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What Are Central Bank Digital Currencies? Arminius Capital 18 June 2021
INTRODUCTION We've all heard of digital currencies like Bitcoin, Dogecoin, and other cryptocurrencies. What most people haven't noticed is that the world's central banks are planning to issue their own digital currencies. In fact, China has already been trialling digital renminbi on its unsuspecting citizens. What will central bank digital currencies (CBDCs) mean for banks, payment systems, and national economies? CBDCs differ from other cashless payment instruments such as credit transfers, direct debit, stablecoins, or cryptocurrencies, because they are "government money", being direct liabilities of the central banks. Issuing this "extra currency" involves costs, but CBDCs also allow central banks to see real-time transactions, create audit trails, monitor criminal activities, and prevent money laundering. Central banks had been quietly pondering CBDCs for several years, but most of them kept their ideas under wraps for fear of confusing their political masters. The world's parliaments are largely composed of middle-aged white men who know less about online phenomena than their teenage kids do. Until two years ago, talking about CBDCs would simply confuse the politicians. The turning point came in June 2019 when Facebook unveiled its plan for a global digital currency called "Libra" (as in the tampon). Libra was to be a blockchain-based currency operating under Swiss regulation, which could be used in any country and also for money transfers between countries. In order to avoid the wild fluctuations in value which we have seen in Bitcoin and other crypto-currencies, Libra was to be a "stablecoin", which meant that its value was to be based on a fund of actual currencies and US government bonds. Unfortunately or not, Facebook completely screwed up the launch of Libra. Management was not prepared for the regulatory requirements, even for such basic issues as talking to the Swiss regulator (that speaks 4 languages, in addition to English), incorporating privacy protections, and complying with anti-money-laundering rules. More importantly, the company was totally deluded about its reputation in the eyes of US politicians and the US public. Questioning by US congressmen was mostly very hostile, making it abundantly clear that Facebook was neither liked nor trusted. No, really. Politicians in other countries expressed similar criticisms of Libra and Facebook. In response, the company announced in September 2019 that it would not launch Libra anywhere in the world until it had gained approval from US regulators. This public relations disaster saw the departure of some of Facebook's key partners, extensive re-design of Libra (including basing it on the US dollar alone), the renaming of Libra as "Diem", and the indefinite deferral of any launch. For central banks, however, it now became possible - even desirable! - for them to talk about their plans for digital currencies. A new sense of urgency also came from the Chinese central bank's announcement in October 2019 that it had been developing a digital renminbi since 2014, and would start public trials in April 2020.
TRIALLING CHINA'S DIGITAL RENMINBI China's central bank has not yet finalized the design of its digital renminbi, which is also known as the e-CNY (for electronic Chinese yuan) or DCEP (for Digital Currency and Electronic Payment). DCEP is intended to simplify retail and wholesale digital transactions and inter-bank settlements, with the added aim of reducing money laundering, gambling, corruption, and terrorism financing. The DCEP technology will allow users to transfer money by touching each other's phones, regardless of whether they are connected to the internet. But the DCEP will operate entirely through the banking system - Chinese individuals and companies will not have accounts at the central bank. DCEP will certainly not undermine the Chinese banking system. The four biggest banks, with about 40% market share, are not only State-owned but also play essential roles in the Chinese government's fiscal and monetary policy mechanisms. DCEP will employ encryption which will allow users to carry out transactions without identifying themselves to merchants. The Chinese authorities may also choose to pay some salaries or benefits in DCEP, and they may require some taxes to be paid in DCEP. According to the central bank, DCEP is not intended to replace cash completely, or to supersede the two privately-owned digital payments systems, Alipay and WeChat Pay, which are used by more than 90% of China's population. The two systems are operated by the tech giants Alibaba and Tencent respectively. These systems are able to collect detailed data on all users and their transactions, then to analyse this data in order to market other products to them. Although the central bank has said that DCEP will not replace Alipay and WeChatPay, the owners of these two payment systems know very well that they are being targeted. China's financial regulators have spent the last three years bringing both payments systems very firmly under government control in terms of settling, reporting, and reserving. In 2021 the regulators forced the parent companies to become fully regulated financial holding companies, which meant that they had to clean up their activities, and also to divest a number of lucrative peripheral businesses which they had started in recent years. In addition, Alibaba and Tencent have "given" DCEP access to the details of their hundreds of millions of users. China's tech giants will do exactly what the Party tells them to do, and they WILL do so with visible enthusiasm (cue the enthusiasm, please). The Chinese central bank will be able to see and record all account balances and all transactions for every DCEP unit, and the resulting economy-wide picture will give it a fine-grained, real-time view of macro and micro trends. It will, however, apply the principle of "controllable anonymity" to sharing this information. Participating banks and merchants will only be able to see transactions in which they are involved, and they will not be permitted to retain their part of the transaction data for any longer than needed. The DCEP will eventually be used for cross-border payments, once all the kinks have been ironed out of its domestic operations. For example, it is not yet clear how overseas DCEP users could make purchases in China, or what DCEP access would be given to foreigners visiting China. (See Chorzempa 2021.) But China's central bankers have been at pains to stress that, although DCEP may eventually facilitate the internationalization of the renminbi, it is not intended to compete with the US dollar as a means of international transactions or a global reserve currency. These functions depend on long-term factors such as capital export controls, trade volumes, available swap lines, user preferences, and relative volatility, which are mostly outside government control. (See Zhou 2021.)
THE FIRST CBDC IS ALREADY UP AND RUNNING The Bahamas launched its Sand Dollar on 20 October 2020 after ten months of trials. The new digital currency is not a stablecoin or a cryptocurrency. It is issued as a liability of the Central Bank of the Bahamas, equivalent to the existing paper currency and backed by the same reserves as the paper currency. It is open to wholesale and retail use by all banks, merchants, and payments providers operating in the Bahamas, although prohibited from acceptance by non-domestic payees. The transactions trail is fully auditable and will be monitored for fraud prevention and criminal activities, but user confidentiality will be preserved by strict regulatory standards. Holdings of Sand Dollars by individuals, businesses, and non-supervised financial institutions are subject to size restrictions, so that the Sand Dollar does not operate as a close substitute for traditional bank deposits. Circuit breakers will be used to prevent systemic failures or bank runs. (See Central Bank of the Bahamas 2019.) The Bahamas is over-endowed with banks, but most of them do not cater to the local population of 389,000, who are scattered across more than 700 islands. GDP per head is USD$27,000 (about half of Australia's), with a sharp division between rich and poor. The Sand Dollar is intended to:
The Sand Dollar could be described as cash without the anonymity. Its use is also subject to some restrictions which are intended to reduce systemic risk and protect financial stability. Its economic function is similar to the effect which the spread of mobile phones had in many under-developed countries, where they improved national connectivity quickly and cheaply by skipping the traditional step of building a landline network.
POLICY CONSIDERATIONS For the next few years, CBDCs will be in the design and testing stage. Their parent central banks know that they enjoy the crucial advantage of total security, because a central bank can't go broke, whereas any privately-owned bank may default at any time. (Remember how the GFC took down Lehman, Bear Stearns, Wachovia, ABN Amro, Royal Bank of Scotland, Northern Rock, and many more banks?). But, in order to achieve broad acceptance, CBDCs also need to be cheaper or faster or more efficient or more private or more convenient than the alternatives. (See Brainard 2020.) CBDCs also bring new risks for financial stability. For example, they may be so attractive that they begin to replace bank deposits, thereby depriving banks of a vital source of funds. They may crowd out cash in retail transactions, and thereby limit the choices of the poor, rural, and elderly, as has been happening in China. Because CBDCs can be moved from account to account almost instantaneously, they could trigger a run on a bank, or even a run on the currency. Thanks to Facebook's PR disaster, many governments are now legitimately worried that their money supply and payments system - as well as their citizens' personal data - may one day fall under the control of some foreign technology company. (See Panetta 2021.) Two weeks ago, Fed Governor Lael Brainard set out some of the major policy considerations which need to be taken into account when designing a CBDC:
No matter how a CBDC is designed, it will have to be written into a country's legislation regarding the central bank, legal tender, and the banking system. This task will be neither quick nor easy. What regulators will not do is to give legal tender status to unregulated stablecoins or crypto-currencies, because if these become legal tender, they may be hoarded or suddenly transferred, which would make it possible for financial stability risk to be concentrated in issuers or holders whose operations, cash flows, and balance sheets are not visible to the authorities. That means the regulators might have to deal with "a run on the bank" when it didn't even know there was a bank, let alone that it was in trouble. (See Brainard 2021.)
DESIGN FEATURES OF CBDCS China's DCEP and the Bahamas' Sand Dollar are not the only ways to run a CBDC. For example, both are designed as an account-based, centralized ledger with total visibility for the purpose of preventing money-laundering and other crimes. A CBDC could also be designed as a token-based, anonymous transaction tool, offering the same level of privacy as cash. (See Bache 2021.) To Chinese policymakers, a CBDC is a means of resisting the dominance of the two tech giants Alibaba and Tencent in the payments system. CBDCs may be retail (for everyone) or wholesale (big users only). A retail CBDC may operate through the banking system, like China's, or it may interface directly with consumers and companies, allowing them to own accounts at the central bank. A wholesale CBDC would be restricted to wholesale users (such as banks) who will use them for inter-bank transfers of large sums, or for their reserve accounts at the central bank. (See Estenssoro 2021.) A CBDC may be subject to complete centralized control, like China's, or it may be run as a distributed ledger ("blockchain"), perhaps with partial oversight and selective permissioning in order to restrict its use for illegal activities. No central bank is likely to issue a CBDC which is purely based on a distributed ledger (blockchain), because this would lack the essential functions of transparency and control. Would a CBDC pay interest to its holders? Of course, cash does not pay interest, but there may be reasons why a retail CBDC would do so. A CBDC which paid negative interest (i.e. its value decreased the longer it was owned) would contain a powerful incentive to be spent sooner rather than later. For a wholesale CBDC, however, the issuing central bank might pay variable rates of interest when it wished to incentivize banks to hold CBDC deposits or reserves rather in alternative forms. It is unlikely that CBDCs will be used for cross-border transactions in the near future, because of the legal and administrative difficulties. Any cross-border CBDC would have to meet the regulatory obligations of every jurisdiction where it was used. Because these obligations can differ widely from country to country, the regulatory burden would be considerable. The same goes for the administrative requirements of each country's payment systems. Any cross-border CBDC would have to interface perfectly with payment systems on both sides. There are two forms of cross-border CBDC which might be adopted relatively early. The first is a CBDC which was restricted to central banks only: it might be adopted by a small group of countries, with its acceptance widening over time. The second is what Facebook still hopes to do with Libra/Diem: a CBDC which handles small-value international transfers such as the remittances of migrant workers. Such a CBDC would need regulatory approval of the sending and receiving countries, but it could be hedged around with restrictions to prevent domestic use, money laundering, and criminal activities. This "remittance CBDC" would fill a market gap, because current global payments systems charge 5% to 7% commission on small remittances.
HOW FAR BEHIND ARE OTHER CENTRAL BANKS? At present, more than fifty central banks are researching the costs and benefits associated with issuing their own CBDCs. (See Boar and Wehrli 2021.) Few of them have made their research public, but the European Central Bank (ECB) set out its ideas in detail last year. (See ECB 2020.) The ECB described seven scenarios under which a digital Euro (e-euro) would be worth creating:
The ECB's retail euro would be legal tender, operating through banks and other authorised intermediaries. Protecting privacy would be important, subject to the trade-off against identifying money laundering, tax evasion, and other criminal activities. The amounts which individuals and businesses could hold in their accounts would be limited in size. Initially at least, the e-euro would be restricted to EU residents, with the possibility of short-term exemptions and later expansion. The ECB does leave open the possibility of allowing "bearer e-euros" which would not require the usual identification by users. It also considers the possibility of issuing two types of e-euro: one would be used for basic transactions, offline as well as online, while the other would function as a policy instrument carrying a variable (and potentially negative) interest rate.
WHAT WILL HAPPEN WHEN THE RESERVE BANK OF AUSTRALIA CREATES ITS OWN CBDC? Last year the Reserve Bank of Australia ("RBA") published a short paper outlining the issues associated with a CBDC. (See Richards 2020 and Richards et al. 2020.) The paper concluded that CBDCs were a solution for problems that did not exist in Australia. We already have financial inclusivity, in that almost all Australians have transaction accounts and the means to execute online transactions via mobile phones, credit cards, etc. The current payments system is efficient, relatively cheap, and open to new players. The other policy considerations listed by The US Federal Reserve's Governor Brainard are not material issues in Australia. So Australia's big four banks need not worry about CBDCs in the next few years. The RBA indicated that it would continue to monitor developments in the global CBDC space, and that it would not hesitate to introduce a CBDC if there were compelling reasons. The RBA paper did discuss some of the design choices for an Australian CBDC. Preliminary indications are:
CONCLUSION The digitization of money has only just begun. It will take at least five years before we will have realistic assessments of what works and what doesn't. The design choices which central banks make in their digital currencies will eventually affect all the players in the financial system. Arminius Capital will provide regular updates on significant developments. REFERENCES Bache, Ida Wolden. 2021. Fintech, Big Tech, and Cryptos - will new technology render banks obsolete? Oslo: Norges Bank. Speech 11 May 2021. Boar, Condruta and Wehrli, Andreas. 2021. Ready, steady, go? - Results of the third BIS survey on central bank digital currency. Basel: Bank for International Settlements. BIS Paper 114. Brainard, Lael. 2021. Private Money and Central Bank Money as Payments Go Digital: an Update on CBDCs. Washington DC: US Federal Reserve. Speech 24 May 2021. Brainard, Lael. 2020. The Digitalization of Payments and Currency: Some Issues for Consideration. Washington DC: US Federal Reserve. Speech 05 Feb 2020. Brunnermeier, Markus K., James, Harold, and Landau, Jean-Pierre. 2021. The Digitalization of Money. Basel: Bank for International Settlements. BIS Working Paper 941. Central Bank of the Bahamas. 2019. Project Sand Dollar: A Bahamas Payments System Modernization Initiative. Nassau: Central Bank of the Bahamas. Chorzempa, Martin. 2021. Testimony to US-China Economic and Security Review Commission. Panel 4: China's Pursuit of Leadership in Digital Currency. Washington DC: Peter G. Peterson Institute of International Economics. Estenssoro, Amalia. 2021. Central Bank Digital Currencies: Back to the Future. St Louis: Federal Reserve Bank of St Louis. European Central Bank. 2020. Report on a Digital Euro. Frankfurt: European Central Bank. Panetta, Fabio. 2021. Evolution or revolution: the impact of a digital Euro on the financial system. Frankfurt: European Central Bank. Speech 10 February 2021. Richards, Tony. 2020. Retail Central Bank Digital Currency: Design Considerations, Rationales, and Implications. Sydney: Reserve Bank of Australia. Speech 14 October 2020. Richards, Tony, et al. 2020. "Retail Central Bank Digital Currency: Design Considerations, Rationales, and Implications." Reserve Bank Bulletin, September 2020. Sydney: Reserve Bank of Australia. Zhou, Xiaochuan. 2021. The Digital Currency and Electronic Payment System. Beijing: Tsinghua PBSCF Global Finance Forum. Speech 22 May 2021.
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