22 June 2022
The debate about central bank digital currencies (CBDC) remains difficult. In part this seems due to resistance from the banking system, politicians and central bankers themselves amid a lack of conviction about the case for CBDC. CBDC is often viewed as a substitute of existing payment arrangements. Yet, CBDC matters because it aims to expand functionality of central bank money to serve across a wider range of use cases, signal support for financial innovation and act as catalyst for a more diversified and resilient payments infrastructure. It is also not only about central bank money innovation but the strengthening of the financial system at large.
Opposition to CBDC is not too different from attempts historically to block establishment of central banks themselves. In the U.S., famously, adoption of a central bank was long resisted amid concerns that a large government institution will unduly undermine the role of commercial banks: “I’m not in favor of a central bank. It would be a political power which in my opinion would be very detrimental to banking interests” (Banking Law Journal, 1909) was a representative position of the opponents. When in 1913, the Federal Reserve system was finally established, the U.S. was the last leading economy to adopt a central bank, it was therefore based on the less threatening “sectional” approach of 12 Federal Reserve Districts rather than a single centralised institution.
Central banks typically issue two formats of money: Banknotes and reserves. The former are physical tokens, predominantly held by the non-bank public and relies on the cash infrastructure. The latter is scriptural or book-entry money recorded on account-based platforms and held only by commercial banks mostly to conduct large value payments.
Central banks need to consider if banknotes and reserves can remain competitive against the emergence of alternative settlement mediums. The evolution of the payments landscape also forces central banks to assess if access to central bank money remains equitable to maintain a level playing field among increasingly diverse market participants.
The innovation with CBDC is the adoption of a new format of money, digital tokens with properties akin to digital bearer instruments, programmable and recorded normally on blockchain or other distributed ledger technology platforms.
The adoption of digital tokens is comparable to the introduction of modern bank notes during the last quarter of the nineteenth century. Then, bank notes were intended to complement silver and gold coins to address a rapidly changing economic environment.
CBDC is not so interesting as a payment instrument but offers a new approach to settlement. Scriptural monies exhibit four payment processing steps typically distinguishing payment, clearing, netting and settlement involving several institutions often additional to the transacting parties. Digital tokens, similar to physical tokens, allow to collapse the four into a single step, that is, the payment is the settlement. It offers important efficiency gains, new payment features and direct monetary relations normally on the basis of a peer-to-peer network irrespective of space and time. Conventional systems may be able to meet some of those features but are estimated to be significantly more cumbersome and onerous to adapt. CBDC demonstrates the central bank’s support for financial innovation.
CBDC naturally has a role especially where central bank money is the preferred medium. It will most likely see adoption in wholesale payments and securities settlements and possibly as a settlement layer for card and automated clearing house networks. CBDC can offer settlement in instant and atomic, both legs of the transaction have to succeed or none does, token-for-token exchanges facilitating payment versus payment and delivery versus payment transactions, where securities are available in a digital token format, and eliminating open positions and settlement risks. In retail payments, central bank money is of limited importance but could serve to produce a more diversified and competitive domestic retail payments infrastructure.
The biggest impact of CBDC will likely be in international wholesale settlement. Central bank money today is issued locally and can serve only domestic transactions except for bank notes. CBDC offers new approaches to make central bank money available for international payments while preserving needed controls to ensure international use of central bank money is consistent with monetary policy objectives. In the foreign exchange market, CBDC could be allowed to be exchanged outright in different denominations between resident and non-resident institutions (non-resident institutions are foreign institutions from a balance of payments point of view) thereby extending the safety of central bank money to the international sphere, making foreign exchange transactions peer-to-peer, riskless and providing an entirely new architecture for international payments (see e.g., wholesale CBDC project Jura).
International payments rely on a very narrow set of national currencies. If the new functionalities of CBDC produce a reduced need for network effects and shift the relative attractiveness of currencies, it could lead to the adoption of a greater variety of currencies, reduce existing dependencies and likely result in a more robust and balanced international payments system.
Blockchain technology is unlikely to be an impediment for adoption. Existing blockchain platform are able to accommodate most payment needs in a production environment. Inter-operability between blockchains has also largely been solved and solutions for the integration with existing payments systems, a necessary condition for successful adoption, have also been developed. Privacy concerns need to be addressed but blockchain applications offer a broad range of possible approaches.
Legal and regulatory obstacles should be minor for CBDC for domestic transactions. CBDC is after all only a different format of the same money, but adoption of blockchain-enabled platforms may require some additional provisions. In an international setting, a big challenge to adoption remains to identify a common governance and regulatory structure on the use of CBDC by non-residents.
To ask what problem CBDC will solve may be the wrong question. It may also be unduly biased by addressing only known use cases. CBDC is to ensure central bank money can remain competitive, adapted to a rapidly evolving payments environment and serve across a wider range of financial market infrastructures. Those should be key considerations for CBDC adoption.