Macro Analysis /
Global

Is there a need for digital currencies?

  • What issues do digital currencies help solve?

  • There are a number of downside risks to the widespread adoption of digital currencies

  • Do the pros of adopting digital currencies outweigh the cons?

Kieran Siney
Kieran Siney

Head of African Markets

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ETM Analytics
1 February 2022
Published byETM Analytics

Is there a need for digital currencies?

It is no secret that currency markets are plagued by a number of structural and systematic challenges, particularly in Africa. Issues such as currency illiquidity and excessive levels of volatility have for decades had a significant impact on economies, trade and the ease of doing business. Digital currencies and cryptocurrencies offer a real-world solution to some of the key currency challenges on the continent.

Africa has led the adoption of digital currencies in a bid to resolve some of the continent’s currency problems. The Central Bank of Nigeria launched the continents’ first digital currency, the e-Naira, last year. Ghana is also progressing towards rolling out its own digital currency, with the e-Cedi already in a trial phase. A number of other African countries, including South Africa, Kenya and Rwanda, are also looking to create their own digital currencies backed and issued by central banks as the appeal for digital currencies grows on the continent. Major central banks are also undertaking their own studies into the adoption of a digital currency.

What issues do digital currencies help solve?

One of the main attractions of digital currencies for central banks is that it simplifies the circulation of money into an economy, whether it be through monetary or fiscal policy. Moreover, digital currencies have extremely fast transfer and transaction times and accomplish the transfer of funds without an intermediary. As such, digital currencies are usually instantaneous and low-cost, especially when compared to traditional payment methods that involve banks and clearinghouses. Moreover, it is worth pointing out that digital-currency-based electronic transactions also bring in the necessary record keeping and transparency in dealings.

However, there are a number of downside risks to the widespread adoption of digital currencies

While there are a number of benefits of digital currencies, there are some downside risks to the broad adoption of digital currencies. The Bank for International Settlements said in its report that government-backed digital currencies could lead to higher volatility in deposits and/or a significant, long-term reduction in customer deposits. The Bank for International Settlements concluded that this could, under certain circumstances, affect bank profitability, lending and the overall provision of financial services.

The Bank for International Settlements said in a research report that during a crisis, a central bank digital currency could be perceived as a safe haven. The report noted that evidence from previous systemic bank runs indicates how powerful the impetus of a bank run is and how the reduced transaction costs of a central bank digital currency could exacerbate bank runs.

How can these risks be managed?

Although the adoption of digital currencies comes with some risks, these risks can be managed by central banks forcing tight controls on the currencies. These include hard limits on transfers or holdings of the digital currencies over a lengthy transition period before launching the new assets. Moreover, central banks can implement pricing safeguards, such as uncompetitive interest rates, which could also be imposed to help limit risks.

Do the pros of adopting digital currencies outweigh the cons?

Looking at the explosion in cryptocurrencies, it is clear that there is a need for the adoption of digital currencies by central banks. In a recently published report, the Federal Reserve highlighted that a digital currency would be a safer form of digital payment because the Fed, unlike a bank or the companies issuing stablecoins, can't go bankrupt. It could be easier and less expensive to access for people without bank accounts. Moreover, the Fed could even seek to use the digital currency to influence monetary policy, as it now does by controlling interest rates.

While there are still some significant downside risks that need to be ironed out, we assess that the pros of adopting digital currencies outweigh the cons. That said, though we have already seen central banks such as the Central Bank of Nigeria adopting digital currencies, we expect the widespread adoption of digital currencies by major central banks, including the US Federal Reserve, Bank of England, European Central Bank and Swiss National Bank, to be relatively slow as there is still a lot of scepticism surrounding their adoption.

Following its most recent study, the Fed suggested that a digital currency that would best serve the needs of the nation would follow an intermediated model under which banks or payment firms would create accounts or digital wallets. While pressure is mounting on central banks to adopt digital forms of their currencies, the Fed is likely still some way from issuing a digital currency. China last year took a significant step forward in the implementation of a digital yuan in the form of its Digital Currency Electronic Payment project. It must be noted that the digital yuan is not a decentralized cryptocurrency, but is run on a centralized network controlled by the PBoC. This is a clear sign that policymakers in some of the world’s largest economies are taking the adoption of digital currencies seriously. 

Conclusion

The global currency market is undoubtedly transforming with the rapid expansion of cryptocurrencies, digital currencies and blockchain technology, causing a stir around the globe. Although a number of risks need to be worked out, governments and economies stand to benefit from the adoption of these technologies. While we expect the rolling out of government-backed digital currencies to be slow, we are of the view that this is the direction that the globe is shifting in.