Money makes the world go ‘round. How people and businesses transact, get paid, transfer funds: the whole economic milieu all comes to down to money in its various forms. Thus, when central banks — the institutions that manage a nation’s currency, money supply, and interest rates — are considering digital currencies, the potential impact is massive. These so-called central bank digital currencies (CBDCs) will not only affect payment systems, but there are also ramifications for identity, privacy and even how we think about money.
Often the assumption is that digital currencies mean cryptocurrency, such as Bitcoin. However, a distributed ledger system is not a necessity when creating a digital currency platform. Depending on the needs of the platform and the various trade-offs, either a traditional centralized ledger system or a distributed ledger can be used for digital currency. Other tools and ideas that are driving cryptocurrency innovation are giving insight and opportunities for CBDCs, but they are not directly connected.
Another confusion might be with the whole concept of electronic cash. After all, many payments today are done with a tap, or online, so they seem digital already. However, electronic cash is a store of value that usually represents money held in an account (such as a bank account or digital wallet) while a CBDC would “not merely be a representation of physical money, as is the case with electronic cash, but a complete replacement for notes and coins,” as a Reuters article points out.
Digital currencies currently
A Bank for International Settlements (BIS) survey of 66 central banks found that 80 percent were working on a CBDC in some capacity, and “central banks representing a fifth of the world’s population say they are likely to issue the first CBDCs in the next few years.” Perhaps one of the first will be a digital yuan, as China has been working on various projects in the area since 2014 and there are many rumors of it being launched soon.
One factor propelling developments in the field was the announcement of the Libra project: “Libra is a global, digitally native, reserve-backed cryptocurrency, enabling a more inclusive global financial system.” The project is audacious in its goals and backed by some of the largest companies in the world, including Facebook. While its success is to be determined, the fact that a private money system could actually work seems to have spurred on central bankers to advance their own projects. As Federal Reserve Chairman Jerome Powell stated, “it was a bit of a wake-up call that this is coming fast, and could come in a way that is quite, you know, widespread and systemically important fairly quickly if you use one of these big tech networks like Libra did.”
The promises of digital currency
There are definite advantages of having a 100 percent digital currency system. One of the biggest is the ease of cross-border payments. Instant cross-border transactions at scale, with low transaction and currency exchange fees, with little risk (as they are backed the central banking system), would fundamentally alter international payments, remittance and eCommerce, amongst other industries. Speeding up cross-jurisdictional payments lessens a financial institutions exposure to credit and settlement risk, increases liquidity and payment transparency, as well as reducing the attack surface for cyberattacks and threats.
It’s no wonder then that emerging market economies are the most interested in CBDCs, according to the BIS survey quoted above. For these economies, having their own digital currency would help financial inclusion, increase stability, and improve payments efficiency and safety. Although cross-border payments are a substantial benefit for consumers and businesses, it’s not in the realm of central bankers, who are focused on factors within their jurisdiction.
Other motivations include lowering the cost of handling money and improving the ability to deliver money. The ability to track money laundering, terrorist financing, tax avoidance and other criminal transactions would presumably also improve dramatically, as suspicious transactions could not be concealed as effectively as with a cash system.
For many of the world’s largest economies, the central banks are naturally more reluctant, as the stakes are so much higher and their economies are already (for the most part) functioning well. Maintaining financial stability is one of chief roles of central bankers and the speed of digital currency could exacerbate a run on the banks. What happens in an emergency, such as a wide-spread blackout? Transitioning to a new economic system also has geopolitical considerations; the US dollar is currently the global reserve currency and a “digital dollar” could affect how the world settles trades, stores funds and determines economic policies.
The cost of privacy
Some might see the ability to monitor every transaction as a law enforcement or marketer’s dream. The ability to analyze patterns to decipher criminal, or buying, behavior would be unprecedented. Others would see the same data gathering ability as another tool of Big Brother, and an invasion of privacy.
Physical money is, for the most part, anonymous. People can transact person-to-person, hide their money in a mattress or make purchases with the comfort that their choices are not monitored and they are not potentially discriminated against or put on some type of list.
One factor to consider is that the shadow economy accounts for $10 trillion in transactions every year and employs 1.8 billion people; this underground economy runs on cash. Note, that stat is from 2011 and the numbers from the OECD project that “two-thirds of the world’s workforce will be employed in System D (another name for the unofficial economy) by 2020.” While some of this economy consists of illegal activity and has no legitimate purpose, other parts are workarounds against red tape, corruption or unjust laws. Trying to eliminate this economy is impractical and counter-productive to helping people’s economic situation.
In the March 2020 BIS Quarterly Review, an in-depth analysis of CBDC architecture, one of the key takeaways from authors Raphael Auer and Rainer Böhme is that “a trusted and widely usable retail CBDC must be secure and accessible, offer cash-like convenience and safeguard privacy.”
The balance between privacy and transparency will be one of the most significant decisions in the rollout of a CBDC. The desire to fight money laundering and financial crimes and the desire for conducting financial matters in private are legitimate. Fortunately, there are technologies that can deliver on legal privacy requirements, such as the Right to Financial Privacy Act, and provide tools for law enforcement to access private financial information under strict conditions, such as a subpoena or search warrant.
It’s an open question if these solutions actually do provide the necessary privacy protections under the load and demands on a massive scale. Will accounts be connected to specific identities? Will cryptographic encryption be deployed to protect the accounts? Will there be one central operator, or multiple? What type of ledger system? Numerous scenarios and contingencies will require consideration, and the risks and responsibilities need to be specifically defined.
It’s yet to be seen if public acceptance for the protocols will also be forthcoming. Different societies will have different levels of trust in institutions or privacy requirements, so the types of CBDCs that are introduced might vary widely.
The future of currency?
There is significant room for innovation and changing the whole world monetary order. For example, Bank of England governor Mark Carney suggests that a CBDC could replace the U.S. dollar as the global hedge currency: “it is an open question whether such a new Synthetic Hegemonic Currency (SHC) would be best provided by the public sector, perhaps through a network of central bank digital currencies.”
The exact permutations, timing and details will depend on the country and the central banks that serve them. As the first ones roll out, their public acceptance, effects on the economy and interactions with businesses will be closely watched. If digital currencies can deliver the privacy consumers want, maintain state control over money that central banks need and add in benefits of digitalization such as speed and low transaction costs, the outcome might be a significant jump in economic growth. Digitalization has effected numerous financial areas already; creating a quicker, more seamless, less risky and cheaper economic transaction system is perhaps the next major fintech innovation.