Central Bank Digital Currencies and the Global Financial System: The Dollar Dethroned?

The US dollar survived the collapse of the Bretton Woods system in the early 1970s, and its dominance even rose somewhat after the recent COVID-19 pandemic. The US has long enjoyed the many benefits that flow from minting the dominant global currency—from continuous capital inflows and lower foreign borrowing costs to reduced foreign exchange risk in trade and the power to sanction other nations. While there has been much debate in recent decades about whether the US will maintain its privileged position, to date the dollar has steadfastly defied predictions of its decline. This could be set to change with the development of new monetary technologies and the sanctions imposed this year on Russia’s central bank after the invasion of Ukraine.

Central Bank Digital Currencies (‘CBDCs’) have the potential to disrupt dollar dominance by providing faster and cheaper ways to settle international trade and financial transactions. CBDCs are a form of digital currency issued by the central bank, either for use by the general public (retail) or by businesses (wholesale). The Bank for International Settlements recently found that 90 percent of central banks are exploring CBDCs, with 54 percent considering issuing one in the next six years. China is leading the world in these efforts, with its CBDC—the e-CNY—expected to be the first issued by a major economy. The e-CNY has already been trialled in over 20 cities and used in over RMB100 billion (~US$14 billion) worth of transactions, giving China a massive first-mover advantage.

Our recent paper considers the real challenge that CBDCs could pose to dollar dominance. We situate this development of CBDCs within the broader context of efforts by states to develop alternatives to the US dollar in recent decades, particularly those led by the BRICS (Brazil, Russia, India, China, South Africa) coalition, which was formed in 2009-10 to increase the member nations’ status and influence in global governance. CBDCs are the most promising development for states looking to build alternatives to the US dollar, a quest empowered by the unprecedented sanctions imposed by the West on Russia in response to its invasion of Ukraine in February 2022. In recognition of this risk, the US has now expedited development of a digital dollar, although it is far behind in this particular race.

In exploring these developments, our paper focusses in particular on wholesale CBDCs. While these have attracted much less attention than their retail counterparts and seldom been analysed from a political perspective, their potential to deliver massive efficiency gains in cross-border payments related to trade, investment and remittances could transform the global financial system and disrupt dollar dominance in the long term.

While CBDCs are potentially transformative financially and technically, they could also be so geopolitically. Our paper explores three possible outcomes that could flow from the launch of CBDCs and come to characterise the global financial system of the future. First, a digital dollar could maintain or strengthen dollar dominance, even in spite of alternatives developed by rival states, because a digital dollar will be cheaper and easier to use than today’s arrangements. Second, the US could lose its dominant position in the global financial system as rival states develop CBDC-based alternatives, which risks fragmenting the global economy into two or more competing blocs. If this occurs, states could be forced to choose between joining a  US-led or China-led bloc, with serious implications for national security, economic growth and financial stability. Third, we could see a gradual transition to a multipolar system characterised by cooperation rather than competition, though this outcome seems least likely in the current geopolitical climate.

Each of these possibilities will pose opportunities and risks for states and the global financial system as a whole. However, the second outcome, a global economy fragmented into two or more competing blocs, likely led by the US and China, poses an existential threat to the currently truly global financial system. The World Trade Organisation recently estimated that the disintegration of the global economy into two trading blocs will reduce global GDP by about 5 percent in the long term, with larger losses felt by emerging and developing economies. We could also witness the dismantling of the global reserve currency system—an existing trend accelerated by the freezing of some $300 billion of Russian foreign exchange reserves.

The consequences of fragmentation will be severe and this outcome should, if possible, be avoided. As central banks across the world continue to explore CBDCs and work toward issuance, policymakers must begin working on approaches and strategies to build trust and facilitate greater cooperation among states. Otherwise, a potentially transformative technological development could result in a weaker—rather than stronger—global financial system in the future.

Ross P Buckley is Scientia Professor and KPMG Law – King & Wood Mallesons Professor of Disruptive Innovation at UNSW Sydney.

Mia Trzecinski is a Research fellow at UNSW Sydney.