The Impact of Central Bank Digital Currencies (CBDCs) on Forex Trading

Fiat money in the digital form, issued by the central bank, is known as central bank digital currencies (CBDCs). Over 90% of central banks are pursuing or developing a CBDC. Major economies such as China, the EU, and the US have set a timeline to introduce CBDCs between 2025 and 2027.

The introduction of CBDCs presents numerous significant effects on foreign exchange (forex) trading operations. This article will analyze the most significant CBDCs in development and how they could influence major currency pairs when introduced.

Rise in CBDCs Globally

Surveys by the Bank for International Settlements show that 94 percent of central banks are now developing digital currencies. The main motivations are to enhance financial inclusion, enhance cross-border payment fidelity, and beat the adoption of private cryptocurrencies.

Since COVID-19, the world’s major central banks have accelerated the development of CBDCs. With Forex brokers with cryptocurrencies providing more choices for investors wishing to trade digital assets, this increasing attention on digital currencies is also changing trading. The digital euro and (somewhat less likely) Fedcoin could hit in 2025 to 2027, albeit later than China’s eCNY is now testing domestically.

CBDCs, if widely adopted, could compete with traditional cash and commercial bank deposits worldwide. Such developments could have a significant impact on forex markets.

Impact on Major Currency Pairs

USD/CNY

China is at the most advanced stage of CBDC development with the e-CNY. If adopted nationally, it could increase the yuan’s global use for trade and financial transactions.

According to analysts, each 10% substitution of physical cash in circulation in China could translate into an additional $200 billion of yuan demand. This could lead to yuan appreciation versus the US dollar.

Therefore, introducing the digital yuan may positively impact the Chinese currency long-term. However, in the short term, the impact of forex may be limited by China’s strict capital controls.

EUR/USD

Launching a digital euro could also transform the euro into the world’s second-largest digital currency after China’s e-CNY.

Backed by the Eurosystem’s credibility and the EU’s economic power, the digital euro could boost global transactions. It could also marginally shift the balance of the current duopoly of the USD and euro in forex markets.

In particular, the digital euro may gain traction for settlements within the EU and for international trade with European partners. This could gradually increase demand for the euro relative to the US dollar.

GBP/USD

While less influential globally than the digital yuan or euro, a British CBDC dubbed “Bitcoin” could also impact GBP forex trading.

The implementation of Bitcoin technology for fast international transactions and smart contracts would improve the pound’s appeal to foreign investors thus leading to dollar depreciation. The long-term appreciation of the pound against the US dollar could occur due to potential enhanced demand and gradual currency value growth.

USD/JPY

Japan approaches CBDCs with caution because privacy issues and the risk of removing commercial banks from financial transactions exist. The 2023 digital yen pilot launches indicate Japan plans to issue a CBDC between 2025 and 2027.

If so, the Bank of Japan’s CBDC could facilitate the broader use of the yen for Asian trade and finance. Yet as Japan’s economy is already highly digitized, forex impacts may be modest unless the digital yen gains major adoption abroad.

Therefore, USD/JPY forex moves stemming from a digital yen are expected to be limited compared to other major currency pairs.

Emergence of New Digital Currency Pairs

All the most actively traded currency pairs today consist of fiat currencies, which include the US dollar, euro, and yen. The introduction of CBDCs might create opportunities for new digital currency combinations to appear.

For example, if China’s e-CNY and the EU’s digital euro launch successfully, forex platforms may introduce an e-CNY/EUR pair. Such new pairs would allow speculating directly on the relative strength between leading CBDCs.

Initially, volumes of new digital pairs would be minimal. But over time, deep CBDC adoption could make such pairs more actively traded, creating new forex market niches.

Impact on Forex Market Structure

Today, the $6.6 trillion per day forex market relies on various intermediaries like commercial banks and forex brokers. CBDCs may disintermediate parts of this system.

For example, individuals and companies may be able to hold CBDCs directly with central banks rather than via bank accounts. Cross-border CBDC payments may also bypass correspondent banking networks and forex trading desks.

This could marginally reduce forex trading volumes derived from interbank payments and hedging flows. However, given the vast scale of the forex market, CBDC disintermediation impacts are expected to be limited over the next 5-10 years.

Conclusion

Finally, in summary, this decade should see the introduction of major CBDCs – e-CNY, the people’s bank digital currency of China, Fedcoin, and the digital euro – and these could result in profound effects on the forex market.

The rise of CBDCs may gradually cause the currency demand to shift to the early adopting countries like China and the EU. That could eventually result in some appreciation of the currency against late adopters like the US and UK.

New digital currency pairs may be created by CBDCs that market participants could trade with traditional fiat pairs. But they won’t have much of an impact on the overall forex market structure in the short term.

Traditional fiat currencies continue to control the worldwide payment sector amid the ascending importance of CBDCs. So forex markets will continue relying primarily on fiat and commercial bank money flows for years to come.