Interest in a Central Bank Digital Currency (CBDC) has been rising worldwide due to its potential to reduce transaction costs and risks of lower liquidity.
A CBDC is a digital form of central bank money that is available to the general public. Though people have used digital currency for some time now, a CBDC is different from other forms of digital money because it represents a liability of the Federal Reserve, not of a commercial bank.
According to an analysis made by the Bank of International Settlements, nearly 86.0% of central banks globally are exploring CBDCs, with some countries researching, some testing, and others already distributing CBDCs to the public.
While the United States is still in the research phase, transitioning to a CBDC may affect commercial banks’ operations.
Increased volatility in deposits
Commercial banks make money mainly by providing loans to consumers and businesses, with loans being generated using customer deposits.
Rolling out a CBDC may increase deposit volatility and lead to fewer deposits in the long term.
Though a CBDC is similar to money from a commercial bank, it would give consumers additional safety and liquidity benefits because a CBDC is a central bank liability.
Consequently, launching a CBDC may encourage customers to exchange their bank deposits for CBDCs, however, banks’ ability to issue loans may be limited due to fewer available deposits. To compensate for fewer deposits, banks may switch to alternative market-based sources of funding.
Higher costs of alternative sources of funding
Alternative market-based sources of funding, like wholesale funding, include federal funds, public funds and foreign funds. Depending on the source of funding, the cost of lending may increase, threatening banks’ ability to be profitable.
Furthermore, alternative sources of funding may result in more uncertainty for banks by being faced with regulatory pressure related to the amount of collateral needed to obtain refinancing via a central bank.
To compensate for the loss, commercial banks may increase transaction fees and raise interest rates on loans.
Threat from interest-bearing CBDCs
If the Federal Reserve decides to rollout interest-bearing CBDCs in the future, competition between commercial bank money and CBDCs may increase.
If this does occur, the number of deposits in the overall banking system may decline while also resulting in a shift away from other traditional assets, like Treasury bills and shares in money market mutual funds; overall, this would decrease credit availability, raising lending costs for private and public organizations.
While some countries have already adopted a CBDC, the US Federal Reserve System has yet to make a final decision.
According to Federal Reserve Chair Jerome Powell, the decision to launch CBDC would depend on many factors, mainly the public need for the digital form of central bank money.
In January 2022, the Federal Reserve released its first paper on a CBDC, encouraging a public discussion between the Federal Reserve and stakeholders.
Before the final decision is made, more research is needed to answer questions related to the opportunity cost of CBDCs, financial stability and privacy.
Though a CBDC represents a significant opportunity for the broader financial sector, a key takeaway is that the launch of a CBDC would majorly affect individual stakeholders, a risk that some may not be willing to take.
