As citizens around the world are confronted with the severe curtailment of political, economic and cultural freedoms associated with COVID-19 risk mitigation strategies (e.g., lockdowns, mandatory vaccinations and/or vaccine passports), new risks to economic freedom and prosperity are quickly emerging which citizens must be aware of and remain vigilant about.
One of these risks which is developing with rapid pace are Central Bank Digital Currencies (CBDCs). According to a Bank of International Settlements (BIS) 2021 survey[1]:
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86% of central banks are actively researching the potential for CBDCs;
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60% were experimenting with CBDC associated technology; and
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14% were deploying CBDC pilot projects.
The development of CBDCs potentially represents one of the largest changes to modern banking and finance (as well as the global financial system) in decades[2], even though, as noted by the BIS[3], the concept was proposed by American economist, James Tobin, in 1987[4].
CBDCs have been the subject of much speculation of late regarding their intent and implications within economic and financial circles (both mainstream as well as alternative circles). However, to date, they have generated little debate or scrutiny by the public-at-large.
This latter fact is rather astonishing given the potential scale of change to economic life that may result from the introduction of CBDCs.
Current Structure of Currency
As noted by the International Monetary Fund in 2021[5], economies around the world currently operate under a “dual monetary system” comprising of:
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Publicly-issued currency by central banks in the form of physical cash (coins or banknotes) and central bank reserves which constitute legal tender (i.e., form of currency or money which are legally recognised as a means of payment to settle financial obligations such as debts, taxes, contracts, legal fines or damages)[6]; and
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Privately-issued currency by private commercial banks, telecom companies and specialised private payment providers – that is, digital forms of legal tender that are issued and held by non-government financial institutions (e.g., bank deposits or balances held in payment systems such as Paypal or Alipay).
This dual system is able to co-exist and facilitate commerce and economic activity given that privately-issued currency can be redeemed at a fixed face value of legal tender currency issued by central banks.
Within this context legal tender currency is of a ‘fiat’ nature meaning that its nominal value is set by government decree and does not possess any underlying intrinsic value, such as forms of money backed by a physical commodity such as physical gold or silver bullion.
An important distinction of this dual system is that physical cash and central bank reserves are the liabilities of central banks, whereas privately-issued currency is the liabilities of private sector payment providers.
Historically, a commercial bank would become insolvent when they couldn’t meet their liability obligations, whether this resulted from a bank run, fraud or experiencing technical outages.
Under this dual system, commercial banks and other private sector payment systems play an important financial intermediation role, including:
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managing customer facing activities – i.e., providing retail banking services such as payment accounts, authorisation, clearing, settlement and dispute resolution;
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developing and releasing innovative payment products which more efficiently facilitate commerce both domestically and internationally; and
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ensuring compliance with anti-money laundering (AML) and know-your-customer (KYC) obligations.
Thus, it is argued that central banks play an essential role in the monetary and payment system by providing stability and efficiency, whereas the private sector promotes innovation, diversity and competition.
Definition of CBDCs
Given the above explanation of the current structure of the modern fiat currency system, it is important to define what CBDCs are and what role they may play within this structure.
CBDCs are digital or virtual forms of physical cash represented through an electronic record or digital token that is issued and regulated by a country’s central monetary authority (i.e., its central bank)[7] via a centralised ledger.
CBDCs are centralised, which stand in stark contrast to privately-issued cryptocurrencies (such as Bitcoin) which are decentralised and unregulated.
CBDCs are not uniform and central banks have an immense range of legal, technical, operational and administrative design options to achieve their stated public policy objectives. Importantly, the policy intent of CBDCs will be neither uniform across jurisdictions nor static in time. Instead, they will tend to be a function of a country’s economic, political and social context.
As discussed in greater detail below, CBDCs can both co-exist and operate in parallel with both physical cash and privately-issued currency.
Thus, in assessing whether a proposed CBDC will, in net terms, improve or impair the function of a monetary system and broader economy, each CBDC will require individualised scrutiny and assessment.
CBDC Public Policy Rationale
Advocates of CBDCs suggest that they are necessary, certainly useful, in addressing multiple issues emerging across the global financial system of late. These issues include:
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Faster private sector payment systems – payment system providers such as Alipay are able to process 120,000 transactions per second, which is almost double the processing speed of credit card companies (such as Visa) and are much faster than traditional processing times of commercial banks[8].
Moreover, the emergence of stable coins – i.e., private cryptocurrencies that are backed by a reserve asset (e.g., this can include a basket comprising of fiat currencies (one or more), fiat currency equivalents, or short-term government securities) – means that private cryptocurrencies and their associated digital infrastructure can directly compete with the existing dual-currency central bank-commercial bank system (as described above).
Thus, private sector innovation in payment systems and private cryptocurrencies mean that the existing global financial system with its traditional forms of currency and bank payment systems are too slow and thus are at risk of becoming obsolete legacy systems.
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Retaining sovereign control – the emergence of private sector payment systems means that central banks contain less control of the money supply thus rendering monetary policy less effective as an economic policy tool[9].
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Financial stability – the potential failure of a private issuer of digital currency could disrupt the payment system and destabilise either the financial system of a nation (and even the global economy, if significant enough)[10].
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Financial inclusion – the rise of narrow and private money networks could exclude segments of an economy’s population from enjoying digital financial services or being able to consume particular goods and services[11] (sometimes referred to as ‘unbanked’ customers).
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Zero-lower bound interest rates (i.e., negative interest rates) – the existence of physical cash results in the severe curtailment of the ability of central banks to lower official interest rates below the zero bound (i.e., implement negative nominal interest rates) given the risk that citizens are likely to withdraw from the financial system by hoarding physical cash if negative nominal interest rates are implemented[12].
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Enhancing the effectiveness of fiscal policy – the existing dual-currency system makes the deployment of fiscal stimulus payments (whether one-off payments or continual payments such as Universal Basic Income or UBI) highly cumbersome and inefficient for governments who deal directly with citizens or who issue payments through financial intermediaries[13].
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Declining use of physical cash – the declining use of physical cash in particular economies coupled with the widespread use of alternative digital currencies by the private sector could undermine market competition – for example, where a company uses their dominant position in one industry/sector to control payments and competition in other entities (or sectors)[14].
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Cyber risk – with “Big-Tech” providing payment options through cloud-based technology, such technology presents risks to wholesale and retail market participants which may undermine confidence in digital finance as a means of facilitating transactions and storing value.
Thus, given the issues raised above, advocates for CBDCs argue that CBDCs are able to resolve these issues by:
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settling wholesale and retail level transactions at processing speeds on par with private payments systems offered by “Big-Tech” firms (such as Facebook or Paypal) but at a much lower per-transaction cost, thus arguably generating a rise in productivity;
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providing a resilient and universally-accepted form of digital payment;
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preventing the leakage of the money supply away from central banks towards private payment systems, thus ensuring central bank relevance in the monetary system and that monetary policy retains its policy effectiveness;
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allowing central banks to intervene and stabilise the payments system and by extension the financial system in the instance where private sector failures were to occur;
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providing ‘unbanked’ citizens with the opportunity to participate in the digital economy;
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providing central banks with greater policy flexibility to implement negative nominal interest rates (i.e., official interest rates below the zero bound) without the risk of cash hoarding; and
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making fiscal policy transfer payments (including stimulus payments) more efficient by allowing governments to send central bank issued digital currency directly to the retail accounts held at central banks in the instance where a retail CBDC exists.
CBDC Operating Model and Design Features
Importantly, CBDCs are not a uniform technological innovation and, given the significant diversity in their possible design features, CBDCs can be developed to address different public policy and operational requirements. Access, the degree of anonymity and operational availability are just some of the core characteristics that central bank policy makers need to consider when designing their CBDCs.
Given this, CBDCs cannot and should not be uniformly praised or condemned. Instead, they need to be assessed at an individual nation-state level (i.e., on a case-by-case basis) given its design characteristics and operational effectiveness.
CBDC Operating Model
At its core foundations, each CBDC will have four components which will formulate its operating model. These four components are illustrated in Diagram 1 and include:
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the issuance of CBDC (including what will be issued, how and in what quantity);
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how the CBDC is then distributed through an economy;
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what payment system will facilitate the widespread adoption of the CBDC; and
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how the CBDC will/can be accessed by users (i.e., the user device).
