Central bank digital currencies could be the future of finance. Goldman Sachs analysts break down how they might work

• Central banks around the world are testing digital currencies, in what could be a major shift.
• Goldman analysts broke down the state of play with digital currencies on Tuesday.
• They stressed that central banks want to avoid hurting the commercial lending sector.

Central banks around the world are racing to test and launch their own digital currencies, with policymakers worried about threats from cryptocurrencies, private payment systems and other central banks.

However, central bank digital currencies (or CBDCs) are far from straightforward. Central banks are currently working hard on how they should be designed, and how to stop them threatening the traditional financial sector, among many other issues.

Goldman Sachs analysts, led by David Mericle and Laura Nicolae, on Tuesday published a status report on CBDCs around the world. Here's what they found.

Why are central banks creating their own digital currencies?

A CBDC would be a digital version of banknotes and coins, letting people hold and make payments in central bank money. At the moment, people make digital transactions using electronic representations of cash created by commercial banks, but this can sometimes be slow and costly.

Goldman said central banks in advanced economies, such as the Federal Reserve, think CBDCs could be a way to ensure the safety and robustness of payments systems in the future.

"It has become clear that many central bankers are also motivated by concern that private cryptocurrencies, or stablecoins, or even foreign CBDCs could displace use of the national currency," they added.

In developing economies, central banks think CBDCs could increase access to the financial system and payments efficiency.

Which countries are planning CBDCs?

Goldman said 19 countries already have pilot projects and two have launched CBDCs for public use: the Bahamas and Cambodia. China appears to be the furthest ahead out of the major economies, and has launched various pilot schemes.

More than 25 other countries or economic areas, such as the US and eurozone, are researching CBDCs.

However, the Fed has so far appeared relaxed about digital currencies, saying it is more important "to get it right than be first." Goldman's analysts said the Fed is likely years away from making a final decision on a digital dollar.

What might CBDCs look like?

Goldman's research showed that central banks are converging on a number of features for CBDCs.

A key one is that more banks are considering using a decentralized clearing system, as opposed to the traditional system that inserts a central authority into the payments process. This would make CBDCs akin to cryptocurrencies such as bitcoin, where there is no central authority that keeps tabs on transactions, but complex cryptography maintains the network's safety using a system known as a distributed ledger.

Crucially, however, all central banks using distributed ledger technology are using a "permissioned version" that allows them to choose who can be part of the system, Goldman said. This differs from bitcoin, which is permissionless and open to the public.

Most countries have so far opted for systems where people would have accounts at commercial banks, rather than holding CBDCs directly at the central bank, Goldman said. And several central banks have decided that their CBDC will not pay interest.

What are the dangers of CBDCs?

The decisions to include commercial banks and not pay interest stems from the danger that CBDCs could seriously disrupt the traditional financial system by cutting out main street lenders, Goldman said.

To address this problem of "disintermediation", central banks are also considering setting a penalty rate on holdings above a certain threshold so as to discourage large deposits. The eurozone, China and Sweden are considering balance caps.

CBDCs may also encourage criminal activity by making anonymous transactions relatively straightforward to complete. Central banks have therefore mostly decided against fully anonymous accounts, Goldman said.