What Is CBDC and How Banks Can Benefit From It
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With the advancement of digital technology in recent decades, there has been much interest in finding alternatives to conventional money and innovative financial management solutions, ranging from financial service delivery through Neobanks to complete withdrawal from transactions in fiat money. One of the successful efforts to set a viable alternative asset of value was cryptocurrency. On the one hand, cryptocurrencies like Bitcoin and dozens of other stablecoins created on popular blockchain platforms have become a source of considerable investor revenue due to the skyrocketing demand for alternative money. Yet, the rise of crypto raised many issues, with the most significant concern surrounding the lack of central regulation and control over crypto assets.
A new option in the financial industry that seems to offer a less risky alternative to fiat money is the emerging CBDC concept, which stands for Central Bank Digital Currencies. In this article, the experts of the 4IRE team examine the viability of CBDCs as an alternative to regular currencies from the technological standpoint, such as the instruments and models of their launch, the pros and cons of CBDC introduction at the national level, and scenarios of responses that traditional banks can adopt to fit the emerging financial landscape.
What is CBDC?
Traditionally, any national currency comes in the form of cash, which is notes and coins. In the process of economic evolution, money has also become substituted by digital equivalents, meaning that holders of financial resources can submit their money to a bank and conduct mobile payments, peer-to-peer transactions, invoice payments, etc., via their bank accounts. However, such money cannot be called digital currency in the full sense of this word, as users can still come to a bank and cash their assets out.
From this perspective, one may equal traditional cash to a token-based currency, which means that the asset (e.g., a coin or a banknote) holds the standard value assigned to it by the central controller (i.e., the central bank). The situation with CBDCs is different, with no physical equivalents existing for exclusively digital money. The CBDCs are created following the cryptocurrency model, with the only exception of nations’ central banks holding the responsibility for fixing the CBDC exchange rate and controlling the legitimacy of CBDC exchanges.
The expected features of the CBDC system include:
- The CBDC will exist beyond the boundaries of the traditional banking system, functioning as a parallel mechanism to the fiat currency-based economy.
- Any conversion of fiat money to CBDC will suggest the outflow of resources from the conventional banking system.
- CBDC payments will be conducted directly among users, without third-party engagement (thus guaranteeing quicker processing and lower commissions).
Currently, several renounced banks are considering the option of CBDC launch, but one can’t say that the initiative is totally innovative. According to the survey held by the Bank of International Settlements (BIS) in 2021, 86% of central banks worldwide are now exploring the CBDC path. The CBDC projects have been successfully implemented since 2014, with the pioneering research efforts launched in China, Europe, and the UK.
Among the recent CBDC launch cases, one should note the implementation of Sand Dollar by the Central Bank of Bahamas in 2020, fully launched after the 2019 trial. The People’s Bank of China has become the first institution to launch its digital currency and electronic payment system (DCEP) into use in 2019, while the European Central Bank (ECB) confirmed the start of digital Euro development the same year.
The Chinese DCEP system emerged quickly and integrated into the national financial system smoothly through harmonization of DCEP transactions with WeChat Pay, Alipay services, DCEP acceptance in the transportation and food delivery segments, and cooperation with digital banks (WeBank and MyBank).
A recent European CBDC initiative worth mentioning is the e-krona blockchain project successfully launched by the Swedish authorities. The digital dollar project was announced by the US government in 2021, while the Monetary Agency of Singapore has recently confirmed the launch of a multi-currency system for CBDCs upon its successful DLT-based CBDC project launch in 2016.
CBDC vs. Cryptocurrencies
With the large share of modern transactions conducted online via digital wallets and mobile banking, one might find the CBDC concept confusing. Let’s consider its key distinctions from fiat currency and cryptocurrencies to delineate the CBDC’s spot in the modern financial system, both national and international.
Fiat money is physical money issued by the central bank in the form of banknotes.
Digital money is the equivalent of fiat money that a person can exchange with the authorized bank, with the sum of assets not changing.
Crypto money is a distinct type of asset separate from the traditional banking system, with crypto coins available for the exchange for money or other value but not regulated with any central financial authority.
CBDC is a cryptocurrency equivalent of digital and fiat money, having the same technological infrastructure with crypto assets but at the same time backed by the central banking regulator. In this way, CBDC is fundamentally different from cryptocurrencies in terms of the issuer authority as it poses no risks to investors and holders in terms of tremendous volatility and loss of value.
CBDC design considerations
Despite numerous differences between crypto-assets and CBDCs, the latter still share much of the digital infrastructure with blockchain-based coins and tokens. Thus, most central banks embarking on the CBDC projects consider the available technological options from the blockchain industry to base their projects on. Once the CBDC project is planned, its creators need to determine several critical features for CBDC design, including the models, infrastructure, and access options for the concrete CBDC.
The choice of models for the CBDC technical architecture deals with the issue of intermediation, i.e., who will be the primary holder of CBDC funds. Here, two options are possible, with the one-tier option presupposing the CBDC account location with the country’s central bank. A two-tier model presupposes two kinds of intermediation, one of the central banks and the other commercial banks.
Experts praise the one-tier model for its simplicity and high ease of use, as the direct model ousts the need for any intermediaries in the CBDC transaction process. However, following this model is connected with some serious limitations hindering its adoption in real life. First, the additional workload connected with KYC/AML compliance checks, account storage, transaction processing, and audits may become disproportionate for the current infrastructure of central banks. Second, the CBDC users will enjoy privacy in terms of not sharing their details with private banks but will lose privacy concerning the government as the central bank-processed CBDC transactions will be disclosed to the governmental officials. Third, the one-tier model presupposes the transfer of significant financial amounts from the traditional banking system to the CBDC sector, which is also connected with harmful effects on the banking sector. Thus, the one-tier model is currently regarded as less workable than the second option.
The two-tier model’s principles allow CBDC users to hold their digital assets in private banks or non-banking institutions (e.g., FinTech organizations). Under this model, the central bank assumes an obligation to audit the private banking service providers and ensure that the proper amount of CBDC is held on the user accounts. In this way, the central bank is freed from the need to deliver banking services to the population, retaining only the responsibilities of a central regulator and security guarantor.
As it comes with any other financial solution, the issue of user access to funds is one of the critical design considerations surrounding CBDC development. The central banks need to determine an approach to ownership authentication, which, given the specifics of digital cash, can be conducted in two ways – from the perspective of the account owner and that of assets (tokens). The token-based authentication method relates to the confirmation of user access to, and ownership of, specific amounts of CBDC. In this way, the owner that has access to a digital wallet is automatically authorized to conduct transactions with their assets, which guarantees a degree of anonymity similar to that of cryptocurrencies. The account-based method follows the path of traditional money, requiring the conventional confirmation of user identity for access to CBDC.
While the token-based approach is much more promising in terms of financial inclusion, it undermines the KYC/AML regulations related to financial transactions, thus hindering money auditing and opening paths for money laundering and hassle-free financing of criminal activities. The account-based approach is much safer in traditional banking terms, yet it is not consistent with the financial inclusion philosophy behind CBDC. Thus, central banks still need to negotiate the costs and benefits of each approach to make the CBDC projects workable and beneficial for the target population.
Infrastructure & Technology
In terms of CBDC transactions, central banks currently have two options – using their central databases or resorting to the innovative distributed ledger technology (DLT). Using the central database would liken CBDC transactions to those with fiat money. At the same time, the implementation of DLT technology makes CBDC transactions much more flexible and scalable, though coming with certain overhead costs and new technology adoption issues. Overall, the positivity about DLT use is higher, meaning that the innovative currency solutions require the adoption of innovative technology.
Additional issues: Interest and Caps
Central banks across the globe also face the need to make choices regarding the interest-bearing nature and per-citizen caps of CBDCs. The first concern relates to the very nature of CBDC; while fiat currency is not interest-bearing as such, other types of assets could. Thus, if the central bank issues interest-bearing CBDCs, the latter could become strong competitors to fiat money if the interest rates between the two differ substantially. Making a non-interest-bearing CBDC, in its turn, risks diminishing the central bank’s role in the monetary policy and business planning.
Second, the issue of caps is pressing, with current per-citizen caps for the U.S. and EU CBDC projects making CBDCs less competitive as compared to, for instance, the Chinese CBDC without caps. Besides, posing a cap on CBDC ownership would also weaken the CBDC appeal as compared to crypto funds. Thus, given that compliance with caps is pretty hard to manage to date, central banks opt for the non-capped alternative in most cases.
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The motivation behind creating CBDC
With the rise of alternative currencies (e.g., cryptocurrencies, NFTs, tokens of various kinds), central banks face the challenge of maintaining control over the national financial systems. Money is getting more and more digital, with and without the interference of national regulators, so the central banks of many countries have decided to partake in the digital evolution instead of remaining the bystanders and observers thereof.
An additional factor in favor of new CBDC projects is the quick success of Asian CBDC projects, like those launched by the Chinese PBOC and the banking authority of Singapore. With the backing of the central banks of China and Singapore, these CBDCs are more appealing than crypto assets in terms of stability and guarantees. Thus, to prevent the outflow of capital to other countries’ CBDCs, the USA and several European countries have also launched CBDC research and development efforts.
To date, the impact of CBDCs on the national financial systems is perceived as positive and promising, mainly in terms of monetary sovereignty and financial stability preservation. With the booming rise of private payment networks, central financial authorities are losing control of financial flows increasingly concentrated in the parallel monetary systems. Thus, by launching CBDCs, central banks give users a safer and more stable digital currency option that may attract large funds back to the national financial sector.
Finally, the launch of CBDCs is seen as a positive step forward in the innovation of national banking sectors and introducing new digital infrastructures in response to the broader pressures of technological progress.
Benefits of CBDC
As an artifact of financial innovation and greater financial inclusion, the CBDC concept has many benefits.
- CBDCs combine the strengths of fiat money (safety and stability) and cryptocurrencies (privacy and decentralization).
- CBDCs give greater access to cash in countries with large unbanked populations.
- Wholesale payments are likely to get easier and more affordable with CBDCs.
- With CBDCs, electronic benefits payments can become much more efficient and accessible for the needy populations.
- Cross-border payments are likely to get cheaper and more manageable with CBDCs.
- CBDC as digital currency possesses greater resilience than fiat money today.
- CBDCs are a perfect variant for those wishing to explore alternative currencies but skeptical about crypto assets.
Drawbacks of CBDC
Along with the CBDC benefits, some drawbacks and limitations of their launch are still present.
- The CBDC launch inevitably causes an outflow of money from bank deposits to digital cash, thus causing negative effects on the banking sector.
- The anonymous nature of CBDC poses challenges for KYC/AML authorization, thus increasing the risks of CBDC use for illegal operations.
- CBDC launches are still surrounded by data privacy concerns, with all design models having critical privacy flaws.
- CBDC projects often come with the concentration risks, meaning that they may become a real threat to fiat currency at some point in time.
- CBDCs, given their exclusive digital nature, are vulnerable national security objects, with the risk of a hacker attack to destroy the CBDC system being more realistic than any external damage to fiat currency is.
- CBDC, as a central bank’s project, gives extraordinary authority to the issuer.
- CBDCs are still very costly in terms of development and launch because of the high expenditures on the innovative infrastructure.
CBDC impact assessment for banks
So, are CBDCs a threat or an opportunity for traditional banks?
On the one hand, many commercial banks consider CBDCs as a threat to their prosperity because the outflux of finance from the traditional banking system to CBDC is inevitable. CBDC is a cheaper and more efficient medium for transactions and payments, which presupposes its appeal to large populations and increasing competition between banks working with fiat money and CBDC-processing FinTech companies.
On the other hand, CBDCs launched via the two-tier model in some countries represent an additional opportunity for growth and service coverage expansion for private banks. The major determinant of embracing the transition to CBDCs is for banks to innovate their infrastructure, adopt innovative technology, and react to the CBDC launch proactively with cutting-edge payment and settlement systems.
CBDC storage is an issue of financial architecture primarily concerning the authorized exchange of fiat currency for CBDCs. If the national CBDCs are one-tier, only the central bank can issue this currency to users and store it. If the CBDCs are two-tier, the central bank authorizes multiple actors, including commercial banks and FinTech organizations, for the CBDC transactions and storage.
At present, two approaches to acquiring CBDC are considered by most governments planning the CBDC launch – a direct exchange of government bonds for CBDC and direct CBDC purchases for cash. The first method presupposes a more centralized and government-controlled process of CBDC dissemination, while the second one is much more liberal in terms of the population access to the CBDC funds.
The regulatory environment for third-party providers of services involving CBDC is determined within each country depending on the overall financial sector’s regulations and rules. However, under any conditions, the central bank remains the ultimate authority licensing third parties for operations with CBDC, including CBDC storage, exchange, and processing user payments with CBDC.
Methods of preparing for the CBDC introduction vary depending on the CBDC design specifics chosen by each separate central bank. Thus, the launch of interest-bearing CBDCs would force banks to offer better interest rates on conventional deposits to retain clients. A more nuanced relationship between fiat money and CBDC within the state financial system is also expected to pose challenges for liquidity management. However, with proper digital innovation and infrastructural changes, most banks are likely to benefit from CBDC adoption by getting more clients and expanding their outreach to previously unbanked and underbanked populations.