Central bank digital currencies

Central bank digital currencies a potential game changer

As cryptocurrencies become increasingly popular and the use of physical cash declines, monetary authorities around the world are also getting into the act and investigating a new form of money – the central bank digital currency or CBDC.

CBDCs are digital representations of central bank-issued cash. They can be an electronic record or digital token representing the virtual form of a country’s fiat currency, backed by monetary reserves. By nature, they are centralised, in contrast to cryptocurrencies such as bitcoin or ethereum which use the blockchain or distributed ledger technology and are inherently decentralised.

As economies become digital, CBDCs can ensure that businesses and the general public will have access to the safest form of money – a claim on a central bank. 

Last year, the Bank for International Settlements (BIS) surveyed 65 central banks representing 90% of the global economy, and found that 56 of them are actively researching the potential for CBDCs, including 39 experimenting with the technology and nine deploying pilot projects. This is a significant increase from its first survey in 2017, which found only 38 were doing some work on CBDCs.

Discussions about central bank-issued digital money started around 2013 when bitcoin began to capture the attention of the financial sector and the public. In 2016, several central banks launched research projects on CBDCs in response to the emergence of so-called stablecoins, the second generation of privately-issued cryptocurrencies with a stable value tied to fiat currencies.

Two years ago, Facebook announced the Libra project – now known as Diem – to create a stablecoin tied to the US dollar. The social media giant quickly garnered support from 26 companies, including big names such as PayPal, eBay, Mastercard and Visa, to join the Libra Association established to oversee the project. It was a wake-up call to many authorities that the Libra coin could jeopardise their efforts in preventing money laundering and terrorist financing, maintaining financial stability and ultimately, they could risk losing control of their monetary policies. This sparked a race to study the issuance of CBDCs.

The Bahamas, with a population of 400,000 spread across 700 coral islands, became the first nation to launch a full-fledged CBDC, the Sand Dollar, in October 2020. Residents can now trade the Sand Dollar with any merchant on the archipelago by leveraging a central bank approved e-wallet on their mobile device. Around 90% of Bahamas residents have mobile phones, and the Sand Dollar aims to greatly enhance financial inclusion among the many remote islands.

China’s e-CNY

But what caught most world attention is the speed with which China is progressing with its digital currency or e-CNY project. It was initiated in 2014 by Zhou Xiaochuan, the then governor of the People’s Bank of China (PBOC), who set up a task force to research digital fiat currency. 

The PBOC Digital Currency Institute was established two years later to develop the first-generation prototype. At the end of 2017, the State Council gave the green light to the PBOC to work with commercial banks, telecommunications operators and internet companies to begin designing and testing the digital currency. 

Several pilot programmes on the use of e-CNY for retail activities have been launched since April 2020 in a number of cities, including on the entire Beijing subway system, and on one Suzhou metro line. According to a PBOC progress report this July, the e-CNY has been applied in over 1.32 million scenarios covering utility payments, catering services, transportation, shopping, and government services. Between April 2020 and June 2021, more than 20.87 million personal wallets and over 3.51 million corporate wallets have been opened, with total transaction volume of 70.75 million valued at 34.5 billion RMB (US$5.3 billion). 

The next milestone will be the pilot use of e-CNY during the Winter Olympics in February 2022 for local and foreign visitors. Notwithstanding the e-CNY’s advanced progress however, the PBOC said there is no pre-set timetable for its final launch.

Apart from China, there are 14 other countries, including Sweden and South Korea, which are in the pilot stage of their CBDCs, and preparing a possible full launch. 

It’s important to distinguish three different areas for the application of CBDCs: retail, wholesale, and cross-border, each potentially giving rise to different proposals.

Most central banks’ current focus is on retail CBDCs. According to the BIS survey, advanced economies are motivated to issue CBDCs mainly to enhance the safety and efficiency of their domestic payment systems and reduce transaction costs. Some are also attracted by the smart contracts and programmability features, which can potentially lead to monetary policy measures that precisely target specific public services or structural areas of the economy, with almost real-time feedback. 

Countries such as Norway and Sweden also see CBDCs as a means to ensure continued access to central bank money for households and companies where use of physical cash has declined to less than 10%.

However, for emerging and developing economies where a significant share of their populations don’t have bank accounts, or where physical cash distribution costs are high, the top priority of CBDC initiatives is financial inclusion. The Bahamas is a case in point. 

But there are concerns that CBDCs will diminish the role of commercial banks, or dis-intermediate non-bank payment service providers such as PayPal, AliPay and WeChat. China’s e-CNY addresses these issues with a two-tier operational system allowing banks and payment providers to face the public and continue their functions. 

Data generated by CBDCs would offer new levels of transparency that would help authorities detect unusual payment patterns or illicit activities. This however raises serious concerns about privacy, a key issue that the European Central Bank is grappling with in its investigation into the possibility of an e-euro.

Far-reaching impact

Thus far, central banks have not put much focus on wholesale CBDCs and their use by financial institutions for wholesale financial services. This is an area where the digital currencies can potentially become a game changer.

Securities are currently traded on a country’s stock exchange, but the payments are moved through a different system, typically a real-time gross settlement system operated by its central bank. 

CBDCs may facilitate the merging of financial instrument transfers and payments. If financial instruments were to be available in tokenised form, CBDCs would allow end-to-end settlement in tokens to allow instant delivery versus payment. This can alter how central securities depositories and central counter-party clearing houses operate in a trade lifecycle.

Moreover, pension funds and large institutions typically hold their securities with a third-party custodian. Should the custodian collapse, the assets are legally ring-fenced. However, cash is held directly on the balance sheet of the custodian bank. Should the bank get into trouble, the owner of the cash risks losing all or having to stand in line with other creditors. But CBDCs are held in custody and have no bankruptcy risk unless the sovereign state fails. This will address the weakness in today’s custody system.

The French central bank in July successfully completed an experiment using CBDC for interbank settlement in partnership with a consortium of organisations, including BNP Paribas, Euroclear and Société Générale, facilitated by financial technology firm LiquidShare. The experiment covered the entire life cycle of securities, from issuance and registration in the blockchain to secondary market operations’ settlement. This will pave the way for the development of post-market solutions for digital assets, securities or cash.

Most payment transactions between different currency areas today are conducted through correspondent banking mechanisms. These systems are slow, costly and not very transparent. CBDCs may reduce the inefficiency and high costs of international payments. Some cross-border projects are making good progress, including Project Inthanon-LionRock involving Hong Kong, Thailand, China and the United Arab Emirates, Project Ubin between Singapore and Canada, and Project Stella between the European Union and Japan. 

However, recent discussions on cross-border CBDCs are often framed in the context of intensifying US-China rivalry and potential use of the digital currencies in undermining the US dollar’s dominance, avoidance of sanctions, or bypassing the SWIFT global messaging and cross-border payments system.

Cross-border use of CBDCs will require strong cooperation among central banks. Multilateral collaboration to agree on design principles will be key to address central banks’ concerns about currency substitution risk, capital flow volatility, and contagion risk. This may be difficult to achieve on a wide scale in the near term. 

The BIS anticipates that one-fifth of the world’s population may be using CBDCs in three years. The impact on the financial industry will be far-reaching. It will accelerate digitalisation of the industry, reshaping its infrastructure and ecosystem.

*This article was published in Asia Asset Management’s October 2021 magazine titled “Money of the future”.