Central Bank Digital Currencies Review
A SUMMARY AND FULL REVIEW OF THE DISCUSSION AT THE WEBINAR ON 7 JULY 2020 PART I
Libra prompted central banks to move their work on central bank digital currencies (CBDCs) from the conceptual stage to design and implementation.
Central banks are working on CBDCs for a variety of other reasons, which include replacing physical cash, financial inclusion, boosting economic growth and international trade, suppressing black market activities, increasing transparency in fiscal policy and geopolitical considerations.Multi-currency CBDCs to facilitate price stability and faster payments in international trade were advocated by a former Governor of the Bank of England and are being pursued by China to support regional trade in east Asia.The use of CBDCs to expedite payments in international trade depends on inter-operability between domestic CBDC systems and it will take time to develop the requisite regulatory agreements and technical standards.CBDCs are unlikely to displace the thousands of crypto-currencies now in issue, so multiple forms of money will compete for the attention of consumers and businesses.CBDCs are most likely to stimulate widespread adoption of digital currency, but pose questions about how crypto-currencies will be regulated, taxed and accounted for.CBDCs also create challenges in protecting personal liberty and privacy, sparking interest in CBDC designs that can protect these rights.There is a strong likelihood that the earliest CBDCs will be backed by reserves held at the central bank, preserving commercial bank intermediation and the value of deposit insurance schemes.Central banks differ in their attitudes towards reserving CBDCs for inter-bank payments and allowing retail consumers to use CBDCs to make payments directly to each other.
The biggest risk to financial stability created by a CBDC is that it undermines the funding sources and lending capacity of commercial banks, especially but not exclusively in a financial crisis.
If (as expected) CBDCs increase the importance of central banks in providing liquidity to commercial banks, this has implications for the Basel III bank capital adequacy and liquidity regime.
A division of labour between public sector infrastructure and private sector services (or apps) is expected to follow the introduction of CBDCs, with payments, on-boarding compliance checks and securities settlement emerging as the earliest candidates for development as services.Rapid deployment of CBDCs in the cash leg of securities settlement is obstructed by the need to pre-fund accounts, which increases liquidity costs and reduces netting benefits.CBDCs will happen, less because central banks are concerned about loss of control of monetary policy and more because they are the fruit of longstanding trends in digital and social technologies.
Five years have passed since Andrew Haldane, then chief economist at the Bank of England, first mooted the idea of a central bank digital currency (CBDC) as a solution to the zero lower bound set by the rate of interest. At the time a CBDC was no more than a theoretical concept, introduced to public discourse by the success of Bitcoin. Five years on, the Governor of the Bank of England is talking openly about issuing a sterling CBDC.
Libra has galvanised central bank thinking
What accelerated the interest of central bankers in CBDCs was not Bitcoin but Libra, the digital currency first proposed by Facebook in June 2019. A private currency, in the hands of a billion Facebook users, posed a systemic threat to the monetary monopoly of fiat currencies that Bitcoin never managed.
After Libra, central bank thinking moved quickly from the conceptual stage to design and implementation. Between January 2019 and January 2020 the title of the Bank for International Settlements (BIS) survey of central bank attitudes towards CBDCs changed from “proceeding with caution” to “impending arrival.”  The second survey found 80 per cent of central banks were engaged in some sort of work on a CBDC.
Central banks pursuing CBDCs have different motivations and objectives
But it would be wrong to think that central banks are approaching the CBDC dilemma in a uniform way. Central banks recognise that different designs have different effects and serve different purposes. The Swedish Riksbank, for example, sees an eKrona CBDC as a natural replacement for fast-disappearing physical cash in Sweden.
The People’s Bank of China (PBOC), on the other hand, is interested mainly in retaining control of the domestic payments system and undermining the dominance of the US dollar as the major international trading and reserve currency. It is running a pilot scheme in some cities already, putting other leading central banks under pressure to respond.
Chief among them is the Federal Reserve, issuer of the dominant reserve and international trading currency of today. It has proved difficult for the United States to pursue an equivalent strategy to that of the PBOC, because of tensions between the various arms of government over ownership of the interest-free loans (or seigniorage income) that reserve currency status endows.
For now, the United States is a laggard in the race to issue a CBDC, not least because it has most to lose. Cunctation can be an effective policy, and being first to market is no guarantee of success, but the federal government and the Federal Reserve must eventually respond to the Chinese challenge to the US dollar as the principal reserve currency and medium of exchange in international trade.
The Swiss National Bank (SNB) is tipped to issue a CBDC first. It is part of the group formed in January 2020 with the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank (ECB) and the Swedish Riksbank to be assessing CBDC use-cases. The SNB has also explored using a CBDC to settle trades on SDX, the digital assets exchange built by SIX Swiss Exchange.
The Monetary Authority of Singapore (MAS), which has been experimenting with the Bank of Canada on the use of CBDCs in cross-border payments, is also expected to be early to market with a CBDC. Its Chief Fintech Officer has stated publicly that the only remaining barrier to a CBDC is a decision by the central bank to issue one. MAS has also expressed a willingness to work with the PBOC on CBDCs.
The potential impact of CBDCs on international trade and economic growth
This expression of interest by the MAS reflects a wider debate in Asia, where discussion of ways to reduce dependence on the US dollar to denominate intra-regional trade goes back many years. China is in fact leading a project that aims to create a multi-currency CBDC made up of the Renminbi, the Japanese Yen and the South Korean won.
Monetary esperantos of this kind have a clear political dimension. When former Bank of England governor Mark Carney argued in a speech in August 2019 that a Synthetic Hegemonic Currency (SHC) governed by the public sector and backed by a number of CBDCs could replace the US dollar as the global reserve currency, he clearly thought this a preferable outcome for world trade than a multi-currency CBDC led by China or the Renminbi displacing the US dollar as the most important global reserve currency.
An SHC would probably not be welcomed immediately by national central banks, which are just getting comfortable with the idea of issuing domestic CBDCs. It also raises the question of who would issue such a currency. The Bank for International Settlements (BIS) and the International Monetary Fund (IMF) are the obvious candidates, but they are unlikely to embark on any experiments until the effects of domestic CBDCs are better understood.
However, there is more to the debate about CBDCs and trade than geopolitics. Blockchains were identified early as a useful tool for managing international trade in general and supply chains in particular, and a CBDC enables payments to be made efficiently in a way that on-chain or on-network payments tokens such as Stablecoins have yet to achieve.
In fact, asset-backed digital coins of the kind proposed by Alex Lipton, Thomas Hardjono and Alex Pentland, in a seminal paper of July 2018 entitled Digital trade coin: towards a more stable digital currency , were designed specifically to bridge the gap between on-chain payment tokens and off-chain fiat currency payment systems in international trade.
One country which sees a CBDC as offering a direct boost to trade is the Marshall Islands. Its government plans to auction the Marshallese Sovereign (SOV) CBDC alongside the US dollar, in the expectation it will increase international trade with businesses located in the tiny central Pacific state by making cross-border payment easier. Because it cannot supplant the US dollar the SOV will function as an independent fiat currency. Its supply will be quantitatively constrained (to 4 per cent growth per annum) to prevent depreciation.
Cross-border use of CBDCs depends on inter-operability of domestic systems
Easier cross-border payments through the user of CBDCs will require inter-operability between domestic CBDCs. This is likely to take many years to develop, and hinges on international regulatory co-operation to agree standards. Early insights into how regulators see inter-operability evolving will become available in October 2020 when the Financial Stability Board (FSB) publishes the results of its consultation on the regulatory challenges of cross-border currency and data flows facilitated by “global stablecoins.”
Although regulation has yet to become clear, standards are already being developed by the private sector that will allow CBDCs built on competing platforms to inter-operate. In fact, at the technical level, it is CBDC use-cases that are driving work on inter-operability. Cross-border payments, for example, are within the scope of the CBDC project launched by the Eastern Caribbean Central Bank (ECCB).
CBDCs as a tool to promote financial inclusion
The ECCB runs a single EC Dollar monetary policy across Antigua and Barbuda, the Commonwealth of Dominica, Grenada, Montserrat, St Kitts and Nevis, Saint Lucia, and St Vincent and the Grenadines. Its DXCDCaribe pilot project, which involves the issuance by the ECCB of a digital version of the EC dollar (DCash) as legal tender, entered testing in March 2019 and will go live in the second half of 2020 in Antigua and Barbuda, Grenada, Saint Lucia and St. Kitts and Nevis. In keeping with its cross-border ambitions, the Barbadian dollar is already taking part in the pilot tests.
But the real ambition of the ECCB CBDC is not faster and cheaper cross-border payments; it is financial inclusion. DCash aims to reduce reliance on cash and cheques, accelerate payments throughout the currency union and bring citizens that cannot afford a bank account into the formal financial system. Anybody can take part – merchants and individuals, and especially those without a bank account – and non-bank financial institutions as well as banks are offering DCash wallet services.
The technology built for the project is based on the assumption that DCash will over time displace the EC Dollar. In other words, the ECCB will eventually conduct all monetary policy operations – interest rate changes and liquidity expansion and contraction – in DCash. Naturally, however, cash will not be eliminated during the pilot stage.
The Central Bank of the Bahamas, whose Sand Dollar CBDC entered live testing on 27 December 2019, has a similar agenda. It sees a CBDC as a means of enhancing financial inclusion – and in particular as providing a resilient store of value in an area where hurricanes have destroyed the life savings of some members of the population because they were stored in their homes in the form of specie.
The Sand Dollar is backed by reserves held at the central bank, making it genuine central bank money – a liability of the central bank, like notes and coins. If it was not, there is a risk that the valuation of the CBDC and the traditional version of the currency would fall out of joint.
If values did diverge in that way – and it is certain to happen if sections of a population are denied access to the CBDC – governments would come under pressure to abolish one or the other. The Indian government decision of 2016 to cancel high denomination bank notes provides a discouraging precedent for overly rapid transitions.
That said, the Indian decision aimed to suppress black market activity and counterfeiting. These are problems which a CBDC can help to solve. Untaxed economic activity is particularly prevalent in developing economies, though much of the black economy is explained not by a reluctance to pay taxes but a lack of conviction that the money will be spent on public services by a corrupt political elite. BY improving transparency in public spending, CBDCs can counter that lack of confidence.
The World Bank, whose responsibilities include creating more efficient and transparent tax administration, has already identified this as a potential benefit of CBDCs. It has a joint initiative with the Massachusetts Institute of Technology (MIT) and consultants EY, called the Prosperity Collaborative, that builds technologies designed to improve tax administration. Business supports the initiative, because they expect paying taxes in CBDC on a distributed ledger network to lower the costs and risks of tax compliance.
A CBDC monopoly of digital cash is unlikely to be realised
Yet however many reasons there are to issue a CBDC, every central bank faces one brute fact. This is that the marketplace is already crowded with Stablecoins, utility coins and other crypto-currencies. In fact, Blockchain has given rise to more than 5,500 crypto-currencies whose value is currently measured at US$331 billion.  CBDCs are unlikely to drive them out completely, opening the prospect of multiple forms of money competing for the attention of consumers and businesses.
The likelihood is that hundreds, and probably thousands, of currency choices will be available in the near-term. In much the same way that the Exchange Traded Fund (ETF) market has evolved to offer investors ever-more refined investment choices, the digital asset markets are likely to be characterised by merchant-to-merchant and consumer-to-consumer currencies that cater to a wide range of tastes, pursuits and values.
CBDCs raise question of personal liberty and personal privacy
This raises the question of how these assets will be treated in terms of taxation and accounting as well as regulation, and between as well as within different jurisdictions. There is a political dimension too. A CBDC which offered consumers and businesses an account at the central bank, for example, poses profound questions of liberty and privacy, since it would not only eliminate private bank money but give a State institution oversight of all financial transactions throughout an economy.
As it happens, although crypto-currencies such as Bitcoin were invented to provide a trustless alternative to the conventional banking system, they are not private either. In line with this, the blockchain industry has shed much of its libertarian personality since 2012-13, and most participants are now working on use-cases designed to turn distributed ledger technology into commercial applications that can work within the existing financial system rather than overthrow it.
For some blockchain enthusiasts, this is simply a recognition of reality. At $331 billion, crypto-currencies make up a small fraction of the total supply of money, and even the most successful are rarely used to settle transactions, not least because of their price volatility, insecurity against theft and frequent lack of operational resilience.
Nevertheless, the concern that CBDCs are an attempt by Big Government to defeat a challenge to their authority and control in the monetary sphere continues to resonate. So it is ironic to reflect that fiat currency notes and coins exhibit a quality denied even to Bitcoin: genuine anonymity.
In fact, it can be argued that only CBDCs offer the privacy, price stability, operational resilience and security against cyber-attack that digital currencies need to drive innovation and widespread adoption. In other words, CBDCs are a viable, universal Bitcoin.
On the other hand, a CBDC undoubtedly does confer enormous power on the issuer, and central banks as issuers are not likely to be interested in sweeping reform of the status quo. By contrast with the crypto-currency promise to disintermediate the trusted, regulated intermediary – namely, banks and the central banks where they hold reserves – the CBDCs currently under development are not proceeding on the basis that they will be issued and used on open networks which render existing intermediaries redundant. With CBDCs, as the name suggests, banks and central banks will persist.
This has sparked a discussion among technologists over how to design a CBDC that cannot be abused by an authoritarian government. Techniques for embedding a greater degree of privacy or even complete privacy in CBDC transactions – without compromising compliance obligations – are being developed.
One idea is to issue variants of a single CBDC with different disclosure rules according to the size and riskiness of the transaction. Buying a major tranche of government securities across national borders, for example, would be subject to heavier disclosure requirements by the principals (and any intermediaries) than purchasing a cup of coffee.
However, there is no consistent framework for discussing and deciding these issues, especially on a global scale. To inform policymakers, so they can strike the right balance between retaining the benefits of lower cost and greater access while mitigating the risks of invasions of privacy and loss of liberty, some entity needs to undertake the hard analytical work that can arbitrate not only on how CBDCs will interact with private sector digital assets that have money-like qualities but how individual and businesses will access CBDCs tout court.
The risks and benefits of wholesale versus retail CBDCs
At the moment, it looks as if CBDCs will always be backed by reserves held at the central bank, so that the supply of the CBDC can be controlled, and the risks of a divergence in the value of digital and analogue versions of the same currency contained. The PBOC pilot in Shenzhen, Chengdu, Suzhou, and Xiong’an New Area is issuing CBDC through banks that hold reserves at the PBOC.
Despite efforts, notably by the Bank of England, to open membership of central bank-operated Real Time Gross Settlement (RTGS) payment systems to non-banks, such privileges have yet to be extended to reserves. The holding of reserves at central banks continues to be monopolised by commercial banks.
There are central banks (notably the Banque de France) and governments (less predictably, the Swiss Federal Council) which have a clearly stated preference for restricting the use of CBDCs to inter-bank payments between commercial banks, as opposed to their direct use by households and businesses. Others (such as the Bank of England and the Bank of Korea) are prepared to contemplate issuing CBDCs directly to the general public, but for now this remains a theoretical possibility only.
One reason for central bank caution is that CBDCs create risks to financial stability. Central bank balance sheets have already inflated massively since the financial crisis of 2007-09 and issuing a digital fiat currency can expand them further, especially if the biggest official concern about CBDCs is realised.
This is the risk that commercial bank funding is destabilised as depositors switch from commercial bank money to central bank money, thereby also creating a credit squeeze by undermining the ability of the banks to lend.
This effect can be controlled, by central banks offering tiered interest rates, or adjusting reserve requirements to protect CBDC deposits at commercial banks, and by commercial banks offering higher returns on deposits by investors with a greater appetite for risk. CBDCs also give central banks much earlier warning of a run on a bank because they can see what is happening in real-time.
But in the end any financial crisis will see a flight to quality counterparties, among which the central banks will always rank first. In fact, the availability of fiat currency in digital form is likely to accelerate the pace at which the demand for central bank money actually happens.
A CBDC is, after all, central bank money. Unlike commercial bank money deposits, whose only guarantee is the ceiling set by the deposit insurance scheme to which the banks subscribe, holdings of CBDCs are technically equivalent to holding notes and coins. In other words, the central bank must pay the bearer on demand the value of the CBDC that the depositor holds.
However, this may not hold true in all cases. If the depositor holds a true CBDC through account at the central bank, their holdings will be payable at 100 per cent of their value. If the CBDC is a synthetic version held in an account at a commercial bank whose holdings are based on reserves held at the central bank, deposit insurance will continue to be valuable to have.
If a run on the commercial banks occurred, the central banks would have to fund the assets of the commercial banks. While this is no longer unusual – after all, it is how the European Central Bank (ECB) has supported commercial banks in some member-states of the eurozone for many years – central bank support does require collateral. Not all banks will have eligible collateral.
This prospect has interesting implications for the regulation of capital adequacy. The liquidity coverage ratio set by the Basel III capital adequacy regime, which governs the proportion of highly liquid assets (HLAs) banks must hold, will have to be re-considered if central banks start to play an even greater role in the supply of liquidity to commercial banks. Effective mechanisms for supplying central bank liquidity to thousands of banks will need to be developed.
It might be argued that this retention of control of monetary policy by central banks is what distinguishes a CBDC from a crypto-currency. It is equally important that central banks interested in CBDCs clearly also expect to continue to operate the ultimate payment system, just as they do with RTGS systems today. In fact, in the most advanced CBDC models, central banks are developing the internal technological capabilities to do exactly that.
Ultimately, what matters to any digital currency is whether it is used in transactions. Since no CBDC has yet progressed beyond the pilot stage, none has yet even sat that test. However, the pioneers can expect to influence those that follow, and expectations that a genuinely retail CBDC will be launched soon are low. Most observers are banking on “synthetic” or central bank reserve-backed digital currencies restricted to the commercial banks through which central banks have always conducted monetary policy.
CBDCs should encourage the emergence of supportive private sector services
Many private sector intermediaries will welcome this continuing involvement by central banks, as a guarantor of widespread adoption and effective management of systemic risk, while they compete through innovation to deliver CBDC-based payments and other financial products and services to the general public.
The emergence of multiple technology platforms (such as R3 Corda and Hyperledger Fabric) to develop applications to support CBDC issuance and usage is a clear sign that this is happening already. What is harder to identify is the private sector services or applications that will make use of a CBDC infrastructure – beyond the obvious instance of payments versus payments, that is.
One opportunity lies in the securities markets, where tokenisation of existing securities is retarded by the need to come off the blockchain network or tokenisation platform to settle in fiat currency. If securities could be settled, as well as issued and traded, on the network, it opens the possibility of securities clearing, settlement and custody migrating from a system of custodian bank-operated accounts at central securities depositories (CSDs) on to vertically integrated blockchain networks which provide a fully integrated issuance, trading, clearing, settlement and custody function.
Yet even this possibility faces one substantial barrier. Instantaneous delivery of securities against cash payment (DvP) on a blockchain network requires both settlement accounts to be pre-funded, in the sense that sellers must have the assets and buyers the cash available to settle before they agree to trade.
That has a liquidity cost, further increased by the fact that transactions cannot be netted but must settle gross. Settling on-chain also implies a third cost (investment in the replacement of legacy systems that cannot support instantaneous settlement) and an increase in the risk of making an expensive mistake that cannot be rectified before it is settled or causing a compliance breach (such as a transfer of cash or securities to a money launderer or terrorist) that leads to a hefty regulatory fine.
True, these costs and this risk may be offset by the ability to move surplus liquidity to where it is needed much more quickly. An estimated US$10 trillion is trapped in the form of the liquidity buffers banks and their corporate clients maintain in multiple currency accounts around the world. In theory, CBDCs make it possible to move that liquidity intra-day, rather than netting it at the end of the day. In fact, work is in hand on how to enhance the benefits of the current system by netting intra-day.
Know Your Client (KYC), anti-money laundering (AML), countering the financing of terrorism (CFT) and sanctions screening tests, currently conducted by banks, asset managers and other corporate entities involved in financial services are another area where CBDCs are stimulating the development of private sector services. After all, these compliance checks are not a duty central banks are likely to assume. Indeed, in the case of DCash, the ECCB has made clear they are not its responsibility.
The value of the market is large. One study estimated KYC, AML, CFT and sanctions screening checks are costing financial services firms in the United States, Canada and five European countries alone US$115 billion per annum.  These costs now account for 20 per cent of run-the-bank costs in major financial service firms, and they are increasing at 5 per cent a year.
Why CBDCs are going to happen
Further private sector opportunities will disclose themselves as CBDCs move from theory to practice, and there is increasingly narrow scope for doubt that CBDCs will happen. The regulatory pushback against Libra, reducing what in its first incarnation looked like an existential threat to official monetary monopolies to little more than another Stablecoin, is the end of the beginning rather than the end of the idea of central bank-issued digital currencies.
The main reason to believe this is that CBDCs are not an unexpected event, but a predictable outcome of social and technological trends with a long history, such as the declining cost of computer power, growing on-line commerce, the shrinkage in the use of physical cash and the growing popularity of instant payment. CBDCs are as much a product of those trends as a reaction to crypto-currencies, which originate from exactly the same source, and that – without resorting to technological determinism – is why they will happen.
 Bank for International Settlements, BIS Papers No 101, Proceeding with caution – a survey on central bank digital currency by Christian Barontini and Henry Holden, January 2019; and BIS Papers No 107, Impending arrival – a sequel to the survey on central bank digital currency by Codruta Boar, Henry Holden and Amber Wadsworth, January 2020.
 Lexis Nexis Risk Solutions, True Cost of AML Compliance, United States and Canada Edition, 2019. Lexis Nexis Risk Solutions, The True Cost of AML Compliance, European Edition, September 2017.
Questions to be addressed for the next CBDC discussion
Is a CBDC issued directly to retail consumers, and not via the banking system, a serious near-term or long-term possibility?
Which entity (or type of entity) is best placed to resolve how CBDCs will interact with private sector crypto-currencies?
Which entity (or type of entity) is best placed to develop the technical standards necessary to enable domestic CBDC systems to inter-operate across national borders?
What are the drivers of and obstacles to multi-currency CBDCs?
What product and service innovations are CBDCs likely to encourage?
The Future of Finance is always open to hold further meetings to answer these and other questions and to continue the conversation. If you would like to sponsor such a meeting please contact Wendy Gallagher at the number or email address below. Also view our upcoming meetings elsewhere on http://www.futureoffinance.
Tel: 07725 160903