Summary
The advent of private cryptocurrencies represents a triumph of financial decentralization, with the blockchain acting as a public ledger that is permanent and verifiable, eliminating the need for intermediary institutions like banks. But now a public doppelganger has emerged: central bank digital currencies (CBDCs), government-controlled cryptocurrencies that are either being researched or trialed by an overwhelming 80% of monetary authorities around the world. Will CBDCs tip the scales back toward financial centralization, and in doing so reassert state control over money in the digital era?
Background
A central bank digital currency is precisely what it sounds like: central banks getting into the digital currency space. In more technical terms, it is “a digital form of central bank money that is different from balances in traditional reserve or settlement accounts.” But put simply, a CBDC is a digital representation of fiat currency, which is issued, backed, and monitored by a central bank.
A central bank digital currency allows for a degree of centralized control that has hitherto not been possible. As overseer of digital money flows, central banks could in theory become privy to all individual transactions made with CBDCs, raising obvious privacy concerns and policy responses that will vary by national context. To this end, the central banks of seven democratic countries recently joined with the Bank of International Settlements (BIS) to declare a set of common principles for the development of CBDCs, one of which is that the new monetary instrument should be “underpinned by appropriate standards and a clear legal framework.” The kinds of monitoring and data-collection that could be dubbed “appropriate” remains to be seen. However, a Bank of Canada policy document notes that it would be striving for “a great deal of privacy” in its CBDC rollout, but would stop short of full anonymity so as to allow the detection of illicit activities such as money-laundering. It’s safe to assume that even the most libertarian-minded rollouts of CBDCs will fall short of the pure anonymity of cash.
Thus, the CBDC plays a centralized yin to the decentralized yang of private cryptocurrencies. But there’s also a critical difference in their respective reliability as mediums of exchange. CBDC’s advantage of being central bank-issued fiat currency reduces its intrinsic volatility as a store of value: one US dollar will always equal one digital US dollar, at least in theory. After all, the technology CBDCs are built on allows for new restrictions and applications that confound conventional monetary policy; for example, the possibility of your digital ten-dollar-bill having an expiry date.
A battle for payment supremacy
The crypto-CBDC duality is also useful in conceptualizing the reasons driving the rise of CBDCs. Broadly, CBDCs are a response to the enormous popularity of cryptocurrencies and private transaction platforms, which together are circumventing central banks’ longstanding monopoly over the money supply. More specifically, in the eyes of central bankers, the problem lies in how these new modes of exchange tend to circumvent the typical instrument of central bank control over the monetary system: national banks. Moreover, the use of hard cash has itself been trending down for years, and fell precipitously over the course of the COVID-19 pandemic.
CBDCs are a response to these trends. They represent a way for central banks to evolve alongside the digital economy and, in doing so, maintain the degree of control necessary to ensure monetary and financial stability – the core mandate of all central banks. In practical terms, this means adapting to consumer preferences for greater convenience and lower transaction barriers in the digital (and increasingly cashless) era.
The need to compete with established platforms raises interesting questions, namely whether CBDCs will slot into preexisting transfer methods operated by banks and/or private entities or if they’ll seek to create their own proprietary systems. This is one of the major issues being internally debated in central banks around the world, leading to varying conclusions. For example, Sweden’s Riksbank has partnered with a tech firm to develop a complementary platform that will enable payments, deposits, and transfers of the digital e-krona. In effect, this represents a central bank authority planning a foray into what was once the exclusive domain of commercial banks and tech startups.
Potential benefits
For central banks, the overriding benefit of a CBDC is to regain control over the financial system. This control plays out on the macro level, whereby central banks retain their traditional role of guarantor of systemic stability. It also plays out on the micro level by empowering law enforcement to monitor illicit transactions and money laundering. Such transactions have thrived in the gray areas of global finance which exist outside the purview of central monitoring; according to one estimate, some 1.1% of all cryptocurrency transactions were illicit in 2019, the equivalent of approximately $11 billion US dollars. CBDCs hold out the prospect of bringing these transactions into the light.
Another policy goal of central banks is to ensure the universal accessibility of the CBDC, thus transposing unconstrained nature of cash onto the digital age. Private-sector currency disruptors involve barriers that preclude true mass adoption, generally in the form of technology, account, or compatibility requirements. Central bank CBDC alternatives are designed for universal compatibility across all devices and platforms, and universal accessibility regardless of geography or access to technology. To this end, various authorities are exploring dedicated universal access devices (UAD) to allow users to access their currency at any time, even in a blackout, and without having to rely on a smartphone. These devices would be manufactured and distributed by the central bank. China is already testing one such device: a smart card that acts as a wallet for its digital yuan, ensuring universal access to the CBDC without the need for a smartphone.
CBDCs also have the potential to reduce transaction costs by eliminating the intermediary in domestic and, more significantly, international transfers as well. The fact that this intermediary is more often than not a commercial bank lends itself to another advantage of CBDCs, one that’s generally reserved for enemies of the United States: the ability to evade US sanctions by circumventing the global circuits of US finance.
Potential risks
CBDCs entail privacy risks that were not even conceivable under a conventional cash system. One way to look at it is that CBDCs represent a massive transfer of user data from the private sector (commercial banks) to the government (the issuing central bank). The extent of this transfer varies according to the national regulatory and legal context, but the potential for abuse is clear. For example, one digital wallet being trialed in China’s pilot CBDC project authorizes transactions on the basis of fingerprint data.
But it’s not just data that comes under government control in a hypothetical shift toward CBDCs. So too does a long list of services generally performed by commercial banks, which holds out the prospect of severe disruptions for the contemporary financial system. At the extreme end of the spectrum of potential CBDC designs, CBDCs could supplant the traditional function of commercial banks by acting as a centralized provider of accounting and transaction services; essentially, all currency would be held within the central bank itself. It is unlikely that any country would opt for this ‘direct model’ however, as doing so would require central banks to take on the tens of thousands of workers required to offer the customer service that commercial banks currently provide. The alternative ‘indirect model,’ where CBDCs are issued and monitored by a central bank but held in commercial bank accounts, is not without its own risks. For example, if CBDCs were to be a truly bulletproof store of value, commercial banks would have to hold equivalent amounts of CBDC in their central bank accounts in order to settle all customer accounts on demand. This would restrict the bank’s overall credit capacity compared to the status quo whereby banks are able to lend money based on a percentage of their deposits. Other considerations such as whether or not CBDCs will generate interest in and of themselves, unlike cash, could lead to new and unpredictable externalities. Taken together, these unknowns could represent a source of systemic volatility, which is precisely what central banks are mandated to avoid.
Global rush toward a rollout
The CBDC concept is generating intense interest among central banks around the world. According to research from the Bank of International Settlements (BIS), “80% of the world’s central banks [have] already started to conceptualize and research the potential for CBDCs, 40% [are] building proofs-of-concept, and 10% [are] deploying pilot projects.” The most well-known of these projects is the People’s Bank of China’s digital yuan, which is the result of an exploratory research process dating back to 2014. The digital yuan is already in the advanced trial stage. Other countries exploring CBDCs include Canada, Sweden, Bahamas, the Marshall Islands, and the European Union, and these will be examined on a case-by-case basis in future backgrounders.
