Digital and crypto currencies are rapidly changing the nature of money itself. Digital currencies issued by central banks will have big implications for the financial sector and how banks make money. A proliferation of new currencies could also threaten the stability of the financial system.

Professor Eswar Prasad is the author of the upcoming book, The Future of Money: How the Digital Revolution Is Transforming Currencies and Finance. In this second of two pieces, he discusses the impact on the banking system. The first article, on the role of central banks in digital currencies, is available here.

PRASAD: If you’re in the financial services sector, this is a potentially worrying time because the arrival of a central bank digital currency (CBDC) in your country will make it much harder to compete in terms of digital payments. 

Many central banks are aware of this — they’re aware that a CBDC could limit private sector innovations in digital payments. So what they’re trying to do is provide their central bank digital currencies as tokens, on top of which the private sector can innovate in terms of using those tokens more effectively to intermediate payments between customers and businesses or between businesses and businesses. 

For businesses, I think this is going to be a fairly welcome change. The competition in the digital payment space is going to yield a range of benefits resulting from lower costs and make it much easier to execute payments, both within and across borders. 

An Existential Risk to the Banking Sector?

BRINK: Do you foresee that there will be a lot of resistance to central bank digital currencies from the financial sector? 

PRASAD: At one level, one might argue that an account-based CBDC is an existential threat to commercial banks because consumers and businesses might see a central bank account as being much safer in difficult times, in particular, but even in normal times, compared to an interest-bearing deposit account, especially in periods where the interest rate is low. I think central banks are very cognizant of this. 

The Bahamas, for instance, which has already rolled out its own CBDC, has put limits on the amount that consumers and businesses can hold in their CBDC accounts so that huge volumes of money don’t get swept out of commercial bank accounts. 

But certainly they can no longer count on some of the high-margin businesses that banks now enjoy, especially in terms of facilitating cross-border payments.

There is a legitimate concern about whether we want to live in a world where our privacy, which has already been severely compromised, is further undercut if every financial transaction might end up being visible to either a private firm (a bank or payment provider) or to the government. 

Fintech platforms are also beginning to directly intermediate between savers and borrowers. So it’s not just cryptocurrencies or digital currencies, but various new financial technologies that pose some serious risks to the underlying business model of banks. 

So banks will have to compete more fiercely to retain their edge. Some banks are already adopting the new technologies, but certainly we might be heading to a world where margins on their traditional businesses — intermediating between savers and borrowers in terms of maturity transformation and facilitating payments — are all going to shrink quite significantly.

BRINK: Presumably it won’t affect the world of credit that much. Since CBDCs are not credit accounts, that will still be a viable business.

PRASAD: That’s right, banks are still going to be very important in terms of creating money, because after all, when a bank makes a loan, it creates a corresponding deposit. So commercial banks are responsible for creating most money in modern economies, but certainly there is the concern that if CBDC accounts do catch on, they would undercut the business of commercial banks. And that is a significant worry, as commercial banks remain quite important in terms of creating credit and creating money in an economy.

We may not like big banks — we may not view them as entirely safe — but at least we know how to examine their books and so on. 

As more financial activity moves to unregulated or less-regulated parts of the financial system, there are concerns about whether there could be financial stability risks that we are not quite prepared for, simply because regulation hasn’t quite caught up with the new technologies and all the possibilities they offer.

BRINK: Do you think central bank digital currencies will push out private cryptocurrencies like Facebook’s Diem?

PRASAD: Certainly a digital version of a fiat currency will make it much more challenging for either a decentralized cryptocurrency, such as Bitcoin, or even a stable coin, such as the one that Facebook is designing, to survive. 

Facebook’s main pitch is that its currency, called Diem, would be backed by reserves of U.S. dollars and would provide for more efficient payments, both within and across countries. But if a CBDC can do the same thing, it’s not obvious why people might prefer a Facebook currency. 

Facebook might have certain advantages in terms of innovation, which could make payment systems more efficient or more convenient to use, but the base case for a privately issued stable coin is going to be undercut if, for instance, the U.S. were to start issuing digital dollars.

Less Privacy

BRINK: Your book is called The Future of Money, and you sound quite optimistic about this future. Would that be right?

PRASAD: Overall, I think we are going to benefit in many ways from the remarkable financial innovations that are taking place around us. But there are certain concerns as well. We might end up living in a world where if I were to buy you a cup of coffee, either a private payment provider or the central bank is going to know about it because of the digital trail. 

There is a legitimate concern about whether we want to live in a world where our privacy, which has already been severely compromised, is further undercut if every financial transaction might end up being visible to either a private firm (a bank or payment provider) or to the government. 

And there are potential financial stability risks coming from these new products simply because many of these are new, and we may not even know what sort of technological and other risks there are hidden behind them. 

So overall, I’m optimistic, but that is not to say I don’t see some stumbles on the path toward a cashless future.