CBDCs represent a digital form of central bank-issued money designed to function as legal tender for public use. Retail CBDCs, the primary focus of this discussion, are intended for everyday transactions by the broader citizenry. Monetarily, they are defined as a “digital payment instrument, denominated in the national unit of account, that is a direct liability of the central bank” (BIS, 2020). The primary purposes and aims of CBDCs are of a macroeconomic nature, promising to “enhance payments inclusion and efficiency, as well as ensure competition … and the integrity of [the] payment system” (BIS, 2020). CBDCs offer central banks a novel mechanism to fill the gaps left by traditional financial services.

The evolution of CBDCs is a direct response to the profound changes sweeping across global financial systems. These changes are driven by technological innovation, the rise of private digital currencies, and shifting economic and geopolitical landscapes. CBDCs have emerged as a tool for central banks to maintain monetary sovereignty in an increasingly digital world while addressing the challenges of decentralised cryptocurrencies and private payment networks.

The digital revolution has radically transformed the way money is perceived and used. The advent of blockchain technology and cryptocurrencies, like Bitcoin, ushered in a currency paradigm shift—one that is decentralised, borderless, and free from central bank control (Lambis et al., 2024). Consequent aftershocks have fissured through traditional financial systems and mediums, compelling central banks to reconsider their role in a digital economy. Specifically, the “digitisation of money and payments has mostly been dominated by private sector operators and has given rise to a number of challenges for public policymakers” (Emilios et al., 2024), presenting a significant challenge to the traditional role of central banks in the economy.

For central banks, the rise of CBDCs is not just about financial innovation or pecuniary mobility. Academic pundits and commentators encircle the view that “CBDCs may be seen as an assertion of monetary sovereignty—perhaps the last chance to do so in the face of technological change” (Emilios et al., 2024). By issuing their own digital currencies, central banks aim to retain their ability to manage money supply, control inflation, and ensure financial stability in a world where private digital currencies threaten to undermine these traditional levers of monetary policy.

One of the critical drivers of CBDC development is the promise of enhanced financial inclusion. In many developing economies, large portions of the population remain unbanked or underbanked, with limited access to traditional financial services (WBG, 2022). CBDCs, particularly in retail form, could provide a solution by offering a direct, accessible digital currency that does not require a traditional bank account. For instance, the Sand Dollar—a CBDC issued by the Central Bank of the Bahamas—was specifically designed to address financial inclusion challenges in a country (Branch et al., 2023). Spread across over 700 islands, the Bahamas faced immense challenges in providing financial services to remote, sparsely populated areas, where physical infrastructure was impermissible. The Sand Dollar was introduced to modernise the payment system and reach the unbanked population, offering a secure, blockchain-backed digital token pegged one-to-one to the Bahamian dollar (IMF, 2021). Compared to online banking, retail CBDCs do not require individuals to have an account with a commercial bank, and, consequently, payments access can be facilitated through telecommunications networks and social media or electronic commerce networks (Lannquist et al., 2023). However, some academics suggest that this payments infrastructure—specifically, the provision of digital wallets for CBDCs by non-banking entities—could present potential regulatory issues.

Beyond financial inclusion, CBDCs promise to significantly enhance the efficiency of payment systems, particularly in international transactions. The widespread adoption of CBDCs across multiple countries could foster strong competition among nations to optimise cross-border payment systems. This competition could “lead to lower transaction costs for cross-border payments, which in turn would make migrant labour remittances to their home country much cheaper, adding serious social value” (Emilios et al., 2024). This potential to reshape international payments is a significant driver behind the push for CBDCs, particularly in emerging markets where remittances are a vital source of income.

Geopolitical considerations also play a crucial role in the development of CBDCs. Countries like China have been at the forefront of CBDC experimentation, with the digital Renminbi (RMB) being positioned as a tool to challenge the global dominance of the U.S. dollar. Specifically, “China has expressed the ambition to replace the USD as a global reserve currency through the cross-border use of the digital RMB” (Emilios et al., 2024). Such developments, especially if virally spread, could radically transform current global monetary arrangements and hegemony.

CBDCs have the potential to significantly alter the tools and mechanisms through which central banks conduct monetary policy. The introduction of CBDCs could change the landscape of money supply control, interest rate transmission, and even the broader structure of financial intermediation. While CBDCs offer opportunities for central banks to enhance the precision of monetary interventions, they also pose challenges that could undermine the effectiveness of traditional monetary policy tools.

CBDCs could profoundly affect the transmission of interest rates throughout the economy. With CBDCs, central banks could apply interest rates directly to digital currency holdings, bypassing the traditional banking system. This could enhance the effectiveness of monetary policy, especially in a low-interest-rate environment where conventional tools have proven less effective. Academic scholarship contends that “replacing physical cash with CBDC is the key to eradicating the zero lower bound constraint and giving full play to the negative interest rate policy” (Grasselli & Lipton, 2019). Moreover, “with proper issuance arrangements, CBDC policy rules can significantly improve central banks’ ability to minimise risks and stabilise business cycles” (Barrdear & Kumhof, 2022).

A central concern for monetary policy is the potential for CBDCs to disrupt financial intermediation. If CBDCs are widely adopted by the public, there could be a significant outflow of deposits from commercial banks to central bank digital wallets. Consequently, banks may face liquidity shortages, impairing their ability to lend and provide economic credit. Specifically, a sizeable corpus of literature contends that “CBDC would structurally decrease deposit funding available to commercial banks” (Jesús Fernández-Villaverde et al., 2020; Keister & Sanches, 2019). As a result, “scholars worry that digital currency and digitalisation could cause an inversion of the currency financial intermediation system” (Wang et al., 2022). Notwithstanding, extant literature argues that CBDCs would “only have small negative effects on the financial intermediation system because of the low circulation volume … and [this] would also vary depending on their liquidity” (Wang et al., 2022).

Moreover, CBDCs could complicate the balance between maintaining financial stability and pursuing monetary policy objectives. Specifically, CBDCs “may cause or precipitate a run on commercial banks on the back of mass withdrawals of bank deposits … into CBDC holdings that are remunerated” (Emilios et al., 2024). However, imposing limits on CBDC remuneration and quantity can mitigate such run risks, “complementing traditional central bank tools for emergency liquidity assistance” (Carapella et al., 2024). Central banks would need to carefully manage the rollout of CBDCs to ensure they do not inadvertently destabilise the financial system while attempting to enhance monetary policy efficacy.

CBDCs also introduce new dimensions to international monetary policy coordination. The cross-border use of CBDCs could lead to currency substitution, where countries with weaker currencies adopt foreign CBDCs. Academic scholarship argues that the “best defence against digital dollarisation may be for countries to issue their currencies in digital form”, wherein CBDCs offer an avenue to “adapt domestic currencies to the new state of technology and, in the process, to protect them from outside competition based on digital superiority” (Brunnermeier, 2019). Furthermore, digital dollarisation poses significant risks to the sovereignty of developing countries, particularly those with weaker economies or unstable currencies. Specifically, “significant adoption of money not denominated in the sovereign currency could limit the impact of monetary policy or the ability to support financial stability…. In extremis, such a ‘digital dollarisation’ could see a national currency substituted by another with the domestic central bank gradually losing control over monetary matters” (BIS, 2020).

The agglomeration of CBDCs into the broader financial infrastructure provides a modernisation of the payment systems and increased financial inclusivity, however, potentially at the cost of financial stability. The introduction of CBDCs could disrupt the traditional banking sector, intensify liquidity pressures, and introduce systemic risks that become particularly acute during periods of economic stress. Balancing innovation with the preservation of financial resilience is crucial as central banks chart this new territory.

The potential for liquidity stress is another significant risk posed by CBDCs. The ease and speed of transferring funds between traditional bank accounts and CBDCs could exacerbate capital flight during periods of instability. Specifically, “the introduction of a CBDC may also increase run risks for the banking system in times of stress if the cost of shifting funds between bank liabilities and CBDC is low and execution is rapid” (Infante et al., 2022). Such scenarios could trigger systemic financial stress, especially if existing liquidity management frameworks cannot contain the rapid outflow of funds.

This dynamic is particularly concerning in a crisis scenario. CBDCs could “facilitate a flight away from private financial institutions and markets towards the central bank” (Loh & Coeure, 2018), creating what some have termed ‘digital runs’—massive, rapid withdrawals from commercial banks as depositors seek the safety of central-bank-backed digital currency. Such digital runs could unfold “with unprecedented speed and scale” (Loh & Coeure, 2018), further complexifying liquidity pressures during periods of financial instability.

Furthermore, the proliferation and widespread adoption of CBDCs present complex challenges that extend beyond simple financial disruptions, potentially deepening systemic crises when the banking system is already vulnerable. For instance, although “the availability of CBDC might not have a large impact on individual bank runs... during a systemic banking crisis, transfers from bank deposits into CBDC would face lower transaction costs than those associated with cash withdrawals” (BIS, 2021). This ease of movement could permeate financial contagion, further amplifying the risks of market failure, particularly if “the technology supporting the CBDC were to fail” (Broby, 2022). Additionally, during periods of macroeconomic fragility, the introduction of CBDCs may intensify financial instability as “individuals and institutions seek safer assets, which may lead to a loss of deposits for commercial banks” (Hiep et al., 2023).

Central Bank Digital Currencies stand to transform the global financial system by modernising payment methods and enhancing financial inclusion. However, they carry inherent risks, particularly in their potential to destabilise traditional banking systems, intensify liquidity pressures, and introduce new systemic vulnerabilities. Consequently, CBDCs must be carefully designed with appropriate safeguards to mitigate these risks, such as quantity limits and tiered remuneration. These measures help balance the benefits of innovation with the need to preserve financial resilience. The future of CBDCs hinges on how well these risks are managed and how effectively global financial systems adapt to this new financial landscape.

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