The benefits and potential risks of digital fiat currencies

The benefits and potential risks of digital fiat currencies

June 28, 2018    

Cryptocurrency has taken the financial world by storm since 2008 through its ability to deliver peer-to-peer payment that is faster, cheaper, more secure, more convenient and more efficient than traditional legacy-based banking systems. As a result, cryptocurrency is increasingly becoming a potentially key tool for central banks to leverage for the development of a central bank-backed digital fiat currency (DFC).

These DFCs would be capable of not only taking advantage of the benefits of cryptocurrency, but also overcoming the high price volatility and lack of universal acceptance associated with current private offerings.

By doing so, and if implemented correctly, central bank-backed DFCs have the potential to both significantly transform the accessibility and usage of financial services in respective economies, as well as substantially deepen financial sector development.

This may be achieved through the potential of DFCs to (i) enhance the efficiency of national payment systems, (ii) ease the convenience of payment processes through mobile phones as primary financial service instruments, and (iii) encourage the broad digitisation of traditionally cash-based societies.

By doing so, digitised financial systems stand to benefit from more targeted monetary policy that has greater control over national liquidity flows. Lower transaction costs can also be achieved by both central banks through their reduced need to print, distribute and destroy physical cash from circulation, as well as by commercial banks who may save on costs associated with cash-handling and payment reconciliation processes that eventually translate into high consumer banking charges.

These cost savings, in turn, may result in greater net seigniorage revenue received by central banks through reduced marginal costs to produce physical currency, and the improved uptake of more accessible, affordable, efficient and secure financial services on mobile devices.

These gains to financial market development and inclusion are, however, subject to DFC implementation that is considered and idiosyncratically tailored to a given context where, if hastily applied, could risk exposing consumers to cyber-attack, financial instability and even national payment system failure if proper enabling infrastructure and regulatory frameworks are not ensured.

As DFCs are likely to impose substantial disruptions to national financial systems in these instances, it is important for central banks considering the implementation of DFC to do so with not only an eye on its benefits but also a sober understanding of its potential risks.

Our latest concept note with FSD Africa under our Risk, Remittance and Integrity programme, builds on our engagement with the International Telecommunications Union Financial Inclusion Global Initiative (FIGI) and aims to provide a brief assessment of both the benefits and risks of implementing DFC, as well as recommendations to assist central banks in optimising the value of this technology for the upgrading of national payments systems into the 21st century and beyond, as well as the critical promotion of economic development that is both digitally and financially inclusive.

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