Central bank digital currencies: 10 questions

Central banks have been examining the need to provide a digital means of payment for a long time. The People’s Bank of China (PBoC) started its research in 2014 and Sweden’s Riksbank in 2016, and broader discussion of the topic has built momentum slowly since then. However, the past year or so has witnessed a sea-change in the way that many of the world’s biggest central banks view CBDCs, driven by the rise of private alternatives (cryptocurrencies and stablecoins) and the rapid decline in the usage of cash payments, a trend accelerated by the global pandemic.

The underlying reasoning has varied by central bank. The most recent survey by the Bank for International Settlements (BIS), from January 2021, showed that while some central banks have been thinking about CBDCs to ensure financial stability, many (particularly in the emerging world) have been investigating the benefits of raising financial inclusion. As Figure 3.1 demonstrates, improved payments efficiency or monetary policy tools have also been given as reasons by some central banks.

For households, using a CBDC may not involve any material changes in the way payments are done, but the improved security that can come with a more robust payments system should be a good reason to want to use them. However, this benefit (as well as lower costs of payments) may need to be communicated to encourage consumers to use this new means of payment instead of their existing alternatives.

Central bank digital currencies have often been confused with cryptocurrencies, as both are new means of digital payment. In practice, that is where the similarities end. Figure 3.2 shows the difference between key payment methods – and while a cryptocurrency is a highly volatile instrument that does not function well as a means of payment (given the high transaction costs as well as the volatility), a CBDC should provide a stable, highly efficient means of payment. A CBDC is more akin to a central bank-backed stablecoin (a token with a fixed value) than a cryptocurrency.

Some of the confusion comes from the technology used. While a cryptocurrency uses blockchain technology (a type of distributed ledger technology, DLT), a CBDC doesn’t need to do so. Although most of the pilots across the world today use blockchain technology in one shape or form, it is not a necessary requirement for a CBDC since more traditional technology may suffice.

That distinction is important when thinking about some of the environmental concerns given the widely publicised energy costs associated with blockchain technology.¹¹ Katie Martin and Billy Nauman, “Bitcoin’s Growing Energy Problem: ‘It’s a Dirty Currency’,” Financial Times (May 20, 2021). The idea of central banks (who are putting more emphasis on green issues) using an energy-sapping technology may seem odd, but even if a blockchain were to be used, it may not be decentralised to the same degree as a private cryptocurrency (or use a mining process), making it far less energy-intensive.

A handful of CBDCs have already become available in the world. The first was the Bahamian sand dollar, a project launched in October 2020 that allows users to access the CBDC from a mobile app or a card, and which can be used at participating retailers. The sand dollar can be used widely, although a cap applies to some individual users, such as non-residents. CBDCs have also been introduced by the Central Bank of Nigeria, and the East Caribbean Central Bank has launched DCash, an electronic version of the Eastern Caribbean dollar. However, while these projects are interesting, the interest across the rest of the world remains relatively small.

The timeframes vary greatly. At the time of writing, China’s e-yuan is in a public trial phase, while Sweden’s Riksbank is in the second stage of its pilot. Progress has generally been faster in the emerging world. In Brazil, for instance, the central bank has said it expects the adoption of a digital real to be achieved in two or three years, while the Reserve Bank of India has stated it plans to issue a CBDC in the coming fiscal year, although the design of the CBDC is still to be decided upon.

Uruguay and Ecuador ran earlier pilots and are currently evaluating whether to move towards more widespread issuance. The Bank of Jamaica has successfully run a pilot and plans to release its CBDC in 2022, while in Ukraine additional pilots are scheduled to take place later this year.

In Asia, much work has gone into cross-border CBDCs and wholesale CBDCs, with partnerships between the central banks in Hong Kong, Singapore and Thailand.

In the developed world, where the top priority is “to do no harm”, progress has been slower and it is likely to stay that way, as central banks there prefer to err on the side of caution. The ECB’s report on its potential digital euro suggested that if the project was given the go-ahead, it would likely take another two or three years to develop, test and eventually roll out. Although this means a digital euro is unlikely before 2025, this could still put the ECB significantly ahead of many of its G10 peers. Nonetheless, the joint report from seven major central banks and the BIS from October 2020²² BIS, “Central Bank Digital Currencies: Foundational Principles and Core Features” (October 9, 2020). highlighted that “authorities[…] need to be confident that issuance would not compromise monetary or financial stability, and that a CBDC could coexist with and complement existing forms of money, promoting innovation and efficiency.” As a result, progress in the developed world has been slower, but more central banks have been continually exploring their introduction.

Central banks engaged in pilots and research are now faced with numerous important decisions. Some of these centre on the design of a CBDC from a technical perspective – what underlying technology to use, whether a CBDC should be “direct” (where the relationship of users is with the central bank) or “indirect” (where the CBDC is distributed via the banking system), and whether it should be usable across borders.

Some of the big questions central banks need to resolve include:

Most research seems to suggest that an indirect model will be used, since a direct model carries too many financial stability risks and means that central banks would have to be responsible for onboarding and management of accounts, something they are not easily equipped to do.

Beyond that, there is a question about whether a CBDC should, or will, be interest bearing. To date, pilots seem to be erring towards non-interest bearing CBDCs (which could make a negative interest rates policy almost impossible in practice; the second stage of the Riksbank’s pilot, for instance, has been exploring this in more detail).³³ See Riksbank, “A Solution for the e-Krona Based on Blockchain Technology has been Tested,” press release (April 6, 2021). Other CBDCs, such as China’s e-yuan, will probably not charge or pay interest, at least initially. Hence, it may affect the incentives for using/owning physical cash, which also does not pay interest, but it should have limited immediate implications for bank deposits as well as other remunerating assets.

Privacy concerns have frequently been raised when discussing CBDCs. As the BIS 2021 annual report highlighted, central banks will have to decide how anonymous transactions will be within their CBDC system.

For the ECB, its public consultation found that privacy was one of the top priorities for end users – as citizens prefer privacy over innovation when it comes to what they would like to see from a digital euro (see Figure 3.3).

Essentially, central banks will be faced with a choice, ranging from having almost completely anonymous payments to having an incredible amount of detail on every transaction in the economy. While completely anonymous payments may seem like a good thing for many consumers, they could allow a degree of illicit activity even more easily than cash does today. For central banks, that may not be something they would feel comfortable with.

Equally, although many may not be comfortable with central banks knowing everything they do on a day-to-day basis, that aggregated data could allow central banks and governments to set better policy in real time. A balance will have to be struck, and where different central banks sit on that spectrum will be a choice that will need to be carefully considered.

Therefore, as part of the design process, there is an important question over whether a CBDC should be a token (where the unit is verified) or an account (where the user is verified). The BIS 2021 annual report considered the merits of both options, and suggested that an account-based system would be better, based mainly on its improved properties as a store of value in terms of security, the ability to tier interest rates depending on ownership and the level of anonymity. If a token architecture is chosen, then there is the ability to have anonymous payments – but if an account is chosen, the spectrum is much smaller, as payments have to be verified against a given user, so full anonymity is not possible.

China’s digital currency – known as the “e-yuan” – has made quick progress over the past two years. By the end of 2021, the e-yuan had been tested in over eight million pilot scenarios. A total of 261 million individual wallets have been opened and the transaction amount has reached 88 billion yuan. As recently as mid-2021, there were only 24 million individual and corporate users, and the transaction amount only totalled 34.5 billion yuan.

Over the past year, the PBoC successfully carried out e-yuan pilot tests in a number of cities in mainland China via lotteries and salary payments. The trial operation was expanded from small-scale, closed-loop testing to large-scale, open testing and more. In October 2020, there was a trial in the Luohu district in Shenzhen with 50,000 residents, which was expanded in April 2021 to 500,000. The Beijing Winter Olympics was another major testing ground for the e-yuan, with consumers using it for transportation, dining and accommodation, shopping, tourism, healthcare, telecommunication and entertainment. Foreigners also participated in the pilot test as the Bank of China demonstrated a machine that converts foreign currencies into e-yuan. Users needed to link their passports to the transaction, but did not require a bank account. The total amount of the e-yuan payments in the Beijing National Stadium surpassed that of Visa at the opening ceremony of the Winter Olympics.⁴⁴ Digital yuan transactions beat out Visa at Winter Olympics venue: Report, Coin Telegraph, 10 February 2022.

The cryptocurrency market expanded sharply between March 2020 and May 2021, with the total market capitalisation of the ten largest cryptocurrencies rising nearly ten times (see Figure 3.4). Since then, things have slowed. Perhaps it is unsurprising that cryptocurrency volumes dwarf some emerging market currencies when compared to the FX volume data from the BIS (see Figure 3.5). However, in certain periods cryptocurrency volumes even climbed above $250 billion per day, which exceeded the average daily turnover of some Asian currencies (such as the Hong Kong dollar).¹⁴¹⁴ Triennial Central Bank Survey of Foreign Exchange and Over-the-counter (OTC) Derivatives Markets in 2019, BIS, 8 December 2019. With such vast transactions, it is not difficult to imagine possible spill-over effects of cryptocurrencies into other markets.

Due to the sheer number of cryptocurrencies, it is difficult to account for them all in our comparison with other instruments. Given the large presence of Bitcoin in the cryptocurrency market, however, its volatility can cause a ripple effect to other cryptocurrencies and other instruments. Nevertheless, the relationships between cryptocurrencies and exchange rates are not stable, but are generally weak and inconsistent. One possible reason for this could be the high volatility of cryptocurrencies, which adds a sizeable amount of noise in any analysis.

For a more substantial relationship to develop between cryptocurrencies and FX, the former will probably need to change on a number of fronts, not least via an increase in the level of institutionalisation in cryptocurrencies and deeper market infrastructure. If this happens, we may see evidence of stronger relationships emerging. For now, however, there is little to suggest that these crossovers can be used to make better investment decisions or trade exchange rates based on how cryptocurrencies are performing.

The impact of the launch of CBDCs will largely depend on both the design decisions that are made and how widely used they are. One of the biggest challenges could be to get households and businesses to use CBDCs over other forms of payment, and so the benefits to consumers may have to be outlined to encourage usage. Below, we consider four channels of influence by way of a conclusion.

Payments efficiency: One of the clearest impacts of a CBDC is in improving payments efficiency and cutting payment costs. While many individuals may not notice a huge change in their day-to-day usage of electronic payments, this improved infrastructure could cut transaction costs for businesses – which could be passed on or such costs could be used more effectively. A paper from the Kansas City Fed²¹²¹ Fumiko Hayashi and William R. Keeton, “Measuring the Costs of Retail Payment Methods,” Federal Reserve Bank of Kansas City (2012). has suggested that retail payment costs are estimated to absorb 0.5–0.9% of annual economic output in many countries. This does not just provide an efficiency gain directly, but could unlock those funds to be spent on more productive endeavours by firms, possibly supporting investment or hiring.

Security: CBDCs could allow for more secure payments, as well as removing some of the insolvency and illiquidity risks that come with the widespread usage of private forms of digital money.

Financial inclusion: Cheaper digital payments could encourage more widespread adoption of CBDCs in the emerging world, allowing more people access to digital forms of money and helping to improve financial inclusion and growth. The same could also be true in the developed world, where there are still some people either unbanked or underbanked, and CBDCs could be designed to alleviate the reasons for this.

Programmable money: One impact that has gathered more attention is the ability to have programmable money – ie, funds that can only be used within certain timeframes or for purchasing certain items. This idea has gained prominence during the pandemic due to the nature of stimulus being provided: if direct payments could only be used for food or housing, or were time-sensitive (and thus could not just be added to savings), this could be a very powerful stimulus tool. However, others are more sceptical, believing that such control over what people do with their money could be very harmful and lead to too much state control.

The Bank of England deputy governor Sir Jon Cunliffe gave one example of this, highlighting that a digital pound would allow parents to programme their children’s pocket money so that they are unable to buy sweets,²²²² Eva Szalay, Colby Smith and Thomas Hale, “The End of Privacy? Central Banks Plan to Launch Digital Coins,” Financial Times (June 14, 2021). causing concern among some that this would be too big a step.

However, given that CBDCs will co-exist with cash and other forms of payment for some time to come, these impacts may be more of a slower burn than instantaneous, particularly as usage may start out only in a very limited way.

Reserves: The role of the US dollar as the world’s reserve currency could be impacted if other countries move ahead with their CBDC development and those CBDCs prove to be more attractive than the existing forms of the dollar. As a result, the share of the dollar in international transactions could decline. Therefore, the Fed believes a digital dollar could support the dollar’s global status and with the recent executive order from President Biden for the Treasury Department, the Commerce Department and other key agencies to prepare reports on “the future of money”, progress on that path may have started. For now, the US remains a long way behind some other central banks, but developments will be worth tracking.