No silver bullet

IFR IMF/World Bank Report 2022
11 min read
David Rothnie

Pilot projects in central bank digital currencies are proceeding at breakneck pace, but the quest for optimal adoption and global standards will be slower to achieve

Along with combating inflation, exploring digital currencies is the most popular pastime of the world’s central banks. At the last count, more than 100 countries are investigating the idea of creating a digital currency backed by their central banks. The most high-profile is China, where the PBoC is piloting e-CNY, a central bank digital currency (CBDC) it hopes will one day dominate digital currency markets in a way the physical yuan has yet to achieve.

For now, China is focusing on domestic use. Since its inception in May 2020, e-CNY has been used in more than 260 transactions for a value of Rmb83bn (US$12bn). Meanwhile, the Hong Kong Monetary Authority has set up mBridge, a programme that also includes the PBoC, the central banks of Thailand and the United Arab Emirates, and the Bank for International Settlements. In the US, the Federal Reserve Bank of Boston is working with the Massachusetts Institute of Technology to develop a programming language.

Last year, the European Central Bank announced it was exploring the possibility of launching a digital euro, firing the starting pistol on a two-year investigation phase. On September 16, the ECB selected Spain’s CaixaBank along with four other institutions to develop technology projects associated with the creation of a European digital currency.

Interest in CBDCs have has intensified in recent years, driven by a proliferation of cryptocurrencies and stablecoins. Innovations such as Libra and Diem, the digital currencies proposed by Facebook, are seen as a recent catalyst, as central banks have become concerned about an increasingly fragmented payments infrastructure dominated by a group of private companies. The attraction of CBDCs to policymakers is that they provide a central bank backstop and alternative to these providers – one of the drivers of e-CNY was the rise of Alipay and WeChat Pay, the dominant payment companies in China.

But, for all of the interest, just a handful of countries, such as the Bahamas, Nigeria and Jamaica, have launched digital currencies. There are concerns about cybersecurity, while the sheer scale of the challenge can be daunting.

“Most central banks are quite early in their research on CBDCs: they’re exploring design, but still far from due diligence," said Jessica Renier, managing director, digital finance at the International Institute of Finance. "A sovereign currency has to operate globally, and it can’t afford to fail – that’s a high bar. Especially when we talk about potentially changing the nature of the world’s reserve currency (in the case of the US dollar) and other major global currencies like the euro, that’s going to require a great deal of diligence and confidence.”

Design of CBDCs is led by policy goals which vary by jurisdiction. “Globally, when we look at the differences between emerging and developed market efforts around CBDCs, it really comes down to infrastructure," said Renier. "What financial systems are already in place and what ones aren’t? What problems are you looking to solve, and do you have better ways of solving them already? Either way, the bottom line is: interoperability has to be a priority.

"Another thing we’re seeing across countries right now is that geopolitical motivations for pursuing digital currencies differ, and differing motivations are driving divergences in the speed of research and development right now."

But some common goals have emerged. Research by the International Monetary Fund into six jurisdictions found that all were developing CBDCs in order to modernise or future-proof their payment systems. One of the most common policy goals was financial inclusion – providing access to financial services to reduce poverty; helping facilitate payments, either domestically or cross-border, and ensuring the efficiency and resilience of those payments and reducing fraud.

Another policy goal of a CBDC is to protect monetary sovereignty in countries where the local currency faces substitution either from foreign currencies or crypto, thereby weakening the central bank’s ability to control monetary policy and fulfil its role as a lender of last resort. The development of a CBDC could also be seen as a way of increasing competition in a country’s payments sector.

Fragmentation fears

Recent geopolitical tensions and the trend towards deglobalisaton have led to even more intense interest in CBDCs. In some cases, central banks are developing them with the intention of being self-sufficient and ensuring their payment system has a national backup.

In others, central banks want to create cross-border payment systems among friendly countries or accelerate the acceptance of privacy and data management standards. If a large enough block of countries implements certain standards, the hope is that the rest of the world will follow.

“As policymakers, we must ensure the development of CBDCs does not lead to a more fragmented world," said Tommaso Mancini-Griffoli, chief of the payments, currencies, and infrastructure division at the IMF. "We must resist little groups of well-connected friends that have few connections outside. There’s a risk that a regional group could create a CBDC that is interoperable between themselves with their own rules and governance standards.”

A fragmented payment system means a fragmented world, something that policymakers are desperate to avoid.

“A promising approach is to work with the international community to offer systems that have clear advantages for countries in improving the speed, cost, reliability and transparency of cross-border payments but that also come with global standards of governance,” said Mancini-Griffoli.

The dreaded disintermediation

Commercial banks are keen to play a central role in the development of CBDCs, as they already face disintermediation from the proliferation of private payments providers. As a CBDC offers a safe store of value and is very liquid, it could be preferred to bank deposits, resulting in a flight of deposits to a CBDC. Central banks are aware of this issue and know their role is not to protect bank profits and business models, but a rapid movement out of bank deposits could leave banks in a vulnerable position.

One fintech expert said: “Banks may adapt to more pressure and more competition over time, but if this happens overnight it will be difficult to deal with. So, central banks have come up with all sorts of gimmicks to limit that, like implementing limits on CBDC wallets or charging fees above a certain threshold.”

The IMF study identified three operating models. The first is a unilateral CBDC in which the central bank carries out all functions in the payments system, from issuing the CBDC to distributing it and interacting with end users. The second entails issuance by the central bank but includes a role for private sector firms to interact with the end user. In the third model, digital currency is issued not by the central bank but by private firms that back the issuance by holding central bank liabilities. Hence, this is not strictly a CBDC and is referred to as a synthetic CBDC or sCBDC.

Token gestures

Renier says that, as intermediaries in any future CBDC system, commercial banks must be involved in development and distribution so that the design choices make it feasible for a CBDC to operate with well-regulated financial institutions.

“That means the business model needs to work for banks to offer wallets or accounts. If the risks outweigh the incentives, you may only attract intermediaries that depend on selling user data. That’s not good for consumers,” she said.

This third model is perhaps of most interest to banks, and an example of this is where commercial banks tokenise their own deposits by effectively digitising them.

"It’s about changing the technology for how you hold and transfer deposits," said Mancini-Griffoli. "Instead of settling through a potentially complex clearing house, you would use a blockchain. It would enable people to trade peer-to-peer with others who don’t perhaps have a bank account but an electronic wallet. This is not e-banking on steroids, it’s a new way of conceiving deposits.”

There is also an alternative vision developing to what a CBDC could be. In this scenario, a CBDC is not an asset users carry in their wallet but a platform. It would offer a settlement engine and a programming language and some basic functionality, but then the private sector uses that platform to develop payment instruments themselves that are interoperable and safe, and yet tailored to end-user needs.

In this system, rather than commercial banks developing their own blockchain for tokenising deposits which would lead to interoperability programmes, commercial banks would design those products on a common platform provided by a central bank.

Limited uptake

So far, uptake of CBDCs has been relatively limited, partly by design. Mancini-Griffoli says central banks have not wanted to create a product and market it too aggressively to limit disintermediation.

But, he said: “Some adoption seems necessary to ensure CBDC helps discipline the market for payments and is a viable fall-back option. But managing adoption is tricky. It takes time for a new product to be adopted, and central banks are considering their options on how to inform the public and distribute CBDCs. This is one of the lessons that has been learned. Just building a CBDC and putting it out there doesn’t mean it will be used."

In countries with bigger pilots, such as China, there are very clear limits on the amount that can be held, while in others, fees are payable once CBDC balances rise above a certain amount. In the Bahamas too, any CBDCs held above a limit get swept into a bank account at the end of the day.

Renier observes that in the US the Biden administration recently verbalised policy goals. “In other words, it created executive urgency to explore design," she said.

"How design could evolve is still unknown, but it must evolve in close coordination with the banking system: central banks need to work closely with the banks to understand the real impact on their ability to lend, and to test the actual operation of a potential CBDC.”

For all the frenzied interest around CBDCs, the devil remains in the detail.

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