In October 2020, the Bahamas released a new kind of digital currency: “sand dollars”. These digital tokens are issued by the country’s central bank and are legal tender, with the same legal status as their old-fashioned money — paper notes and coins. The sand dollar is cash; it just doesn’t have a physical form. Residents of the Bahamas can now download an e-wallet onto their phones, load it with sand dollars, and spend away with a simple tap.
For now, only two countries have officially launched such central bank digital currencies (CBDCs): the Bahamas and Nigeria. But many more are actively running CBDC trials, including China and the countries of the Eastern Caribbean Currency Union. More than 100 countries are exploring the idea. In the US, the Federal Reserve this January issued a discussion paper on CBDCs, considering all the risks and opportunities.
This is an exciting moment in the evolution of currency. Recent years have seen a boom in cryptoassets (often called “cryptocurrencies”) like bitcoin; now companies are innovating with less risky alternatives, including so-called stablecoin, and nations are exploring CBDCs. All of these are likely to come to exist side-by-side in a new continuum, with today’s two most common forms of money (cash and bank deposits) facing tough competition. This evolving landscape comes with the promise of making international payments easier, improving access to microloans and reducing transaction costs. But there are also great risks to avoid.
Money, let us not forget, has already come a long way, evolving from beads to gold coins to paper bills and credit cards. In the early 1900s, national currencies were typically backed by commodities; that is no longer true. The United States dollar, for example, was divorced from the gold standard in the early 1930s, becoming a “fiat” currency whose value is backed solely by the word of the government. Then, as computers rose in power and use, electronic payments became ubiquitous.
Recent years have seen a flurry of activity in the rise of cryptoassets (while often called cryptocurrencies, they aren’t really currencies, but rather assets with speculative value and appeal). These are privately issued and secured by cryptography — decentralised assets that allows peer-to-peer transactions without an intermediary like a bank. Since bitcoin’s launch in 2009, an estimated 14,000 different types of cryptoassets have been issued, from litecoin to ethereum, holding an estimated market value of US$2.3 trillion at the end of 2021. They are highly volatile, infrequently accepted and carry a high transaction cost.
The volatility of cryptoassets has created interest in stablecoins, which are typically issued by an entity such as a payment operator or bank, and attempt to offer price stability by linking their value to a fixed asset such as US dollars or gold. Tether gold and PAX gold are two of the most liquid gold-backed stablecoins. There are many stablecoins with various shades of stability, and their growth is exponential. Stablecoins, unlike cryptoassets, have the potential to become global payments instruments.
CBDCs can be thought of as a new type of fiat money that expands digital access to central bank reserves, making them available to the public at large instead of just commercial banks. A CBDC would combine the digital nature of banking with the peer-to-peer transactions of cash. But there are still many questions about how any given country’s CBDC might work: Would funds exist in an account at the bank, or would they come closer to cash, materialising as digital tokens? Would CBDCs pay interest rates like a bank deposit does, or not? In Bermuda, the sand dollar is run through the country’s central bank, has certain quantity restrictions and does not pay interest.
There are some important advantages to CBDCs: They have the potential to make payment systems more cost-effective, competitive and resilient. They would reduce, for example, a nation’s cost of managing physical cash, a sizable expense for some countries that have a large land mass or many dispersed islands.
CBDCs could help improve cross-border payments, which currently rely on multilayered banking relationships, creating long payment chains that are slow, costly and hard to track. CBDCs could also help make payment systems more resilient through the establishment of a decentralised platform, essentially fortifying the payments infrastructure against operational risks and cyberattacks.
Many countries have large numbers of people without bank accounts: The “unbanked” often have no access to loans, interest or other financial and payment services. CBDCs could transform their lives by bringing them into the financial system.
But there are risks, too. A prominent one is if everyone decided to hold a lot of CBDCs and suddenly withdrew their money from banks. Banks would then have to raise interest rates on deposits to retain customers, or charge higher interest rates on loans. Fewer people would get credit and the economy could slow. Also, if CBDCs decrease the costs of holding and transacting in foreign currency, countries with weak institutions, high inflation or volatile exchange rates might watch as consumers and firms abandon wholesale their domestic currencies.
There are ways to get around these problems. For instance, central banks could offer lower interest rates on CBDC holdings (these show up as liabilities on a central bank’s balance sheet) than on other forms of the central bank’s liabilities, or only distribute CBDCs through existing financial institutions.
Institutions are now racing to draw up new rules and regulations to cover all these contingencies and figure out how new forms of money should be treated: as deposits, securities or commodities. The intergovernmental watchdog Financial Action Task Force, for example, has amended its anti-money laundering policies and counter-financing of terrorism standard in light of virtual assets; the Basel Committee on Banking Supervision has issued a paper on how banks can prudently limit their exposure to cryptoassets. The International Monetary Fund (where I work) is on the case, providing independent analysis of these issues.
Everyone will have to think fast and on their feet. Central banks will have to become more like Apple or Microsoft to keep CBDCs on the frontier of technology and in the wallets of users. Future money may be transferred in entirely new ways, including automatically by chips embedded in everyday products. This will require frequent tech redesigns and a diversity of currency types. Whatever form your money currently takes, in your bank, your wallet and your phone, expect the near future to look quite different.
Tobias leads the IMF’s work on financial sector surveillance and capacity building, monetary and macroprudential policies, financial regulation, debt management and capital markets. Prior to joining the IMF, he was a Senior Vice President of the Federal Reserve Bank of New York, and the Associate Director of the Research and Statistics Group. Mr Adrian has taught at Princeton University and New York University, and has published in economics and finance journals, including the American Economic Review and the Journal of Finance. His research focuses on the aggregate consequences of capital market developments.