The ongoing trend toward a bifurcation of global monetary systems is following none of the traditional geopolitical division lines of the West versus the Rest. Instead, it is tracing the broader vector of competition between national currencies.
Two camps, two innovation spaces
Two sets of monetary-policy actors are emerging within this competition to-date: states forced to adopt private technological innovation as part of their constrained monetary systems and states viewing private monetary technologies as an existential challenge to their internal and international power bases.
In the former camp, several states such as El Salvador, Venezuela and Panama have embraced the potential for using stateless technologies (private payments-clearance networks) and currencies (cryptocurrencies) as possible additions to their financial systems. Some countries, such as Iran, have taken a less direct but relatively open path toward adopting cryptocurrencies as state-supported mediums of exchange. All are distinguished by the presence of either push (international sanctions and limited ability to access international banking networks, in the cases of Venezuela and Iran) or pull (fully dollarized economies, such as El Salvador and Panama) factors working in favor of cryptos adoption. Other countries, such as Ukraine, Uganda and Zimbabwe, hope to see new financial technologies develop into viable service platforms for their weak banking and payments systems.
In the latter camp are the United States, China, India, the eurozone, the United Kingdom, Indonesia, Russia and many smaller countries. These actors are pushing toward a less understood part of the monetary-innovation frontier that is potentially more disruptive than cryptocurrencies: central bank digital currencies (CBDCs). Their sudden interest in monetary innovation stems from their central banks’ desires to preserve monopoly control over their domestic monetary policies and use CBDCs to accelerate their challenges to the US-dollar (USD) hegemony. The domestic monetary challenges to which these states are responding may be different. Russia and China share a long-term objective to insulate both countries’ financial systems from the risks of USD weaponization. For India, Brazil, South Korea, Thailand and Indonesia, the attractiveness of CBDCs rests with decoupling their goods trade from the USD dominance over trade settlements. The eurozone and UK seek to open up trade and investment channels free from the extra-jurisdictional nature of the dollar-based financial world and close the doors on the proliferation of private currencies—cryptos that dilute states’ powers in taxation and monetary-policy administration. Hong Kong, Singapore and the Bahamas are international financial-services centers seeking to capture the next phase of the financial-services frontier before their larger competitors. Sri Lanka hopes digital currencies will lower costs and improve transactions security involving its main export, tea.
Challenging the dollar
The CBDCs’ advance poses an existential contest over the dollar’s continued supremacy as the world’s reserve currency. This contest is now developing, with challengers including both state (national central banks via digital currencies) and private (cryptocurrencies) institutions. This is the first time in modern economic history when global competition against the “green buck” is being waged across multiple non-aligned and non-ideologically defined fronts.
In May, the International Monetary Fund’s (IMF’s) Currency Composition of Official Foreign Exchange Reserves (COFER) survey published new data on the USD’s share of global foreign-currency reserves held by central banks. At the end of 2020, it stood at 59 percent, the lowest in 25 years and down from 71 percent since 1999, the year the euro launched. Peak dollar dominance in official reserves was marked in the 1970s at more than 85 percent.
The July 2020 IMF working paper “Patterns in Invoicing Currency in Global Trade”1 looked at global trade flows across a set of countries accounting for roughly 75 percent of world-trade flows. Fifty-eight of 100 countries saw their shares of exports invoiced in dollars fall over time; only 36 countries witnessed their shares of trade invoiced in dollars increase. In contrast, the share of exports invoiced in euros “has increased for more countries (65) than it has declined (26)”.
Data from a November 2020 IMF working paper “Reserve Currencies in an Evolving International Monetary System”2 shows that the USD’s share in global foreign-exchange markets, cross-border banking claims and outstanding internal debt securities remained relatively stable over 1999-2019.
So global evidence is mixed on just how much pressure the US hegemony over global monetary systems is facing. Competition with the USD, primarily from the euro area and China, is heating up, making it more imperative for the US and its challengers to deploy digital—not electronic—currencies.
What makes or breaks a reserve currency?
Economic research offers four key factors that define a reserve currency: economic hegemony of the issuing country; credibility of the issuer as a securer of the reserve currency as a store of value; demand for the reserve currency in global trade and financial transactions; and volume of reserve-currency-denominated financial instruments and commitments outstanding (inertia).
Network effects related to financial and trade flows “exacerbate this inertia and create strong path dependence”.3 Studies show that these factors’ efficacy has changed over time. Following the collapse of Bretton Woods, inertia sustaining the dollar’s dominance as a reserve currency strengthened through the mid-1990s. Since then, the euro’s introduction and developing economies’ rise have undermined this factor’s strength. The importance of networking effects diminished as transactions technologies and financial markets evolved, risk-hedging costs in currency markets declined, and global banking institutions became more geographically diversified. The global financial crisis added to this dynamic by accelerating the regionalization of financial and trade flows.
Cryptocurrencies’ rise in the 2010s, alongside growing the global economy’s financialization, significantly accelerated changes in the patterns of traditional currencies’ functioning. Cryptocurrencies promise user autonomy from centralized banking and monetary-system constraints. Based on data from Chainalysis, published in its annual Global Crypto Adoption Index, the use of cryptocurrencies rose 881 percent worldwide in 20204.
Countries with higher-density use of crypto alternatives to official fiat currencies are far from minnows in the global monetary order. The top 20 cryptocurrency-adoption states include India, Kenya, Nigeria, the US, China, Brazil, South Africa and Russia. While it’s uncertain how China’s recent ban on cryptos trading and mining will play out, a range of major monetary authorities are being forced to react to crypto-assets’ rise. And this reaction is much broader than considerations of the risks of illicit financial flows. Cryptocurrencies are seen as potential challengers to state-monopolized monetary systems—coming when most central banks have run into the quicksand of zero-interest-bound monetary policies.
With inertia and networks’ rationale for continued USD dominance waning, and with the US’ credibility as an impartial arbiter of transactions under pressure, the Federal Reserve (the Fed) cannot afford not to restrict further advances of cryptos and the emergence of competing CBDCs.
The innovation space
More countries are reacting to these trends by developing their own cryptos-targeting and dollar-competing CBDCs.
China began developing a centrally controlled digital renminbi in 2014. By March 2021, Beijing and Shanghai residents could use digital wallets through six state-owned banks. The government is planning to deploy digital renminbi at scale in 2022 in time for the Winter Olympics. These plans are being credited as a catalyst for the government’s stamping hard on cryptocurrencies trading. Parallel to this development, China is opening up digital-renminbi access to foreign investors and users.
Smaller financial-market players have launched digital currencies. In October 2020, the Bahamas unveiled the world’s first functional digital currency, the sand dollar. Pegged to the Bahamian dollar, the sand dollar uses a blockchain-backed digital token to support transactions in goods and services, fund transfers and stock-exchange trading. Medium-sized financial-services players Australia, Malaysia, Singapore and South Africa recently created the first cross-border CBDC exchange program, led by the Bank for International Settlements (BIS)5. China, Hong Kong, United Arab Emirates and Thailand have similar initiatives in development6.
The Bank of England (BoE) recently announced its top-level taskforce to explore the benefits and risks of launching a digital pound, with one of the key reasons being the mounting risk of losses in transactional volumes sustained by the City of London in the wake of Brexit.
Even the ECB, a conservative central-banking behemoth, is on board. The digital euro program is in full swing, following the conclusion of public consultations in July. The digital euro will be an electronic equivalent of banknotes and coins, backed by digital wallets that eurozone residents can hold at the central bank. Officials have since accelerated the promotion of the digital euro as a natural extension of stalled European payments reforms.
Sweden is developing the e-Krona that will use permission-based blockchain technology to support digital wallets, a step neither the Fed nor ECB are currently considering.
The US is lumbering behind the innovation curve. The Fed planned to release its digital-dollar prototype this summer, but the process has stalled. In its late-September update, the Fed committed to publishing a position paper on the e-dollar by the end of October. But many within the Federal Reserve argue that developing a new currency requires the prior creation of a comprehensive legislative framework. If they prevail, the US will lag in monetary innovation.
Electronic cash: the old frontier
What is a CBDC? There are three types of digital currencies: private and, in theory, decentralized; public, centralized and a fully fledged subset of traditional fiat money supply; centralized but parallel to traditional cash.
The decentralized, private types are cryptocurrencies (bitcoin, ethereum) that only approximate actual money as they can support only some transactions and act as imperfect stores of value. As long as no lending is created, their monetary power is restricted to their issuances by miners, and as long as their values in other currencies continue to rise, they partially sterilize the money supply of fiat currencies—they do not add substantively to the monetary base (when you purchase bitcoins, you pay in fiat currency, receiving the equivalent value in digital tokens). This changes if cryptocurrencies become lending currencies, which can happen in financial systems relatively independent of major currencies, or when cryptocurrencies become bases for private peer-to-peer lending.
Cryptos are used predominantly in secured loans, with the cryptocurrency collateralizing the loan. The amount of such lending is naturally bound by two factors: loans are provided by cryptocurrency exchanges and specialist lenders, not traditional and shadow-banking institutions, and they allow borrowers to raise up to half the value of crypto-assets held. The borrower carries the risks of market drawdowns; even so, the volume of these loans is growing, and some lending platforms offer unsecured loans in cryptos.
The centralized digital currencies currently in wide circulation involve dollars, euros, yen and other money that exist in electronic deposit accounts but are convertible into physical currencies on demand—a euro in a traditional bank account is digital as long as its holder does not withdraw its equivalent in cash; any digital-account euro can be converted into physical cash minus transaction costs. Electronic versions of major currencies dominate the world’s financial and monetary systems. In the US, which is hardly advanced compared to Asia-Pacific and Europe, they account for more than 90 percent of all dollars in existence, with physical currency bills and coins in circulation less than one-tenth of outstanding currency.
CBDCs and technological-innovation curve
CBDCs are a new breed of money; they cannot take physical cash forms on demand. And this difference represents a major change in the ways money will be used, with implications for transactions efficiency, economic-policies development, property rights, privacy and security. Purely digital currencies will remain the domain of computer networks, exchangeable only for goods and services based on digital transactions. It remains unclear how these funds can be used in lending and what their impacts on traditional banking-business models based on maturity transformation from shorter-term deposits to longer-term loans are.
Consider the transactional function of digital money. When you pay using electronic cash, your transaction record is present across intermediaries: your bank and payment app and the retailer’s bank and payment app. These payments are reported to centralized authorities (regulators, tax authorities) based on a range of qualifying criteria. These reports are rarely scrutinized beyond filtering for risk flags (money laundering, terrorism financing, fraud). No centralized authority has real-time direct access to payments. Even investigative powers of central authorities are restricted by legal safeguards, data-reporting lags, company policies and informational barriers.
Decentralized cryptocurrencies take this a step further, putting more distance between fund owners and authorities. While this feature of cryptos is trumpeted as a major advantage in facilitating transactions, it is yet another step on the journey your money takes post-purchase. Why? Because until cryptos become accepted as legal tender, we remain anchored to national fiat currencies, using crypto as a credit platform.
Give some, take some away?
CBDCs are the direct antitheses to cryptos; they are backed by monetary authorities, with the promise of security. You can’t lose CBD euros or dollars because a central bank will make your account whole—not always the case with electronic money and certainly not with cryptocurrencies. Efficiency-wise, CBDCs promise lower transactions costs that neither cryptocurrencies nor electronic money can sustain. But practically, this money is not like electronic currency.
First is the question of property rights. Virtually all major central banks that have announced plans for launching CBDCs have claimed that once the digital currency is issued to the account owner, the currency becomes irrevocable. But there has been discussion of using digital currencies to stimulate spending by reducing the real value of digital dollars over time. CBDCs open an opportunity to create super M1 money—money that can be directed to specific uses by monetary authorities. Several Fed economists have suggested that through the digital dollar, the Fed could better manage the money supply and monetary policy by assigning expiration dates to digital dollars; should the velocity of money fall precipitously, account holders could see their digital holdings written down if they fail to spend them within specified periods. Central banks currently have difficulty doing this, as interest rates hover at or just above the much-feared zero bound.
Another issue with CBDCs is their unknown effects on traditional banks. During bank runs, customers rush to convert bank deposits—electronic money—into cash or equivalents such as gold and silver. One of the banks’ major concerns is that the next financial crisis could induce households to switch from electronic funds held in their bank accounts to CBDC accounts—never to return. Outside a crisis, such risk can increase banks’ wholesale cost of funding and lead to higher debt costs. During a crisis, the risk can trigger limits on CBDC-account transfers and undermine account owners’ property rights.
Sweden is the world’s earliest adopter of electronic payments, and Swedes should be perfectly receptive to CBDCs. But Swedish banks’ major concerns with e-Krona are:
- How will their deposits base fare in response to the CBDC creation?
- How will e-Krona alter the demand for mortgages and lending by anchoring customers’ risk appetites more directly to monetary policies?
- Will e-Krona also create a direct link between the supply of mortgages and Sveriges Riksbank’s monetary objectives?
The European Central Bank’s (ECB’s) public consultation process of 2020-21 solicited approximately 8,000 responses from private individuals and businesses on the benefits and concerns surrounding a digital euro. The number one fear expressed by the public was privacy (43 percent), followed by security (18 percent) and facilitation of cross-border payments (11 percent).
Owner autonomy is also an issue; CBDCs create a complete record of transactions on the ledgers controlled by central-government authorities. Government control over private information and transactions is already a source of discomfort. As state-run AI (artificial intelligence) and data-analytics systems evolve, adding more data on private transactions to the already sizable volumes of private data accessible to a range of security agencies may be a step too far. Giving authorities direct channels to not only monitor but control private transactions and wealth is a high cost to pay for faster and cheaper transactions.
These ambiguities are the price of improved transaction efficiency. Electronic-currency payments can take days to move money between the accounts of sender and recipient; electronic cash transfers can be reversed over a period, as long as 60 days, and these reversals can be made unilaterally by the paying party. These lags will be eliminated with CBCs, making transactions irrevocable. Contrast this with electronic cash or cryptocurrencies. The former is legal tender, but the electronic-payments system is not, meaning that a transaction can be declined if the recipient’s bank rejects the payment platform. In cryptos’ case, in addition to facing acceptance barriers, they can incur tax liabilities and have uncertain payments valuations due to extreme volatility.
Demand for CBDCs
The alleged benefits of CBDCs seem to be not very significant to users; in the ECB survey, 9 percent of respondents cited transactions fees as a major concern, even though the ECB has admonished banks for overcharging customers for real-time payments. The Eurosystem will shift all pan-European payments to instant-payments transactions by the end of 2021 through the TARGET Instant Payments Settlement (TIPS) service, with payments to banks fixed at 0.20 eurocent (EUR 0.002) per transaction, 500 times less than what banks charge currently. It is hard to justify the demand for CBDCs based on the improved transactional efficiency of major currencies.
What are the main reasons for developing CBDCs, then? The availability of decentralized, private and anonymous payments methods, including cryptocurrencies, has attracted a growing inflow of illicit funds and a range of grey-economy actors facing constraints on their financial and monetary systems. Cryptocurrencies have challenged, with limited success, central authorities’ control over the money supply provided by traditional electronic money. We are also witnessing accelerating competition among several currencies, namely the renminbi and euro, to undermine the dollar’s near-monopoly as the reserve currency and primary tool for settling transactions.
With the demand for CBDCs driven by central banks’ fears of losing control over the money supply and desire to alter the global balance of monetary power, the only barrier to the CBDCs’ development and deployment is time.
1 International Monetary Fund: “Patterns in Invoicing Currency in Global Trade,” Emine Boz, Camila Casas, Georgios Georgiadis, Gita Gophinath, Helena Le Mezo, Arnaud Mehl, Tra Nguyen, July 17, 2020.
2 International Monetary Fund: “Reserve Currencies in an Evolving International Monetary System,” Alina Iancu, Gareth Anderson, Sakai Ando, Ethan Boswell, Andrea Gamba, Shushanik Hakobyan, Lusine Lusinyan, Neil Meads, Yiqun Wu, November 17, 2020.
4 Chainalysis Insights: “The 2021 Global Crypto Adoption Index: Worldwide Adoption Jumps Over 880% With P2P Platforms Driving Cryptocurrency Usage in Emerging Markets,” August 18, 2021.
5 Bank for International Settlements: “Project Dunbar: international settlements using multi-CBDCs.”
6 Bank for International Settlements: “Multiple CBDC (mCBDC) Bridge.”