How Central Bank Digital Currencies (CBDCs) Will Transform Forex Trading

The forex market is one of the most liquid financial markets with millions trading through from Monday to Friday. It is also a market where participants can buy, sell, hedge, and speculate on the exchange rates between currency pairs. With over $7.5 trillion in daily transactions, it is a market that is very attractive to people looking to make money trading. However, retail traders aren’t the only ones interested in this market as banks, governments, corporations and hedge fund companies, also take part considering the fact that the value of currencies are decided by this market. However, like every field, change is creeping into the industry through the development of what is known as central bank digital currencies. There is a lot of mixed reactions to these developments, as some are dreading it, claiming it would be the end of forex trading, while others can’t wait to have it implement with China already using it to transact over 980 billion dollars.

In this article, we would be discussing what CBDCs are, countries that are trying it out, the reaction of traders to this development and what the expected effect of this development would be.

What is a Central Bank Digital Currency

Central bank digital currency (CBDC) is a type of digital currency that is issued by the central bank of a nation. It is similar to cryptocurrencies, and it is worth the same as the nation's official (fiat) currency and has a central bank fixed value. To put it another way, it is the digital equivalent of a country's fiat currency that is used to support the cashless society and economy of that nation, which consists of individuals who conduct business online and have resorted to using cryptocurrencies as a source of funding. CBDCs, unlike cryptocurrencies, are centralized and supported by the trust and authority of the issuing government.

Now, because the forex market is simply a market place for trading on speculations about the rise and fall of a currency in comparison to another country's currency, it is no surprise that the adoption of CBDCs will also include the ability to trade on them. However, CBDCs' entry into the forex market presents a number of challenges and opportunities for both retail traders and forex firms. 

Types of CBDCs

CBDCs has three major types namely: retail, wholesale, and hybrid.

1. Retail or Direct CBDCs:

Designed for the general public and everyday use, these are the most well-known and acknowledged CBDCs.

 Retail CBDCs are intended to fully function as a fiat currency substitute, so they enable users to conduct routine, simple everyday transactions and payments without hiccup like physical cash. Getting a hold of them is also easy as the general public can purchase retail CBDCs through digital wallets, smartphone apps, or other payment methods. 

2. Wholesale or Indirect CBDCs:

This is the opposite of retail CBDCs, the general public is not supposed to have direct access to wholesale CBDCs. Instead, they are designed for use between financial institutions, such banks and is transferred to them directly. You cannot easily acquire this, neither can you use it to do simple transactions, instead it is used for high-volume, high-value transactions, such as securities settlements and interbank transfers. 

3. Hybrid CBCDs

As the name suggests, hybrid CBDCs incorporate elements of both wholesale and retail CBDCs. Since both the general public and financial organizations can use hybrid CBDCs, they are more versatile than the other two types. Hybrid CBDCs can be used for both routine transactions and expensive purchases, according on the needs of the user.

Motivations Behind the Development of CBDCs

There are a lot of reasons why central banks of different countries are exploring CBDCs. In this article we would be discussing four reasons in detail.

1. Increase inclusion of population:

A large part of the global population does not use traditional banking services, particularly in developing nations, and this trend skyrocketed when Covid 19 hit in 2020, and movement was restricted. CBDCs as digital currencies have the potential to cater to this group by providing access to digital financial services. This would automatically enable greater participation in the country’s economy and drive substantial economic development in these regions. Proponents believe that CBDCs’ innovative nature can facilitate financial inclusion and offer significant benefits to those previously excluded from formal banking systems.

2. Reduced reliance on Physical Cash

The use of physical cash is declining, and digital transactions are taking over, whether we like it or not, and this is a situation that most countries' central banks are unprepared for. CBDCs are these banks' attempts to retain monetary control because they serve as a digital alternative to physical money, allowing central banks to adapt while maintaining control.

3. Improving the Speed of international Payments

Sending money from one country to another is slow and expensive because of the involvement of multiple intermediaries, which is especially problematic when you have a deadline or target. CBDCs however could simplify this process by reducing the number of intermediaries, making international payments faster and cheaper.

4. Going up against cryptocurrencies

Although cryptocurrencies are popularly accepted and recognized, there are still a lot risks associated with their decentralized and highly volatile nature. Central banks use CBDCs to provide a government-regulated alternative that provides the stability and trust associated with traditional currencies.

Countries that are already using CBDC or trying to implement it 

Over134 countries in the world, which makes up the major part of the world’s economy, are trying out CBDCs. While some countries have successfully implemented it, others are still researching to see its potential and the ripple effect of its implementation. 

1. China: The China e-CNY (digital yuan) has processed over 7 trillion in transactions, that is approximately 987 billion dollars. It was launched for the public in January 2022 and took flight especially during the 2022 winter Olympics 
2. The Bahamas: The second on our list is the Sand Dollar, a national CBDC launched in the Bahamas. However, compared to China digital yuan, the Sand Dollar just makes up 1% of the country's circulating currency. It was launched in October 2020 and the Bahamas is also considered the first country to launch a Central Bank Digital Currency 
3. Nigeria: The Central bank digital currency in Nigeria is called the eNaira. It was introduced to reduce the huge dependence on cash, and also reduce the physical abuse of the country's currency.  It was also an attempt to promote investment in the country from traders and finally raise naira's worth in foreign exchange. It was introduced in on 25th October 2021 although it is currently not doing so well.
4. The European Union: While this is still in planning and development stage, the European Central Bank is looking to create a central bank digital currency or more specifically a digital euro. The major goal is to promote ease in transactions among all the EU countries.
5. The United States: Finally at the end of the list we have the most generally accepted currency 'dollar' and the United States looking to maintain relevance simply by keeping ahead with the trend and create a CBDC of the dollar.

PROs and CONs of CBDCs

Undoubtedly, the introduction of CBDCs would impact the financial system in general and forex (foreign exchange) in particular. Like everything else, these effects can be classified as either positive or negative, so there are advantages and disadvantages to using CBDCs. We are going to list just a few:

One of the primary pros of CBDCs is their ability to provide a secure and dependable method of digital payment and remittance. CBDCs can be used in both online and offline transactions, and they can be integrated into existing payment systems. They can also be used to ease international payments, which is difficult with fiat money. In fact, most central banks around the world have already begun experimenting with CBDCS and its economic potential. Another advantage of CBDCs is their ability to provide financial inclusion to those who are currently unbanked or underbanked. CBDCs can improve people's access to financial services and participation in the digital economy by offering a digital alternative to cash. This is especially beneficial for people in developing countries who have limited access to traditional banking services.

CBDCs may also have some cons. One con is that they may lead to increased surveillance of financial transactions, leading to privacy and security concerns. 

In addition, CBDC implementation could be costly and complex, and there may be risks associated with CBDC integration into existing payment systems. Another con is that banks might have to contend with more competition from CBDCs, which could result in lower profits and less credit offered. Last but not the least, the use of CBDCs may limit central banks' ability to implement monetary policy, potentially leading to higher inflation or other economic problems. 

In foreign exchange, the cons are more pronounced. One is that CBDC transactions can be tracked, unlike cash, which raises concerns about government monitoring. Even if some designs provide "controllable anonymity," users may still be concerned about their financial privacy. Two, there is also the possibility of misuse or data breaches. For forex traders, these privacy concerns may reduce trust in certain currencies, particularly those with a history of government misuse of power. Three, all digital systems are vulnerable to cyberattacks, and CBDCs are no exception. Because they are digital, they are susceptible to hacking, fraud, and data breaches. Four, there is a risk that hackers can attack CBDC platforms or financial data can be stolen, misused, or fabricated, causing financial system disruptions with more consequences, particularly if such events make headlines. A compromised CBDC system could cause losses and destabilize the financial system. Strong security measures are necessary to protect digital currencies and thereby retain traders’ trust.

Traders’ reaction to news of CBDCs implementation by countries

Contrary to expected beliefs, most forex traders are actually reacting negatively to the implantation of CBDCs, their views and opinions can be seen on public groups like Quora and others.

One trader even when as far as listing all the reasons why CBDCs were a bad idea.

He posted “CBDCs are copycats to cryptocurrency. CBDCs are centralized. CBDCs mean financial slavery. CBDCs mean financial confidentiality disappears. CBDCs mean financial security decreases. CBDCs mean financial privacy decreases. CBDCs is the start of financial Armageddon. CBDCs is the death of financial freedom. CBDCs mean the central bank controls everything. CBDCs mean we are monitored 24/7.”

Another trader posted that “CBDCs will probably end the FX market, and any speculation/trading for that matter. CBDC is not just a digital currency but also a programable token, or as Bill Gates put it: “If you complain about the government, we’ll switch it off and you won’t have access to your bank account and money for food”. If CBDC becomes a reality, we’ll probably all be doomed, except for those who can grow their own food.”

However to say that all reactions to this new development was bad would not be telling the truth. A lot of prop firm companies very happy with this as it brings another new instruments to offer to traders to trade. So more customers, more options and of course more money. Although to be able to trade this new currency or even create currency pairs of this digital currency, it would require some changes and improvements on all trading platforms.

Impact of Central Bank Digital Currency on Forex Trading

Now to the most important part of this article, how does CBDCs affect forex trading? How would it transform forex trading?  There is absolutely no doubt that CBDCs implementation would affect the foreign exchange market.  Now this part is to gauge how much of those impact are good and how much are bad. 

CBDCs were created for the purpose of benefiting the society, smoothen and easen transactions while also helping  central banks retain their monetary control as they do with physical money or fiat currency. 

So the very first impact is the fact that with the introduction of CBDCs and popular adoption by the central banks of the world, there would be new instruments to trade. CBDCs are still currencies, albeit, digital ones, and the forex market is a marketplace of speculation on currencies so new currencies, new instruments to speculate on. Forex trading platforms would open it for trading under futures or options, but anyone would simply be a new profit opportunities. 

Secondly, arbitrage is the act of buying currencies and other securities in one market or trading platform and then selling it in another market or platform in other to make profit off the difference in prices from those two platforms and is a very big part of forex trading. But with CBDCs, it would be very difficult to make profit with arbitrage as the digital currencies would be the same through out all the platforms.

Also with this adoption, there would be a new influx of people who want to make money in the forex market because of this new trading option; that is, the CBDCs. Forex trading platforms would also see a return of traders who have given up, but they would be interested in this new option. 

However, there are also some negative impact that would arise as a result of this digital currency implementation, and among them include high implementation costs for forex trading platforms, concerns about privacy and security by traders, fear of governmental capital controls and the potential negative impacts on the banking sector which provides the liquidity support for the forex market.

The Butterfly effect of CBDC on Commercial Banks

Under the negative impact of the implementation of CBDCs, we mentioned that CBDCs would affect the traditional banking system, which plays a major part in providing liquidity for the forex market.

The following ways below is how this negative effect would pan out:

1. With the introduction of CBDCs, most people would prefer to have CBDC instead of physical fiat currencies, and for commercial bank this would mean less deposits, meaning they would have to reduce the money they can lend, and this include the forex market so automatically less liquidity. 

2. To be able to maintain profits despite the low and decreasing patronage, banks would have to raise the interest rate on loans, effectively halting economic growth and so negatively affecting the country's economy and currency value. Which would in turn affect the any forex trade involving that country's currency.