Central banks should be concerned about digital currency

October 26, 2021
digital currency

The rise of bitcoin and other digital currencies has been widely reported, and it has the potential to have a significant impact on financial institutions and central bank operations. Will paper money eventually be phased out? 

Will bitcoin and its brothers eventually supplant the dollar, euro, and yen? Is it appropriate for central banks to create their own e-currencies? What are the advantages of digital currencies? What are the dangers?

Many central banks are aware of this, and they are concerned that a CBDC could stifle private-sector digital payment innovation. So they’re attempting to supply their central banks’ digital currencies as tokens, on top of which the private sector may innovate in terms of using those tokens more effectively to facilitate payments between customers and businesses or between businesses.

The Bahamas, for example, which has already implemented its own CBDC, has set limits on how much money consumers and businesses can keep in their CBDC accounts in order to prevent large sums of money from being swept out of commercial bank accounts.

However, they can no longer rely on some of the high-margin activities that banks presently enjoy, particularly in the area of cross-border payment facilitation.

A significant amount of money has already been converted to electronic form

Although most countries still use real currency (with the exception of Sweden, where cash usage is fast declining), consumers all across the world commonly conduct transactions without it, paying using credit cards or mobile phones. Furthermore, much of the money issued by central banks (bank reserves) is only available electronically. As a result, the concept of digital currency is not entirely new.

We had to learn how to cope with credit cards after they introduced them. And nothing happened…we made it through. As a result, we will do the same.

Cryptocurrencies are unlikely to take the place of government-backed money anytime soon

Bitcoin and other cryptocurrencies are popular, but most people do not trust them as much as they do the US dollar, euro, or Japanese yen, which are all backed by a central bank. Despite the loss of trust in political institutions, the vast majority of people still prefer money backed by a central bank, and this is unlikely to change very soon.

Bitcoin networks process a very small number of transactions per second, compared to a hundred times for an interbank Visa system. One factor is that there is a disparity in investment. That emphasizes the importance of having a coordinator because you’re getting portions of a system where a lot of money goes into the mining part [of bitcoin] and very little goes into everything else.”

Nonetheless, digital currencies have the potential to significantly alter the financial system

Digital currencies and other payment system advances might speed up domestic and cross-border transactions, lower transaction costs, and eventually provide poor and rural households more access to the financial system.

Payment methods will undoubtedly become a lot more efficient. Payment systems that have been decentralized and that are intermediated, not through traditional banks but through alternative platforms, can be used to make very small micro-transactions with street sellers in China and India. And one can easily see this catching on.

Furthermore, new technologies make it easier for money to reach everyone, which means we’re effectively talking about real-time money transfers from one cell phone to another. And that is a vision for the future that is worthy of consideration.”

However, these new technologies also pose significant obstacles

Digital currencies and related technologies are anticipated to lower transaction costs and the cost of gathering and sharing information, which sounds wonderful but has the potential to destabilize financial markets and increase contagion from one market to the next. They could jeopardize traditional banks’ business models and roles in the financial system, making it difficult for central banks to maintain financial stability, as they rely heavily on the banking system.

When one considers how new technology allows for much more free flow of information, it’s easy to see why financial markets should function considerably better. But, as we know from the work of many researchers… 

In an economy where there is a lot of information but not a lot of processing ability, certain information aggregators may become very powerful, and this can lead to situations where informational cascades occur, and herding and contingent behavior worsens, not because of a lack of information, but because there is too much information but not enough signal extracting and processing capability.

Should central banks issue digital currencies of their own?

Few central banks are seriously considering establishing their own digital currencies, which would allow the public to make electronic deposits at the bank, but many are discussing the possibility. Only a few central banks, including Ecuador and Tunisia, have launched their own digital currencies thus far. Sweden is considering issuing an e-krona, as the use of cash is dwindling faster than in virtually any other large economy.

In addition to preventing a central bank from losing market share to bitcoin, issuing its own digital currency could make it easier for a central bank to pursue negative interest rates (charging depositors a fee rather than paying interest) during a slump. 

However, if depositors withdraw money from traditional banks to deposit it at the (safer) central bank, an official digital currency might eliminate the function of traditional banks as intermediates and lenders, posing significant concerns during a financial crisis.


Banks will continue to play a significant role in the creation of money, since when a bank provides a loan, it also produces a deposit. So, while commercial banks are responsible for the majority of money creation in modern economies, there is concern that if CBDC accounts become popular, they could undermine commercial bank activities. And this is a major concern, because commercial banks continue to play a substantial role in the creation of credit and money in the economy.

We may not like financial firms and do not believe they are completely safe, but we do know how to inspect their books and other records.

As more financial activity shifts to unregulated or less-regulated sections of the financial system, there are concerns that financial stability risks may arise that we aren’t fully prepared for, simply because regulation hasn’t kept pace with new technology and all the possibilities they provide.