Will digital currencies offer a new method of payment in international trade?

Countries and companies are launching digital currencies

Digital currencies have been a hot topic over the past year, especially in a context where cash transactions have been dwindling fast due to the Covid-19 pandemic. This trend is expected to continue when the pandemic eventually wanes. As a result, digital currencies have come to the forefront as a potential alternative method of payment, even though it’s more than a decade since the first digital currency – the cryptocurrency Bitcoin – was launched (2009), and thousands of other digital currencies in the form of cryptocurrencies have followed since. One interesting point to note is that cryptocurrencies were mainly created by private companies and not by countries. To date, the only country that has launched a cryptocurrency is Venezuela with its “petro” in 2018, although further countries have also been diving into the subject of digital currencies. In 2019, about 80% of central banks worldwide were considering issuing a digital currency of their own, but in the form of central bank digital currencies (CBDCs), rather than a cryptocurrency. A notable example is the European Central Bank, which is hoping to launch its digital currency in 2025. Around half of the central banks have even progressed past conceptual research towards experimenting and running pilots. China wants to launch a digital state-backed currency, the “e-yuan”, in February 2022 when Beijing holds the Winter Olympics, and the Bahamas is one of the furthest evolved countries after launching its “Sand dollar” CBDC at the end of 2020. The question is what exactly are digital currencies, and will they offer a new method of payment for international trade in the future?

Not all digital currencies are the same

There are many forms and sub-forms of digital currency. Here we focus on the key difference between cryptocurrencies and CBDCs. A cryptocurrency is a currency that is not supported by a central bank or other public institution, which safeguards its value. This is very different to a CBDC, which is the digital equivalent of cash, and represents a form of debt on the central bank, just as cash is. Therefore, acceptance of cryptocurrencies is based entirely on users’ trust in the technology and – if it is pegged – in the private company ensuring the peg. Contrary to cash or CBDCs, this acceptance does not depend on one’s trust in a central bank. So how can a cryptocurrency generate trust between users? Cryptocurrencies rely on distributed ledger technology, such as a blockchain, to construct a ledger (effectively a shared database) that is maintained across a network. To ensure that the same cryptocurrency is not spent twice, each member of the network verifies and validates transactions using technologies derived from computing and cryptography (the science of hiding information). Once a decentralised consensus is achieved among the members of the network, the transaction is added to the ledger, which provides a complete history of the transactions. So, unlike CBDCs, cryptocurrencies cannot be manipulated by a central bank or public institution but cannot be seen as debt on a public institution either. That being said, within the categories of both cryptocurrencies and CBDCs there are many potential sub-forms. CBDCs may differ in underlying technology (e.g. use of a blockchain) and in their aim (as a safe haven when there is a banking crisis, as a tool for monetary policy, etc.). As for cryptocurrencies, they can also rely on different technologies and have different intended uses (e.g. as a medium of exchange, a way to speculate, a way to protect against inflation, etc.).

Why are central banks investigating the use of CBDCs rather than cryptocurrencies?

In 2018, Russia and Iran agreed to use cryptocurrencies for their trade interrelations as they offer a solution for countries that wish to circumvent US sanctions. As virtually all USD transactions pass through the US, transactions involving entities sanctioned by US authorities may be blocked or rejected, even in the case of mere contracts between Russia and Iran. Moreover, unlike other currencies, when transferring cryptocurrencies the SWIFT payment system – the world’s largest electronic payment messaging system – is circumvented, while SWIFT has cooperated with the US in the past in order to make sanctions more effective. Recently, noteworthy companies are also starting to accept or offer products connected to cryptocurrencies such as large payment providers (Visa and Mastercard) and PayPal. So the launch of new CBDCs might seem unnecessary, although they have a bigger chance of being used as a payment method than cryptocurrencies for several reasons. Firstly, despite recent interest in cryptocurrencies, the overall market capitalisation is still under that of major companies, and small compared with the size of global capital markets. Moreover, a rather limited acceptance for payment restricts the use of cryptocurrency as a medium of exchange. Secondly, there are still many problems related to the acceptance of cryptocurrencies as a payment method, such as customer protection (privacy and security), compliance with the laws and regulations of countries (e.g. taxes) and its use for money laundering and terrorist financing (due to the pseudo-anonymity of many cryptocurrencies). These issues have even led to a ban of cryptocurrencies in certain countries. Thirdly, cryptocurrencies are not efficient for use in large volumes, as they are relatively slow and require a high computing capacity (due to the underlying blockchain technology). Therefore, it is also enormously energy intensive; there are estimates that the entire network for Bitcoin (the most popular cryptocurrency) consumes more energy per year than a number of countries, such as Sweden or Ukraine. And finally, the most important challenge is probably the volatility of the cryptocurrencies themselves. They are currently thinly traded and less liquid, which leads to large fluctuations in value, making them interesting for speculators and less interesting for trade. Graph 1 shows the yearly fluctuation of the Bitcoin – the best known and most popular cryptocurrency in the world – vis-à-vis the USD (last update: 25 May 2021). Though yearly fluctuations are very large, on a monthly basis the currency can gain or lose 50% of its value. That being said, cryptocurrencies are constantly innovating and so-called ‘stablecoins’ try to solve the wild fluctuations by being pegged to real-world assets such as legal tenders or gold. As cryptocurrencies are constantly evolving in order to tackle the aforementioned problems, it is in the interests of governments to introduce publicly backed digital currencies to reduce the risk that private cryptocurrencies replace government tenders. With CBDCs, the danger to financial stability from reliance on purely private payment systems would lessen, and, moreover, in theory CBDCs could also give the central bank a tighter grip on monetary policy. At present, the central bank raises the interest rate in the hope credit availability shrinks from the banks and, as such, affects the real economy. Depending on the form that the central bank choses, a CBDC could affect the real economy directly, for example with negative interest rates on the accounts of the central bank. A government could even chose to influence its citizens’ actions by rewarding positive behaviour with instant extra digital currencies, and punishing bad behaviour by means of the instant removal of digital currencies. 

CBDC as a way to pay for international trade?

Many of today’s CBDC projects and pilots have a primarily domestic focus. First and foremost, any CBDC will be designed for domestic users and the domestic payment system; for example, the recently launched “Bahamian Sand dollar” CBDC is only for local use. Unfortunately, different legal and regulatory frameworks and payment systems present a significant obstacle to cross-border payments with CBDCs. Allowing the international use of CBDCs – as the underlying technology could make it faster, cheaper and more inclusive (for the underbanked) than current cross-border payments – also brings additional considerations regarding the safe functioning of the international monetary and financial system. A CBDC of one jurisdiction could impact another jurisdiction’s monetary policy or financial stability. An example of this would be undesirable volatility in foreign exchange rates. “Digital dollarisation” could also occur when the digital currency is used in addition to or instead of the domestic currency of another country, which usually happens when a country's own currency loses its usefulness as a medium of exchange due to hyperinflation or instability. Furthermore, depending on how the CBDCs are implemented, there is a risk that they could be used to avoid laws and regulations in cross-border payments (e.g. tax avoidance or avoidance of capital controls).

Nevertheless, central banks are looking for ways to overcome these problems by working together. 
China is going one step further by developing a global blockchain-based service network (BSN), and in February 2021 it was announced that SWIFT has set up a joint venture with the Chinese central bank’s digital currency research institute and clearing centre. Although it is still in the design phase, the BSN plans to roll out a universal digital payment network to support different countries’ CBDCs. The aim is to develop a standardised digital currency transfer method and payment procedure, which could even gain a central role in future international financial transactions. If this is indeed developed and widely used, it may result into a huge shift on the geopolitical landscape. Currently, the USA has a high degree of control over international financial transactions (due to the widespread use of the USD), but if the Chinese BSN is introduced and widely accepted it might give China a similar influence. This could well be the case since the USA has stressed that it does not need to be the first to launch a CBDC (although the Biden administration recently stated that a CBDC was a priority). A Chinese CBDC might become important internationally, most notably in Africa, where there is ample space for the digital currency as many economies are underbanked but increasingly connected through mobile devices towards digital payments. That being said, much will depend on the set-up of the CBDC and the accompanying policies (e.g. the yuan is subject to capital controls).

So, in the short term, a CBDC will be initially for local use, although in a more distant future the use of CBDCs for international trade is becoming increasingly likely. Countries that can issue a digital currency that is internationally accepted or that can roll out a universal digital payment network to support different countries’ CBDCs could profit from a first-mover advantage (if the many problems surrounding CBDCs for international trade are tackled). And eventually it could even result in a geopolitical shift of financial power away from the USA, if another country is able to successfully launch a widely accepted CBDC first.

Analyst: Jolyn Debuysscher – j.debuysscher@credendo.com