Welcome to our series on central bank digital currencies (CBDCs), a topic which is of great interest to us as the technology behind the Tezos network is currently being evaluated for use in the French Central Bank’s CBDC project.
In this series, we will explore the concept of CBDCs, starting with an introductory article in which we explain the motives behind their creation, what is driving their rise across the world, the major challenge of their development and the possible risks associated with them.
The twilight of cash
Over the past decades, the use of cash has steadily decreased. Paper money has standed on the precipice of history, and the global coronavirus pandemic has abruptly kicked it off into its depths. In its place, we are increasingly using digital payments, whether it is through our phones, credit cards or other digital wallets.
Crises spur rapid technological progress, or, as the saying goes, necessity is the mother of innovation. A global transition from paper money to digital for decades has been going on for decades, and that shift has been accelerated by the global pandemic. Although health experts conclude that the risk of virus transmission through bank notes is small, it hasn’t made a dent in the emerging new narrative; paper money equals death.
When the pandemic first hit, banks quickly took notice. The Fed introduced a new protocol, quarantining cash circulated in Europe and Asia for up to 10 days as a precautionary measure. South Korea’s central bank removed all cash from circulation for two weeks or, in some cases, even burned paper money.
The private sector has similarly shifted towards digital payments, discouraging customers from paying in cash. Courier services such as Grubhub, Deliveroo, DoorDash, and Wolt now operate in contactless fashion, no longer accepting cash or discouraging its use.
Money for a digital age
Currently, the role of cash is being increasingly taken over by conventional digital payment systems. Every time you shop online or pay with your card, you are paying with digital money. However, that kind of digital money is backed by your commercial bank, meaning that it is a less secure form of money than cash, which is backed by the issuing central bank. Additionally, paying with your card or online is very much unlike paying in cash in terms of privacy, accessibility and ease-of-use.
What we need is a digital version of cash - a central bank digital currency (CBDC). A currency that is modern, secure, fast, simple and available to everyone, including those who lack access to bank accounts. A digital form of money that is backed by the central bank and distributed fairly and equally to everyone, regardless of their wealth, status.
CBDCs aren’t just some imagined concept of the future, they are already here and are being used by hundreds of millions of people across the world. Several governments, including those of China, Sweden and Canada, have ongoing pilot projects, while dozens of other countries are researching and developing their own CBDCs initiatives.
The reasons behind these initiatives vary from government to government, but the decreasing role of cash is a common theme. And as people increasingly use digital payments, governments want to avoid a situation where virtually all transactions are made via commercial banks, essentially removing central banks from the picture.
Another motive is preparation for an increasingly more digital economy. While internet access and smartphone ownership is becoming a standard throughout the world, access to banking services is still limited in many regions. A CBDC wallet that would only require a smartphone’s NFC chip (or even the RFID in ID cards and passports) could elegantly solve this problem.
CBDCs could also lay the groundwork for a much faster and cheaper system of international payments and remittance. And by being ‘smart’ money that is programmable, they could also be used for implementing monetary policy, sending stimulus packages and other roles useful to both governments and citizens.
Balancing privacy and regulations
Implementing a CBDC successfully will be no easy feat. One of the largest challenges lies within the delicate balance between providing privacy for small payments while subjecting large transactions to regulatory oversight.
If a CBDC is designed to fill the diminishing role of cash money, then privacy must be a central concern for any democratic government that develops it. On the other hand, regulators will want to subject CBDC transactions to anti-money laundering (AML) checks as well as combating the financing of terrorism (CFT), in addition to detecting other illegal activities.
The seeming dichotomy of user privacy and regulatory oversight may find a neat solution in distributed ledger technology (DLT). A distributed ledger can provide the foundation for an all-digital currency that provides pseudonymity-based privacy for smaller transactions while subjecting high value transactions to AML/CFT regulations.
In case of smaller transactions, a user’s identity is handled under a pseudonym and transaction history is hidden from parties other than those of the user and whoever they select.
With larger transactions, all relevant institutions (including the AML authority and the central bank) are privy to the identities and transaction histories of the involved parties.
Transactions have a value limit that is automatically enforced. When this value is reached, the transaction is forwarded to an AML authority that decides what happens next.
Under such a system, large digital payments are subject to AML/CFT regulations while the privacy of users engaging in small value transactions is hidden from other parties, including central banks, intermediaries and merchants.
Consequences and possible risks
As any disruptive technology, the proliferation of CBDCs carries several risks with it and could have negative consequences if not considered during development.
A CBDC must be carefully designed so that it will not disrupt the two-tiered banking system present in most countries. Storing money in a CBDC account could become more attractive than having an account in a commercial bank, as the latter is a less secure form of money compared to the former. This simple fact could lead to widespread bank runs that would severely reduce the reserves of commercial banks and inhibit their ability to provide loans.
On the flip side, if CBDC accounts become too popular, then central banks would also have to take on the responsibilities traditionally assumed by commercial banks - credit risk analysis, know your customer (KYC), AML mechanisms, determining which payments are acceptable and which are not. Central banks would have to massively expand their staff in order to fill these roles, something that is likely not in the interest of any government wishing to preserve its commercial banking industry.
The infrastructure for a CBDC must be designed with the highest degree of security possible. This will be particularly difficult if the CBDC in question will be designed to operate without internet access. A successful attack on a CBDC network would not only incur large financial losses, but it could also destabilize an entire country’s banking system and potentially cause much more than just economic damage.
Finally, as is the case with all major technological advancements, there is a risk that CBDCs will be exploited by governments to control their citizens, infringe upon the individual rights and provide authoritarian regimes with another tool for suppressing political opponents. How we use technology is ultimately dependent on us, and the various CBDCs that will emerge over the ensuing decade will reflect the values of their issuing governments.
We hope you’ve enjoyed reading our introductory blog for CBDCs. Over the ensuing months, we will be returning to this topic, examining it from various angles as we look into the underlying technology, the design, the politics, the security aspects of CBDCs and more. Stay tuned for our coverage of CBDCs, and in the meantime, you can read more about Tezos and the TezEdge node, subscribe to our Medium, follow us on Twitter or visit our GitHub.
References
Auer, Raphael A., Giulio Cornelli, and Jon Frost. Rise of the central bank digital currencies: drivers, approaches and technologies. No. 8655. CESifo Working Paper, 2020.
Bindseil, Ulrich. "Tiered CBDC and the financial system." (2020).
Darbha, Sriram, and Rakesh Arora. Privacy in CBDC technology. No. 2020-9. Bank of Canada, 2020.
Kshetri, Nir, and Nir Kshetri. "The Economics of Central Bank Digital Currency." (2021).
Panetta, Fabio, Cash still king in times of COVID-19, (2021)
Ward, Orla, and Sabrina Rochemont. "Understanding Central Bank Digital Currencies (CBDC)." Institute and Faculty of Actuaries (2019).