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The Coming Wave of Government Digital Currencies

Phone being used for a payment

The COVID-19 pandemic has meant that the use of notes and coins for payment has fallen to historic lows.

Hygiene concerns mean that most of us are using contactless payments rather than cash, even for very small payments.

The current public health crisis has hastened what was already a growing trend, and most people believe that physical cash will one day - perhaps soon - cease to exist.

Behind the scenes, the finance departments of governments all over the world are preparing for the day when society goes cashless - and more than 80% of central banks are investigating the use of Central Bank Digital Currencies (CBDCs) as part of the solution to the challenges this will bring.

You may be wondering what the big fuss is about. When you spend £5 with your contactless debit card, surely you are already using digital pounds?

This is true to a certain extent, but there is one big difference: CBDCs do not need banks in order to allow individuals or businesses to hold accounts or to make payments.

Under the current system, your debit card allows you to transfer value from your own bank account (or your balance with a particular fintech company if you are using a prepay or travel debit card) to the bank account of the person you buy something from.

If you are both customers of Barclays, for example, the balance of your account will be debited and the merchant’s account will be credited, without the need for any records outside Barclays to be updated. If one of you has an account with HSBC, the banks will need to settle the outstanding amount with each other, and update the bank accounts accordingly.

While technology has meant that these processes have become automated over time and become more efficient, the advent of open-source cryptocurrencies such as Bitcoin has led governments to investigate whether similar technologies could be used in a virtual currency system overseen and administered by the government.

This would mean that individuals and businesses could hold digital wallets directly with the issuing central bank (in the case of the UK, the Bank of England) and that payments between these wallets could happen in real-time, without having to go through a settlement process between different commercial banks.

Other advantages of this approach are that:

  • Individual customers do not have to prove to a bank that they are creditworthy or profitable in order to use the digital wallet system
  • When such a system is used, it means that it is possible to create programmable money
  • Banks and fintechs are freed up from the mundane business of settlements and enabled to create profitable new consumer-focused solutions

There are still many people who do not have access to bank accounts and are unable to take advantage of convenient digital payments, even in the UK.

Innovative solutions have sprung up to fill this gap, for example mPesa in Kenya, but it is in the interest of governments worldwide to come up with solutions that enable their citizens to participate fully in the digital economy, with all the savings and convenience this implies.

The idea of programmable money is a little more complicated, but the short explanation is that it is possible to attach certain rules to payments, so that governments would be able to issue money that could only be spent on particular products, or which had a set expiry date.

Take, for example, the ‘Eat Out to Help Out’ initiative, which was aimed at stimulating the hospitality sector by giving diners a 50% discount on meals in participating restaurants. The scheme required restaurant owners to reclaim funds from the government, which is an administrative overhead at a time when they are already under pressure.

A CBDC with programmable properties would mean that funds spent by the consumer on particular days, for particular purposes, could be automatically refunded or topped up without a complicated reclaim process.

Of course, there are significant risks with any kind of government-overseen financial system like this. In a situation where a CBDC wallet was the only payment option, it would be possible to restrict or monitor the activities of political dissidents by, for example, attaching rules that certain wallets were not allowed to pay for flights or certain publications.

While some countries, such as the Bahamas, are already running pilot schemes for CBDCs, China is leading the way, and is already trialling the use of its Digital Currency Electronic Payment (DCEP) wallets in four cities, including the tech hubs of Shenzhen and Chengdu.

Being able to use cash for payments gives us a certain level of privacy that it is easy to take for granted, so while this new breed of sovereign digital currency can offer some advantages, it is important to be wise to the dangers that may result from moving to such a system.

Read more about government-issued digital currencies in The Cryptocurrency Revolution.