CBDC – The era of sovereign digital money – Part 1

The dwindling relevance of physical cash

It was in 2020 when I first heard about “Anthropophobia” – you know, the fear of being around other people. And honestly, with Covid then lurking around every corner, who could blame us for wanting to avoid human contact? Those were also the times when we abhorred the sight of physical cash and craved the novelty in contactless payments. In India, the irony could not have been starker. Just a few years back, India had had endured demonetization when everyone and their uncle were scrambling to get their hands on cash. Who knew that we would be running away from it just a few short years later?

Globally, not just the general public, but governments also went berserk during the pandemic. The US Federal Reserve quarantined banknotes that came in from Asia. Korea went one up and started burning banknotes. And China went as far as ‘deep cleaning’ and even destroying potentially infected cash coming in from hospitals. The world was a very strange place back then.

While we got exposed to the drawbacks of physical currency during the pandemic, the onset of digital economy had had enticed us to digital payments and away from physical cash some years earlier. In other words, since more and more business was conducted online, cash was losing its appeal as an efficient means of payment. Ideally this should have suited the central banks and the sovereign governments since less use of cash meant lesser money to be printed. It goes without saying that the cost associated with manufacturing, safeguarding, circulating, and managing physical money, combined with the persistent danger of counterfeiting renders cash an extremely inefficient mode of payment.

Now that would have worked for the central banks if the switch from cash was made to digital payments within a cohesive monetary system. But two threats emerged that changed this basic paradigm – one was the gradual foray made by the Big Tech firms into payments and the other was the emergence of Distributed Ledger Technology (DLT) that allowed decentralized settlement of electronic funds. Both need to be understood in slightly greater detail.

Over the last decade or so, our economy has had become increasingly digital. Powerful firms have emerged with tremendous network effects; and their leverage of software and data has created very high entry barriers in a ‘winner take all’ kind of scenario. Now, as legacy payment infrastructure started coming up short to cater to this digital economy, innovation started coming in from the private sector. It was only natural that these big digital firms started bundling digital payments with other services, and their wallets/gift cards started mirroring deposits. Although the incorporation of payment flows within these novel payment networks produces notable improvements in efficiency, the absence of compatibility necessitates the adoption of multiple payment providers and results in a payment system that is more fragmented. And therein lies the opportunity for central banks to introduce seamless interoperability either by upgrading their payment infrastructure or through some sort of digital cash.

The other threat comes from the world of crypto, where regulations are still in their nascency. Normally, the volatility associated with crypto rendered them unsuitable for payments. But the emergence of stablecoins have addressed that problem, even though the blow-up of the Terra UST somewhat shakes that confidence. Retail payments with stablecoins is still not a feasible proposition though, as low throughput makes it unreliable. This could have been solved with permissioned DLT, something that Meta wanted to do with their Diem Initiative.

(If you are interested to know more about the Terra UST fiasco and the embryonic death of the Diem Project, don’t forget to check out our article on *The Curious Case of the Stablecoins*)

A Central Bank Digital Currency (CBDC) has the potential to address these twin threats. It can be a suitable substitute for cash, and aligned with the needs of a digital economy. It has none of the inconvenience normally associated with physical cash handling; and it can be programmed to work under specific constraints so that the impact is more targeted and immediate. And it can seriously negate the impact of stablecoins by providing a better, albeit sovereign, alternative.

In this note, we peel the onion a little further to unravel this new innovation in the world of payments.

By the way, do you know that the small town of Tenino in the U.S. state of Washington, with a population of less than 2,000, decided the best way to support low-income residents hurt by the COVID-19 pandemic was to print money designed exclusively for use in the city? Innovative? You bet. Scalable? Maybe not. But we will later in this article see why a CBDC would have been a better and far more scalable option in this regard.

To be continued – stay tuned for part 2.

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