Major central banks around the globe have taken steps towards identifying a framework for building a central bank digital currency (CBDC). What are the advantages and drawbacks of such a virtual currency? And what would a digital euro look like?
- A central bank digital currency (CBDC) would be a new risk‑free digital form of currency issued by a central bank, and which performs all the essential functions of money.
- Major central banks around the globe, including the Bank of England and the European Central Bank (ECB), are exploring the common principles and key features for building a CBDC.
- In October 2020, the ECB published a report analyzing the viability of a digital euro that could be used in retail transactions and be available to the general public.
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In recent years, technology has played a key role in reshaping the financial and banking systems. From regtech to fintech initiatives, the new technological wave has shaped and accelerated the digital agenda of many players (as a matter of creating a survival strategy), and changed the shopping and payment habits of billions of people, who together form a new digital-native generation of consumers.
New digital currencies
Cryptocurrencies and distributed ledger technologies (DLT) attracted the attention of researchers and policymakers. And while the speculative component of Bitcoin (and other cryptocurrencies) brought in a layer of opacity and mistrust, the fascination was enough to generate new activity streams in opening the scene to digital currencies projects, including Facebook Libra.
Libra qualifies as a ‘stablecoin’, a privately managed digital asset pegged to an existing asset (e.g. USD or euro) and based on a private version of blockchain, allowing users (once launched) to send Libras via a dedicated app on their smartphone.
But what challenges can such initiatives pose to the role of banks and central banks when it comes to money that they issue?
In a changing world, we need to think about how payment systems can evolve in the near future, which technologies can really be leveraged, what regulatory framework is required, and what kind of role central banks may retain or enhance to balance the need to respond to changes in customer demand and monetary policy structural requirements.
What is a CBDC?
In the current scenario, central banks already provide financial institutions and banks with electronic accounts. Consumers can only keep central bank-issued money in a physical form e.g. banknotes or coins. Only banks and other financial institutions can hold electronic central bank money, in the form of ‘reserves’.
If a central bank issues a CBDC, then the public is able to store assets and make payments using that digital asset. This could have implications for monetary policy, financial stability and the way the current financial system ecosystem works.
CBDCs would be different to cryptocurrencies, which are privately issued and not backed by any central party and do not perform the essential functions of money. Cryptocurrencies are too volatile to be a reliable store of value, they are not widely accepted as a medium of exchange, and they are not used as a unit of account.
Some privately issued cryptoassets — ‘stablecoins’ — may aim to overcome these issues by looking for more stability via some form of backing, although depending on those backing the assets, other risks may appear.
CBDCs would be a new risk‑free digital form of currency issued by the central bank, and performing all the essential functions of money.
Central banks take first steps towards a CBDC
In 2019, six central banks announced their collaboration on a central bank digital currency, and more recently a joint report Central bank digital currencies: foundational principles and core features, was published on 9 October 2020.
The group included Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank (ECB), the Sveriges Riksbank (Sweden), and the Swiss National Bank, as well as the Bank for International Settlements (BIS).
While none of those central banks have formalized their decision on issuing a CBDC, the report is a real step forward for this group of central banks in agreeing the common principles and identifying the key features in building such digital currency, from monetary policy implications to features, but also trade-offs, regulatory issues and design logic.
Any future CBDC framework must be resilient, secure and achieve the required operational integrity levels; has to be at very low or no cost to end users; must be governed by appropriate standards and a clear legal framework; and, most importantly, has contribute to promoting competition and innovation, while envisaging a role for private sector, too.
From a technological perspective, the risks and benefits of using DLT need to be analyzed versus a more traditional centralized approach.
And when it comes to motivations and objectives for supporting the CBDC initiative, some key topics highlighted in the report are:
- Cash usage decline trends;
- Resilience, whereas private systems may fail;
- Increased payment systems diversity;
- Improved cross border payments;
- Additional levels of financial inclusion;
- Defense of public privacy, versus the full anonymous paper notes system;
- Faster governments and central direct payments.
The report concludes that a collaborative effort will continue to explore trade-offs. Any further developments of CBDCs require a commitment to practical policy analysis and applied technical experimentation.
While the analysis has already started, the path of innovation in payments and money-related technologies is accelerating, and therefore requires an acceleration of the experimentation stage.
- People’s Bank of China (PBoC), is in advanced stages for issuing a retail digital currency; an initiative supported by four state-owned banks and three telecom companies.
- The Monetary Authority of Singapore, is progressing with CBDC Project Ubin, launched in 2016 and supported by state investment firm Temasek and J.P. Morgan.
- Bank of Thailand is working on Project Inthanon and developing a proof of concept with development firm ConseSys. The central bank also announced results of its cross-border CBDC experiments with the Hong Kong Monetary Authority’s (HKMA) LionRock project.
Prospects for a digital euro
Within a scenario of accelerated innovation and increased demand for digital payments, the Governing Council of the European Central Bank established a High-Level Task Force in January 2020 with the objective of making steps forward on the concept of a CDBC in the euro area.
In October 2020 the Report on a digital euro was published by the ECB.
The term ‘digital euro’ relates to a liability of the Eurosystem recorded in digital form as a complement to cash and central bank deposits. The aim is for the digital euro to be used in retail transactions and for it to be available to the general public.
Such a digital euro would be another way to supply the euro, and it would not become a parallel currency. It should be convertible on a par with other forms of the euro.
A key ECB assumption is that citizens place the most confidence in digital money that is issued by their domestic monetary authority compared with any private initiative.
While cash remains the dominant means of payment in the euro area as a whole, its use is declining in several countries and preferences might change rapidly and unexpectedly. This has been demonstrated by the COVID-19 crisis, which has shifted payment habits towards contactless payments and e-commerce.
A digital euro could also contribute towards reducing the overall cost and ecological footprint of the monetary and payment systems.
However, additional work is required in the area of confidentiality, because via their own digital currency, central banks could acquire sensitive information on users. This same privacy issue is a concern whether the project is undertaken by the public sector, or indeed the private sector.
Last but not least, some digital euro design options could affect the intermediation function of banks and their funding costs.
The analysis concludes that any potential solution must satisfy a number of principles and requirements that the ECB identifies in its report — including robustness, safety, efficiency, and protection of privacy — while complying with relevant legislation in such areas as money laundering and the financing of terrorism.
The ECB supports the idea that the public sector may be best placed to provide the safety, scale, level of convenience, and accessibility needed to allow citizens, businesses and financial institutions to participate in the digital payment market.
Towards mid-2021, the ECB will consider whether to launch a digital euro project. This would trigger an investigation phase to identify at least one minimum viable product that would be able to meet the defined requirements.
First mover advantage?
The BIS has reported that the great majority of central banks are working on some kind of digital currency project, so the process has already begun on a global scale.
Central banks’ primary objectives are to maintain monetary and financial stability, so a CBDC should be structured in a way that supports those targets.
The ECB considers digital euro to be digital symbol of progress and integration in Europe. Together with cash, a digital euro would be accessible to all and offer greater choice and easier access to ways of paying.
On the private initiative side, the Libra Association — based in Geneva — recently applied for a payment systems license with the Swiss Financial Market Supervisory Authority (FINMA).
This decision has international consequences, and requires consultation and collaboration with central banks and other international authorities. The application status and the length of the process are not known, which is in line with the usual procedures in the Swiss jurisdiction.
The recent move of Libra from the original multi-currency basket envisioned to a dollar-pegged stablecoin variation supports the idea of a more direct link into local currencies, allowing more use cases.
It remains to be seen whether Facebook Libra (in its new 2.0 edition) can really integrate with central banks’ initiatives, or if one is able to displace the other.
Regulatory framework adherence, ease of use, and time-to-market will be game-changers in a market that is hungry for innovation, and where COVID-19 has accelerated the growth of e-commerce and the decline of cash when measured against contactless payment systems.
As reported in a November 2020 ECB paper: “Introducing a CBDC sooner rather than later could give rise to a significant first-mover advantage to its issuer.”