Since early March, the banking sector has been in a state of shock.
It all started with Silicon Valley Bank (SVB), followed by Signature Bank, First Republic, Credit Suisse, and PacWest Bancorp. So far, these have absorbed the most damage, and some have already ceased to exist.
Others still remain in danger, especially the small regional banks with limited liquidity. Their clients are concerned about stability, and some have been moving their assets to larger banks.
This doesn’t promote either stability or healthy competition.
When most customers withdraw their assets, banks are left without sufficient liquidity to either run their business or meet reserve requirements.
This is how banks go out of business.
The Federal Reserve (or Fed) stepped in, trying to calm down the market by providing liquidity guarantees or finding buyers for the most troubled banks.
It yet remains to be seen if the lender of last resort can keep its promises because it’s not a simple or cheap endeavor.
But this may be the last time the central bank deals with bank runs. Central banks around the world are working on what they hope would be a permanent solution that may resolve this issue once and for all.
Will CBDCs Solve Banking Crises?
Think of a world where funds are directly distributed to final users (private or institutional) from the central bank, bypassing commercial banks.
There is no need for commercial banks to keep liquidity, as it all remains on the balance sheet of the central bank. In this case, a bank run is technically impossible.
Would it eliminate commercial banks? Unlikely, but possible, and only if the new technology is adopted.
This technology is Central Bank Digital Currency (CBDC), which is based on blockchain technology and uses some of the advantages that the platform provides.
It shortens transaction times and minimizes the cost of each operation. But unlike most crypto assets, which also run on the blockchain, it will be centralized since the central bank will control money flows.
In other words, central banks recognized blockchain technology as superior in certain ways to the way the current banking system works and tried to adopt it.
And unlike the highly speculative crypto projects and even stablecoins (which proved themselves unstable), CBDC will be supported by the country’s balance sheet and taxing power.
In this case, if the CBDC of a given country fails, it means the nation is defaulting on its obligations and can go bankrupt. (In the most extreme case.)
The adoption of the new technology is still in its infancy, but some countries are already shifting to digital currencies. Small countries such Bahamas and Cambodia launched local digital currencies and pegged them to the US Dollar.
China launched a pilot project in some of its cities and starting from this May, public workers in the city of Changshu will receive payments in CBDC. A city of 1.7 million people will pilot test the idea of a digital yuan.
Other nations, including the United States and European Union, are moving in the same direction. They plan to implement the new technology in the coming years.
Central want to control every financial transaction flow and hope that it will help keep the financial system liquid and stable.
At the end of the day, digital currency adoption is inevitable, and investors need to stay educated about the coming changes. For now, the downside is limited, but giving full control of your personal funds to the government isn’t the best option.
This is why diversification will be the most prudent first step in order to protect your wealth when CBDCs become widespread. Investors would do well to diversify both geographically and across asset classes.
Decentralized digital assets, precious metals, collectibles, and other investment tools will be a smart addition to investors’ portfolios.
Thank you for your loyal readership,
The Financial Star team