How commercial banks can prepare for central bank digital currencies

As more countries explore central bank digital currencies (CBDCs), commercial banks should prepare now for their impact.

Growth of the cryptocurrency market is soaring and is expected to hit US$4.94b by 2030 – more than triple the size of the market in 2020, according to one new study¹. Central banks are now responding through the development of their own digital currencies as a solution to some of the most pressing issues of the financial system, including the declining use of cash, a lack of financial transparency and financial inclusion. When built around digital IDs, CBDCs also offer huge potential to improve cross-border payments (assuming countries work together to share IDs) and limit the risks of currency substitution.

According to the think tank Atlantic Council², 81 countries, are exploring a digital currency, and five countries have already launched one. So, what are the implications for commercial banks?

Wholesale or retail CBDCs?

It’s important to remember that CBDCs are a new form of currency, not a new form of payment. An important decision for central banks is whether they issue wholesale CDBCs (generally to existing central bank clients) or retail CDBCs to the wider public. While they’ll require an alternative payment rail, banks’ roles in this – processing payments electronically, safe holding of deposits, and capital lending – are unlikely to change, but may adapt. The introduction of wholesale CDBCs is unlikely to affect the structure of the two-tier banking system which is necessary to lessen the credit risk of central banks and enable consumers to access all the services they expect of commercial banks.

The wider adoption of CBDCs is still expected to have significant implications for commercial banks, though the impact will vary depending on whether countries pursue wholesale CBDCs or retail CBDCs.

Key impacts of the use of CBDCs on commercial banks:

Disrupting the payments sector: retail CBDCs could undermine business models for existing payments providers, who extract significant network fees for facilitating payments. Wholesale CBDCs may cut demand for private payments instruments, reducing the cost burden on merchants and consumers by competing away these rents. Reducing the potential for financial crime: if built around digital IDs, CBDCs bring a new level of transparency to the financial system, potentially reducing financial crime. Of course, the flipside is also true – like any digital currency, CBDCs may present new opportunities for criminals. Negative interest rates: even mildly negative interest rates can hit commercial banks hard, as they have limited ability to pass on costs to depositors. Deposit base volatility and net interest margin (NIM) risk: if retail CBDCs are deployed, banks may be competing with central banks for deposits. This could destabilise their funding base, force deleveraging and threaten net interest margins. Seigniorage would be retained by central banks or governments. Capital market disruptions: a retail design choice might disrupt capital markets by creating a new risk-free asset. Interaction between wholesale CDBCs and retail stablecoins: the issue of stablecoins has largely been made by specialist fintechs to date, but commercial banks may need to consider the relationship.

CBDC design will be influenced by public and regulatory concerns

As well as considering monetary policy, central banks will consider a range of issues in CBDC design, particularly anti-money laundering (AML), know your customer (KYC), cybersecurity and data privacy.

In June 2021, the Bank of England released its consultation paper looking closely at the opportunities and risks of new forms of digital money, including a UK CBDC. Other regulators are considering responses to CBDCs, including how to ensure financial inclusion and safeguard data privacy, which a European Central Bank study³ found was consumers’ biggest concern around a potential digital euro.

Next steps for banks

CBDCs are likely to be deployed across more markets as the digitisation of our economy increases. Commercial banks should prepare now for their increased adoption – key steps could include:

Setting the vision: Understanding how CBDCs will impact the bank, depending on its region, customers and strategy can help leaders identify how to best operate in the new ecosystem. Preparing infrastructure: Upgrading legacy IT infrastructure to accommodate CBDCs is inevitable – but it’s also a good opportunity to accelerate digital transformation plans. Integrating systems: Considering how customers will use CBDCs can help banks ensure systems are integrated front to back to accommodate different touchpoints (i.e. mobile apps) and different CBDCs from various countries. Exploring new opportunities: The potential of CBDCs to improve efficiencies and reduce risks may allow banks to cut short-term costs and consider longer-term opportunities. These may include regaining ground in payments and enhancing financial inclusion.

As the digitisation of our economy increases and more countries consider the adoption of CBDCs, their deployment is likely to have a significant impact on commercial banks which should act now to understand and prepare for their continued rollout across global markets.

¹ https://www.coindesk.com/markets/2021/08/25/cryptocurrency-market-will-more-than-triple-by-2030-study/

² https://www.atlanticcouncil.org/cbdctracker/

³ https://www.ecb.europa.eu/press/pr/date/2021/html/ecb.pr210414~ca3013c852.en.html