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Private digital currencies are booming and central banks are catching up

Yan Xiao and Ziyang Fan

Digital currencies are growing: the market is valued at more than $2 trillion and involves more than 15,000 varieties. In 2021, El Salvador even adopted Bitcoin as its legal currency.

While private digital currencies are blooming, central banks are catching up. In October 2021, Nigeria joined the Bahamas, the Eastern Caribbean States and Cambodia as one of the first jurisdictions to officially launch central bank digital currencies (CBDCs). Based on the Atlantic Council’s CBDC tracker, 14 countries have launched CBDC pilots while 16 countries are developing CBDCs and 41 are conducting research.

From precious metals to paper money, currencies are crucial for global trade and commerce. As society enters the digital age and more forms of digital currency compete for virality, what does it mean for international trade?

There are three potential ways digital currencies could change international trade:

1. Digital currencies could cause an increase in efficiency for cross-border payments

The speed of settlement for cross-border payments varies from the same business day to five business days. Human interaction is often required in the process of verifying the sender and recipient’s information, for example for anti-money laundering and combatting terrorism financing (AML and CTF) purposes. As a result, the speed of payment is often determined by how much the business hours of the sending institution and the receiving institution overlap; and whether the sending and receiving institutions rely on the same messaging standards.

For digital currencies that rely on decentralized ledgers, money could be sent and received within seconds and around the clock. Future regulatory compliance requirements on digital currency service providers and foreign exchange controls may have an impact on the speed.

2. Digital currencies could provide alternative credit information for trade finance

There’s a $1.7 trillion global trade financing gap, which heavily impacts SMEs who typically don’t have established financial records with banks. Public ledgers of digital currencies could be used to share payment and financial history to underwrite loans for import and export. At the same time, strong privacy protocols would need to be enforced in order to achieve this.

3. Digital currencies could alleviate the issues of de-risking

De-risking creates obstacles for countries perceived with high AML and CTF risks who want to participate in global trade and can increase the transaction costs for buyers and sellers in those countries. While digital currencies do not help reduce the risks of AML and CTF, they could provide alternative payment methods to allow consumers and merchants from those countries to be reconnected with international buyers and sellers.

What European countries are developing digital currencies?
What European countries are developing digital currencies?
Image: Statista/Atlantic Council

New issues caused by digital currencies

Despite their promising potential, digital currencies may not, however, solve some existing problems facing international trade and could raise new issues including:

  • Last-mile problems for financial inclusion: Financial inclusion will continue to be a problem for countries or communities that cannot afford the digital devices needed to hold digital currencies or do not have access to basic infrastructures such as electricity, internet, identification services or outlets to convert cash into digital formats. In the context of global trade, without the basic infrastructure, communities, and especially SMEs, that are excluded today will face an even greater challenge in a world where money is widely digitized.
  • Supply and demand of foreign exchange: It is debatable whether digital currencies could encourage all countries to trade more. While the potential benefits may help increase trade volume for certain countries, it does not change the fundamentals of international trade, which depend on comparative advantages. For countries that struggle with economic development or political stability, they may continue to face these challenges even with digital currencies. The currencies of those countries with limited trade with the outside world would remain undesirable. As a result, even if one type of digital currency gains global presence, converting that into local currency to allow for international trade may still be expensive and difficult if the demand for such local currency is limited internationally.
  • Implications for foreign direct investment (FDI): Many questions are raised by the intersection of cross-border investments and digital currency, as the current framework, such as the bilateral investment treaty (BIT) and the protections it offers, was built well before the age of digital currencies. Would digital currencies be considered as “covered investments” under BIT? Would BIT protections apply to investments made by and in digital currencies? How would the tokenization of FDI work under the current rules? Both states and foreign investors need guidance on these questions.

The international trade community needs to be prepared and capture the opportunities of this new age by closing the digital divide. As we head towards a new age where money and trade in goods and services are more and more digitized, it is crucial to ensure no one is left behind. Investments are needed to provide the right infrastructure for the future, to ensure accessible and affordable connectivity for all.

It is also important for policy-makers to work closely with the technical service providers behind digital currencies to fully understand the potential benefits and risks. Laws and regulations can then provide sufficient protection without stifling innovation. The digital currency governance consortium has provided a great example of public-private partnerships with more than 85 public and private organizations working together to address issues related to digital currencies.

Furthermore, the advancement of payments technology needs to be accompanied by the digitization of trade. A chain is as strong as its weakest link and with heavy reliance on paper documents and a lack of legal support for e-documents or e-signature, the benefits of digital currencies will be limited. Trade policy-makers need to focus on building the right physical and legal infrastructures to create trade for tomorrow.

To achieve the full potential of digital currencies, it will be crucial for countries to sign new types of trade agreements to enable market access for private issuers of digital currencies, to allow payments to operate in conjunction with each other, and to allow data to flow freely and with trust. Singapore, Australia, the UK, Chile and New Zealand have championed such forward-looking trade agreements.

While traditional financial institutions have started to offer settlement through digital currencies and some retailers have started to accept digital currencies, adoption on a large scale is still a long way off, particularly in the cross-border setting. There are yet many technical and regulatory challenges to overcome, ranging from issues of interoperability to the issues of AML, CTF and consumer protection. There’s no doubt, however, that we are entering the age of digital currency and more work needs to be done to allow participants of international trade to reap the benefits.

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