Will CBDC disrupt the traditional banking model?

Hatchworks recently attended an informative webinar about CBDC (Central Bank Digital Currency) organised by OMFIF and has separately conducted research into the topic. CBDC is a concept created by central banks (CB) and allows people to hold deposits directly with them instead of storing deposits at commercial banks.

However, this itself can create systematic risks for commercial banks as they use deposit funding for lending; fewer deposits will lead to less money for this purpose. The ‘fear’ by commercial banks is that Central Banks (CB) could use this new digital monetary system to offer loans directly to consumers.

A study by the Bank of International Settlements (BIS) shows that 80% of worldwide central banks are engaged in CBDC related research and 50% of central banks are running experiments/PoC (Proof of Concept). 10% plan to introduce a CBDC in the next 3–6 years and 20% in the next 6 years.

Countries that are currently testing CBDC are China, Marshall Islands, Sweden, Eastern Caribbean, and the Bahamas.

It’s worth noting that China already has its own trial version of the CBDC, called ‘’DCEP’’ (Digital Currency Electronic Payment). Currently, it’s being piloted in 4 out of the 680 cities in China. So, there is still a long way to go, but China could be the first nation to push it through. Beijing claims it is essential to have a digital currency system in a world “clearly transforming into a digital economy’’.

DCEP is not a cryptocurrency, as China uses a central state owned database to control the currency. The value of DCEP will be pegged 1:1 with the Yuan. PBOC (People Bank of China) has already created an authorized application that provides users to access their digital wallet as an alternative to physical cash.

China’s DCEP will not pay any interest. However, users will receive interest when they deposit digital currency into the commercial bank. Deposit interest rate on CBDC money stored in a digital wallet might be very low — in fact, near zero, but in return consumers have 100% safety.

The biggest benefit for the Chinese government having its own digital currency is to monitor/track how citizens are spending their money. Some resources predict that if China is successful implementing DCEP across China and the rest of Asia, Yuan could become the world’s reserve currency, replacing USD.

Key takeaways from the webinar (not Hatchworks’ views):

• In many ways Facebook’s Libra mission to build a global payment system and financial infrastructure was seen by central banks as a threat, and consequently was one of the main reasons the CBDC concept was initiated.
• Most CBDC proposals have fixed maximum deposit levels to prevent bank runs.
• The impact of CBDCs will be slow, playing out over the next 10 years with no material unified policy for a few years.
• Risks to financial stability regarding capital flight redeposits are over-estimated. Restrictions would include caps in the CBDC wallet or interest rate differentials.
• Central banks have a mandate to maintain stability and prevent systematic risk.
• The Chinese CBDC model would be where the central bank takes control of the currency. In contrast, commercial banks and other players would provide CBDC to the public. This symbiotic approach seems the most logical.
• China is a precursor in fintech and is already 12 months ahead in Blockchain terms, compared to the western world.
• 5–7% of global GDP comes from money-laundering. CBDC could be a possible way to solve this problem.
• Currently, Facebook, Amazon and American tech firms have large distribution networks which means any digital currency they launch could pose a threat to systemic stability. This would become a big challenge for commercial banks, as well.
• In a world where tech giants offer their own digital currency and CBDC exists, a use case for commercial banks could be to provide KYC data to Facebook and other tech firms and charge for it. A big question remains on whether and to what extent big tech will be allowed to usurp bank business models.
• Decentralised finance (De-fi) may compete head on in lending markets as people holding crypto are currently not recognised by banks, because banks don’t value crypto as real collateral. Commercial banks need to start digital units/divisions focused on revenue opportunities that replace losses in traditional business from CBDC.
• Lending through savings accounts (not cash deposits) could make borrowing even more expensive. So, central banks may need to become direct lenders, but this itself creates risk as central banks don’t have any loan infrastructure.
• P2P (peer-to-peer) lending will not solve the problem, because it has no leverage.
• Wary of having a single system as in crisis periods its good for people to have different mechanisms to move money. This means there is room for different types of digital currencies to co-exist.
• It’s still not clear which technology CBDC will be based on; one possible option is DLT trading, i.e. the trading (without clearing and settlement) of CBDC and other digital assets.

Our take

In our view, in times of financial instability and economic downturns, a flight to safety begins and therefore the allure of CBDC offering risk-free deposits (non-yielding) vs commercial banks offering near-zero interest rates on risky deposits does mean the risk of ‘bank runs’ will be higher in a CBDC model than currently. However, the lifeblood of the economy relies on lending by commercial banks to businesses; a process which is a direct function of the quantity of deposits on commercial bank balance sheets, borrower default scores and lender appetite to lend. If these deposits dry up, banks cannot lend and this itself will create a vicious cycle where savings rates skyrocket and investment plummets — something no central bank wants. This can be mitigated somewhat if central banks usurp all functions of commercial banks including their lending activities and manage to obtain the wide customer distribution networks commercial banks have amassed in the last century. We view this as unlikely.

Hatchworks do not view this “digital monetary system” as a commercial bank killer, especially if the Chinese DCEP model is implemented. In our view this model is the one with the least likely impact to financial or systemic stability and one that is symbiotic with existing commercial bank networks and loan infrastructure.

While CBDCs allow for better tracking of money through the economy (and thus, less money laundering/illicit activities), they (central banks) also can inject liquidity directly to consumer’s wallets which in times of financial distress can bypass the problem of quantitative easing (QE) money getting stuck at the commercial bank level. While this will inevitably lead to inflation, it can result in less pronounced drops in economic output in periods of stagnation or decline as consumers and businesses have access to liquidity. It remains to be seen what limits CBDC wallets will impose on their users; will users not be allowed to spend money in certain avenues that the CBDC seems illicit? Or services offered in jurisdictions that are on sanction lists? Another question of course is, if this cash is a handout, then it requires no repayment and such liquidity injections can serve their purpose. If this cash needs to be repaid, however, then the central bank will need the assistance of commercial bank loan origination, vetting and other associated infrastructure. This would mean that commercial banks will need to be paid by the CBDC.

All in all, based on the research done so far, the lack of policy coordination across various proposed CBDC models and range of uncertainties surrounding their implementation means CBDCs in our view will take a proper decade if not longer to implement. It is unlikely they will obviate commercial banks any more than the current disruption fin-tech is affecting, to commercial bank models. What is more likely is a symbiotic relationship between commercial banks and central banks which sees CBDC’s being distributed by the former on behalf of the latter. It is also likely that CBDC deposits will carry zero or near zero interest rates and cash deposits at banks, higher interest rates. There is also a chance that CBDC has restrictions on where it can be spent. These restrictions may be even more punitive than those on cash currently in order to ensure that people still use commercial banks, thereby further increasing the allure of decentralised currencies (eg. bitcoin etc).

We believe there are other routes to achieving central bank goals of ensuring liquidity during periods of crisis and adequate levels of economic growth and/or inflation. Increasing deposit insurance premiums for private sector/commercial banks may hit bank margins but could mean commercial banks offer depositors much higher default coverage than the standard $75–100k/account level found in modern economies. To ensure QE liquidity doesn’t get stuck at the bank or interbank level, central banks can create CBDC wallets which function only during times of distress and allow consumers/businesses to access liquidity and then cease function when GDP levels normalise.

We view the DCEP as an experiment to better track user behaviour and consumption patterns, by the Chinese government. The positive side effects are less use of money in criminal activities and direct access to liquidity in periods of hardship. We do not believe the DCEP is a currency created to pose any risk towards commercial banks and underscore the fact that the DCEP or any commercial bank currency is very unlikely to be decentralised as central banks want control.

Team Hatchworks