Bitcoin was envisioned to be a decentralized global currency to challenge central bank supremacy. Ironically, threatened by the risk of private cryptocurrencies, sovereign central banks are taking some of the best features of such currencies (e.g., blockchain, smart contract) and collaborating at a global scale to build a new form of money called Central Bank Digital Currencies (CBDC). CBDCs will have a massively disruptive impact on the global economy, which means preparing for this transformation is paramount for all stakeholders.
What is CBDC and why should you care?
CBDCs are digital fiat currencies issued by Sovereign Central Banks and offer multiple benefits over the current monetary arrangement. Today, Central Banks issue Physical currencies (banknotes and coins) for general purpose usage. Storage and distribution of such physical currencies are inefficient and costly and involve high risk of counterfeits and other security risks. Most of the electronic money in use today is minted by Commercial Banks and not by Central Banks, which results in a systemic risk of bank failures to honor its settlement obligations. CBDCs can help mitigate this risk and support the emergence of a more efficient cashless economy.
CBDCs offer programmability of money helping governments and central banks to use this tool for providing targeted subsidies. For example, to reduce leakage in agriculture subsidies, CBDCs can be programmed in a way that they can be utilized for only agribusiness purchases. With its Smart Contract Technology, governments can enforce specifically targeted policy implementation around financial inclusion or negative interest rates. From the analytics inherent in the CBDC systems, Central banks can calculate Inflation Rates and accordingly control Monetary policy interventions.
CBDCs can significantly reduce the risk of Tax evasion and money laundering. As these currencies can keep a history of all past transactions, banks can track the flow of money and monitor any such risks. CBDCs also help in improving the cost, risk, and agility of cross-border payments improving global commerce.
Various Models of CBDC Issuance
There are multiple vendors and central banks prototyping with various models of CBDC usage, target population, issuance, and distribution models. Broadly, we can consider the below combinations for a CBDC economy.
Based on Issuance – Centralized vs Decentralized: Distributed Ledgers are the cornerstone of a trustless economy. But CBDCs do not necessarily need to be on Distributed Ledger as Central banks enjoy a high level of public trust. At the same time, centralized ledgers carry their risks of security attacks, and therefore a “permissioned” DLT approach may be most suitable.
Based on Purpose – Retail (general purpose) vs Wholesale: Retail CBDCs are held by citizens and companies (e.g., Project Sand Dollar in the Bahamas, Project Bakong in Combodia, etc.) whereas Wholesale CBDCs are restricted to Financial Institutions or foreign governments for Payments Settlements (example Inthanon-LionRock). Wholesale use cases include Securities Settlement and Cross border Payments whereas General Purpose CBDC use cases include commercial transactions, stimulus/welfare payments etc.
Based on Distribution model – Direct vs Indirect vs Hybrid: While Central Bank or Monetary Authority is the issuer of CBDC, distribution of CBDC can be left with commercial banks to avoid duplicating the efforts involved in the creation of a new set of accounts. In the Direct model, Commercial banks will have a limited role to play but in the Indirect and hybrid models, Private Commercial Banks or Payment Service Providers will maintain the wallets/accounts and distribute the CBDCs to end-users.
Based on Holding Methods – Account-based vs Token/Value-Based: The account-based model will need strong identity and access management systems and will have less privacy and more government visibility of every transaction using CBDC. On the other hand, Token/Value-based models will have bearer characteristics like today’s banknotes which offer a very high level of privacy for their users.
Challenges of Implementing CBDC
CBDC is a futuristic concept of money issuance and distribution and faces multiple challenges for mass adoption. Some of them are:
1. Managing conflict of interest of incumbents – The CBDC design should consider the impact of CBDC on Commercial banks, SWIFT, Payment Service Providers (e.g., the sudden pullout of funds from commercial bank money may result in run-on banks). If CBDC implementation is too costly or cannibalizes their existing revenue streams, getting a consensus on implementation would be difficult.
2. Training and motivating the public on using new technology especially where technology infrastructure is not developed. The public needs to be incentivized with offers/benefits to start using CBDC and they need to have stable internet infrastructure for using CBDC.
3. Coexistence of old money and new money – How today’s bearer cash-based ownership will co-exist and reconcile with decentralized CBDC models needs to be resolved.
4. Operational Risks (systemic failures, cybersecurity challenges, and fraud risks) – Any systemic failure, counterfeiting, outage or fraud will reduce public confidence in the newly minted CBDC systems.
5. Interoperability – Integrating today’s payment experience with newly designed CBDC systems to avoid disruption – CBDC designers need to think about how to reduce the disruptive impact on the user’s payments experience and make them interoperable.
6. Privacy Concerns – Although CBDCs help in controlling money laundering and tax evasion, state surveillance of every transaction is a privacy concern. Hence CBDCs should ensure people can use them without disclosing their identity beyond the minimum requirement. Naturally, for high-value transactions, government and central banks can mandate to report for checking AML & Tax evasion related concerns.
7. Providing offline capability – Can CBDCs provide offline payment capability (like bearer functionality as physical cash) when connectivity is unavailable? Most countries are exploring offline capabilities through phones, smart cards, and wearable devices/wallets.
8. Getting political alignment on new Central Banks Rules – This is especially important to even achieve interoperability between multiple Central Bank Laws.
9. Achieving the network effect – How can this new system scale and become ubiquitous to achieve the benefits of the network effect.
10. Performance & Scalability – A CBDC platform must be able to support huge volumes without any performance issues and should support the variability of performance demand.
What lies ahead?
Although there are clear benefits of CBDC, the adoption of the right CBDC based economic model is still in infancy. We are seeing coordinated efforts between multiple Central Banks, Commercial Banks, and Technology Providers to roll out CBDC proof of concepts. Considering the long-term transformational impact these models will have on the economy, the implementation is expected to be undertaken in phased manners, fine-tuning the strategies over time. If you are an economist, banker or payment professional, CBDC will keep you busy for the next decade – truly exciting times ahead!