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A look at Central Bank Digital Currencies

Talk of CBDCs is not new, but as progress is being made - with different countries at various stages of development - it's becoming more of a mainstream talking point. The Cloudbet Blog takes an introductory look at the concept of CBDCs, how they might function and what that might mean for our financial future.

Soundings on the idea of Central Bank Digital Currencies (CBDCs) might not have rung out if it wasn't for stablecoins and the benefits they have demonstrated in recent years, having grown to capture over $20 billion in value.

Stablecoins emerged from the cryptocurrency space following increased demand for an asset that could somehow peg to fiat currency but be transferred over blockchains, avoiding the friction, high cost and delays in moving money between bank accounts and crypto platforms. They maintain price stability by increasing or decreasing the money supply, generally as fiat-collateralised or crypto-collateralised tokens.

Stablecoins have shown the benefit of accessing and transferring fiat-pegged value domestically and internationally far more efficiently and cost-effectively than existing payment systems. They have grown in popularity alongside cryptocurrencies, becoming a threat to the traditional banking system under the control of a country’s monetary authority.

This combination, and the perceived threat from newer proposals like Facebook’s Libra, has led to increased discussion of CBDCs, from the People’s Bank of China (PBoC) to the Bank of England (BoE), the European Central Bank (ECB), and the US Federal Reserve.

But what exactly are CBDCs, what are the benefits and risks, and how could they affect our lives?

What are CBDCs?

While there may be some similarities between the two, the key difference is that stablecoins represent a form of competing private money and CBDCs would still be a centralised form of government/central bank issued money, albeit an evolution of existing fiat.

Some elements of blockchain or distributed-ledger technology may well be used in their implementation, including a digital token. However, they are likely to be permission-based systems rather than open, permissionless networks like Bitcoin.

CBDC is not a well-defined term, but envisions the idea of a digital representation of the fiat currency it is seeking to replace or augment. Each unit is a uniquely identifiable claim on the central bank to be used as a store of value, medium of exchange, and unit of account. In contrast to existing digital bank accounts, CBDCs would be a form of base money - a liability on the central bank, requiring them to maintain reserves and deposits, rather than a private bank.

The Bank for International Settlement (BIS), the bank for central banks, recently described them as providing “cash-like safety and convenience for peer-to-peer payments” in a paper on the key requirements of potential CBDCs.

An array of experimental CBDCs are under consideration, which could be account-based, token-based, or a combination of the two. However, a clear proposal is somewhat elusive, and no country has officially launched one yet. Regardless, the potential impact on the financial system is the most profound since Bretton Woods, with the IMF suggesting: “The world of fiat money is in flux, and [CBDC] innovation will transform the landscape of banking and money.”

Central Bank and jurisdictional interest

CBDCs are generally in a hypothetical stage globally. Some proof-of-concept programs are underway, however, and interest is growing, with 80% of central banks studying the subject, according to a recent survey. A list of current initiatives can be found here.

At a high level, the G20 Financial Stability Board (FSB), plus finance ministers and central bank governors representing other countries, are already working with the IMF, World Bank and the BIS on CBDCs. They seek to formalise the use of CBDCs within the banking system, establishing standards and regulations for their issuance. The IMF and World Bank suggest they will have the technical capability to facilitate CBDC transactions between these countries by 2025, including potential scope for a global stablecoin, probably building on the SDR, or collaboration with private but regulated stablecoin providers, as well as nation-state CBDCs. That follows a report from seven top central banks and the BIS proposing a transnational front for CBDCs.

Some central banks and countries are further along the development process than others, however. The PBoC has been working on a project for China called DC/EP (Digital Currency/Electronic Payments) since 2014, with Chinese banks and institutions brought in to help develop the system in 2017. In what appears to be the most advanced CBDC program worldwide, the system began testing the Digital Yuan in Shenzhen, Suzhou, Xiong'an and Chengdu in 2020. Bank of Japan (BoJ) Digital Yen experiments are also close behind.

The BoE has discussed the idea of a blockchain-based central bank currency since 2015, particularly in reference to implementing negative interest rates. Credited with coining the term CBDC in 2016, it issued a discussion paper on its approach to designing a CBDC in 2020 as part of the decision-making process on whether to introduce one, followed by a Treasury Department announcement regarding draft regulations on stablecoins and a research program for CBDCs as an alternative to cash. The UK Chancellor described them as a cheaper and faster way to make payments.

Rumors of a Digital Euro surfaced in Spain, with the ECB commenting in 2019 that: “The ECB will also continue to assess the costs and benefits of issuing a CBDC that could ensure that the general public will remain able to use central bank money even if the use of physical cash eventually declines.” This was followed by a report in October 2020, proposing the idea of a Digital Euro and beginning an experimental phase to assess the benefits. A decision on whether or not to issue a Digital Euro is expected in 2021.

The Federal Reserve has been the most conservative in its approach to CBDCs so far and is not actively developing its own. This is perhaps unsurprising given the global reserve currency status of the USD.

There are also potentially more significant consequences for the US and its banking system than others in their implementation. The opposition of most Americans is another factor. It was involved in the joint report with central banks and the BIS and continues to analyse the benefits, arguing that the priority should be to “get it right than to be the first.” However, Federal Reserve Chair Jerome Powell also warned of the potential downsides and suggested “for the US, the Reserve has yet to find a compelling case for a CBDC.”

The central banks of Uruguay, Russia, Thailand, Brazil, Venezuela, Sweden, Australia and Singapore are also among the first to be considering introducing a CBDC.

Benefits and Risks of CBDCs

CBDCs can introduce several benefits and risks from either the perspective of a particular central bank/government or end-users:

Significantly reduced cost in financial transactions with the removal of intermediaries, facilitating low-cost payments from micro to large scale transactions, particularly across borders.

Technological efficiency of real-time peer-to-peer payments, without relying on intermediaries like banks and clearing houses adding to delays.

Financial inclusion, allowing any citizen access to a basic bank account.

Transparency, whereby central banks and governments can track every currency unit to combat crime and enable efficient and timely tax collection, removing the need for more intermediaries. However, this comes with huge privacy implications for citizens and the power for authorities to sanction people under their own criteria.

A modern alternative to physical cash, which is likely to be phased out. It would maintain seigniorage income for governments, though result in severe privacy and inclusion implications.

Security of an interoperable digital currency, issued and governed by the central bank to provide greater trust in the underlying infrastructure of money.

A boost to confidence and competition in banking and payments systems building on top of it, attracting customers with incentives and easy onboarding.

The financial safety of a CBDC would reduce the risk of fractional reserve banking, reducing the necessity of deposit-guarantee schemes.

Direct monetary policy would be feasible, one-step removed from governments, allowing for more central bank control over the money supply than indirect tools like quantitative easing and interest rates. Micro-targeted payments and other stimulus measures would be possible, and it could potentially lead to a full reserve system.

Some proposed CBDCs allow for new currency issuance, retaining fiat inflationary policies that risk such digital versions of currencies being devalued over time too.

Potential bank runs could see citizens withdrawing funds ahead of a transition.

An alternative global payments network, limiting the impact of current sanction power from a small group of countries and legacy systems like SWIFT, but opening up the global financial system for others.

Future implications

Despite drawing on similar technology, CBDC implementation proposals are the antithesis of decentralised cryptocurrencies, often involving the provision and control of accounts at the respective central bank for all citizens. That facilitates some of the benefits mentioned, but comes with some major risk to privacy, and potentially, certain freedoms.

How could CBDCs play out?

Following the tumultuous events of 2020, we are likely entering a prolonged period of economic uncertainty - though this arguably began around 2008 and has still never really solved. Having gone through the initial liquidity event brought about by the pandemic and a brief period of hope during the summer of 2020, the realities of the economic consequences are beginning to hit home.

While there is light at the end of the tunnel, such events tend to take time to unwind, and a period of insolvency can be expected. With the banks already hit by a lack of income from payment holidays and increasing defaults, wider insolvencies across various and multiple economies could have a globally systemic impact.

Given that 2008 is still fresh in many minds, further bank bailouts are unlikely to be palatable, and so the previously unthinkable may happen. Banks, at least retail ones, may no longer be considered too big to fail. Armed with CBDCs, central banks and governments could well decide to let the banks collapse next time.

Potential bank runs, or the introduction of CBDCs themselves, combined with an inability of deposit-insurance schemes to cope at scale, could lead to central banks offering to replace 1:1 the deposits held in retail banks. New CBDC balances would then sit in central bank citizen accounts. The central bank could manage the underlying infrastructure, with the front-end bells and whistles and customer service competed for by the remaining retail banks and fintechs.

Faced with the alternative prospect of people losing their bank deposits, this would likely prove a popular move. However, given the already declining use of cash, and an increased reluctance of retailers to accept it as payment following the pandemic, the approach of replacing fiat deposits with CBDC deposits alongside eradicating cash has very real privacy implications.

Under such a scenario, all cash-less transactions made in fiat currency would be digital, tracked by the central bank and, by extension, the corresponding government. Many people may be unconcerned whether central banks or governments know what they spend their money on, but it does pose serious questions over privacy nonetheless. It is not inconceivable that unfavourable donations, the buying of particular items, or in some jurisdictions, supporting certain organisations, may have negative repercussions.

Automatic debiting of taxes, including “one-offs” or tax increases, would be likely - and for many people this may well be a boon. However, inflationary debasement through the issuance of more currency seems inevitable, leading to another rebooted but devaluing fiat currency over time. On the plus side for those holding decentralised cryptocurrencies, this would likely drive further demand. 

At the end of the day, centralised fiat, digital or otherwise, is still centralised fiat.

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