Updated: Nov 3
Advancing technology and a growing trend towards peer-to-peer transactions facilitated by online platforms has ushered a revolution in the field of digital payments. Even the Central Banks want to exploit these new technological developments and are investigating the technology of ‘Central Bank Digital Currency (CBDC)’ to use it as a medium to not only proliferate the space of digital payments but also make it accessible to the public at large and expedite the payments and settlements mechanism for retail and wholesale payments. More than 60 Central Banks are researching on the use of CBDC’s in their economy, with countries like China, Sweden, Canada and the U.K launching pilot projects. But astonishingly, it is the smaller countries such as the Caribbean, Bahamas and Cambodia which are leading the charge on CBDC’s with live projects such as Bahamas Sand Dollar, Bakong Cambodia, and Eastern Caribbean DCash. Taking into consideration, the rising consensus towards the use of CBDC’s for advancing the economy, even the RBI is exploring the use of CBDC’s, and has already started working on a pilot project, with plans to launch its own CBDC by the end of 2022. Amidst all these developments, it is imperative that we don’t stay blindsided to the potential pathbreaking impact CBDC’s can have on the functioning of the payments and settlements system and the economy. Through this article, the author makes an attempt to apprise the readers of the fundamentals of the technology and partake in an analysis discussing its pros and cons.
Before delving into further analysis, it is crucial to note that CBDC’s should certainly not be mistaken for cryptocurrency, at the risk of sounding reductionist, CBDC in very simple terms is just fiat currency but in a digital form. The RBI defines CBDC as “legal tender issued by a central bank in a digital form. It is the same as a fiat currency and is exchangeable one-to-one with the fiat currency” (Reserve Bank of India, 2021). Despite being considered as ‘legal tender’ and equivalent of fiat currency the digital nature of CBDC allows it to hone characteristics specific to the function it has to perform, hence the purpose for which CBDC is being issued will have a great influence on its design.
Possible iterations of CBDC’s
Since CBDC’s are essentially a form of programmable currency, there are a lot of customisations which the issuer can make to alter its characteristics, such as:
They can be token based or account based. A token based CBDC can be formulated on a centralised blockchain with the Central Bank as its regulator, which would operate via a public private key mechanism. On the other hand, an account based CBDC is similar to the current account-based model with respect to physical currency and would essentially require a banking relationship with the CBDC holder and the bank, where each transaction is debited or credited through the account(Fernández de lis & Gouveia, 2019 ).
They can be made universal via the system of token-based currencies or private via the system of private currencies (Fernández de lis & Gouveia, 2019 ).
They can be anonymous (like cash) or identified (like current accounts). The first corresponds to the idea of token-based CBDCs, and the second to account-based CBDCs (Fernández de lis & Gouveia, 2019).
They can be programmed to pay interest at the option of the issuer, which essentially translates to interest being enabled as a feature on such currencies (Fernández de lis & Gouveia, 2019).
From the various possible customisations of CBDC’s, there are three basic objectives which can be culled out, acting as the basis for issuing of it: (i) to improve the working of wholesale payment systems; (ii) to enhance the instruments available for monetary policy (iii) to innovate new methods of monetary policy and quantitative easing during financial crisis. However, the conundrum with respect to achieving each of these goals is that every individual goal requires us to create a CBDC with different characteristics, which would be interacting with different categories of individuals/institutions and thus have different levels of market and technological penetration. To cut it short, there are a lot of variables which have to be considered for designing a CBDC which results in added complexity. For better understanding of the readers, the author has made an attempt to conceptualise the CBDC which can be issued to achieve the aforesaid said goals, herein below:
(i) If the objective is to improve the functioning of wholesale payment systems, it can be argued that Digital Ledger Technology (DLT) can provide an excellent basis for such CBDC’s. First of all, since we are just referring to wholesale payments, we can have a DLT platform which is just restricted to banks, financial institutions, and large corporations . The best suited CBDC for such transactions would have to be tokenised, identifiable and restricted. It can or cannot be interest bearing depending on the contractual obligations between the parties involved in wholesale payments. It will be tokenised because it is based on a DLT and coupled with a public/ private key system along with a consensus mechanism programmed into that ledger to authenticate transactions. This way the Central Bank would have not have to waste any of its human resources completing compliances to affect those transactions because such work would have then been automated owing to the transaction happening on a DLT and a rigid consensus mechanism. The only role of the Central Bank would be to act as an intermediary with secure IT systems put in place ensuring smooth transactions. The role of the Central Bank would be similar to that in traditional RTGS or NEFT transactions, where it is placed at the fulcrum of the system hence it will retain control over the entire transaction including features of the system, like admission, membership and due diligence.
(ii) If the aim is to replace cash with a more efficient means of payment, the Central Bank should introduce a CBDC that is universally available – a public Distributed Ledger can be set to manage the payments and settlement of CBDC or the existing account-based infrastructure of commercial banks could be utilised where the CBDC can be directly transferred to the account of the individual. Tracking of transactions through CBDC’s poses major data privacy concerns to remedy these concerns the low cost transactions can be kept anonymous, this would reduce the compliance burden of data collection on the Central bank and a threshold can be decided upon by the Central Bank beyond such transactions would be monitored (Mancini-Gri§oli et al., 2018). Such a CBDC would aid in cutting major costs which the government has to incur to sustain the system of physical currency such as - the logistics of digital currency would come at a fraction of a cost, compared to that of physical currency, investment in setting up the requisite infrastructure for manufacturing and transportation of physical cash would be saved, the digital currency deteriorate over time, and won’t be vulnerable to falsifications if the requisite technological safeguards are implemented.
iii) If a CBDC has to be made to innovate new methods of monetary policy and quantitative easing during financial crisis, the three must have characteristics for it would be universality of transaction, identifiability, ability to bear interest. It has to be traceable because this way the Central Bank would be able to track the amount of money which is being transacted. It would have to be non-interest bearing or bear a negative interest rate because we don’t want people to hoard cash. Hence, during times of financial crisis to flush money into the economy instead of issuing cash to the people which they might hoard or invest in some savings oriented, we can give them essentially provide them with CBDC’s which won’t bear any interest the public would have no other option but to spend it and increase the flow of money into the economy. This enhances the level of flexibility the Central Bank has when deciding upon quantitative easing policies because issuing of CBDC’s delinks credit and the payments mechanism.
The Impetus For Issuing CBDC’s
As enumerated in the earlier section CBDC can be tailored to meet unique requirements and essentially offer more functionality than traditional ‘cash’ in that regard. However, it is not just the versatility of the CBDC which is encouraging the Central Banks to adopt a digital alternative to paper and such shift can actually be argued to be motivated by concerns like potential influence of privately issued digital currencies, international trade and currency dominance.
Privately Issued Digital Currencies
The advent and growth of cryptocurrencies has posed a major dilemma in front of the Central Banks that whether privately issued currencies can offer competition to fiat currencies. Since most of the privately issued currencies don’t have a derivative asset from which they derive their value, thus they are vulnerable to price fluctuations based on their perceived future value by the market which makes them extremely volatile. However, what they lack as a store of value they lack as a store of value they compensate for with features like peer-to-peer cross border transfer, automated verification and settlement mechanism, the ability to have smart contracts encoded on them (Brunnermeier, James, Landau, 2019). All of this leads to the cryptocurrency having a reliable digital network which fosters the trust of their users in them, affecting their demand and supply which in turn determines their price. The idea of having these private currencies to gain popularity and permeate into a sovereign economy and conducting their own ‘monetary policy’ is what threatens Central Banks (Brunnermeier, James, Landau, 2019). Like every private entity, they would conduct their ‘monetary policy’ to suit their own private interests rather than public and the Central Bank would not be able to effect its own monetary policy through such currencies which could be disastrous for an economy. Moreover, the entities who are transacting in such private currencies would then completely be at the behest of such unregulated private issuers. Hence the money which has been denominated in such private currencies would not have any form of protection and be completely dependent upon market forces. In addition to their immunity from the monetary policies of the Central Bank, if such currencies were to fail, they would have negative systemic effects on the economy of that country which it might not be able to manage.
Digital dollarisation is the idea that once a CBDC gains sufficient international consensus it will become the dominant mode of transaction in which international trade will be conducted, thus becoming the de facto medium of exchange (Agur, et al., 2019). By building international digital networks a CBDC can internationalise itself and thus strengthen the CBDC’s and by extension the fiat currency’s function becoming global store of value and attain full capital account convertibility which in layman terms means that the individuals using the CBDC for international transactions could easily convert it into local currency without facing any restrictions (Agur, et al., 2019). Thus, countries with smaller or underdeveloped economies or even countries with stable economies for that matter are susceptible to the risk of digital dollarisation. If a country with large digital networks were to penetrate the market of such countries through its CBDC (owing to the virtues of global store of value and full capital account convertibility and seamless peer to peer transaction), the citizens of that country would also prefer transacting in that CBDC instead of their native currency. This would incidentally translate to the native currency becoming weaker in relation to CBDC.
Despite the potential threat of private currencies exerting a greater influence on the economy or ‘digital dollarisation’ of some other CBDC instead of the native country’s there are a plethora of concerns which need to be addressed before a CBDC can be implemented.
The technology which will act as the substrate of the CBDC is still unclear. Since the CBDC would be issued by the Central Bank itself, it has a colossal duty of ensuring that the CBDC remains secure from any form of cyberattacks. Any security breach with respect to CBDC besides from tarnishing the reputation of the Central Bank and stifling further growth and permeation of the CBDC, can also lead to an economic crisis for the country, thus making the technology extremely sensitive and high risk in nature. The Central Bank would have to go above and beyond to establish a security infrastructure for the CBDC before it is implemented and ensure that technology which will as the foundation of the CBDC is immune to any form of digital security breach, hacking or malware attacks. At this juncture it is important to emphasise that even if a CBDC implemented with the DLT as its base which is considered a secure technology when it comes to protection cyber-attacks (Frankenfield, 2021), would not be able to offer the same level of protection because the ledger would be centralised and be controlled by the Central Bank. A decentralised ledger is usually protected from cyberattacks because it has thousands or maybe millions of nodes acting as servers where the ledger has been replicated and the hackers have to hack 51% of those servers to make any changes to the transactions recorded on the ledger (Frankenfield, 2022). But in the case of a centralised ledger the hackers would just have to take control of a few servers and the entire reserve of CBDC would be at their disposal. Hence, a novel solution would have to be figured out with respect to the above solution.
Data Privacy Concerns
Data Privacy is another important metric which the Central Bank would have to clarify on in relation to CBDC. Since CBDC would be a digital form of currency no matter how, when or on which platform it is spent, it will always leave a digital print on the internet. So, any transaction done with a CBDC would inherently be traceable. It is clear that due to practices like money laundering and terrorism financing an anonymous CBDC is something that no Central Bank would be amenable, in a similar manner the common public might not be amenable to a CBDC which is traceable at all times. A survey conducted over three months on a ‘digital euro’ has found that a majority of participants spread around Europe preferred an offline privacy-oriented solution over an online solution with implications for anonymity and privacy (Ledger Insights, 2021). Sufficient safeguards should be introduced against such concerns ensuring that the data of the citizens collected is only used for the legitimate purpose it is being collected for (Purpose Limitation) and is stored only for the period necessary for processing (Storage Limitation). Adding to privacy concerns is the assumption that if the use of CBDC becomes widespread in an economy the Government might be able to abuse this system similar to that of ‘Social Credit’ system in China and deny you the right to use the CBDC in your possession, the Central Bank should also guarantee regulation against such practices (Kobie, 2019).
Technological Literacy can prove to be a major barrier for the adoption of CBDC. In developing countries where the population struggles with financial and technical literacy, to secure the success of retail CBDC the Central Bank would have to come up with an interface which is simple enough for everyone to access to it. In India where digital transactions have seen a significant due to the impressive implementation of UPI technology, cash still remains the prevailing medium of transaction (Reserve Bank of India, 2021). Thus, ease of use and awareness in relation to the technology remain crucial factors which need to be looked into because if the technology is not made accessible, the general populace will still be strongly inclined to use cash instead because it is the age old, trusted alternative.
Commercial Bank Disintermediation
Assuming that the costs of maintaining and transacting in CBDC is lower than the services provided commercial banks, this would spur a large movement from bank deposits to CBDC which will be maintained by Central Banks this would lead to a cash crunch for commercial where they would have to provide incentives to retain their customers. Commercial banks earn significant revenue from facilitating payments and if the Central Bank were to offer cheaper payments alternative via the medium of CBDC it would lead to further reduction in commercial bank profitability (Wadsworth, 2018). To remedy this commercial bank might take certain steps such as increasing the interest rates on their deposits on investing in high yield but risky assets putting more stress on their balance sheets (Wadsworth, 2018). This could significantly worsen the financial stability in an economy, which is why such structural considerations need to be kept in mind while considering the issuance of CBDC. In addition to this depositors might convert their deposits into CBDC if they become aware of a bank being under stress and this might to practically unstoppable ‘digital bank runs’. This change in role of the Central Bank from an ombudsman to that a competitor of commercial banks can have grave consequences for the entirety of banking system, which is why a hybrid system needs to be worked out, wherein significant safeguards are envisaged for commercial banks from the spill over effects of CBDC and they are also able to profits from the adoption of this technology.
Through CBDC the Central Bank can pass through the effects of monetary policy via individual CBDC holders. However, if the government wants the CBDC to effect monetary policy they would have to relax the assumption that a currency can’t be interest bearing (Wadsworth, 2018). The complications don’t just end there in countries with high inflation rates, they may choose to convert their cash into CBDC of countries with low inflation rates, such large capital movements via the medium of CBDC can greatly influence exchange rates and affect asset prices which also be needs to take into consideration (BIS, 2018). Likewise, in times of crisis if the interest rates on CBDC are higher than interest being offered by banks on deposits this can lead to a liquidity crisis for banks because CBDC would serve as a better store of value (BIS 2018). If the demand for CBDC is high the Central Bank might have to invest lower quality assets so that it could have a larger balance sheet to support the issuance of CBDC. All of this could worsen the financial stability of an economy which begs the question whether instruments like CBDC should be used to regulate monetary policy in the first place, when such tasks are already being conducted through traditional tools such as repo rate, open market operations, discount rate, cash reserve ratio etc.
CBDC with its properties like seamless peer to peer transfer of funds, cross border transfers, disintermediation and shift from paper leading to reduction of costs surely presents a lot of benefits and can be evidently touted as the next step for the advancements of nation’s economy. The fact that over 60 countries are researching on its implementation clearly indicates that they want to cash in on the first movers’ advantage and salvage the benefits which come with ‘digital dollarisation’ of their respective currencies. Nonetheless, owing to the disruptive nature of this technology, its scale of implementation, the external effects it might have, the ambiguities surrounding which have been discussed in the aforementioned section of this article, it is best advised to tread with caution. Any economy would only be able to reap the benefits of its CBDC if it’s able to navigate through the externalities which it will cause while interacting with a numerous amount of diverse economic participants.