ChatGPT may have stolen the spotlight, but central bank digital currencies are the innovation to watch

Central banks across the world are responding to the challenge posed by the rise of decentralised finance by creating their own digital currencies
Central bank digital currencies have the potential to revolutionise the global monetary system and give billions of unbanked or underbanked people access to finance

Andrew Sheng

Published: 1:30am, 1 Jul 2023

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ChatGPT has been touted as the tech breakthrough that could revolutionise daily operations, raising productivity and ushering the world into a new era. However, a series of technological innovations beginning with the digitisation of financial services, including blockchain and the arrival of digital currencies, is slowly but surely transforming the financial landscape.

As central bankers grapple with the complexity of digital money, they have come to realise a new monetary system is already on the cards and could be close to reality. What will this new monetary system look like?

The Bank for International Settlements (BIS) is the de facto central bank of central banks. Its real function is to be the intellectual hub where central bankers analyse and discuss emerging challenges and issues.

Its annual report is the authoritative view of how mainstream central bankers see the world. In recent years, it has led thinking by exploring the implications of digitising money on the role of central banks. Beginning in last year’s annual report, the BIS has started talking about three journeys – monetary and inflation trends, including interest rate tools; their impact on financial stability; and how technology is transforming the financial landscape.

Central bankers stand at the apex of the mainstream financial system, which is highly centralised and top-down. Central banks have been put in charge of money the state creates. Sovereign money is by law that which people use to settle any debts.

The US dollar accounts for over 80 per cent of total foreign currency trading and about half of global trade invoicing, which means that most foreign exchange is finally settled across the books of the Federal Reserve. The United States owes the rest of the world about US$16 trillion in net foreign exchange, so the Fed’s capacity to expand or decrease money supply has global power.

The big picture is that central bank power in terms of balance sheet size has ballooned over the years via quantitative easing, with central banks’ share of global financial assets rising from less than US$9 trillion in 2007 to US$44 trillion in 2021. Central bankers are in charge of debt-based banks, which today account for about 40 per cent of global financial assets. Non-bank financial institutions (NBFIs), mostly fund managers and largely equity-based, account for the other half.

Pedestrians pass the Marriner S. Eccles Federal Reserve building in Washington on June 3. The dominance of the US dollar means the Federal Reserve has a pivotal role in the global financial system. Photo: Bloomberg

After the 2008 financial crisis, the Financial Stability Board was created to oversee global systemic financial stability as central bankers kept trying to exercise oversight over NBFIs. Asset managers and politicians are unwilling to allow central bankers too much power, especially since central bankers are not democratically elected but appointed officials.

The countervailing power against mainstream finance is decentralised finance. The latter has long existed in the form of informal finance, which is prevalent because many people are still unbanked and do not have access to formal finance, especially banks and equity markets.

Digital finance can empower billions of unbanked or underbanked people by cutting out traditional financial intermediaries that are expensive and, in some cases, predatory. Using the internet and blockchain’s distributed ledgers, decentralised finance is able to not only compete with conventional centralised finance but also become opaque to official oversight. If this happens, the state and central banks could lose a degree of control.

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After dithering over regulating cybercurrencies for fear of stopping innovation, central banks allowed cryptocurrencies to reach a peak market value of US$3 trillion before their collapse, becoming a force that could threaten state control. This forced central banks to think about how to use central bank digital currencies (CBDCs) to create a digital finance world in which they still stand as the spider in the financial web.

Through the BIS Innovation Hub, central banks have been thinking through and piloting how the new monetary and financial system could work. The breakthrough was the realisation that money is not just conventionally thought of as a unit of value or means of payment but also a store of value.

Digital money is really a token, a standardised lump of information that contains not only data but also the rules by which the token can be exchanged for value. Money has transformed into a digital lump that contains your information as well as value. It can be transformed into complex instruments such as securities, so what if all such information and the rules by which it is packed can be traded through a standard token that can be exchanged through a global unified ledger?

How to unleash CBDCs’ potential without disrupting commercial banking

This global unified ledger is effectively the tech platform whereby everything is settled through CBDCs. This is enormously complex in design and execution, which means that most people would not understand how it works. But it promises to produce a trusted, transparent, efficient and resilient financial system that avoids scams and enables official oversight.

The latest BIS annual report suggests this infrastructure can be built by the private sector with CBDCs as the foundation token. In effect, CBDC tokens are the building blocks of a new world of digital money and finance. Notice that tools such as ChatGPT are hardly mentioned, because artificial intelligence is only another step on the journey to digital nirvana.

This is a lot for most people to process. The third chapter of the BIS annual report is a must-read since it sketches out the new monetary system’s foundational architecture. If this all sounds like an exaggeration, watch this space. Your financial future depends on it.

Andrew Sheng is a former central banker who writes on global issues from an Asian perspective