Definition and meaning: Central Bank Digital Currency (CBDC), also called digital fiat currency or digital base money, is a digital version of a fiat currency like Euro, Dollar or Yen issued by a central bank.
CBDC/digital base money is being issued by a central authority like a central bank or government. It is by law, a means of payment. A holder of a CBDC coin would have a claim on the central bank.
At the time of writing, no country has established a digital central bank currency. But some are working on it. For instance the European Union with its digital Euro announced by the European Central Bank (ECB), Venezuela with its Petro, or China. Sweden is also working on a CBDC and the bank of England is researching a digital British Pound too.
In the following sections, we explain selected topics of central bank digital currency (CBDC).
Typical Requirements of CBDC
Need to know and data privacy: customers or users of the central bank digital currency systems should only have access to those data they need to know in order to make a transaction. For example, an account holder only needs to know its incoming payments (sender, amount, subject, date, etc.), its outgoing payments (receiver, amount, date, subject, account, etc.), and its balance. The sender doesn’t need to know the balance or other transactions of the receiver.
The “need to know” principle can of course grant operators or other entities like governments insights into transaction data.
No anonymous transactions: While users prefer anonymous transactions, governments require KYC and AML processes where sender and receiver of payments are revealed.
Absolute finality: A transaction (payment) should be final once it got approved. Ideally, this happens quickly after sending a transaction.
Cost efficiency: There should be a balance between cost and benefits.
Quick turnaround: Transactions (payments) should be processed quickly.
High throughput: The system should be capable of dealing with a high number of transactions. Here, peak times need to be taken into considerations.
Transparent governance and user orientation: The system should be user-oriented and understandable by users.
Types and Design Choices of CBDC
There are several types and design choices of central bank digital currencies. In the following bullet points, we highlight and briefly explain some selected possible design choices.
Programmability: A basic design question is, whether the CBDC should be programmable or not. Programmable money would leverage more benefits like payment automation of performance and consideration. If one party fulfills the agreement the contract is executed automatically. So, this eliminates the default risk.
Programmable money means that scripts get executed in the wake of a transaction. This could also allow the creation of additional assets (tokens) based on the CBDC. Distributed ledger technologies (DLT) with their smart contracts can be a role model in this regard. Programmability requires an API that can be used by users.
Application: CBDC’s can be available for different groups. The strictest application would be a Wholesale CBDC where only banks and public authorities have access. It would be used for inter-bank payments and for security trading.
Another approach is a Retail CBDC, where everybody can send and receive CBD money.
A third approach could be to open the CBDC for machines.
Issuance: In a retail approach the CBDC can be issued directly by the central bank or via commercial banks. A direct issuance would create a claim on the central bank (like with banknotes) whereas an indirect issuance would create a claim on the very commercial bank [indirect model]. But it would also be possible to design an indirect issuance in a way that there is a claim on the central bank [hybrid model].
Operation: Closely related to the issuance is the question of who provides the CBDC-related services like user interface, giving loans, payment transactions, point of sale integration, etc. This could either be done by the central bank or by commercial banks (private sector).
- No integration of the private sector: All services are provided by the central bank
- Integration of the private sector: The central bank provides a core ledger with just the basic functionality. Besides, it offers an API (automated program interface) that can be accessed by authorized and regulated payment service providers. Those payment service providers take care of things like point-of-sale integration, AML, KYC, support requests, etc. They can also offer additional services that are not provided by the ledger itself.
- Hybrid model: In a hybrid model, the central bank provides an extended core ledger. It has a rudimentary user interface that allows users to execute basic functions like opening/closing accounts and remittances. More sophisticated functionality is to be provided by private companies that are regulated and authorized.
One benefit is that private banks are more flexible to address the customer’s needs. Due to competition, they are likely more innovative regarding customer services and additional features. Private banks would also take care of the point-of-sale integration which reduces the workload for the central bank.
A downside could be that an integration of the private sector creates frictions that mitigate efficiency gains. It could also create privacy concerns because private service providers would have access to the transaction data of their customers (as they have right now already). On the other hand, a private sector layer could prevent a data flow to the central bank.
Relying only on private payment service providers could also violate financial inclusion. Banks could exclude certain customers from their services or set fees prohibitively high. Direct interaction with the central bank could make sure everybody is able to use the system.
Replacement of vs. coexistence with banknotes: CBDC can either fully replace banknotes or coexist with/complement banknotes and deposit money. A coexistence could increase acceptance within the people of a country as they don’t need to fear revocation of their money. But a coexistence could increase the money supply and spur inflation. Besides, running two money systems could cause higher costs and in the end, one system might win the most acceptance and replace the other perspectively.
Data management: Transaction data and code could be stored/executed on a single server, a distributed database, or on a blockchain.
A single server poses a high risk of centralization and failure. Manipulation could be undetected for a long time. Sharing the data on a distributed but centralized database could mitigate those risks. Another approach could be a blockchain where data is stored on a distributed system and every node can execute and verify code and transactions. Usually, a permissioned or semi-public blockchain with limited access would be the preferred solution over a fully public blockchain.
Discussion and Implications of CBDC
There are several topics about Central Bank Digital Currencies which are lively discussed. While some people see great opportunities in a centralized, government-controlled digital currency, others see big risks. In the following sections, we explain the most prevalent topics.
Depending on the issuance and design, a central bank digital currency could make intermediaries obsolete. Banks that manage deposit money would lose their right to exist since customers could interact directly with the central bank when transferring digital money to other accounts.
It could also cause a bank run where end-users convert their deposit money into CBDC. Bank runs could destroy commercial banks. Deposit money has the inherent risk of default since it is only a claim on the commercial bank. If this bank gets into trouble customers might lose their money. As a central bank cannot go bankrupt by default, CBDC is considered safer.
There are different options how to avoid a bank run:
- Forbid conversion between CBDC and deposit money.
- Set a maximal amount of CBDC per person
- Impose a negative interest on CBDC if a certain amount is reached.
Financial inclusion is a major concern. There are hopes that financial inclusion gets better with CBDC but there are also critics.
On the pro side of financial inclusion we have:
- Free bank accounts
- Everybody could get a bank account by law
On the con side we have:
- People without valid ID or failing to identify themselves could be excluded from the use
- Transaction cost could be prohibitively high
- People without access to electronic banking devices would be excluded
By default, a CBDC is not anonymous. At least the issuing central bank has full insight into the transactions. In order to provide a certain degree of anonymity, additional measures (technical and regulatory) need to be taken.
In a two-tiered system (central bank – retail bank – customer) banks could check compliance with AML. Thus, the transaction history of the sender would not be revealed to the central bank.
Another approach in a retail model is that end-users could get a certain number of “anonymity vouchers” which can be redeemed with their retail bank. They prevent the transfer of data from the retail bank to the central bank. The problem here is, that at least the retail bank has insight into the payment data.
With the ability to track every single transaction comes the ability to block individual transactions. It is often argued that this prevents illegal activities like money laundry or terrorist financing. But this could also be abused to prevent the political opposition from getting access to the internet, travel, and other good and services.
Thus, a central bank digital currency poses serious risks since there is no alternative.
Privacy and Anonymity
Privacy and anonymity are huge concerns with CBDC. Users often prefer anonymous and private transactions. Cash allows anonymous payments, whereas every electronic payment system creates a record in a database.
How transparent or private transactions and users are, depends on the implementation details. If all data are processed by the central bank without further privacy measures (like zero-knowledge proofs), there is no privacy. A solution to this could be intermediaries like commerce banks that process transactions and do AML and KYC tasks. But again, transaction data would be known to those entities.
It would be possible to directly impose negative interest rates on users. On the other hand, newly created money could be distributed directly to users. It comes close to helicopter money.
Another concern is the transparency of the operation of a CBDC system. It comprises rules and their enforcement regarding money creation, privacy, censorship, safety, etc.
Electronic systems are very complex and difficult to understand. They can contain bugs or deliberately coded backdoors that allow malicious actions to certain users.
Costs and Operational Efficiency
There are two aspects to consider: societal costs and central bank costs.
CBDC could mean free bank accounts but that’s not inherent to a CBDS and depends on the model and government decision. It also could mean that bank accounts come with fees.
Central banks expect strong cost efficiency gains due to a streamlined IT infrastructure and lower transaction costs in the interbank-context. It would also reduce the costs for providing (production transport, storing, validation, destruction) physical banknotes and coins.
Cash handling costs can be significant. The federal reserve bank estimates that 960 million USD in 2019 was spent by the federal reserve bank for cash handling. In comparison, roughly 300 million USD were spent on electronic banking systems. However, the exact amount depends heavily on the design and functionality. But at the same time costs for using an electronic payment system can be high for users.
Payments without significant delay can be achieved with current systems too.
Micro Payments and “streaming money”
A digital currency could allow sub cent payments. First because of the smaller units and second because of the lower costs for a transaction.
Automated payments are a big hope of CBDC. They are closely linked to programmability. It is a potential feature of a central bank digital currency. Like smart contracts, they allow the automated execution of certain operations (code/scripts) on the core platform. This could include multi-signature payments and time-gated payments among others.
A big advantage could be that the automated code execution is guaranteed by the central bank.
The promise is that international payments can be faster with a digital central bank currency. This however depends on the connection between different systems. Transactions into different currencies could require a clearing that takes some time.
Blockchain and CBDC
Blockchain can contribute to the success of CBDC. It provides various consensus mechanisms that prevent data manipulation. Besides, smart contracts proved very useful and can support programmable money and automated payments.
- Digital Euro: https://www.researchgate.net/publication/341354711_The_Digital_Euro_and_the_Role_of_DLT_for_Central_Bank_Digital_Currencies
- Discussion paper of the Bank of England: https://www.bankofengland.co.uk/-/media/boe/files/paper/2020/central-bank-digital-currency-opportunities-challenges-and-design.pdf?la=en&hash=A71920A2FFB6511E43F787019C549262049CC7A8#page=21
- Analysis of CBDC by the US Federal Reserve: https://www.federalreserve.gov/econres/notes/feds-notes/comparing-means-of-payment-what-role-for-a-central-bank-digital-currency-20200813.htm
- ECB: https://www.ecb.europa.eu/euro/html/digitaleuro.en.html