Did you ever have that surge in excitement at school when you were playing a game of football or netball or whatever with your mates, and then out of nowhere one of the really good players from two years above decided to come and play? It felt like the cool kids had decided your game was fun, so they came to get involved. Everyone tried a little harder. Maybe a high five at the end of the game?!
… but then they ruined it for everyone. They scored loads of goals and it became really one sided. They took control.
And so it is with Central Bank Digital Currencies (CBDCs). We can’t be sure whether the game is going to become more fun, or if they’re actually going to change it for the worse. But in this post I’ll explain what they are, why they’re important, where countries are with them and leave you to make up your mind.
Below is the money flower (with a spelling mistake) which was designed by the Bank of International Settlements. It’s helpful to put everything into perspective.
CBDCs are in purple (well you can definitely read if you’re this far in, so you probably worked that out for yourself). I’m just going to focus on retail, or general purpose, CBDCs for now. So the difference between what’s happening now and what might happen in a CBDC world is their peer to peer nature.
So what does that mean?
Well one of the ways that money is created is by central banks increasing their balance sheet (i.e. they just say they have more money, and thus it is so) by buying government bonds. That’s quantitative easing. But that process is very insular. It involves the Central Bank and the government’s own bonds, which are then traded in the market as a single entity e.g. a gilt. The bank creates the money and gives to the government, which can then spend it as it pleases, through the institutions that it works with.
With CBDCs, the Central Bank can create a digital form of money that it can then provide to anyone that has the right digital infrastructure. It’s peer to peer. So the central bank effectively has more entities that it can interact with when it’s creating money. It looks a little something like this:
If you have a digital wallet, then the central bank can issue money directly to you, rather than through a government or a bank, which effectively means that the ‘promise to pay the bearer’ which is on most currency is backed by the central bank.
This is a really important point. The money you have with your personal bank is typically not legal tender. A dollar in your bank account is not the same as a dollar bill in your hand; it is more a promise of the bank to give you a physical dollar upon your request. It is a bank's liability to fulfill those requests. Usually, a bank has no issues in fulfilling that promise, hence the line between your money in the account and the physical cash gets blurred. But if the bank ceases to function and goes bankrupt, this distinction makes all the difference. Because you don't hold a legal tender in your bank account but only the "bank's promise" so to say, it means that if the bank doesn't exist anymore, you can't hold anyone to your claim, and are effectively losing your money. What is even worse is that if enough people think that their bank might run into solvency issues, they will withdraw their money to save it from loss. If too many customers of a bank do that - called "a run on the bank" - the solvency of that bank is reduced additionally and can lead to the bank's collapse.
You’ll remember from my blog on the Savings and Loans crisis that I’m a little confused about what we think a bank is there to do, and what they actually do. This might be one really great consequence of CBDCs; that in fact the holding of our money could just be with the central bank, and the other banks would be there for investments, financial products and so on. They don’t store, they make it grow.
A central bank for storing. An investment bank for investing. Different functions, different risk profiles, different expectations. Makes sense.
There are two types of retail, or general purpose, CBDC, which are distinguished by their verification of payment; token based CBDCs and account based CBDCs.
In the account based system, an intermediary verifies the account holders’ details, which are then stored in the digital wallet. It’s like doing virtual KYC, that’s then stored in your digital account. Ownership of a CBDC is then tied to the account. I am therefore I own.
In the token based system, coins, notes and so on are tokenised and claims are honoured based on a digital signature that is created by public/private key encryption. Here the ownership is tied to knowledge of something. I know, therefore I own. Bit of a summary in the below:
So where are we now on CBDCs?
Well the sentiment amongst Central Bankers has been improving.
(Now I think we need to take this with a pinch of salt, as we don’t know whether it’s based on tons of speeches from one or two central bankers, or one or two speeches from tons of central bankers. Makes a big difference.)
Certainly interest is on the rise… this is from Google Trends:
And most countries are working on a CBDC of some description:
So what are the potential benefits?
As mentioned earlier, they can eliminate the risk of bank runs, as all of your ‘deposit risk’ would just be with the central bank
This direct connection between you and the central bank means that costs should be lower for you
They facilitate cross border flows in particular by lowering the cost of cross border transactions as there aren’t so many fee-taking intermediaries
They remove the cost or needing to implement full financial infrastructure within a country, which would bring financial access to the unbanked
Of course, as with everything, there are an equal number of concerns:
If CBDCs change the global financial payments system, it’s unclear at the moment what they might mean for household expenses, investments, interest rates and so on; or indeed the economy as a whole
Should CBDCs offer an alternative to a conventional bank deposit, it’s uncertain how this might impact the banks; their stability, profitability and therefore the jobs they create. Of course many would have little sympathy for the position, but bottom line is that, particularly in the UK, banks contribute to GDP, create a lot of jobs and are therefore an important source of revenue for our public services
If banks do lose deposits, then they will have to turn to more expensive sources of funding, which they will likely pass on to their customers through the costs of the products they sell e.g. mortgages
One of the main concerns (and one of the speculated reasons that China has pushed on and is so far ahead in the ‘CBDC race’) is a loss of privacy. CBDC transactions will not be anonymous, unlike traditional cash transactions. For example, Nigeria’s digital currency faced criticism citing potential surveillance and curbs on freedom. Ways to address such fear could include making data visible only to the financial intermediaries, such as banks and third-party payment companies, and not automatically to the central banks
It’s likely that a CBDC would be the target of hackers, and as such, the design and implementation of a CBDC would need to be extremely robust
Finally, there is some considerable concern, based on some reasonable evidence, that the uptake of CBDCs might be limited. In the Bahamas, the per capita value of CBDCs is just 86 cents compared with the per capita cash value of $1,365. Less than 0.5% of Nigerians are using the eNaira. Outstanding e-RMB is at only $2 billion or 0.13% of outstanding M0 and 0.005% of M2, as of December 2022. Reasons for the slow update range from inertia and complexity to a lack of digital literacy
It’s unlikely, however, that this is just going to be about a single country and the impacts on its economy and its people. This will almost certainly become a political tool that will impact the financial functioning of the world. In September 2022, China carried out a mCBDC (multiple central bank digital currency) bridge test, which was developed by the BIS and included China, Hong Kong, Thailand and the United Arab Emirates. The aim was to deliver real-time, cheaper and safer cross-border payments and settlements, and it worked; more than 160 cross-border payments and foreign exchange transactions totalling more than $22 million were made during the first trial involving four central bank currencies and real-value transactions.
So perhaps both sides are getting a grown up player to score loads of goals; it’s just that the teams are now called China and the United States.