CBDCs: Transaction Efficiency and Economic Growth
Looking back at an old article from Ripples official site
A recent survey from the Bank of International Settlements (BIS) found that 90% of central banks are now exploring implementing central bank digital currencies (CBDCs)—up from just 80% in 2021. It’s expected that many central banks will follow the lead of the Bahamas, China, the Eastern Caribbean and Nigeria in minting their own CBDCs.
In our two most recent posts on CBDCs, we explored their potential to advance financial inclusion globally, as well as the hurdles to realizing this ideal. CBDCs, and more generally digital currencies, have many different applications and use cases, including as the core of more efficient transactions and drivers of economic growth. In fact, a survey of over 1,600 financial institution leaders globally cited using blockchain for payments as a key driver of efficiency.
In this post, we’ll again evaluate the benefits of this technology, relative to challenges, in this case, to better understand how various uses of digital currencies can help accelerate economic growth and drive efficiency across industries and applications.
Key Use Cases and Practical Applications
Why are CBDCs gaining traction as a way to revolutionize the current monetary system?
The primary benefits of CBDCs include:
- Superior transaction efficiency as payment/settlement time is reduced
- Technological advantages of a decentralized blockchain working in conjunction with a centralized authority that leads creation, privacy and distribution of digital currency
- Financial inclusion through elimination of expensive third-party fees for cross-border payments and increased accessibility to payment channels
These benefits can stimulate the economy as both businesses and consumers engage in a more efficient, affordable payments system governed by the nation’s central bank.
Small Business Consumer to Business (C2B) Transactions
At the consumer-to-business level, there are many frictions involved when it comes to small business transactions, including an inefficient process (or lack thereof entirely) for recurring merchant transactions and costly credit card fees. The use of a digital currency can help remove these frictions and improve merchant operations via new efficiency models that enable real-time payments—regardless of amount, frequency or location.
Some examples of a digital currency solution streamlining C2B transactions include:
- Reduced friction in onboarding a business via digital currency instead of credit cards
- Increased access to digital currency channels for both businesses and consumers outside of the traditional bank route (e.g. telco provider or agent)
- Fewer intermediaries between the consumer and business (such as credit card companies or banks making the transaction) which reduces lost profit, risk, and required audits
Business-to-Business (B2B) Payments
B2B payments are an interconnected web of relationships: from senders and receivers, to banks and other financial intermediaries. The nature of B2B payments has historically been one of batch payment terms and complex payment arrangements. With the use of digital currencies, alternative, more efficient options become available, including: conditional payments (e.g. contingency payments when a good is delivered or service is completed), micropayments (e.g. payment is made at each incremental delivery of value), and platform service arrangements for more complex, multi-party payment agreements without all the intermediaries.
Economic Growth
Traditional fiat currency systems create a multitude of frictions that can cause transaction slow downs, affecting the health of an economy. These include delays due to transaction communications between institutions that may need to reconcile or remediate errors in the payment flows. There are also working capital and supply chain constraints that further prevent the most efficient allocation of financial resources. Digital currencies backed by central banks can eliminate these systemic costs for individuals and businesses by enabling faster payments and redeploying capital at higher rates via digitized transactions and currency interactions.
Key Hurdles to CBDC Implementation: Going Beyond the Hype
Of course, to fully realize these use cases and the promise of improved efficiencies from digital currencies, there are practical hurdles to implementation that must first be overcome.
Resistance to Change
While the existing money transmittal system is inefficient, the general public is accustomed to this system and naturally resistant to change. Credit card payment systems have been around for a long time, and so has the technology framework that those transactions run on. Many countries have built up decades of muscle memory using a credit or debit card, making it difficult to alter habits—even though cost is high for both businesses and consumers using this system.
Many fintech apps and solutions like Klarna and Affirm are nibbling away at these entrenched behaviors by offering card-like benefits without an actual credit card, including “buy now, pay later” options to help ease the adoption curve. While incremental improvement on existing technologies or one-off solutions like these are a great start, they ultimately limit innovation and prevent broader adoption if there is no implementation of a widespread solution.
CBDCs can efficiently and quickly distribute funds directly to consumers, lowering the resistance barrier. For example, when governments began issuing stimulus checks to citizens for COVID relief, the process was extremely slow and cumbersome, as individuals waited months to receive their checks in the mail—some even waited only to receive notification that there was an error with their paperwork or that the delay was extended. With a digital currency-backed system, these types of payments could be made in real-time directly to an individual’s digital wallet, removing inefficiencies and greatly streamlining the process.
Privacy
Expectations around privacy vary greatly by country and are important to the success of a CBDC. In countries where surveillance is routine, people are more accepting of a government presence in their financial lives. In other countries like the US, citizens are hesitant toward the government having visibility into their personal or business transactions. And with an increase in data protection regulations like that of GDPR in the EU, this further complicates the cross-border payments landscape and how that data is processed.
This is a challenge as CBDCs must balance individual privacy with the need to prove identity and prevent money laundering and other illicit activity. That dance becomes more difficult for cross-border payments as many countries possess different privacy laws and standards for Know Your Customer (KYC) and Anti-Money Laundering (AML) requirements.
Central banks, governments and private enterprises are all focused on the problem of privacy, with some proposed early ideas including the use of blind or group signatures and zero-knowledge proofs. Ultimately, there will likely be a multitude of international standards around privacy, and interoperability between those standards will be essential to effectively reconcile these concerns with fraud prevention.
One advantage that digital currencies provide is more flexible options for privacy and monitoring. Rather than being limited to reliance on heavily-regulated intermediaries, the technology provides other security options that can be incorporated into the core platform or peripheral systems and processes. This flexibility enables different forms of digital currencies to be developed with varying trade-offs in privacy vs. monitoring. In other words, the flexibility of CBDCs lends itself to different end-users who have different privacy and monitoring needs, use case requirements, and varying levels of risk tolerance.
Risk Mitigation
While CBDC momentum is growing, the reality is that most are already late to the game. The majority of the 100+ countries exploring the idea of a CBDC are playing catch up to the handful that have launched actual pilots and the hundreds more private blockchain and cryptocurrency companies already supporting payments and financial applications.
As the industry rapidly evolves, it’s no longer sufficient to merely be researching CBDCs. Central banks need to have teams assembled and resources allocated against a strategic plan. Without a tangible approach and measurable progress, countries will continue to fall behind more progressive nations.
A digital currency solution should look to overcome inherent risks associated with existing centralized payment rails like single point of failure and the lack of underlying infrastructure to mitigate risk. Issues may arise with any system, but smart infrastructure design should accommodate these specific issues and ensure the cascading effects are limited.
The solution that digital currencies offer as a distributed payments system can remove the “single point of failure” aspect from the equation, making the underlying infrastructure more robust, risk-averse, and better positioned for reliability, growth and efficiency—all while central banks retain sovereignty over monetary policy and currency output.
CBDCs as a Growth Accelerator
There is a tight relationship between the efficiency of a nation’s payment rails and the nation’s economic growth. For example, a flatter system for cross-border payments reduces onboarding friction, cost, time, and risk. These efficiencies open new markets for local goods as well as more options for importers. A nation with a CBDC becomes more competitive and accessible on the world market.
Additionally, when these systems are built on a distributed blockchain, two superior differences stand to benefit all parties involved: a high rate of reliability and lower cost compared to traditional systems. Reliability reduces the need for large capital expenditures and complex legal arrangements to introduce and maintain new products and services. Economic growth is then facilitated by this decreased cost, thus allowing for a greater number of, and more innovative, products and services to come to market.
Ultimately, these advantages can be obtained and these challenges can be overcome with the right teams and technology in place. There will undoubtedly be a range of digital currency solutions put forward—with some nations favoring public-private partnerships while others lean into government-led CBDC efforts or even a hybrid of the two—but whatever the final form, the potential for economic growth and greater efficiency is simply too large to allow near-term hurdles to hold back innovation.
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