Just what exactly is a CBDC (Central Bank Digital Currency)?

You’ve heard of Bitcoin, but what about … Bank of England Coin?

As finance continues to digitise, one of the few things that have stayed the same has been the use of cash. Although many of us use digital tools to manage our finances, cash is still a central part of a country’s financial life. In recent years though, following on from the rise of cryptocurrencies like Bitcoin, central banks have started to plan for and in some cases introduce their own ‘digital currencies’ referred to as a CBDC or Central Bank Digital Currency.

This is the first of two blog posts looking at the introduction of Central Bank Digital Currencies (CBDCs).

What is a CBDC and how does it differ from a cryptocurrency or online tool like Apple Pay?

Currently, central banks typically have two ways they issue currency, both of which are liabilities to them.

Physical currency: This is the issuance of banknotes and coins that we all can use in our day-to-day lives.

Commercial bank digital balances: These are essentially electronic bank accounts held by commercial banks themselves at the central bank. (It’s worth remembering that one of a central bank’s main functions is to effectively provide bank accounts to banks.)

Commercial bank digital balances are important because they are used by banks to fulfil reserve requirements. They are vital for central bank tools such as quantitative easing (QE) and paying interest on reserves.

In this sense, electronic currency already exists; but only for banks. CBDCs would change this by switching our use of physical currency to a new digital currency.

This is different from current tools such as Apple Pay or online banking as those tools use money that is a liability to your respective commercial bank. When you spend £100 on Apple Pay, that is a claim against your balance at your bank.

A CBDC would be a liability to the central bank and therefore could impact the central bank balance sheet. If you spent £100 of CBDC, that would be a claim against the central bank.

At this point, it is key to note a few points about the banking system:

· Loans are assets for banks and deposits are liabilities (money in your account is a claim against the bank)

· Central banks have balance sheets made up of assets and liabilities

· Central bank liabilities (cash and electronic balances) are crucial to the settling of transactions in the economy

Any transactions that we might make will end up as transfers of reserves between our respective commercial banks on the liabilities side of the central bank balance sheet.

CBDCs would be different from cryptocurrencies as they would not be so volatile. Money in the banking system is built on trust in the issuing authority (central bank). Cryptocurrencies in their nature are a decentralised network that can be vulnerable to attack or manipulation which makes them far more volatile. CBDCs would be an alternative to the banknotes in your wallet and would be just as stable as a store of value.


What makes CBDCs interesting?

As with many things, the pandemic has accelerated our move toward financial technology and physical currency has not been exempt. More businesses than ever stopped accepting cash during the pandemic, a wise decision considering that banknotes can hold a live flu virus for up to 17 days. A digital currency would not only eliminate these risks but simply make payments faster and more efficient in an age where most people already use digital currencies.

From a commercial perspective, CBDCs could reduce transaction costs and make payments more reliable. Central banks are looking to pair the introduction of a CBDC with new or existing instant settlement systems that would allow transactions to process faster and enable all parties to send and receive money immediately.

CBDCs also have the ability to become ‘programmable money’ in which certain transactions (such as paying taxes) could occur automatically under certain conditions. This ‘programmable’ nature will allow for greater integration with a range of commercial financial and accounting software to expedite crucial payments and transactions that form the backbone of the economy.

Nonetheless there are concerns over privacy and data breaches as arguably ‘programmable money’ would give more power to large corporations and governments in an age where digital privacy is more valued than ever.

CBDCs are also thought of as a way to promote financial inclusion. Many fear that, although brilliant, private sector currency innovation may exclude those who cannot access the digital world so well. By proposing central banks as custodians of a digital currency, inclusion can be made a priority when building a new payments infrastructure. On the other hand, there are many households that are unbanked but, with the wide prevalence of mobile phones, do have access to the internet. The introduction of a CBDC could help millions of unbanked people around the world have better access to their money and a wider payments network.

The final key benefit of CBDCs is potentially expediting the transmission of monetary policy. As CBDCs would be technically held in central bank accounts, most likely through an indirect account provider, CBDCs could improve the transmission of monetary policy to retail customers and reduce current lags in policy effects. Depending on whether a CBDC would be interest-bearing, there could be sizable impacts when a central bank decides to change rates. More generally, there is likely to be a need for a greater level of reserves to balance the increase in central bank balance sheets as a result of changing demand for CBDCs.

How would a CBDC work?

Although the consideration of CBDCs comes from the rise of blockchain-based currencies. This is not necessarily the only possible system. The most important element of CBDCs is having a digital ledger that is maintained in a transparent manner by the central bank.

Cryptocurrencies such as Bitcoin and Ethereum use a permissionless (public) blockchain, this favours decentralisation but is wholly inappropriate for use in financial systems as it lacks any regulatory function. Regulation is crucial for anti-money laundering purposes and the general prevention of criminal activities occurring on the network.

Currently, central banks are exploring a permissioned blockchain in which the currency is controlled and validated by a single or select number of institutions.

Although this type of system would be successful if initiated by a consortium of central banks, it may not be efficient on a national scale. The path to CBDCs is increasingly looking to be initially based on a simple digital ledger at the central bank.

Once nations have digital currencies and their implementation is effective and reliable, a blockchain based digital currency could be considered with cooperation between central banks globally. For the time being, a simple digital ledger is the most likely way forward.

Nonetheless, blockchain certainly has some key benefits to a CBDC. It has unprecedented transparency, potentially quicker payments and is extremely useful for ‘programmable currency’. Blockchain smart contracts are automatically executing contracts that make transactions when certain conditions are met. This is perhaps the most efficient way of programming money to produce automated transactions such as tax and interest payments.

CBDCs are likely to look different from country to country and will be much harder to implement in some nations than in others. For example, a US dollar CBDC would have significant ramifications for trade, finance and debt issuance and the CBDCs effect on the dollar’s position as the global reserve currency would need serious consideration.

CBDCs are still very much in the developmental stage and progress is likely to remain slow. Nonetheless, there is certainly a place for them in an increasingly digital world once the initial problems have been ironed out. CBDCs will be gradually adopted and it is likely that we will barely notice the decrease in cash in our society.

….Next week we’ll discuss the implementations of CBDCs and their potential risks.


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