Having discussed the benefits and structure of Central Bank Digital Currencies last week, we now turn to the current state of their implementation and the risks associated with their use. CBDCs are still very much in their early stages but 86% of central banks are keen to research and trial them, partly to provide an alternative to cryptocurrencies that are often considered by regulators to be a risky and unreliable asset.
There have been a few launches of CBDCs and many more proposals. The general structure of CBDCs involves partnering with commercial banks to help provide the currency. Central banks will hold and maintain the digital ledger and provide the high level infrastructure for payments in the currency. Central banks then provide API access to regulated and authorised payment service providers (PSPs) and financial institutions. Customers and businesses can then register with the network through their PSP to allow payments. Most proposals and issuances of CBDCs do not allow them to bear interest, particularly in the early stages, so that implementation can be achieved without having too great an effect on potential monetary policy outcomes.
The eYuan/ e-CNY
The eYuan has been one of the more significant launches of a CBDC and the People’s Bank of China (PBOC) has begun rolling out the digital currency version of the CNY across major cities as a large-scale trial of the currency. China already has significant digital payments usage dominated by Tencent and Alibaba with their products WeChat Pay and Alipay but the PBOC has been working on developing a digital currency since 2014, when cryptocurrencies were still relatively young.
China has adopted a two-tier strategy similar to what we have discussed in which commercial banks partner with the PBOC to provide the eYuan to customers. The PBOC hopes the eYuan can help banks and PSPs compete with the dominance of WeChat and Alipay who are also likely to implement the digital currency in their apps. China hasn’t been particularly clear on the technology behind the eYuan but it is thought to be not based on blockchain technology, instead using the simple digital ledger that we discussed last week.
China initially used free distribution of the eYuan (also known as e-CNY) to incentivise uptake of the currency including $1.5 million worth during Lunar New Year 2021. It looks to have succeeded with 261 million individual users by January 2022 and $13.78 billion worth of transactions having been made in 18 months. The rollout has been a success for the PBOC and the uptake has been impressive given the limited number of regions that the eYuan is currently available in. Nonetheless WeChat Pay and Alipay still control over 90% of Chinese payments using a traditional bank account model, a dominant hold on a huge market. China has also partnered with Thailand, the United Arab Emirates and Hong Kong to explore a cross-border permissioned decentralised ledger that would speed up international transactions.
Furthermore, CBDCs have been launched in Nigeria and the Bahamas. Nigeria has struggled to increase users and very few transactions occur through the system. This is perhaps a symptom of rushing to release the digital currency without first having a restricted pilot scheme and a clear implementation policy. The Bahaman CBDC known as the ‘Sand Dollar’ has been a moderately greater success but with 60% of transactions still occurring with cash, there is much progress to be made in the small nation.
Several other countries are beginning to trial CBDCs but until more major economies such as the US, UK and the Eurozone introduce them, the role of CBDCs and their usage are likely to remain limited outside of China.
What are the risks of adopting CBDCs?
The introduction of CBDCs in major economies will be a slow, carefully regulated process. There are major risks associated with CBDCs, particularly in terms of cybersecurity, privacy and maintaining the integrity and stability of the banking system.
Having seen the cybersecurity problems that cryptocurrencies have been plagued by, central banks are understandably nervous about the cyber attacks that will undoubtedly accompany CDBCs. A crucial feature of national digital currencies is that they must always be available and central banks cannot risk having the network brought to a halt or, worse, having digital coins stolen or unfairly created. Governments must accept that CBDCs will come with many costs but a large one is going to be the constant investment in securing the system.
Secondly, there are significant concerns over digital privacy. Everybody from regulators to phone companies are focused on data protection and privacy after a series of scandals and consumers want to be sure of their digital presence. CBDCs pose both a risk and an opportunity in this sense. The opportunity is that CBDCs are less associative than bank accounts with many trials requiring only a phone number to open an e-wallet, therefore allowing for a certain degree of privacy from banks. Consumers have greater access to currency and can transact more easily, a particular advantage for the unbanked. On the other hand, government control of the currency and the logging of all transactions in a central database provides a chance for government control and surveillance of individuals and their financial activities. This is a particular concern in China where real-time transaction tracking and privacy intrusion justified by “anti-terrorism” has stoked fears of Beijing exercising undue control. Nonetheless, the increased role of government in consumer finance is likely to provoke unease over CBDCs around the world.
Further challenges involve the status of the banking and financial system. Current economic management and monetary policy is based on an economy with physical currency held through the banking system. The introduction of CBDCs, particularly interest-bearing ones, would have significant effects on everything from interest rate transmission to bond markets to exchange rates and trade finance. There is a substantial risk of excessive disintermediation where bank deposits are converted to CBDC, a process which reduces a commercial bank’s balance sheet.
This balance sheet reduction could happen quickly in large quantities at any time and could drive up loan costs and credit markets at best while potentially endangering a bank’s existence at worst. There is also a risk of bank runs as the frictions caused by withdrawing physical cash would be avoided and customers could retrieve their funds instantly. Many physical limitations that prevent customers endangering the banking system would be removed by the introduction of CBDCs.
