Central Bank Digital Currencies: The Future of Money

INTRODUCTION

Money is almost as old as human civilization. All monetary tokens, bank notes for example, are a form of IOU, expressing a social relation between creditor and debtor (Ingham 2004; Dodd 2014). The historical forms which money has taken have varied and the concept itself has been studied across many scientific and philosophical disciplines. The role and allocation of money in the multifarious forms of social, cultural, economic and political organization has always been crucial in influencing the structures and functioning of those organizational and societal forms.

It is broadly accepted, from historical and anthropological studies (Gayer 1937), that fiat money arose by the state issuing credit-tokens which were used by the state to purchase goods and services (including the military means to fight wars) and the state issued those credit-tokens in payment of taxes by citizens. In this manner the state’s public monetary sphere subsumed the existing private credit networks, providing a guaranteed monetary anchor.

Money is not a physical object, but rather a system of recording account settlements denoted in a common notional unit of account. Money is not a commodity, whether it is physical money (cash) or digital money.

Luigi Einaudi (Gayer 1937: 265) indicates the historical evidence:

Books and pamphlets and statutes of the ninth to the eighteenth century are unintelligible if one does not bear in mind the distinction between money of account or imaginary money and effective or coined money. Usually, the money of account was called libra, livre, lira. Men kept accounts, drew instruments of debt, sold and bought goods and securities and property rights in imaginary money, which they never saw. Coins had strange names, they poured into each country from all parts of the world, were gold and silver and half silver dresses, were minted at home or by foreign princes. They made no difference to people who continue to talk and negotiate and keep accounts in libras.

This account indicates the irrelevance of a commodity-based money and the necessity of having a unit of account based monetary system.

The cryptocurrency Bitcoin affords a modern demonstration of the inherent paradox in commodity-based money. It has a strictly controlled chain in supply (via hash-mining) and a maximum limit on creation over time (21 million coins). However, it has failed as a means of payment because of the extreme variability in its price relative to other commodities, including gold, and in its exchange rate with national currencies. The difference between a Bitcoin system and a unit of account settlement system is that the former neither provides a full balance sheet of debits and credits nor, crucially, a clearing system for netting balances. Its distributed ledger system simply records credit transfers, to ensure proof of payment and security, entirely within its closed system. Bitcoin does not have a unit of account monetary system function.

Jan Kregel explains the essence of the national central bank mediated system in providing the full accounting that Bitcoin lacks:

If instead of individual accounts all participants in the system had accounts with a central bookkeeper who would keep track of the debits and credits in number units of account, the overall accounts would always balance, but there would still be individual imbalances that now could be automatically compensated by the central bookkeeper. If the bookkeeper is also the sovereign issuer of libra notes or mints gold libra coins they can arrange for the appropriate debts and credits in terms of notes or coins in the accounts of debtors and creditors. But since these are book entries, the notes and coins need not actually be transferred or even exist. In fact, they could be done away with (or buried in a vault or left under the sea … in this social accounting money of account system, credits balances have value if they can be used to extinguish debts incurred in the production of goods and services.

(Kregel 2021: 13)

The central bookkeeper is, of course, the central bank.

Subsequent historical development led to the existing complex monetary system in a modern capitalist economy. Nonetheless, the creditor–debtor relationship is still at the heart of the economic development structures, allied to the monetary payment and settlement mechanism underlying economic exchange. It is important to recognize that money, in itself, has no intrinsic value. The monetary system serves the ultimate economic purpose of encouraging the deployment of the physical resources of land and human resources to hopefully productive ends.

Hence, underlying the monetary system are three acknowledged and essential functions: (1) as a medium of exchange (accepted payment for goods and services); (2) as a store of value (available future purchasing power); and (3) as a measure of value/a unit of account (against which goods and services are measured and deferred payment of debt is accepted). It is this last function on which the previous two functions rest and that acts as the bedrock of a modern capitalist economy. The state, in the form of a central bank, guarantees the currency that it issues and spends and accepts as payment of taxes, fines, and fees (so-called fiat money), and acts as the nation’s bookkeeper, providing settlement of debts and credits.

Currently, commercial banks create loans to private citizens and companies which the central bank matches with reserves for the banks. Bank accounts are then used to facilitate payments, using this private money guaranteed by the central bank, issued to the regulated banking sector.

The government also has an account with the central bank, which it uses to pay for its expenditure on goods and services, and also uniquely, issues further interest-bearing sovereign debt as required. This debt may be purchased by the private sector, and any surplus is purchased by the central bank. In this manner, providing there is sufficient confidence in the fiat currency as a measure of value, and the probity and stability of the commercial banks is established, the economic and social functionality of the country is maintained.

The central bank provides the anchor for the modern monetary system, with additional support to the private financial system being provided by arrangements, such as prudential financial regulation (including Basel international regulation on banks’ holdings of tiered equity capital) and deposit insurance to protect retail consumers.

Other private forms of money (IOUs) can and do exist, but they are unlikely to be widely accepted, as currently is the case with stablecoins, even though these crypto-assets are linked to the value of a fiat currency, like the US dollar. In guaranteeing a fiat currency, the role of the central bank is crucial, as the financial institution that is a country’s monopoly banknote issuer, manages the domestic money supply, sets interest rates, and acts as the lender of last resort to commercial banks. The central bank also serves as a clearing house for the final settlement of payments – it is the banker’s bank. Many central banks also have supervisory and regulatory powers to ensure the solvency of commercial banks and the wider financial system, for instance, the Bank of England’s Prudential Regulation Authority (PRA).

However, the advent of private digital currencies (so-called cryptocurrencies) may in future threaten the stability of the current monetary system, based on fiat currencies. This potential has awakened central bank interest in issuing a retail digital currency, and in improving the efficacy of cross-border payment via extension of the existing wholesale digital currency system. Retail digital currencies issued directly to individual citizens, either to accompany, or potentially to replace, paper currencies and coinage are being considered by central banks. The decline of the use of cash in developed countries (and some developing countries) has been another motivating factor in considering the introduction of retail digital currencies. As research by the Bank of International Settlements (BIS) – an international forum for monetary policy discussions and facilitating financial transactions for central banks – states:

In jurisdictions where access to cash is in decline, there is a danger that households and businesses will no longer have access to risk-free central bank money. Some central banks consider it an obligation to provide public access and that this access could be crucial for confidence in a currency. A CBDC could act like a ‘digital banknote’ and could fulfil this obligation.

(Chen et al. 2021: 66)

It is unsurprising that, in our increasingly digitalized society, the creation of central bank electronic money issued directly to the general public is being actively considered. The concept of a central bank digital currency (CBDC) was proposed decades ago by Nobel Laureate James Tobin (Auer 2020). However, discussion of CBDCs has increased noticeably since 2016 not least within the central banking fraternity itself and within several national governments. These discussions have been precipitated by the rapid expansion of private digital currencies, especially stablecoins, whose value is linked to fiat currencies, often the US dollar.

Research into the potential of central banks establishing their own retail digital currencies, complementing private retail payment systems, is being actively pursued by around 90 per cent of central banks across the world (Kosse & Mattei 2021). The detailed research involves technical and economic considerations, involving assessment of the implications for national monetary policy and the commercial banking sector. However, adoption of a CBDC will generate a variety of impacts on commercial banks and on the general public.

Retail CBDCs, with a direct relationship between the central bank and the public, would be a major step forward in the increasingly digital economy. The structure of political economy may be significantly altered as a result. The changes will make transparent the key issues concerning credit and money in society – that is the importance of maintaining trust between debtor and creditor, and the key role of central banks in providing citizens’ ultimate trust in the probity and finality of financial payments in national and other wider regional jurisdictions. Any alteration to the current monetary system arrangements will require the maintenance of public confidence.

To date, only four central banks, those of China, Nigeria, the East Caribbean Currency Union, and the Bahamas, have launched and are actively piloting or operating their retail CBDCs. The Swedish Riksbank has pursued a private retail CBDC proof of concept, and many other central banks are working on both retail and wholesale CBDCs, either individually or in collaboration. For developing countries, a major objective of the CBDC is to widen access to banking services, given that few people in developing countries have conventional bank accounts, although many more do have smartphones, which are being used as electronic payment instruments, in addition to payment cards.

For the developed world, the two chief motivations for introducing retail CBDCs are firstly, the need to counter the potential danger to financial stability of unregulated cryptocurrencies and the proliferation of stablecoins, and secondly, the need to adjust to the decline in the use of cash and the increasing use of smartphones for payment, which offers the potential for digital payments innovation by central banks. For China, it has been the fact that 94 per cent of mobile retail payments were accounted for by the commercial payment providers Alipay and Tencent (Engen 2022). Other factors include the high costs to merchants of debit and credit cards, despite technological advances, and the view that commercial banks have been slow to innovate and conservative in their responses to challenges from new private payment service providers.

Digital money does already exist, but its disbursement is restricted to regulated financial institutions, primarily commercial banks, whose customer interface is with these banks’ private money. Retail CBDCs modify this conventional two-tier monetary system by making central bank digital money directly available to the general public, in the same way that cash is a direct claim on the central bank.

The first incarnation of a retail CBDC was launched in Finland in 1992, with the Avant smart card system (Grym 2020). The Revolut prepaid card is a modern, updated digital version of the same idea (Revolut 2020). Interestingly, the Avant card was designated as e-money, and fell within the EU’s e-money Directive, which means electronically, including magnetically, stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions, and which is accepted by a natural or legal person other than the electronic money issuer (Grym 2020: 15). Specifically, there was no credit risk involved, any payment was direct and complete. However, the e-money issued on the card had to be accepted as payment by someone other than the issuer. The lack of this demand was the problem that led to the demise of Avant, although there are some lessons to be learned from the (failed) experiment. Demand for a retail CBDC from the general public, and its acceptability by merchants, will need to be demonstrated. The advantage of CBDCs, as with the Avant card, is the absence of credit risk. Once the digital money stored on the card was spent, it was extinguished.

An attribute of retail CBDCs is the absence of credit risk for payment system participants, as they are a direct claim on the central bank and its balance sheet. A retail CBDC is the digital equivalent of cash – although unlike cash it is not anonymous – provided by the central bank. All other forms of central bank digital money currently in use are private money and represent a claim on an intermediary, such as a commercial bank. When the central bank issues its digital retail money directly to individual citizens and non-financial companies, it will represent a potential revolutionary change.

Turning to wider transnational implications of CBDCs, an increasing number of central banks are exploring the issuance and use of their fiat currencies in digital form – known as wholesale CBDCs – for cross-border financial transfers. This development has been stimulated by concerns for global financial stability at the prospect of unregulated stablecoins being used for cross-border financial transactions. Such a private money development will have uncertain implications for the regional and global financing of trade and other international transactions (commercial and personal). However, on the other hand there is also concern about the impact of the use of CBDCs, such as China’s digital yuan, for this purpose. Chapter 5 sets out the issues raised to date, especially in the United States, relating to the development and extended use of China’s digital yuan (e-CNY) for international trade. Clearly, realizing the full potential of CBDCs in increasing efficiency of cross-border payments will require international collaboration. The technical developments required are already being discussed and tested within the BIS’s m-CBDC Bridge project involving countries including China. Sister projects, Project Dunbar, involving Australia and South Africa, and Project Helvetia involving the Swiss and French central banks are now reporting. The m-CBDC Bridge is a prototyping project and is perhaps the most important of the various regional wholesale CBDC projects, exploring the feasibility of expanding the national real time gross settlement (RTGS) systems in a cross-border, multicurrency environment.

Notwithstanding the uncertainties inherent in the on-going development of central banks’ thinking on the issues, this book will examine the implications of the likely move to both retail and wholesale CBDCs, in the coming decade and beyond. It will focus on three main aspects: first, the nature of the introduction of retail CBDCs, which will have ramifications for monetary systems and the operation of monetary policy, for the operations of the commercial banking sector, and, not least, for its socio-economic impacts on citizens and the overall political economy; second, it will consider the various retail CBDC models and the technological options available for the establishment and operation of CBDCs; and third, it will investigate the international aspects of CBDCs, particularly in terms of the future potential for cross-border trade and financial transactions, involving wholesale CBDCs, including the potential development of large digital currency areas.

The book will examine the motivations of central banks in responding to the technological innovation and business development of new payment-providers, cryptocurrencies and, especially, stablecoins, alongside a detailed exploration of their approaches in the light of the current lack of comprehensive and consistent regulation of crypto-assets and exchanges. The following chapters will explore the current positioning of central banks in considering, researching, developing and implementing CBDCs; survey the contemporary monetary landscape, including the domestic monetary and legal implications of the technical CBDC model options being considered; examine the underlying selection of database technologies available and being considered by central banks; assess the impact of CBDCs on the commercial banking and financial sector and on intra-regional, cross-border trading and the wider international financial system; and, finally, it will consider the political economic impacts of CBDC and the implications for the future of money.

1

RETAIL AND WHOLESALE CBDCS

Central banks are actively involved in the research, development and piloting of retail digital currencies. The factors stimulating this active interest are several: (1) the decreasing use of cash for transaction purposes, especially in developed countries; (2) the increasing use of smartphone utilization in developed countries; (3) the absence, in less developed countries, of wide access to formal banking arrangements combined with the widespread availability of smartphones; (4) the availability of emerging digital information and communications technologies, driving a global digital age; and (5) a potential enhanced ability to target central bank monetary policy directly at individual consumer spending. There is also an urgency for central banks to explore wholesale cross-border CBDCs, given central banks’ desire to maintain international financial stability. These various concerns are seen by central banks, and by governments, as requiring a defence of fiat currencies, the crucial trust-anchor role of central banks, and monetary/financial stability, within monetary jurisdictions (BIS 2021).

Central banks are especially concerned with the problems and risks associated with private international cross-border payments, and the opportunities presented for establishing wholesale CBDCs for cross-border financial transfers. Currently some 92 central banks around the world are participating in the various worldwide projects. For example, an April 2021 stock-take of central bank research and design efforts finds that out of 47 current retail CBDC projects, 11 are in addition exploring or piloting single national currency and multi-currency wholesale CBDCs in cross-border