Sovereign Money Re-Imagined
CBDCs in the 21st Century
tl;dr
Central bank digital currencies, or CBDCs, are seriously exciting stuff! They give central banks a way to reinvent money in line with how we use cash less and less. CBDCs let central banks directly tweak interest rates to shape whether we spend or save—no slow banking middlemen needed.
These digital cash formats help central banks upgrade ancient payment systems too, making transfers way smoother while expanding access. CBDCs also keep central banks relevant as private players like fintech apps and crypto disrupt their control over money flows.
Now CBDCs split into retail and wholesale types—everyday digital cash for you and me versus stuff banks trade between themselves. Under the hood, systems range from permissioned blockchains to current payment rails or a bit of both to balance some crypto benefits and stability.
Central banks are actively researching CBDCs to avoid losing control over money creation, upgrade outdated payments technology, wield more direct monetary policy tools like interest rates, and counter alternative digital currencies.
CBDCs permit applying interest rates directly on currency holdings rather than indirect signaling via banks. This promises more impactful monetary policy transmission. CBDCs also enable deeply negative rates given lower bound limitations of physical cash.
However, risks around global rate divergences, incentivizing shadow banking, uncontrolled spillovers, and amplified cross-border contagion effects require coordinated governance between systemic CBDC issuers and recipient nations to ensure stability.
Despite monumental complexities, global traction behind CBDCs is rising substantially with accelerating research and technology development. Key markers include international collaborations between central banks, a shift towards interoperable CBDC designs, and growing private sector participation.
Managing stability risks, cyber threats, access inequalities, surveillance overreach and global coordination intricacies remains pivotal before operationalizing ambitious CBDC systems, no matter how promising. For now, cautious, pragmatic progress focused on resilient integration with existing structures warrants highest priority.
Introduction
Central bank digital currencies (CBDCs) represent one of the most transformational concepts emerging at the intersection of monetary policy, financial technologies, and governance. They are here to stay regardless of the criticism it has generated over the past year on its structure and overall centralized control.
There are compelling reasons for accelerated research and analysis around CBDCs across both public and private sectors globally. CBDCs hold sweeping implications for how central banks conduct monetary policy in the 21st century as cash usage subsides. They portend foundational changes to domestic retail, cross-border, and interbank payments systems, necessitating careful infrastructural design. CBDCs also offer opportunities to expand financial access, uphold monetary sovereignty against cryptocurrencies, and even program money for customized usages.
Given their multi-faceted ramifications, developing a robust understanding of CBDC architectures, capabilities and impacts will prove critical for central bankers, regulators, economists, financial institutions, and technology innovators worldwide. This report explores the core considerations around CBDCs that warrant dedicated study across areas of monetary policy, financial stability, integrity and inclusion.
What is a CBDC?
A central bank digital currency (CBDC) is a digital form of fiat money that is issued by a nation's central bank. It serves as a digital version of a country's sovereign currency and is denominated in the same units, like US dollars or euros. A CBDC is designed to serve as digital cash or digital money that can be used by both individuals and businesses to make digital payments and transactions.
Unlike decentralized cryptocurrencies like Bitcoin, a CBDC is centralized, regulated, and its supply is determined and controlled by the issuing central bank. The value of a CBDC is pegged 1:1 to the value of the corresponding physical fiat currency. Just like paper cash, a CBDC also serves as valid legal tender that can be used for payments similarly to physical banknotes and coins.
The Concept of Digital Currency
Digital Currency: A digital currency is an electronic form of currency that exists only in the digital realm. Unlike physical currencies, such as coins and banknotes, digital currencies are intangible and typically operate via computers, smartphones, and the internet.
Here are some of their defining characteristics:
Digital Form: They exist only in digital or electronic form, making them intangible.
Decentralized or Centralized Management: Some digital currencies are decentralized, relying on a distributed ledger technology, while others, like CBDCs, are centralized and issued by a state authority.
Instantaneous Transactions: They allow for instant transfers over the internet, often at lower costs compared to traditional banking systems.
Accessibility: Digital currencies can be accessed through digital wallets or online platforms, providing wider accessibility, especially in underbanked regions.
Security Features: They often employ advanced cryptographic techniques for security, making transactions secure and, in some cases, anonymous.
Differences between CBDCs and Cryptocurrencies
While both CBDCs and cryptocurrencies are forms of digital currency, they differ significantly in their structure, purpose, and governance:
Issuance and Regulation:
CBDCs: Issued and regulated by a country's central bank, CBDCs represent a digital form of a nation's fiat currency. They are legal tender backed by the government, ensuring trust and stability in their value.
Cryptocurrencies: Decentralized and not controlled by any central authority. Cryptocurrencies like Bitcoin and Ethereum operate on a distributed ledger (blockchain) and are typically not considered legal tender.
Purpose and Use:
CBDCs: Aimed at modernizing the financial system, enhancing efficiency in payments, and ensuring financial inclusion. They are designed to complement existing monetary systems and provide a digital alternative to cash.
Cryptocurrencies: Often created as alternatives to traditional currencies, aiming to provide a decentralized medium of exchange. They are also popular as investment assets and for their potential in smart contract applications.
Value Stability:
CBDCs: Their value is stable as they are pegged to the respective country’s fiat currency. They don’t exhibit the high volatility typically associated with cryptocurrencies.
Cryptocurrencies: Known for their price volatility due to market demand, speculation, and limited supply in some cases.
Transactional Anonymity:
CBDCs: Typically offer less anonymity compared to cryptocurrencies. Transactions may be traceable to comply with national regulatory frameworks like Anti-Money Laundering (AML) standards.
Cryptocurrencies: Provide varying degrees of anonymity. Some cryptocurrencies like Bitcoin are pseudonymous, while others like Monero offer higher levels of privacy.
Technology Infrastructure:
CBDCs: Can be based on various technologies, from traditional centralized databases to distributed ledger technologies, depending on the design chosen by the issuing central bank.
Cryptocurrencies: Primarily use blockchain technology, a type of distributed ledger that records all transactions across a network of computers.
Integration with Financial Systems:
CBDCs: Designed to seamlessly integrate with existing national financial systems and legal frameworks.
Cryptocurrencies: Operate outside of traditional financial systems, often leading to challenges in integration and regulatory acceptance.
In summary, while both CBDCs and cryptocurrencies represent innovative steps in the evolution of digital money, they serve different purposes and are built on different foundational principles and frameworks. CBDCs are an extension of a country’s fiat currency system, while cryptocurrencies are independent digital assets with their intrinsic mechanisms and market dynamics.
Types of Central Bank Digital Currencies (CBDCs)
CBDCs are broadly classified into two main types based on their targeted user base:
Retail CBDCs and
Wholesale CBDCs.
Additionally, the underlying technology framework categorizes them into
Token-based and
Account-based systems.
There have been some discussions and thoughts being shared which argue that rather than a binary classification, CBDCs can be viewed along a spectrum from pure retail to pure wholesale, allowing hybrid versions. The distinction between retail and wholesale CBDCs is not always clear-cut.
Retail CBDCs target usage by general public including households and businesses for widespread digital payments. Wholesale CBDCs focus on settlement between banks and financial institutions.
However, there could be stages in between:
CBDC access expanded from banks to wider regulated non-bank payment providers:
A CBDC could allow access not just to commercial banks but also to regulated payment firms like card networks, mobile payment operators, and clearing houses. This retains oversight while encouraging more innovation.
For instance, tier-1 tech firms and fintechs may be allowed CBDC access for developing consumer and business payment interfaces, crypto exchanges could leverage CBDCs for faster settlement. However, strong KYC norms and transaction monitoring would apply to these entities. So the CBDC sits between pure retail and wholesale availability. This hybrid model balances widening access to spur greater competition and efficiency in retail payments while retaining regulatory control over the ecosystem.
Limited foreign participation permitted:
CBDCs could also blend domestic and international scope. Cross-border payments and settlements efficiency could be improved by allowing some foreign banks and payment firms conditional access to a domestic CBDC. For example, correspondent banking relationships and crypto exchanges in overseas markets important for trade and remittance flows could be given restricted participation rights. This facilitates innovation around faster currency conversion and international transactions. Again the system diffuses attributes of retail CBDC like worldwide reach with controls typical of wholesale CBDCs.
Rather than limiting CBDCs to siloed retail or wholesale classifications, controlled hybrids taking the best of both bring practicality benefits.
In summary, token-based and account-based CBDCs refer to the underlying mechanism of the CBDC, focusing on how the currency is represented and transacted (as tokens or account balances). In contrast, retail and wholesale CBDCs distinguish who the intended users of the currency are (general public vs. financial institutions). These concepts can overlap; for instance, a retail CBDC could be either token-based or account-based, depending on its specific design and intended use.
Now, what are Central Banks playing around with? What do they choose and how?
Central banks face pivotal technology architecture decisions on whether to build CBDCs on decentralized systems like Distributed Ledger Technology (DLT) or retain existing centralized payment rail paradigms. Here is an in-depth analysis:
Distributed Ledger Technology
Blockchain and Distributed Ledger Technology (DLT) offer groundbreaking possibilities as resilient foundations for national digital currencies and associated transaction/ownership management.
A blockchain constitutes an expanding cryptographically secured ledger replicated across participating nodes without reliance on centralized intermediaries. This lends exceptional transparency, integrity, auditability, and censorship resistance unmatched by legacy databases.
However, public blockchains prioritize accessibility over permissions, with transaction validation through automated consensus between pseudonymous global nodes. This misaligns with central banking preferences for regulated known validators and tiered participation constraints.
Customized DLT, However, Holds Promise
Permissioned ledgers with known, KYC-verified validators that append transactions to shared ledgers can support CBDC needs for security, visibility and programmability while still retaining control through consensus protocol governing rights.
Such selective decentralization isolates benefits around integrity and resilience without diluting oversight by distributing all infrastructure aspects. For example, China's Digital Yuan architecture allows traceability by design with controlled anonymity revocation unlike decentralized cryptocurrency models.
Hybrid Approach Would be Recommended
Tradeoffs remain between decentralized and current centralized technological paradigms. But most officials concur that hybrid arrangements isolating DLT components that enhance security, availability and auditability from other proprietary infrastructure better reconcile stability needs currently.
Full decentralization also remains unproven for national retail CBDC transaction volumes requiring exceptional resilience. Hence, permissioned ledgers that can be integrated with existing centralized payment systems offer a balancing pathway for responsibly securing advantages of DLT within the institutional character of currency issuance systems.
Centralized Payment Systems
Central banks have operated large value interbank payments Settlements through inhouse Real Time Gross Settlement (RTGS) platforms like TARGET2 in Europe and IMPS in India that seamlessly interface with core banking infrastructure.
These time-tested mainframes with structured databases, access controls and communications protocols prioritizing throughput, resilience and reliability align better with the risk mindsets of monetary custodians over decentralized software stacks pioneered in cryptocurrency domains.
Upgrading Centralized Rails Crucial
Challenge lies in that centralized retail payment systems globally still grapple with archaic batch processing models and lack interoperability. Rectifying this through common communication protocols, open banking standards and writable Application Programming Interfaces constitutes an essential enabler for currency digitization initiatives to bear fruit.
Payment platform modernization hence remains an urgent prerequisite to unlock CBDCs' promised benefits across retail remittances and institutional settlements. Legacy architecture overhauls thus warrant consideration alongside explorations into permissioned ledgers.
Now, when we consider the above points, it’s important to relegate the following few point of views.
Global interoperability will mandate interlinked decentralized mechanisms between CBDCs themselves rather than just homegrown centralized systems working in silos.
If a digital euro, digital yuan or digital rupee remain confined within respective regional payment rails alone, it would limit the disruptive overhaul promised by CBDCs. Achieving global currency portability, near-instant swapability and programmable monetary contracts rely on currencies communicating via decentralized, borderless transaction validation layers.
So some decentralization will inevitably emerge as a practical imperative more than strategic choice as economies seek to provide CBDCs global legitimacy and universality in a more interconnected world.
Deconstructing practical decentralization
However, the decentralized components even for interfaced CBDC ecosystems need not automatically imply public permissionless networks. Distinctions remain between decentralized governance, decentralized infrastructure and decentralized access, with each axis requiring separate evaluation.
For instance, retail CBDC transactions even while transferring across borders could rely on permissioned ledgers or lightly decentralized communication protocols while still retaining strong access controls and centralized issuer oversight totally unlike the Bitcoin paradigm.
But why are central banks exploring this concept?
Why even think of centralizing a technology (Distributed Ledger Technology DLT) that is meant to be decentralized by nature?
Central banks have several key motivations driving their growing interest in developing CBDCs:
As the use of physical cash declines globally, central banks risk losing control over money issuance and payments systems to private providers. Central banks until recent times enjoyed monopoly over instruments of transaction settlement thanks to sovereign currency issuance and management of interbank payments systems. Advent of private payment processors, mobile money wallets and cryptocurrencies now directly threaten this exclusivity. Retail CBDCs allow incumbent custodians of money reinvent accessibility to state-guaranteed settlement media as societies transition towards electronic payments. Control over infrastructures for underlying finality thus stays secured in the hands of regulated central node operators rather than ceded to big tech disruptors.
Launching digital cash in the form of CBDCs allows them to offer digitized alternatives. CBDCs also enhance a central bank's monetary sovereignty in the face of foreign digital monies like cryptocurrency gaining wider mainstream adoption. CBDCs present central banks the chance to upgrade aging payments infrastructure and offer greater efficiency, security, control, and visibility over payments. CBDCs can expand financial access and inclusion for unbanked and underbanked populations by allowing access via digital wallets/accounts instead of traditional bank accounts.
Historically, physical currency constraints prevented central banks from directly tinkering with negative interest rates given the zero bound imposed by cash holdings and storage costs. Digital programmability intrinsics to CBDCs potentially permit direct calibration of money holding costs economy wide rather than via bank rate signaling. This allows central banks assume more leverage in influencing consumption or lending behavior through realized policy rates. Interest costs on money hence get unlocked as a sharper signaling tool.
So, how will issuing digital cash (CBDC) affect monetary policies? How will the ripple effect of such policies be controlled?
In traditional banking systems, central banks influence interest rates primarily through open market operations, reserve requirements, and discount window lending. These tools indirectly affect the lending and borrowing rates set by commercial banks, which then influence consumer behavior.
Open Market Operations: By buying or selling government securities, central banks inject or absorb liquidity, affecting short-term interest rates.
Reserve Requirements: Changing the reserve ratio impacts how much money banks can lend, influencing interest rates.
Discount Window: Central banks lend to commercial banks, setting the base rate, which influences overall lending rates in the economy.
In this system, the transmission of monetary policy to consumer-level interest rates (like mortgage rates, savings rates) is indirect and can be slow. Moreover, the lower bound of interest rates in such systems is typically zero or slightly negative, as holding cash becomes preferable when rates drop too low (the zero lower bound problem).
For instance, the European Central Bank (ECB) sets its main refinancing rate as the policy benchmark. However, retail and corporate lending rates offered by commercial banks do not fully adjust downwards if this benchmark is cut. Banks worry about profit impact and fund sourcing difficulties by lowering deposit rates.
With the introduction of CBDCs, central banks could have a more direct tool to influence interest rates, potentially bypassing some traditional banking intermediaries.
Direct Interest Rate Application: CBDCs allow central banks to apply interest rates directly to digital currency holdings. This can be a more efficient mechanism to transmit changes in policy rates to the broader economy.
Breaking the Zero Lower Bound: CBDCs could enable central banks to implement deeply negative interest rates if needed, as the alternative of holding large amounts of physical cash is less practical than holding digital currency.
Behavioral Incentives: CBDCs could be programmed to carry varying interest rates under different conditions, potentially influencing consumer behavior more directly than traditional interest rate adjustments.
For instance, a Fed-issued CBDC would allow directly dictating the interest to be earned on those CBDC balances rather than going through the banking system intermediation.
If the Fed wants to make monetary policy more accommodative, it can apply negative or ultra-low interest rates on CBDC balances that users directly earn as central bank depositors. This automatically transmits stimulus without relying on banks to cut lending rates. Banks would have no option but to stay competitive with any rate paid on Fed liabilities.
We can predict certain Scenarios.
CBDCs introduce new dynamics in monetary control, offering central banks unprecedented tools to shape economic activity, but also present challenges and uncertainties.
Global rate divergence risks: If major economies set widely differing CBDC interest rates, risks emerge. For instance, the PBOC applying -3% digital yuan rates, while the Fed retains positive 2% CBDC rates. This encourages destabilizing capital shifts out of yuan into dollar holdings, given huge yield differentials. Managing inflation, hence, requires coordinated rate setting between systemic CBDC issuers.
Risks of incentivizing shadow banking: Aggressive negative CBDC interest rates may perversely expand higher yield seeking unregulated lending like crypto Defi markets. This undermines financial stability if investors access credit from unlicensed pools rather than via banking system to bypass punitive CBDC rates. Hence, CBDC rates require intelligent calibration by working with banks to set deposit floors so shadow allocation does not thrive.
Negative rate offloading impacts will be unpredictable: For instance, the US Fed makes its CBDC available to say the Bank of Japan for more efficient settlement. If the Fed made CBDC rates negative as monetary stimulus, BoJ now finds it beneficial to offload its share of CBDC reserves rather than accumulate lower yielding assets. This impacts currency markets with sudden Dollar selling and Yen buying. Further BoJ may be forced to correspondingly lower its rates causing a contractionary ripple back into Japan's banking system.
Fiscal coordination imperative: Central bank CBDC interest tinkering if detached from synchronized moves by treasuries and regulators can breed uncertainty given immediate pass-through. Signals must be consistent across levers like trade, taxation etc so that stimulus cutoffs do not balloon deficits or tightening spurs volatility across broader asset prices.
Global contagion risks amplify from connected CBDCs: Such scenarios we listed above can trigger unpredictable currency gyrations and volatile capital flows simply from interest rate divergences. In crisis scenarios, offloading cascades of CBDC reserves can massively destabilize weaker economies. While efficient cross-border transmittal promises significant upside, the amplified two-way flows also warrant development of risk mitigation mechanisms before monetary policy changes flow unchecked between linked CBDC payment rails. Managing contagion will necessitate coordinated governance between reserve currency issuers and recipient economies.
While so far, you might be thinking, hmm, CBDCs are not worth it. It might act as a source of digital financial attack on the one hoarding CBDC circulation with partnerships and treaties in place.
Needless to say, we are wrong.
CBDCs have seen great traction within world governments taking an active approach to launch and adapt CBDCs:
Examples of Countries Exploring or Implementing CBDCs
Further indicators of rising CBDC traction:
Multilateral collaborations on CBDC infrastructures: Initiatives like Project Dunbar, a joint effort by the Bank for International Settlements (BIS) Innovation Hub and central banks of Australia, Malaysia, Singapore, and South Africa to build and test shareable CBDC platforms validate viability. The BIS facilitates international cooperation among central banks.
Focus on interoperability: Project WARP is a collaboration between the BIS Innovation Hub and central banks of US, UK, EU and Switzerland. It aims to explore the interoperability of different planned CBDC platforms for efficient cross-border payments.
Private sector participation: Technology firms like IBM, Accenture, and Amazon Web Services are actively contributing solutions around scalable CBDC designs leveraging distributed ledger tech. Their involvement validates implementability.
Wholesale transition to retail models: While initial pilots target interbank use cases, the eventual goal for most programs seems to expand for general-purpose retail CBDCs, given stability and privacy solutions under development.
What about regulations? What about compliance? How does that work?
Regulatory constructs and legal foundations require meticulous groundwork for introducing complex shared digital infrastructure like CBDCs with extensive jurisdictional mandates and economic obligations.
International Regulatory Alignment
Given their inherently borderless nature, CBDCs require global synchronization early on around permissible transaction types, technology standards, user data handling protocols and compliance reporting formats to prevent fragmented siloed systems across markets that complicate scalability.
The Bank of International Settlements through its multiple innovation arm proof-of-concepts already enables such regulatory harmonization across participating central banks and treasuries.
Additionally, the IMF also provides advisory support regarding the creation of conducive policy environments welcoming responsible CBDC adoption.
Varied precedents across data sovereignty, securities issuance, and currency usage restrictions assuming ethical-social import can complicate consensus building across developed and emerging economies. Progress remains gradual, although necessary.
However, a significant aspect of international regulations is to mitigate systemic risks that could arise from the widespread adoption of CBDCs, such as monetary policy interference, digital currency wars, or the destabilization of weaker currencies.
Reconfiguring Legal Frameworks
Domestically too, legislative reforms precede introduction of systemic state-operated innovations like CBDCs with extensive jurisdictional mandates and economic obligations.
Nations hence require updating legal tender definitions, banking sector participant classifications, financial surveillance powers and even technology infrastructure oversight provisions to responsibly accommodate CBDC operationalization within rule of law bounds.
Jurisprudence around contracts and asset transfers also warrant alignment with programmabilities planned for digitized sovereign currencies and associated tokenized instruments especially across event triggers, escrows and dynamic registrations.
Anti-Money Laundering and Surveillance
Anonymity and pseudonymity, which attract users towards cryptocurrency constructs stand incompatible with compliance duties like KYC norms for valid user identification by regulated intermediaries in CBDC transaction pipelines. This allows tracing underlying wallet identities using due lawful procedures upon suspicious activity alerts.
However, privacy remains imperative where possible by anonymizing identities instead of complete transaction histories. Exploring privacy-preserving analytics that glean only essential patterns from economic flows holds significance in upholding ethical data stewardship standards within CBDCs as a public good.
Additionally, we can add in that the guiding policy formulation through collective inputs spanning industry, government, and academia right from technology evaluation stages allows balanced frameworks addressing genuine adoption barriers people face. Structuring such participative governance creates greater visibility into risks that can undermine long term welfare like surveillance overreach, access inequality or system stability for course corrections.
Another imperative remains future-proofing, defining legal principles and architecture choices instead of narrow, short-term considerations. For instance, interoperability frameworks, OECD-level personal data protection standards, and decentralized system design principles make evolving regulations resilient rather than requiring continual overhaul with each new application.
Finally, when it comes to the reciprocal obligations across issuers, cross-border CBDC systems call for formal cooperation mechanisms between reserve issuers and dependent economies to synchronize diplomatic protocols, security standards, and even collective representation in global forums around technology ethics or financial access.
Conclusion
There’s no denying CBDCs signal a potentially big leap in reimagining money for the digital age. However, rushing into something as monumental as sovereign currency digitization without judicious planning risks vast unintended turmoil. For all the promise around efficiency and inclusion, prudent integration with prevailing systems remains essential to prevent needless instability.
Most central banks seem to recognize the enormity of challenges involved. Rock-solid guardrails around stability and security logically outweigh fanciful notions of decentralized anonymity that remain far too risky for financial watchdogs. Customizing distributed components to suit institutional needs makes better sense than wholesale decentralization while still upgrading outdated payment systems.
But make no mistake, the road ahead is filled with policy hurdles around privacy, legal readiness, tech resilience and cross-border coordination. Even with multi-industry partnerships, formulating balanced frameworks remains infinitely complex. And fragmented national efforts dilute the entire value proposition of seamless global CBDC interlinkages.
So while central banks now stand at the cusp of a rare reset promising expanded retail participation, we must temper hopes with harsh ground realities. Equitably delivering this vision depends enormously on foolproof cybersecurity, air-tight anti-fraud measures and managing risks we likely haven’t even conceived of yet. Overconfidence at this embryonic stage can severely undermine responsible adoption. For now, guarded optimism alongside meticulous contingency planning seems the prudent way forward.
Find L2IV at l2iterative.com and on Twitter @l2iterative
Author: Arhat Bhagwatkar, Research Analyst, L2IV (@0xArhat)
References
Disclaimer: This content is provided for informational purposes only and should not be relied upon as legal, business, investment, or tax advice. You should consult your own advisors as to those matters. References to any securities or digital assets are for illustrative purposes only, and do not constitute an investment recommendation or offer to provide investment advisory services.