Long reads

The pros and cons of CBDCs

Jamie Crawley

Jamie Crawley

Reporter , Finextra

Multiple central banks are looking closely at developing digital currencies to address the threat posed by projects such as Libra. There are many benefits to be found in central bank digital currencies (CBDCs), likely to be magnified amidst the Coronavirus pandemic as more and more transactions are carried out electronically and cash usage continues its decline.

However, central banks must grapple with the challenges and complexities of issuing a CBDC which mean there is still some way to go before we can expect to see a digital pound, a digital euro or a digital dollar.

China’s long-expected digital currency, on the other hand, is drawing close to completion with trials set to take place across four cities, involving companies such as Starbucks and McDonald’s.

The People’s Bank of China (PBoC) has said that the digital currency/electronic payment (DCEP) could be available in time for the 2022 Winter Olympics, to be hosted in Beijing.

This points toward a 2021 launch to give the new currency a sufficient bedding-in period ahead of being used at a major global event such as an Olympic Games.

Added to this, the Agricultural Bank of China, one of the parties to PBoC’s project, appears to have released a test app to a limited number of users containing several features pertaining to the digital currency.

China’s progress in the launch of a digital yuan will be watched closely by the numerous central banks looking into developing one of their own. This list appears to encompass every major central bank around the world, including the Swedish Riksbank, the Bank of Canada and the Bank of Japan, as well as the Bank of England, the Federal Reserve and the European Central Bank.

RIP Cash

Without the centralised control of the country’s economy and financial system that the one-party Chinese state can boast, it may be difficult to treat the DCEP as any kind of blueprint for how other nations might develop, launch and administer their own digital currencies.

Nonetheless, all central banks would appear to have very similar aims in mind, and therefore a model could be established for what a successful digital currency would look like.

The first of these would be as a remedy to the decline in the use of cash. This is a trend that has been occurring over many years but is likely to accelerate as a result of the Covid-19 pandemic. A combination of more online shopping, the closure of shops and the ones staying open encouraging payment by card has already seen a considerable decrease in the use of cash, and it is possible that this will become closer to the norm post-lockdown.

So, while the extinction of cash has long-since been regarded as inevitable, the current crisis is likely to usher it toward the exit door even quicker.

Campaign group Positive Money has recently produced a report encouraging central banks to create digital alternatives to cash to address this trend, fearing that the disappearance of physical cash leads to the “privatisation of money itself” with commercial banks enjoying an oligopoly over digital money and payments systems.

A bank like the Swedish Riksbank is concerned by the decline in the use of cash, as this diminishes a central bank’s influence on its currency’s circulation.

“Sweden is probably at the front of this conversation on CBDCs, possibly because the decline in cash usage is much more advanced than in other countries like the UK,” Ben Dyson, head of the digital currencies team at the Bank of England, said on a recent webinar discussing the bank’s plans.

“Around 50% of retailers in Sweden expect that they will no longer accept cash by 2025.”

If the Riksbank issues a digital currency, it would ensure that krona’s circulation remains healthy. The alternative would be a cashless Sweden where it makes little difference whether consumers transact using krona, dollars, euros, yen or even bitcoin.

Bitcoin, Libra and more

CBDCs would allow central banks to challenge cryptocurrencies like bitcoin and digital coins launched by private companies such as Libra.

Bitcoin and the like have multiple limitations, which hinder them from being accepted as an adequate substitute for money. As the Bank of England’s director of fintech, Tom Mutton, summarised on a recent Innovate Finance webinar: “It is not a secure store of value, it doesn’t really work as a method of exchange and it’s not a unit of account”, therefore it fails on all three of the criteria for something to serve as money.

Nonetheless, cryptocurrencies will continue to be a curiosity for people and businesses frustrated by the time-consuming and costly processes associated with the transfer and settlement of fiat currency.

Whether or not bitcoin, ethereum et al are able to solve their shortcomings, the underlying premise of a frictionless digital payment method will remain an attractive one and would then encourage similar ventures to be launched technology giants like Facebook.

The social media company’s Libra project drew a great deal of criticism and scrutiny from governments and financial bodies in the months after its announcement last year and has now made key concessions to its original project in order to appease regulators.

Whatever form Libra finally emerges in, if it ever does, it is unlikely to be the last attempt by a private company to disrupt the financial world with a digital currency of its own. Facebook’s controversial record with the use of customer data may mean it could never gain the commercial support required to bring such a project to market with sufficient scale. However, a similar venture by Microsoft or Amazon may be looked on more differently, given their largely more favourable reputation when it comes to data management.   

Therefore, central banks will be aware that CBDCs are their opportunity to address the problems associated with inefficient and costly payments, while still maintaining control over the fiat currency itself.

Blockchain or not?

Any attempt to remove some of the frictions to payments and other transfers of money, though, will inevitably remove some of the securities and protections that exist for consumers and businesses currently.

Finding the effective combination combination between speed and efficiency and security and resilience is one of several tradeoffs that central banks would need to grapple with in developing a digital currency. CBDCs then require some very careful design choices to be made.

Ben Dyson cites the use of blockchain technology as one example of these, saying the Bank of England does not presume that a digital pound would necessarily be based on DLT.

“Decentralisation may enhance the resilience and availability of a CBDC,” he says, “but it may also have a bit of a negative impact on performance, privacy and security.”

Blockchain technology would for example make a digital currency’s mechanics less vulnerable to attack if the distribution model means there is no single point of failure. On the other hand, this would come at a cost of the Bank of England ceding some control of the currency’s rails and also lengthen the amount of time needed to verify transactions (a common complaint with DLT).

Other choices to make

Central banks would also need to make decisions to make in the potential tradeoff between centralisation and decentralisation in the composition of digital currencies.

Primarily, a central bank must decide whether to circulate its digital currency directly to consumers without the use of intermediaries, such as commercial banks.

This model would mean that the central bank retains full control and oversight of the currency’s circulation and spending data and would appear to be a simple approach to take.

It would however require the central bank to take deposits from customers and businesses who wish to use the digital currency, seemingly bringing it into direct competition with commercial banks.

This would also burden the central bank with many of the legal and regulatory requirements associated with commercial banking operations, such as customer service and carrying out KYC/AML, which would not be a task to undertake lightly.

“Central banks would maybe need to start offering lending to consumers, blowing up their balance sheet, and also be responsible for the next layer of service, such as providing the apps and wallets for storing the currency,” says Jan Lebbe, ING’s blockchain initiative lead.

“This does not fall into central banks’ core knowledge, so I favour the position of the Bank of England, for example, who seem happy to leave this to the private sector.”

The Bank of England is currently weighing up these tradeoffs and, like other central banks, are favouring a two-tier or “’hybrid’” model, which involves relying on intermediaries like commercial banks to circulate the currency to consumers and take responsibility for some of the tasks mentioned above.

Could a CBDC be too attractive?

Nonetheless, the Bank of England is currently weighing up the balancing act it must play in avoiding making the digital currency too attractive relative to other forms of money and bank deposits, but still ensuring it can attract widespread use from consumers.

Choices need to made relating to who can access and hold the CBDC, whether or not it bears interest, whether there are limits on the amount that can be held or transferred, and how easy it is to convert CBDC back into other forms of central bank money or bank deposits.

Looking at the question of interest specifically, Ben Dyson says:, “We haven’t come to a final view yet, but there’s a lot of work on understanding what impact renumeration could have.

“The level of interest that’s paid on a CBDC, if any, would be one of the factors that affects how much demand there is for it.”

This would also have a knock-on effect on the cost of funding and the level of credit provided by the banking sector and the level of risk that would be taken on to the central bank’s balance sheet.

These are some of the areas that the Bank of England and its peers will be examining closely and seeking insight from other stakeholders in the months and years ahead.

However, despite the cautious approach central banks appear to be taking for the time being, it seems inevitable that they will find a way to address the complexities of CBDCs to ensure they see life – the threat of cash’s decline and of privately-developed currencies like Libra filling the void is too great.

Central bank digital currencies

Pros

  • Address decline in use of cash, likely to accelerate amidst Covid-19 – help central banks maintain control over currency’s circulation and support financial inclusion
  • Challenge threat posed by cryptocurrency or other digital coins launched by private companies like Facebook’s Libra
  • Fast, efficient method of payment and exchange

Cons

  • Potential competition between central banks and commercial banks for consumer deposits, interest and lending
  • Questions over CBDC requiring central bank to undertake KYC/AML etc and other operational burdens usually handled by commercial banks
  • Necessary tradeoffs in technological infrastructure between security and efficiency

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