currency was “technically viable” and that a new payment system could be designed that would offer “significant improvement over centralised payment systems”. 

In February 2021, the UAE bank joined another cross-border pilot, the mBridge project, involving the People’s Bank of China, the Hong Kong Monetary Authority and the Bank of Thailand.

These projects are resource-intensive and become even more so as their scale increases

International Monetary Fund report

Later that year, the partners said early results demonstrated a substantial improvement in cross-border fund transfer speeds, from days to seconds, and the potential to significantly reduce banking costs.

Others in the Gulf have been more tentative. The Central Bank of Bahrain has been running a pilot to test cross-border payments in US dollars, in conjunction with Aluminium Bahrain, Bank ABC and US bank JP Morgan.

In a statement in May 2020 announcing the move, the Bahraini bank said it would look to expand the collaboration to CBDCs, but as yet has not announced further moves.

Iran is also reported to be preparing to launch a pilot retail CBDC scheme in the near future, while the Central Bank of Oman has set up a taskforce to study the issue.

Qatar Central Bank governor Sheikh Bandar bin Mohammed bin Saoud Al-Thani told the Qatar Economic Forum in June that “we are still in foundation stage. We are evaluating the pros and cons of issuing CBDC and to find the the right technology and platform.”

Most of the Gulf countries have one key advantage with CBDCs, at least when it comes to intra-regional trade. As most of them maintain a currency peg with the US dollar, there are no foreign exchange risks involved in bilateral trade.

The one exception is Kuwait, whose currency peg is based on a basket of currencies including the dollar and others.

However, progress is still likely to be gradual, given the challenges and risks. While the pilot schemes have generally been successful, scaling them up to a full launch could be tricky.

In an August 26 report, Cross-Border CBDC Payments Moving Closer, Fitch Ratings analysts Monsur Hussain and Duncan Innes-Ker said issues of trust and varying levels of technical sophistication between countries needed to be addressed – if not, multiple rival systems could emerge, creating complexity and cost.

“There is a risk that CBDC-based cross-border payment systems will become balkanised,” they said.

They also warned that smaller, less-developed sovereigns could be vulnerable if a system enables faster, more volatile international capital flows. 

As with banknotes, there is also the risk of counterfeiting and fraud, which could happen at a far greater scale in the digital realm.

As the IMF pointed out in a paper, Behind the Scenes of Central Bank Digital Currency, issued in February: “CBDC projects are resource-intensive and become even more so as their scale increases.”

Such issues explain why the Arab Monetary Fund suggested in its 2021 report that “The road towards issuing digital currencies is still long for most Arab central banks.” 

On the other hand, the advantage of faster, cheaper trade remains a strong draw and a digital currency can also be useful in tracking financial flows as part of anti-money laundering and counter-terrorist financing.

So, while practical uses for most cryptocurrencies have yet to be convincingly demonstrated, there is a clearer case for central bank-backed versions.

However, there are already cautionary tales of what happens if a country rushes ahead without preparing the ground properly. Ecuador cancelled its retail CBDC – the Dinero Electrónico – in 2018, just three years after launch, amid low uptake.