It is no revelation that central banks are actively engaged in both the research and piloting of central bank digital currencies. But the mechanics of how they are conducting their programmes is not as widely recognised. This is largely because the information is buried within the pages of mundane reports, speeches and discussion papers. A few headlines might be glossed over in the financial press, but the technical aspects are usually not considered.
In January 2019 the Bank for International Settlements published a paper called, ‘Proceeding with caution – a survey on central bank digital currency‘. I briefly covered the survey in an article published back in September last year. Back then the BIS reported that a majority of banks were engaged in active research on CBDC’s, but none were yet in a position to launch a digital variant of physical money.
The BIS followed this survey up in January 2020 with some new research – ‘Impending arrival – a sequel to the survey on central bank digital currency‘.
We learn that the 70% of central banks that were researching CBDC’s has now risen to 80%, with many of them reliant on ‘research conducted by international organisations (in particular the BIS and the IMF) or regional networks‘. The BIS’s Innovation Hub initiative, established in the summer of 2019, has been key in coordinating the advancement of CBDC’s projects worldwide. This is one of the reasons why banks are operating in step with one another.
As the survey points out, ‘collaboration through international vehicles such as the BIS Innovation Hub will be necessary to avoid any unforeseen international consequences.’
General manager of the BIS, Agustin Carstens, expanded on this in the institution’s quarterly review:
The Hub will catalyse collaborative efforts among central banks, and cooperate, when appropriate, with academia, financial service providers and the broader private sector to develop public goods for the benefit of the global financial system. As the Hub gathers experience, a home-grown agenda will quickly be developed. A key question informing the BIS Innovation Hub’s work is whether money itself needs to be reinvented for a changing environment, or whether the emphasis should be on improving the way it is provided and used.
In regards to CBDC, there are two variants. The first is a wholesale offering, which would be used to facilitate payments exclusively between financial sector firms. The second, known as a retail or general purpose CBDC, would be for use by the public. It is the latter which is of increasing concern to central banks.
According to the survey, a general purpose CBDC could prove as either a substitute or a complement to banknotes. A similar position was taken within a discussion paper on CBDC published by the Bank of England in March. In the foreword to the paper, former governor Mark Carney stated that any CBDC would act as a ‘complement to physical banknotes‘.
However, in March 2019 Agustin Carstens was adamant that the introduction of CBDC’s would mean an end to cash:
Like cash, a CBDC could and would be available 24/7, 365 days a year. At first glance, not much changes for someone, say, stopping off at the supermarket on the way home from work. He or she would no longer have the option of paying cash. All purchases would be electronic.
Who is right? I believe that allowing cash to co-exist with a CBDC long term is not what global planners have in mind. For a period of time this may prove the case, but eventually when cash usage drops to perhaps less than a tenth of all transactions is when we would see the beginning of a process to eliminate cash from circulation. All remaining banknotes in your possession would be converted into CBDC’s.
As the survey outlines, just under 50% of the world’s central banks are ‘investigating the public’s use of cash and a third are concerned that access to cash could decline in the medium term‘.
Cash use has been gradually declining over the last ten years, but since the outbreak of the Covid-19 coronavirus it has collapsed to new lows. One thing the survey is clear on is that ‘cash use is the key to driving many central banks’ plans‘. Whether Covid-19 will result in the time frame for introducing CBDC’s being brought forward is so far unknown.
If the BIS paper is an accurate indicator, then around 70% of central banks see it as unlikely that they would issue any form of CBDC ‘in the foreseeable future‘. But then again banks have apparently moved away from classifying the implementation of a CBDC as ‘possible‘, which the survey suggests may be a sign that ‘research and experiments‘ are ‘helping to clarify a firmer stance on issuing a CBDC in the near term‘.
For clarity, the BIS considers near term as anywhere from one to three years, and the medium term anywhere from one to six years.
Two countries that are piloting CBDC technology are Sweden and Uruguay. The survey reveals that both nations are looking to trial ‘non-interest bearing, non-anonymous CBDCs that are available 24/7 with restrictions on the values that can be held and distributed through intermediaries.’
Staying with the BIS, as part of their quarterly review released in March they published a paper called, ‘The technology of retail central bank digital currency‘. The primary question in the paper is whether a CBDC should be a direct claim on the corresponding central bank, or an indirect claim that is managed via payment intermediaries.
This is an area that former IMF managing director Christine Lagarde addressed in 2018 at the Singapore Fintech Festival. She raised the prospect of central banks going into partnership with commercial banks and financial institutions, with the idea being that the private sector would interface with customers, store their wealth and offer a range of services. ‘But when it comes time to transact, we take over‘, Lagarde said.
Banks and other financial firms, including startups, could manage the digital currency. Much like banks which currently distribute cash.
Or, individuals could hold regular deposits with financial firms, but transactions would ultimately get settled in digital currency between firms. Similar to what happens today, but in a split second. All nearly for free. And anytime.
Related to this is how the BIS and its members regularly talk about the ‘architecture‘ of CBDC’s – in essence, how they could be modelled and whether the infrastructure underpinning them should utilise a centrally controlled database or distributed ledger technology (DLT).
The BIS indicate here that ‘most likely central banks would consider only permissioned DLT‘. In practice a permissioned DLT would mean access to the network must be granted by participants in that network – participants who would be controlled through regulation devised at the central bank level. As looked at in previous articles, DLT is not the decentralised panacea that many of its advocates claim.
The narrative on CBDC’s has advanced significantly from early 2018 when the BIS began focusing on ‘money in the digital age‘ and what role central banks will play. We have now moved beyond CBDC’s just being a concept. Global planners are getting into specifics about how CBDC’s could be designed.
First, let’s look at what is termed a ‘direct CBDC‘. This would be a claim on the central bank and would also see the bank itself handling retail payments. In this scenario the central bank would keep sole record of all retail holdings, and would mean that they alone would be responsible not just for issuing the CBDC, but delivering it to customers. It would require central banks to expand their operations enormously and in effect have a presence on the high street. Judging from the BIS paper, a direct CBDC is not being considered as the most viable.
Next comes the ‘hybrid CBDC‘. Again, this would be a claim on the central bank but the difference is that the bank would periodically record retail holdings. This means the holdings in question could be transferred from one payment service provider to another – the intermediaries Christine Lagarde talked about – resulting in no single point of failure. The BIS deem this advantageous in the event of a major system outage. To quote the paper directly:
As the central bank does not directly interact with retail users, it can concentrate on a limited number of core processes, while intermediaries handle other services including instant payment confirmation.
The hybrid CBDC architecture could be implemented at scale using today’s technology and with a relatively modest infrastructure even in the world’s largest currency areas.
If we were to assume that the hybrid CBDC was the preferred choice, the next stage is how customers would access it. The two options mooted by the BIS are a token or account based CBDC.
A token CBDC would allow universal access requiring no bank account. Instead, customers would take possession of an online ‘digital signature‘, which would be exclusive to them and used as the vehicle to authorise payment. The argument goes that by deploying this sort of CBDC it would offer a stronger level of privacy than an account based CBDC.
One of the downsides, as the BIS detail, is an elevated risk of losing funds ‘if end users fail to keep their private key secret‘. More importantly though, at first glance a token based system would afford people too much anonymity for the establishment’s liking. As the paper mentions:
Law enforcement authorities would run into difficulties when seeking to identify claim owners or follow money flows, just as with cash or bearer securities.
Retail CBDCs would thus need additional safeguards if they followed this route.
An account based CBDC would be very different. This would ‘tie ownership to an identity‘, replicating a traditional bank account in that claims would be held on a database that records the value of payments along with ‘reference to the identity‘. Whilst the BIS visualises some drawbacks in terms of global universal access, in particular rolling it out in all jurisdictions, the benefits for the banking elite are obvious when it comes to tracking user activity at every turn.
The next consideration after a CBDC configuration is established is cross border payments. Regularly in speeches central bankers will lament that payments of this nature are too slow for modern commerce. Payments can take days to clear and be costly. A global CBDC network is being touted as a solution, with payments sent from one side of the world to the other being accessible immediately.
According to the BIS, a coordinated design effort ‘would represent a unique opportunity to facilitate easier cross-border payments.’ Coordination is imperative to the whole CBDC agenda. Currently, every major central bank in the world is advancing their CBDC programmes.
For my next article I will be looking at a Bank of England discussion paper on central bank digital currencies that was released just prior to the Covid-19 lockdown in the UK, and expands on the CBDC models outlined by the BIS.