Since emerging a few years ago, the concept of central bank digital currency (CBDC) has gained momentum. Practically every central bank around the world is either planning to explore or is already exploring the potential risks and benefits of turning money digital. Most of the research to date focuses on theoretical descriptions and conceptual models of CBDC, but few are able to explain in practical terms what CBDC might look like in everyday life. The following is an attempt to bring the concept back into the real world. But before digging into the crux of the matter, let’s get a few misconceptions out of the way.
To DLT or not to DLT?
For some reason CBDC is sometimes associated with distributed ledgers or cryptocurrencies. To make a simple point very clear right from the outset, CBDC neither requires distributed ledgers nor does it benefit from them. To explain why this is so, it is helpful to elaborate what digital money actually means.
All forms of non-cash money can be called digital. Digital money is simply an ownership record of money. When you are in possession of digital money, it means instead of holding physical currency, someone keeps record of how much of it you are entitled to. It makes no difference how such records are kept. Any record-keeping device will do, whether it’s a tally stick, a piece of paper, a spreadsheet, or a blockchain running on a peer-to-peer network.
Since the invention of the computer, apart from small incremental improvements, no new technology has emerged that would enable a bank to do its record-keeping notably better than before. A blockchain network would not be particularly suitable because it would be slow, poorly scalable, have latency issues, and because it would be complicated to incentivise and govern how its nodes should operate. It’s just much easier and more efficient for a bank to keep its ledger behind a firewall and let nobody near it.
Banks already have access to CBDC, but no one else does
Since commercial banks already have accounts at the central bank, and all those records are digital from the outset, CBDC would be nothing new to banks. Therefore, if there will be a new financial instrument called CBDC, it will not be ‘wholesale’, it will have to be ‘retail’. We already have ‘wholesale’ CBDC and it’s simply what central banks are already doing.
The general public, meaning ordinary people and business entities, cannot deposit money in the central bank. Why would they want to? One reason is that central bank money is safer than any other financial asset in the economy. Money deposited in a commercial bank is very safe, too, but depositing it in the central bank would be safer.
CBDC could also replicate some of the practical aspects of cash transactions. Cash enables a high degree of privacy; you can pay someone in cash without anyone knowing about it and without the recipient knowing who you are. Also, cash can be held and used by anyone. Moreover, cash transactions are quick and final. These features, i.e. universal access, privacy, finality and instantaneity, are lacking in today’s digital payment solutions, although instantaneity is something that is within touching distance.
What are central banks bringing to the table?
CBDC means getting some or all of these features into digital payments. It doesn’t really matter how they get there, as long as they do. What central banks are doing now is trying to figure out the best way to get there. In other words, how do we give the general public access to a non-cash financial instrument that is as safe and liquid as cash and which provides a similar degree of privacy, finality and instantaneity? That is the key question of CBDC.
No one has the solution yet, but we can easily rule out some options. CBDC will not involve a blockchain, as we have already noted. It’s also highly unlikely that central banks would get involved in retail banking, since it’s not their area of expertise, and because it would distort competition in the market. What we are left with is some form of electronic money. E-money is different from a bank deposit in that it pays no interest, and that its issuer can’t use customer funds for any other purpose apart from crediting a payee. The customer doesn’t always understand this difference, though, which is why funds held by e-money institutions can be considered kind of quasi-deposits.
Do we actually need the central bank for any of this? If there is sufficient demand, we would expect commercial entities to provide a solution. As it turns out, there already are numerous non-bank e-money issuers on the market (services like PayPal, AliPay, Revolut, Transferwise, and M-Pesa are all examples of e-money). They provide the public with quick and easy ways to make payments. But the one thing that a central bank can do better than any commercial provider is asset safety. As it stands, every payment service requires a user to pre-fund a payment account. Currently, these customer funds are safeguarded in a commercial bank. Safeguarding them in the central bank instead could make a difference. If customer funds were deposited in the central bank, then the money would be as safe as it can possibly get.
An EMI for EMIs?
There are two ways this can be accomplished. Either the central bank itself issues e-money, or it merely safeguards the funds that commercial e-money issuers collect from their customers. The latter option is much easier to implement while delivering practically the same outcome. In effect, the central bank would become not just a central bank but also a kind of central e-money institution. One of the traditional roles of a central bank has been to act as a bank for banks, taking deposits from commercial banks, which in turn have taken deposits from the general public. Since we now also have non-bank payment institutions taking money from the public in the form of quasi-deposits, it would make sense if some or all of that money, for the sake of safety, would be deposited in the central bank as well. In addition to being a bank for banks, the central bank would become a sort of e-money issuer for e-money issuers. For all intents and purposes, the result would be CBDC.
The details regarding privacy and universal access remain to be resolved, but they are matters of policy, not technology. The appropriate levels of each can be achieved through regulation and standards, regardless of who provides the service.