CBDC coin and piggy bank on white background
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Shearman & Sterling: Will CBDCs Change the World?

A CBDC is a new type of currency aiming to work in tandem with fiat currencies used worldwide. The main component of CBDCs which sets them apart is the fact they operate on a blockchain, creating a token of the country’s currency and recording all transactions of that token in an immutable way. CBDCs are still very much in their infancy, with most countries still experimenting with the concept. 

Barnabas Reynolds is a partner at Shearman & Sterling and head of the firm’s Financial Services Industry Group. Barney is a leading financial institution practitioner specialising in banking and financial markets law and regulation. Here he shares his thoughts on the benefits of CBDCs, and whether they will ever eliminate crypto. 

What are the pros and cons of CBDCs?

The potential benefits of CBDCs include simplifying back-office processes, saving costs and potentially de-risking the financial system. Currently, certain payments are implemented on an end-of-day basis, which leads to intraday risk. CBDCs can facilitate cheaper and safer settlements, allowing for instantaneous payment, with nobody waiting for their money. Increased and centralized visibility could lead to more accurate, and possibly more automated, regulation, in comparison to simply accepting a cryptocurrency. Consumers could also potentially make payments more easily and cheaply, as we could eliminate some intermediaries. 

Possible downsides of CBDCs include privacy concerns, as the state would be collecting data on who is paying whom, when, and (potentially) for what purpose. Then there’s a risk factor in the hands of the consumer, who is tasked with keeping their password or security key, potentially without a failsafe to account for human fallibility. 

Would CBDCs eliminate the need for banks?

It’s true that CBDCs pose a possible threat to the traditional banking model, although it is not as existential as some would have us believe. A great deal of financial regulation concerns banks as maturity transmission entities, meaning they borrow short-term and lend long-term. This lending structure is a vital component of any working economy today. 

CBDCs could challenge this model, because while cash is fungible, CBDC tokens are not, which means that the owners of the tokens could expect those to be safeguarded and not on-lent, threatening the banks’ ability to lend to the degree they do now. It’s possible that consumers might consent to having their tokens lent out, but that’s an open question, and could come with high-interest rates. It’s possible that the lending of tokens becomes the default, meaning consumers would have to opt-out rather than opt-in, but that model would have to pass a muster of consumer protection laws. 

All of these challenges can of course be navigated, through commercial adjustments, education, discussion, updates to terms and conditions and broader regulations. Banks are likely to be in the best position to manage most of those matters.

Could CBDCs ever eliminate crypto?

There are some fundamental differences between cryptocurrencies and CBDCs, and I think the market has room for them both. Cryptocurrencies, such as bitcoin, are comprised of digital tokens with a decentralized ledger, generally created via blockchain technology, and offering anonymity to holders. CBDCs, on the other hand, are centralized, with ownership and jurisdiction fully identified by the central bank; while CBDCs could also potentially use blockchain, it might be more likely that they run on a different technological platform. 

Both CBDCs and cryptocurrencies have the potential to lower transaction costs, flatten the financial system for greater access for individuals and small businesses, and speed up cross-border transactions. CBDCs could have the added benefits of controlling the flow of money in times of crisis, and providing consumer confidence which could have a stabilising effect on the economy.         

Will smaller countries be more inclined to create a CBDC or adopt crypto?

Countries large and small are considering the cost savings, transaction efficiency and democratisation of their economies that could come with creating a CBDC, while weighing the risks to financial stability and integrity. Adopting crytpo requires significantly less infrastructure and therefore may seem like a more attractive option for smaller or more impoverished countries. El Salvador is being closely watched in this space right now, because earlier this year they became the first country to accept bitcoin as legal tender. The move is likely meant to attract outside investors and boost the country’s economic prospects. However, the International Monetary Fund has cautioned against this move and is encouraging the country to limit its scope due to the potential risks and liabilities. 

Smaller countries with healthy, functioning economies may not want to stir the pot, and may wait for larger countries to pave the way. As it currently stands, cryptocurrencies, while obviously attracting great interest for their potential use, are still not at the point of threatening the traditional economy. Money is so central to our lives that most people are naturally conservative and cautious about it coming in a new form. 

While China is forging forward with a digital yuan, many other larger countries are moving more cautiously. Lord Mervyn King, former Governor of the Bank of England, recently questioned the UK Treasury about a big potential risk with CBDCs, which hinges on confidence. King made the point that if depositors become concerned about the solvency of a bank, as often happens during times of economic stress or crisis, there could be a run on money from banks as people rush to convert their cash to the federally-backed digital currency. This could potentially have a hugely detrimental impact on the broader financial system, by causing contagion effects for other financial firms.

The UK Treasury offered one potential solution, which would be setting a limit on the amount of CBDCs that an individual could hold at any given time. Whether or not that’s viable, the important thing to remember is that regulators are working closely with industry professionals to determine the safest, most effective path forward.  

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