#15 Central Bank Digital Currencies

Unpacking what CBDCs are and when issuing them makes sense

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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;

Additionally, payment methods are analysed using the four core themes of;

1. Efficiency - how costly is it to ensure end to end transaction and settlement;

2. Availability - cash for instance is always available;

3. Reliability - incidences of downtime;

4. Safety;

The diagram below from a 2018 G4S cash report stacks up cash against other payment methods.

Source: G4S World Cash Report

Cash is a very powerful payment mode and only underperforms when it comes to executing remote payments and higher value payments due to its bulky nature. The above also helps in the design of digital payment methods, when you take out distance and bulkiness, it’s very difficult to compete against cash

Central Bank Digital Currencies;

Now that there’s a basic understanding of how the overall monetary framework works as well as why cash is a useful payment method, we can then take a dig at Central Bank Digital Currencies.

Understanding CBDCs is a complex undertaking because as it is there is no clear definition that encapsulates both design and distribution. It is envisioned as being a new form of Central Bank backed money issued in digital form for the purposes of lower value or retail payments and forming part of the Base Money supply i.e. M0. It would obviously have to serve the key purposes of being a store of value, medium of exchange and unit of account.

Digital money is not a new concept, Central Banks issue digital money at a wholesale level to banks and any other approved entities that maintain accounts at the Central Bank. CBDCs are then envisioned to be digital formats of money targeted at retail transactions. 

The Bank of International Settlements has a very useful “Money Flower” that helps with the taxonomy behind CBDCs. The four key factors are;

1. Accessibility;

2. Digital/Physical;

3. Issuer;

4. Token/Account Based;

Source: Bank of International Settlements

It can be assumed that Central Banks want CBDCs to be widely accessible, digital and to control their issuance. In this case, the two key areas are highlighted in black. CBDCs can either be issued as tokens or accounts. 

Design and Distribution Considerations

There are three core areas of design and distribution that Central Banks have to think about when reviewing their CBDC strategy. They are;

1. Token/Account considerations;

2. Direct or Indirect distribution;

3. Whether they will bear interest;

Token/Account

Payment methods can either be token-based or account based. A token based system includes cash, cheques and say cryptocurrency where the burden of authentication is based on the validity of the token not the bearer of the token. Credit cards, bank transfer and other account based systems work based on the ability to properly identify the owner of the account. A CBDC could either be token-based or account based.

A token-based framework could work like Crypto-currency where the CBDC issues digital tokens based on private-key architecture. These could be held in digital wallets issued by the Central Bank. Alternately, the Central Bank could enable citizens to hold accounts with the Central Bank directly in which these CBDCs could be held.

Direct/Indirect Distribution

Assuming that the Central Bank decides on an account-based system, the next question that emerges is whether these accounts should be held at Central Banks or at intermediate institutions such as Banks and Wallet Providers. Recent moves by the People’s Bank of China suggest that the Chinese are exploring distributing CBDCs via Alipay or Wechat.

There are major considerations when deciding on the distribution strategy. Direct distribution could starve banks of deposits and thus the ability to perform maturity transformation which is critical for the proper functioning of an economy. If CBDCs are held at intermediate institutions such as banks, then they will likely be forced to maintain 1:1 reserves i.e. ensure that the total CBDCs held at the Central Bank correspond to the sum of CBDCs held at each digital wallet. This will also take away the maturity transformation element in banking. Additionally, given that maturity transformation is off the tables and intermediaries wouldn’t be able to charge high fees, what would be the incentive to handle KYC and build systems to host digital wallets from a commercial perspective?

Interest Bearing

Will CBDCs bear interest or be non-interest bearing? The consequences of having interest bearing CBDCs held at the Central Bank could have significant ramifications for monetary policy and the business of banking. The interest earned by CBDCs could become the de-facto monetary policy rate. In modern advanced economies, the transmission of monetary policy is effective with the existing systems of targeting short-term rates through open market operations. In developing countries, a CBDC interest rate could become more effective in managing monetary policy as the transmission would be more direct.

One thing to have in mind is that CBDCs are claims on the government i.e. legal tender. Bank balances are claims on banks. In the instance of a bank crisis, CBDCs would be considered safer and people would shift all their holdings into CBDCs. Currently, bigger banks benefit from bank runs since people shift money to safer-banks. The business of banking concerned with accumulating short-term but stable deposits for long-term lending would be adversely affected particularly where interest rates are present. A number of Central Banks are considering having caps on each person’s CBDC holdings.

Summing it Up

The diagram attempts to show how CBDCs will fit into the existing payments system largely as an alternative to cash and the existing digital wallets. The diagram shows an instance of direct distribution by the Central Bank.

Advantages and Disadvantages of a CBDC;

Advantages

1. Safety of legal tender - with the proliferation of digital wallets in Asia and Africa and card payments in Europe and North America, CBDCs provide customers with digital legal tender thus enabling everyone to participate in economic activity. Cash is a public good;

2. Financial inclusion - a well designed digital currency can enable financial inclusion. Nonetheless, India has shown that you don’t have to create a digital currency to drive financial inclusion with the India Stack.

3. Electronic payments - For the government, a digital currency gives more traceability and real time data on economic activity. This can have useful benefits as regards tax evasion, policy design and direct intervention such as fiscal stimulus. 

4. Cross-border payments and trade - In theory, a digital currency can enable easier cross-border settlements and remittances particularly if digital wallets are available globally. You could consider for instance sending money to a relative back home using your digital KES or ZAR wallet with direct settlement and zero cost;

5. Resilience - You would imagine that the Central Bank would invest in more resilient architecture that has better uptime than existing electronic modes of payments. This is largely in theory and is yet to be borne out in the real world.

6. Programmability - Digital currencies would have programmability just like Ether on top of the Ethereum blockchain. This programmability could for instance be used when the government wants to stimulate consumption by issuing digital currencies to its citizens and setting an expiry date so that people are incentivised to spend. The programmability is a double edged sword as in theory the Central Bank could invalidate your wealth by making your CBDCs worthless.

Disadvantages;

1. End to fractional reserve banking - The design choices around whether citizens hold direct accounts at Central Banks or in intermediate accounts could have ramifications for fractional reserve banking and maturity transformation. Direct holdings at the Central Bank would starve banks of deposits particularly retail deposits thus affecting their ability to lend. This would affect committed lines of credit/overdrafts and long-term loans which are predicated on having low cost stable deposits. This would have negative multiplier effects across the economy leading to low growth. It’s a non-starter really.

2. KYC and compliance - Again the design choices are critical. A direct token that is based on private key infrastructure would help customers retain their anonymity. Nonetheless, money laundering is based on converting cash which is bulky and anonymous into digital money so that it can be easily moved. If you mix anonymity and ease of movement into a digital token, then it’s a gift for criminal enterprises and terrorists. On the other hand, either a digital token or account based that’s based on proper KYC checks would be a significantly complex operational undertaking by the Central Bank. Either way, most customers would like to retain the anonymity of cash whilst Central Banks would like to maintain KYC and compliance checks.

3. Data Privacy - Building on the above, citizens will have to give up their data privacy and have a comprehensive history of all their transactions held by the government. This is possible in China, but in many democracies this would be politically unpalatable.

4. Security - Again based on the design choices maintained by the Central Bank. A centralised system creates a single point of failure that could take down the entire nations payment system. There are additional risks of cyber-security and national security considerations around having a digital payments system that is susceptible to hacking;

5. Too much Central Bank power. The promise of cryptocurrency is premised on decentralising power away from the incumbent financial system with the Central Bank at the pinnacle. CBDCs could raise the following issues;

   1. If CBDCs issue accounts to citizens, they will hold vast deposits and would thus become the main source of wholesale funding to banks. How will they decide who to lend to and how to analyse credit risk? With time, these decisions could be politicised;

   2. In less robust judiciaries, the Central Bank could simply switch off your CBDC account thus leaving you unable to transact and participate in the economic system.

On the balance, it seems the disadvantages significantly outweigh the benefits and the benefits are largely theoretical. Moreover, the benefits could be achieved in different ways as opposed to through a CBDC. The question that arises is why then would anyone consider the issuance of a CBDC.

Motivations for CBDC particularly from China and Sweden;

There are two major motivations for the issuance of a Central Bank particularly for China and Sweden. 

In both China and Sweden, digital payments have grown significantly. In Sweden for instance, Cash in Circulation as a percentage of GDP is the lowest in the world at 1.4% compared to a EU average of roughly 8%. In some countries such as Greece and Spain, CIC/GDP stands at around 15%. Additionally, only around 18% of customers want to use cash as a payment method in Sweden.

In China, mobile payments have come to dominate most low value payments. According to a survey done in 2018 by Ipsos, over 83% of payments done in China are done via mobile payments. There are thus liquidity and concentration risks if specific private entities control the country’s payment systems. In fact this is one of the reasons why UPI of India are trying to limit market share for UPI participants.

Source: Daxue Consulting

Therefore in both Sweden and China due to a number of reasons, cash is becoming less relevant in day to day payments. Cash is considered a public good by the government, everyone should have access to cash payments so as to participate in economic activity. If private modes of payments proliferate, then the Central Bank can no longer guarantee the value of cash as a public good. 

It is with this in mind that both Sweden and China are exploring a digital currency not as a replacement to existing digital solutions but as an alternative that ensures that everybody has participatory access. It is no wonder that China is seeking to work with Ant Group and Tencent to distribute digital currency. The difference is based on the taxonomy of digital currency as legal tender and existing digital money as a claim to a private bank.

Additionally, China could also be playing a much longer-term game based on their existing Belt and Road Initiative and their concept of a dual circulation economy. As part of their 2025 strategy, China has core technologies such as 5G, AI, IoT, smart manufacturing and smart logistics. China is playing a long game where all these technologies are integrated and supported with a CBDC as the native payments layer. Consider for instance that you will be able to order directly from a Chinese factory using smart contracts, track your goods from factory to shop floor using IoT running on Huawei 5G technology with a payments layer that is programmable. You could for instance agree that you pay 10% upon order confirmation and 90% upon the good arriving at your warehouse and all this is managed via smart contracts. All the parts are in motion when it comes to providing 5G in all Belt and Road partners, providing port software and investing in logistics.

China wants to redesign the global trade system using modern technology and applying first principles thinking. The CBDC in this instance would be wholesale CBDCs with participating banks and technology partners globally. Here is a very useful resource on the long-term CBDC play by David Goldman of the Asia Times. He’s a very knowledgeable resource on matters China and the strategic ambitions of the Chinese government. The thinking by David Goldman contrasts the analysis by the Wall Street Journal.

All things considered, Sweden and China as pioneers of digital payments have valid reasons for issuing CBDCs. Even then, CBDCs will be designed and issued as complements of existing payment methods and not a direct replacement. In many other jurisdictions, the need for a CBDC just doesn’t yet exist and therefore there should be no rush to issue one.

In the long-term, the ubiquity of digital private payment systems and their depth in terms of volumes of payments vis a vis cash should be monitored as this will form the basis of issuing a CBDC.

As always thanks for reading and drop the comments below and let’s drive this conversation.

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