Central Bank Digital Currencies and The Future of Money

Central Bank Digital Currencies (CBDCs) are potentially one of the most significant innovations in the evolution of money. In this article, we explore different aspects of CBDCs and their impact on the future of money.

We conclude that the future will see a mix of CBDCs, stablecoins and crypto currencies exist alongside other traditional digital and physical currencies. Rather than being a zero-sum game, the presence of CBDCs will grow the overall footprint of digital currencies in the economy.

There is no doubt that Central Bank Digital Currencies (CBDCs) are in the spotlight. From mainstream media to policy makers and from regulators to bankers, there is growing discussion about this new payment technology.

In fact, according to the Bank for International Settlements, 85% of the central banks in the world are currently either studying or piloting CBDCs. 

So, what’s behind the big buzz and what are the key points one can take away? 

While CBDCs are a complex topic and their narrative is still developing, in this article we take a broad view of their key features and the main scenarios that are likely to emerge in the coming years.

CBDCs and Tokenized Money 

Throughout history money has evolved. Beginning with the use of everyday objects to precious metals to the gold standard and finally to fiat in 1971, money has changed in line with broader technological and social shifts. 

The development of computer technology in the second part of the twentieth century allowed money to be represented digitally. By 1990, in the United States, all money transferred between its central bank and commercial banks was in electronic form. By the 2000s most money existed as digital currency in bank databases.

While digital money has been around for a few decades, many argue that we are now at the verge of digital money 2.0. Not the account-based electronic money that’s been around for the past several decades, but a new type of token-based digital money. Tokenization, often via blockchain, is the basis of cryptocurrencies, stablecoins, and many proposed central bank digital currencies (CBDCs).

The new wave of tokenized money started with the introduction of Bitcoin in 2008 as the first widely used decentralized, peer-to-peer, cryptocurrency based on distributed ledger technology called blockchain.

Another inflection point came with the announcement of Libra (now renamed Diem) in 2019 by Facebook. Conceived as a private stablecoin - a privately issued crypto currency pegged to a stable asset (e.g. fiat money, physical gold etc) - Libra/Diem led to the development of a number of other stablecoins.  

It is against this backdrop, that Central Banks around the world have ramped up interest in CBDCs. Conceived as a digital representation of fiat currency, CBDCs are a liability of the central bank in the same way as physical currency. This is a major differentiator between CBDCs and other tokenized money forms such as cryptocurrencies and stablecoins. 

Types of CBDCs

Wholesale vs Retail

One way of categorizing CBDCs is with respect to their implementation model. CBDCs can be either wholesale or retail. In the wholesale model, access to central bank digital currencies is restricted to a limited group of commercial banks and clearing institutions; conversely, in the retail model, access is widened to corporates and businesses or generally across the economy to all consumers. 

Currently, wholesale efforts are more prevalent in advanced economies that have more developed interbank systems and capital markets. In contrast, retail CBDC projects are more common in emerging economies with financial inclusion expected as an outcome. 

Account based vs Token based 

Another way of categorizing CBDCs is to consider their underlying format. Specifically, CBDCs can either be account based or token based. 

In an account based format, ownership of the CBDC is linked to an identity whereby a transaction is an update of payer and payee balance. This type of format resembles the systems we use today for sending digital payments. 

In a token based format, ownership of the CBDC is linked to a proof. Using cryptography, it is possible to verify digital signatures to execute and verify transfer. Thus, a transaction is a change of ownership of a specific unit of account or token. In this sense, the tokenized format resembles ownership of cash. 

Importantly, tokenized CBDCs - along with other forms of tokenized money such as cryptocurrencies and stablecoins - can be programmed. Such CBDCs represent ‘programmable money’ whereby different logics are wired within the definition of money itself and where rules in payments between multiple peers can be automated.

What are some of the perceived benefits?

The buzz around CBDCs is growing as they are meant to have many benefits. For example, the cost of managing and transferring cash is high for governments and this technology can reduce expenditure. 

Moreover, safe money accounts at the central banks could boost financial inclusion for all segments of society allowing any legal resident or citizen to be provided with a free or low-cost basic bank account. 

Lastly, CBDCs make it easy for a central bank to keep track of the precise location of every unit of the currency and this makes it easier to tackle tax evasion and financial crime. 

So, what is the downside?

As is the case with most technologies, there are also some potential risks associated with CBDCs. For example, if citizens pull too much money out of banks at once and purchase CBDCs, it could trigger a run on banks. 

Centralizing digital currencies through the government could also increase data privacy concerns.

Finally, some current legal frameworks are not comprehensive enough or modernized enough to deal with the new forms of money. In the absence of robust legal systems, the issuance of CBDC poses legal, financial and reputational risks for central banks.

What is the current state of play? 

To date, no country has officially launched a large-scale CBDC regime. Many central banks, however, have launched pilot programs and research projects aimed at determining a CBDC's viability and usability.

In 2016, the Bank of England was amongst the forerunners to start discussions for a CBDC followed by the Central Bank of Sweden. Soon after People’s Bank of China, Bank of Canada, and central banks of Uruguay, Thailand, Venezuela, Sweden, and Singapore, among others, began exploring the idea of introducing a central bank-issued digital currency. 

It is anticipated that China will transition to mass adoption of a CBDC by the Beijing Winter Olympics in 2022. By one estimate, China’s CBDC could account for 15% of all Chinese electronic payments in ten years.

Our Key Takeaways

Clearly the discussion and debate around CBDCs will intensify in the coming years. As with any new technological innovation, both the pros and cons will have to be well considered; intended and unintended consequences will also need to be examined.

However, it is apparent that the potential benefits of CBDCs are now firmly on the radar of most policy makers.  

Below we highlight some key points to take away from the unfolding story of CBDCs: 

• It is highly probable that the future of money will be a mix of centralised, decentralized, account based and token based with CBDCs, stablecoins and crypto currencies co-existing alongside traditional digital and physical currencies. 
• Most countries are currently looking at wholesale CBDCs as a first step, since retail CBDCs may be associated with greater risk. However, with ongoing research and piloting one can anticipate that safe and efficient retail CBDCs will also be rolled out in due course.
• Irrespective of the model used - wholesale or retail, account based or token based - CBDCs will provide a big boost to digital currencies in the coming years. Tokenized CBDCs, in particular, will lend themselves to several use cases. For instance, it will make it possible to explore automated taxation and conditional welfare payments.
• CBDCs may also see some countries leapfrog others, similar to what we are seeing in the digital payments space in the emerging markets. 
• In many cases, the rollout of CBDCs will involve public private partnerships. For instance, under one framework of retail CBDC, the central bank may issue the currency to a regulated intermediary who then distributes it to the public. There are numerous models currently being studied which involve the private sector to varying degrees. However, it is clear that technology companies, fintechs, third party providers and banks will all have a role to play within the CBDC architecture. 
• Concerns over data privacy will have to be well balanced with the potential benefits of CBDCs - the nexus between law, technology and finance will become more significant in public policy and practical implementation.
• At the moment, CBDCs are the focus of macro-economic debate but in some years the ripple effects will trickle down to businesses and consumers.