#15 Central Bank Digital Currencies

Unpacking what CBDCs are and when issuing them makes sense

Hi all - This is the 15th edition of Frontier Fintech. A big thanks to my regular readers and subscribers. To those who are yet to subscribe, hit the subscribe button below and share with your colleagues and friends. 🚀

This week, I introduce an Executive Summary for those who would like a quick summary before diving into the main article.

"Give me control of a nation's money and I care not who makes it's laws" — Mayer Amschel Bauer Rothschild

Executive Summary

The idea of having Central Bank Digital Currencies is gaining traction globally as our ideas about money in the digital age evolve. China is well on its way to issuing a digital renminbi and Sweden is also working on a e-Krona project. Countries such as Bahamas have already issued a digital currency. Central Bank Digital Currencies are largely defined as digital currency issued by the Central Bank directly or via bank intermediaries to facilitate lower value payments. They can be issued in either token format with private keys or as accounts held at the Central Bank.

The main advantages are traceability of transactions, the ability to make direct stimulus payments, accessibility and availability, availing digital legal tender to the public as well as programmability. There are significant disadvantages that in my view outweigh the benefits. These include KYC costs and complexity, the disruption of the existing banking business model i.e. maturity transformation, concerns around data privacy, cyber risks as well as over-centralisation of power within the Central Bank.

Sweden and China are issuing CBDCs largely as an alternative to existing digital payments because cash is a public good whose availability as a payment method should be safeguarded by the government. Concentration of payments by private players can lead to exclusion and lack of control by the Central Bank. Not all countries at the moment need to issue CBDCs. The key consideration should be cash in circulation as a percentage of GDP as well as the percentage of cash payments to total payments. As these reduce, then Central Banks should dust off their CBDC plans.

China is also playing the long-game of having the CBDC as the native currency of their new digital trade based platform that will run on 5G, IoT, smart manufacturing and smart logistics.

Introduction

In this article, I try to unpack what a CBDC is, the different iterations in which it can exist and what the motives behind the moves by Sweden and China in issuing digital currencies are. It is very interesting that the pioneers of our current money systems i.e. bank notes and cash are the ones leading the charge towards digital money. Paper money was invented in China in the 9th Century and the Riksbank of Sweden was the first Central Bank to print cash notes. 

It is important to first understand how our current money systems work and then see where CBDC’s come in and particularly where they add value. The issue with inventions and technology is that they must solve a problem, otherwise there’s a tendency to innovate for the sake of innovation. CBDCs are being introduced largely to solve a payments problem and thus we’ll have to analyse money and the various forms of money within the domain of payments.

In a previous post about Bitcoin and the history of money, I gave a decent primer on our current monetary systems. Money essentially evolved from Barter Systems to a commodity based monetary framework with Gold at the core of it, to the current Fiat monetary system where cash is legal tender i.e. money derives its value from the government that is issuing it.

Within the modern monetary framework, the issuance and creation of money is done by Central Banks with commercial banks acting as their distribution partners. Money can be either created digitally or it can be printed as cash. The former is often the most prevalent. Cash is printed by the Central Bank and distributed through banks to the general public. Banks then distribute it via ATMs and bank branches.

There are four main payment methods currently in use across the world. They are;

1. Cash;

2. Cards - debit, prepaid, credit;

3. Bank based payments - cheques, direct debits, RTGS etc;

4. Digital Wallet payments;

They can be viewed from the diagram above. In all these payment modes, banks play a key role in settlements and providing the architecture. For digital wallets, the wallets can either be an interface to your bank account or the wallets providers must maintain equivalent balances within the banking sector an example being Mobile Money in Africa. In all these payment methods, the control of money supply is monitored by the Central Bank through banks.

Despite the proliferation of digital forms of payments in most markets, Cash has remained a core part of payments particularly in Europe (ex Sweden), Africa, South America and North America. Cash is still king and that is largely due to the following reasons;

1. Cash is legal tender that means every merchant has to accept cash payments. In Sweden, contract law supersedes payment laws and that’s why merchants can reject cash payments in Sweden;

2. Cash is easy to use - low tech and easy to understand and use. 

3. Cash offers immediate settlement and transfer of value between two parties without an intermediary, this also enables direct reversals in case the cash or goods being transferred are not proper;

4. Cash is anonymous - it’s a bearer instrument and offers anonymity in payments. Nobody knows when a cash transaction occurs apart from the two parties exchanging it. This is one of the reasons why cash is very popular in illicit activities;

5. Due to availability and reliability - cash is a fall-back/safe-haven asset. This is particularly evident in fragile countries where you’re always advised to keep some cash both foreign and local in case of any emergency;

6. Cash helps with budgeting - you can withdraw money based only on your spending needs. This is a very critical fact. At the low end of the spectrum, most people prefer cash because it helps them maintain financial discipline. In fact, I’ve spoken to many customers who weren’t comfortable with a digital payments solution we offered because it could lead to overspending;