What is the next step in the evolution of digital money?

Following cryptoassets, a new generation of central bank digital currencies is poised to transform our understanding of money and how to manage it.

The Bahamas launched a new digital currency called "sand dollars" in October 2020. These digital tokens are legal currency, with the same legal status as their old-fashioned money — paper notes and coins — and are issued by the country's central bank. The sand dollar is money; it only lacks a tangible form. Bahamas residents may now download an e-wallet on their phones, load it with sand dollars, and spend with a single tap.

Only the Bahamas and Nigeria have officially implemented central bank digital currencies (CBDCs) at this time. However, many others, including China and the Eastern Caribbean Currency Union, are conducting CBDC trials. More than a hundred countries are looking into it. In the United States, the Federal Reserve produced a discussion paper on CBDCs in January, taking into account all of the risks and opportunities.

This is an exciting time in the history of money. Cryptoassets (also known as "cryptocurrencies") such as bitcoin have exploded in popularity in recent years; today, firms are experimenting with less risky alternatives, such as so-called stablecoins, and governments are looking into CBDCs. All of them will almost certainly coexist in a new continuum, with the two most frequent forms of money (cash and bank deposits) experiencing stiff competition. This changing environment holds the prospect of simplifying foreign payments, increasing access to microloans, and lowering transaction costs. However, there are significant concerns to be aware of.

Let us not forget that money has evolved over time, from beads to gold coins to paper bills and credit cards. National currencies were often backed by commodities in the early 1900s; this is no longer the case. In the early 1930s, the US dollar was decoupled from the gold standard, becoming a "fiat" currency whose value is completely determined by the government's word. Then, as computer power and use grew, electronic payments became commonplace.

Cryptoassets (commonly dubbed cryptocurrencies, but they aren't truly currencies, but rather assets with speculative value and appeal) have experienced a flurry of activity in recent years. These are privately generated and cryptographically secured decentralized assets that allow peer-to-peer transactions without the use of a middleman like as a bank. Since the inception of bitcoin in 2009, an estimated 14,000 new forms of cryptoassets have been created, ranging from litecoin to ethereum, with a market cap of US$2.3 trillion by the end of 2021. They're extremely volatile, rarely accepted, and have a large transaction fee.

Stablecoins, which are often issued by a payment operator or bank and try to provide price stability by connecting its value to a fixed asset such as US dollars or gold, have sparked interest due to the volatility of cryptoassets. Two of the most liquid gold-backed stablecoins are Tether gold and PAX gold. Stablecoins come in a variety of colors of stability, and their growth is exponential. Unlike cryptoassets, stablecoins have the potential to be used as worldwide payment instruments.

CBDCs are a new sort of fiat money that broadens digital access to central bank reserves by making them available to the general public rather than only commercial institutions. The digital nature of banking would be combined with the peer-to-peer transactions of currency in a CBDC. However, there are numerous unanswered concerns concerning how a CBDC in any given country might operate: Would money be held in a bank account, or would it be closer to cash, manifesting as digital tokens? Would CBDCs pay interest at the same rate as a bank deposit, or would they not? The sand dollar is issued by Bermuda's central bank, is subject to quantity restrictions, and does not pay interest.

CBDCs have a number of significant advantages: They have the potential to improve the cost-effectiveness, competitiveness, and resilience of payment systems. They would, for example, lower a country's cost of managing physical cash, which may be a significant price for countries with a huge land mass or numerous dispersed islands.

CBDCs have the potential to enhance cross-border payments, which are now reliant on multilayered banking relationships, resulting in extensive payment chains that are slow, expensive, and difficult to manage. CBDCs could also aid in the resilience of payment systems by establishing a decentralized platform, effectively protecting the payments infrastructure from operational risks and cyberattacks.

Many people in many nations do not have bank accounts, and the "unbanked" have limited access to loans, interest, and other financial and payment services. CBDCs have the potential to change their lives by integrating them into the financial system.

There are, however, dangers. One example is if everyone chose to buy a lot of CBDCs and then withdrew their money from banks all at once. To keep consumers, banks would have to boost deposit interest rates or charge higher interest rates on loans. Fewer people would be able to obtain loans, and the economy would likely slow. Furthermore, if CBDCs lower the costs of holding and transacting in foreign currency, nations with weak institutions, high inflation, or unpredictable exchange rates may see people and businesses flee their home currencies wholesale.

There are workarounds for these issues. Central banks may, for example, charge a lower interest rate on CBDC holdings (which appear as liabilities on a central bank's balance sheet) than on other types of liabilities, or only distribute CBDCs through established financial institutions.

Institutions are now scrambling to draft new laws and regulations to address all of these issues, as well as determining how new forms of money should be classified: as deposits, securities, or commodities. In light of virtual assets, the Financial Action Task Force has modified its anti-money laundering rules and counter-terrorism financing standard, while the Basel Committee on Banking Supervision has produced a paper on how banks should prudently restrict their exposure to cryptoassets. The IMF (where I work) is on the case, offering independent analysis of these challenges.

Everyone will have to be quick on their feet and think on their feet. To keep CBDCs on the cutting edge of technology and in users' wallets, central banks will have to emulate Apple or Microsoft. Money could be exchanged in whole new ways in the future, perhaps automatically through chips embedded in common items. This will necessitate constant technological redesigns as well as a wide range of money types. Expect your money to appear very different in the near future, regardless of what shape it presently takes in your bank, wallet, or phone.

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