Demystifying the Future of Money - CBDCs
The future of money remains one of the most broadly debated topics in economics and finance. This article focuses on the role CDBCs may play in the broader global economy.
What is a CDBC?
A CDBC is a Central Bank Digital Currency which is simply a digital or virtual version of physical money issued and backed by a central bank.
Digital currencies aren’t new. Virtually all money circulating in society today is digital. However, unlike existing digital currency, which is mostly issued by trading banks (commonly referred to as private money), a CDBC is issued by the central bank.
The existence of CDBCs presents consumers with a new choice; either to deposit their savings with a trading bank or directly with the central bank.
The Central Bank Franchise System
To understand this choice, it’s helpful to consider the special relationship established between trading banks and the central bank. This relationship is analogous to a simple franchise arrangement.
Trading banks are the franchisees, whilst the central bank is the franchisor. Central banks issue operating licences, in this case, banking licenses permitting franchisees to offer products and services on their behalf. The franchisor ensures the quality of products and services offered through direct oversight.
In the modern banking system, central banks impose conditions of registration on each licensed trading bank. Primarily, these conditions require banks to maintain minimum capital and liquidity thresholds, manage risk responsibly, and regularly report their financial health to the central bank. In return, the central bank allows certain privileges to incentivise trading banks to offer products and services on their behalf.
Whilst being similar, central banks are not created equal. Some play a much broader role within the financial system than others. In the US, for example, the Federal Reserve (the FED), through associated reserve banks oversight around 4,500 trading banks. In addition, the FED also sets short-term interest rates, manages inflation targets, economic conditions, and unemployment. In contrast, the Reserve Bank of Australia (RBA), which has similar responsibilities, oversights only 96 banks. The Reserve Bank New Zealand (RBNZ) oversights only 26 banks, the largest four of which are Australian owned.
Broadening Central Bank Access
Through the implementation of CDBCs central banks will play a broader role in each country’s financial system.
For the first time, central banks will accept deposits from consumers, without requiring trading banks to act as intermediaries. This establishes a new and previously unavailable relationship between retail customers and the central bank.
Traditionally, retail customers could only transact with trading banks, whilst trading banks and other selected financial institutions could engage directly with the central bank. Unofficially, CDBCs have existed between some wholesale market participants and central banks for decades. Extending this privilege to retail customers is both new and innovative.
What changes might CDBCs enable?
The most obvious change expected from CDBCs is the structure of the banking system. By allowing retail customers to engage directly with the central bank trading banks will no longer be the gatekeepers to central bank money.
The toll bridge established though the franchise system is technically removed, requiring trading banks to compete with the central bank for retail deposits.
What impact will CDBCs have on trading banks?
CDBCs are unlikely to materially change trading bank’s role in the broader financial system. They will, however, alter the landscape for retail deposits and retail payments. The latter creates an opportunity for private companies to bring innovation to the retail payment market.
Despite the risks of disintermediation, the relationship between trading banks and larger wholesale customers is unlikely to be impacted. All activity between trading banks and their wholesale customers is already digital. Therefore CDBCs, whilst an innovation for retail customers, are unlikely to result in material changes to the wholesale customer/trading bank relationship.
Could CDBCs cause a run on the central bank?
Trading banks play a critical role in mitigating central bank risk. Through allocating capital and lending against good collateral at a fair and reasonable rate, trading banks provide a cushion between markets and the central bank.
Crucially, trading banks manage the liquidity gap between short-term deposits and longer-term borrowing. The liquidity gap, if not appropriately managed, can cause major systemic risk. Failure to manage this liquidity gap by trading banks expenses them to a potential run-on-deposits, which was a feature of the 2008 financial crisis.
Whether or not a CDBC could create a systemic risk for the central bank may depend on the overall adoption of CDBCs. Given that CBDCs are likely to be predominantly retail, and perhaps only a proportion of retail deposits, it is unlikely that trading banks would be sufficiently disintermediated for the central bank to become vulnerable. If this were true, CDBCs would not be in the best interests of either central banks or the public.
Could CDBCs capture all retail savings?
This is highly unlikely. If retail customers require mortgages, loans, or credit cards, they may still need to retain their primary savings account with the trading bank from whom they borrow. Central banks are also unlikely to offer lending products; therefore trading banks are likely to retain most retail deposits.
There is also limited incentive for the central bank to disrupt the retail deposit market. Trading banks are required under their licenses to maintain sufficient retail deposits to underpin lending. The imposition of minimum core deposit ratios by central banks ensures the financial system remains appropriately leveraged and stable. Without retail deposits, trading bank lending is severely restricted.
Could a country have more than one CDBC?
The short answer is no; each country can only have one legal tender currency. The Bank of International Settlements (BIS) issues every country with a single settlement code. This code is programmed into the payments apparatus in each country to allow domestic payments to settle and to recognise cross border payments.
China is an example of a multi-currency system with a single BIS code. China has two currencies, CNY (Renminbi) and CNH (Offshore CNY); however, both currencies settle using the same BIS code, CNY. This ensures there can be no arbitrage between CNY and CNH upon settlement.
Will CDBC’s improve payments?
Yes and no, depending on the design of CDBCs and the corresponding payments architecture chosen by central banks. Should central banks open their payments platforms to integration with private providers, then genuine opportunities for innovation exist.
However, in some countries like New Zealand and Australia, domestic payment systems are already highly efficient ‘point of sale’ systems, meaning settlement is immediate upon sale. Cheques that have traditionally required over the counter payments infrastructure are no longer used in many advance economies, whilst use of physical cash is also minimal.
Payments efficiency has often been proposed as a potential use case for cryptocurrencies. Whilst there could be benefits of this technology in developing economies, they are unlikely to have the same advantages in advanced economies. Cross-border payments, and foreign exchange, on the other hand, are still considered expensive even in advanced economies and could be improved through CDBCs.
It is important to recognise though, that payment systems are notoriously complex and expensive. Currently, most payments are executed on behalf of retail customers by trading banks, although private providers like Stripe and Apple Pay are capturing larger proportions of the international market.
Whilst trading banks view payments as a cost of service, private companies have sought to profit from them. The high costs associated with anti-money laundering and fraud require extraordinarily large volumes of payments to reach break-even. For example, Stripe is yet to turn a profit despite processing almost US$1 trillion of payments annually.
Will CDBCs use blockchain technology?
Whilst the design CDBCs will be determined by each Central bank, adoption of blockchain technology is an unlikely feature.
Whilst popular, public blockchains are not a new concept; the first blockchain-like protocol was proposed in 1982, long before the development of the modern digital banking system; while blockchain technology is necessary for cryptocurrency, it is not a pre-requisite for a CDBC. The double spending risk inherent in cryptocurrencies due to having no centralised authority to maintain their ledger is not a risk prevalent in CDBCs. Central banks that maintain their own ledger do not have a double spending and are ultimately accountable for any unlikely errors.
Central banks could choose to issue CDBCs on their own private blockchain; however, this is also unlikely. If central banks were to operate all the nodes of a private blockchain themselves, any perceived benefits of blockchain technology would be undermined, resulting in a high-cost low-return model.
Will CDBCs improve central bank transparency?
Whether or not CDBCs improve transparency is largely dependent on the level of transparency prevalent in each jurisdiction. Most developed country central banks regularly report their money supply statistics to the public. In addition, they often report other important information, including the assets, liabilities, and derivatives positions of trading banks.
In addition, certain other activities undertaken by central banks to support the broader financial system are subject to a high degree of public scrutiny, including sensitive information which may be delayed avoiding the risk of stigma. An example is the discount window operated by the US Federal Reserve. Trading banks who use the facility are only reported publicly two years after usage to avoid the presumption the bank is in trouble. Whilst the FED actively encourages use of the discount window, the stigma associated with the 2008 financial crisis has caused trading banks to be reluctant to use the facility.
Could CDBCs advance the democratisation of finance?
Potentially, yes. One opportunity might be for central banks to open their reverse repo facility to retail customers as well as institutional. This would allow retail customers to purchase government securities and lend them back to the central banks with an agreement to repurchase them at a higher price in the future. Trading banks use these facilities as a source of liquidity, which could also be made available to retail.
Opening the architecture of the payment system is another. Encouraging private companies to participate in the development of the payment system could be innovative, potentially resulting in faster payments and lower costs.
Will CDBC reduce the risk of money laundering?
The risk of money laundering exists in any exchange of value, whether it be exchanges of currency, physical or intangible assets, by individuals, trading banks or central banks.
Central banks via their role as regulators, currently require trading banks to validate every payment to protect against money laundering or financing terrorism. The resulting penalties for failures to comply with know-your-customer requirements are punitive.
Critics of central banks will no doubt argue that physical cash, which continues to be printed and circulated by central banks and is largely censorship resistant, facilitates a significant proportion of current illicit activity.
Could CDBCs help bank the unbanked?
Central banks have long tried to solve the problem of the unbanked. In developed countries less than 0.5% of people don’t have access to basic banking services whilst in developing countries, this number rises to as high as 50%.
CDBCs may not materially improve these statistics in either developed or undeveloped economies; in fact, they could worsen. Firstly, CDBCs being digital, require an internet or mobile connection, and secondly, the unbanked tend to be less trusting of central banks than they are of trading banks.
Whilst banking the unbanked is an issue that central banks have sought to tackle, it is unlikely that CDBCs will help shift the dial in the right direction for the time being.
When will CDBCs be broadly adopted?
Many advanced economies have been working on implementing CDBCs for some time. Whilst in May 2020, a global survey showed that only 35 countries were considering CDBCs, more recently that number has been as high as 114 countries, representing up to 95% of global GDP.
Eleven countries have already launched a CDBC, whilst China has piloted the largest digital currency experiment. The digital Yuan, which has already reached 260 million people, is expected to expand across the entire nation throughout 2034
Eighteen of the G20 countries have entered the advanced stages of CDBD development, with seven already in pilot. Australia, Thailand, South Korea, Brazil, and India will take significant steps to piloting their own CDBC in 2023. The United Kingdom has proposed the introduction of a digital Stirling, whilst the New York Federal Reserve has shifted its wholesale CDBC experiment into the development stage.