Central Bank Digital Currencies — Innovation, Opportunities and Risk

In this time of pandemic, central banks have a unique opportunity to keep pace with technology change and enable a move towards digital currency. There is a risk that physical cash could be infected and citizens are increasingly getting attracted to digital payment solutions that are transparent, immutable, low cost and convenient to use. While there are many ‘wallet’ type solutions e.g. AliPay, WeChat Pay available in the market, citizens could lose their deposits due to transfer of this custody risk to private wallet providers and are relying on auditors and regulators to supervise these various private providers. But what is to say that the collateral backing these private digital currencies (or coins) is indeed in place? Who is the lender of last resort to safeguard citizen’s assets?

Central Bank Digital Currencies (CBDC) would be an exciting innovation where governments could make use of DLT, offer digital equivalent to fiat currencies, backed with legal tender and offer a formal substitute for the consumer that is trusted and protected from loss.

Implications of CBDC on commercial banks

With CBDC mechanism in place, Central banks could directly deposit digital currency into household accounts or issue tokens “coins” against government bonds or liabilities. This will significantly expand financial inclusion and expand liquidity to unbanked segments of population, but at the same time threaten the traditional model of commercial banks as agents of central banks.

Today, commercial banks create reserves indirectly by issuing loans. With retail CBDC in place, households could directly access credit at low interest rates and use P2P loans with greater availability. This may threaten the most profitable revenue stream for commercial banks. In addition, with higher interoperability and safety of mobile money, commercial banks will be forced to offer higher interest rates to prevent depositor outflow further reducing margins.

CBDC would give central banks more direct control over monetary policy and inflation. At present, central banks often try to manage the money supply indirectly by tweaking reserve interest rates or QE via commercial banks. By issuing digital currency, they would have a direct line into households wallets. They can affect savings and spending habits of households by levying interest rates or issuing tokenised government liabilities. This in turn could result in a completely new distribution and selling platform, where participants can transact on tokenised government securities and setting prices, further reducing the role that commercial banks play in monetary policy today.

Potential Risks and Opportunities of CBDC

CBDC introduction will transform the public financial landscape, banking system and related payment methodologies but in turn also create new opportunities. There are risks and challenges that need discussion.

Data and Privacy Risks

Key advantage of CBDC built over DLT (Distributed Ledger Technology) on blockchain is that records stay immutable and by design are permanently recorded. This offers ‘big data’ opportunities to central authorities for policy decisions and tracking consumer spending habits but also opens up to privacy risk. A privacy and security framework would have to be designed to balance different interests between user anonymity and law enforcement.

CBDC could be designed in a way to be fully compliant with relevant regulations e.g anti money laundering requirements to a greater extent than existing private payment systems. This however poses twin problems as compliance with AML will not allow truly anonymous payments. A better design could try to address this by setting up isolated walls — for e.g a user making a payment on a digital shop should be able to do so using CBDC without revealing their identity to the shop owner but at the same not having or expecting anonymity with law enforcements.

It is also important to improve transaction monitoring, and assess the financial stability risks posed by fraud and under regulation in DLT. In theory, CBDC can be build on centralised ledgers as well but then will miss out on many innovations on the DLT side such as offline transactions and real time reconciliation and speed. DLT based CBDC could make remittances, and cross border transactions much more efficient, once central banks agree around a common set of standards to support inter operability.

Custody Risks

Hardware and software security standards would have to be met for proper custody management e.g ‘hot ‘ and ‘cold’ backups, updated cryptography solutions and multi party consensus to prevent security breaches. Customers who voluntarily take part in private crypto currency understand or at least accept to a certain degree the risks associated with it, but governments using digital currency won’t have that luxury and would be fully seen as responsible for having the right infrastructure, fraud controls, dispute resolutions and compensation mechanism for loss in place.

With a much larger user base in CBDC involving ‘non technical users’, if a user forgets their private key, their funds may be lost forever. Therefore innovative custody solutions would need to be provided by public or private players to have high security around storage of private keys and a mechanism to ‘freeze’ and reissue CBDC where a corresponding private key has been lost. Citizens need to be trained as well to keep private keys secure and not fall victim to social engineering and phishing attacks.

Payment Risks

Introduction of CBDC could also pose some risk to payments. Most proposed frameworks of CBDC are build on ‘stablecoins’ design. However, depending upon the type of asset backing these stablecoins, these coins may be unable to provide stability of value at par with fiat currency and create a new form of systemic financial risk for the central banks to manage.

Concentration Risks

In contrast to above, a very successful CBDC design could disable or crowd out existing payments system and ultimately reduce the choices in payment options for end consumers, resulting in a new form of concentration risk. This could mean competing private players exiting the market and reducing innovation in this area.

Technology Design Risks and Innovation trade offs

Many CBDC design proposals want to support programmable money functionality “smart contracts’ but this comes with significant trade offs. Complex computations on the block chain would have an impact on its performance, slowing individual transactions. Alternative would be for smart contracts to be separated as modules distinct from the core ledger and reserved for approved payment API’s only. This highlights the need for proper forward looking design thinking at the start of CBDC rollout.

There is a perpetual trust issue in the general public if governments or centralised bureaucracies have in them to come up with a well designed CBDC platform and stay constantly one step ahead of cyber security hacks and threat elements. In many ways a DLT based CBDC in an anti thesis to the original motivation behind digital currency such as bitcoins, where central banks weren’t considered nimble enough to innovate or trusted to keep citizens assets safe. There is a genuine political risk in citizens not accepting digital cash and CBDC not meeting its objective.

Final Thoughts

As recently as Oct 13th, G20 has announced that BIS (Bank of International Standards), World Bank and IMF are coming together and formalising the use of CBDC in banking systems. This is an exciting development. The next generation of payments will need to support a more digital economy and allow for seamless transactions between households and businesses. A well designed, robust, CBDC platform could enable a wide range of firms compete to offer CBDC related payments services and innovate in this area to give users a fast, efficient and inclusive service. Like any successful product rollout though, risks would have to be carefully managed and mitigated.