Central Bank Digital Currencies (CBDC): A Comprehensive Primer
What are CBDCs and how could they change the way we interact with modern banking infrastructure?
It’s a digital world, Charlie Brown, where cash payments are becoming more obsolete, replaced by electronic transfers from commercial banks.
Yet, with the popularization of cryptocurrencies and other digital currencies, questions have been raised surrounding the future of our payment infrastructure, and what such a future may look like.
In the next stage of payments, I believe adoption of a new Central Bank Digital Currency (CBDC) by the Federal Reserve, would improve and transform existing US banking and payment infrastructure.
Currently, 105 countries, which represent 95 percent of global GDP, are exploring options for a CBDC. This is a massive jump from just May 2020, when 35 countries were exploring this same idea. 25 countries have launched a form of test product for their CBDCs, which include major economic forces such as China and South Korea, with 10 nations having actually implemented a digital currencies in their own economy (Atlantic Council).
Yet, despite all this global interest, there remains much confusion among the average person as to what a CBDC is, how it differs from the electronic deposits held by traditional banks, as well as its relationship with cryptocurrencies.
Throughout the rest of this essay, I will address
What CBDCs are versus Cryptocurrencies and traditional digital deposits
Explore the Benefits and Risks of CBDCs
Speculate how the Federal Reserve could potentially implement this new payment system
Evaluate CBDC’s potential impact on traditional banking infrastructure and monetary policy
How Is a CBDC Different From Bitcoin?
To be clear, a CBDC is not a cryptocurrency, in fact the two fundamentally differ in numerous ways. Yet, it was the boom of cryptocurrencies which heavily inspired the idea for digital currencies.
To explain this, let’s start by looking at Bitcoin. Bitcoin is the original cryptocurrency, which utilized a consensus-based ledger system to create a decentralized system of payments. It is essentially a list of immutable, verified transactions (the blockchain) which relies on numerous parties (miners) governing one another and verifying new transactions to create a list-based, frictionless payment system free from all third-party control. In plain English, it’s a list of ownership verified by a completely decentralized system.
The token/currency of the Bitcoin protocol is a bitcoin, just as a dogecoin would be for Dogecoin, and any other cryptocurrency out there. However, the key is that a cryptocurrency token is not fiat money and can fluctuate wildly with speculation.
The growing popularity and functionality of independent digital payment networks such as Bitcoin challenged the idea of government control over currencies, which has led nations to experiment with the possibility of implementing their own digital currencies. The Federal Reserve grew especially nervous with Facebook’s introduction of “Libra”, as it raised represented a borderless payment network, independent of banks, governed by a private corporation.
In contrast, the value of a CBDC on the CBDC platform is the digital equivalent to a dollar, guaranteed with the full faith and credit of the government, maintained by a central bank.
This, among other things, is the key difference between cryptocurrencies and CBDCs. Yet, the common thread between the two is is the use of a secure digital ledger, which allows transactions to tracked, updated, and verified in real-time.
How Would They Work?
But what specifically is a CBDC and what is its connection to the digital deposits and payments made through commercial banks?
A CBDC would be the digital equivalent of cash, and a direct claim on the Federal Reserve as a government-guaranteed means of payment with zero credit risk.
There would be two components to it, the CBDC itself and the infrastructure built to support it, which would be separate from the traditional cash and bank deposit systems we currently use. Despite this, CBDCs would still be denominated in USD should be considered a complement to traditional cash and deposits, not replacements (Bank of England).
There are two types of CBDCs, each serving different purposes: a wholesale CBDC and a retail CBDC.
A wholesale CBDC would be available only between select financial institutions and would be used to help expedite and automate cross-border transfers. It is important to note that wholesale CBDCs are not the highest priority for the Federal Reserve as they are already working on a separate system, called FedNow, which seeks to expedite payments within the banking system by bringing banks into the Federal Reserve’s banking and payment systems (Brookings). In addition, wholesale CBDCs would be unlikely to influence how the general populations spends money, as it would be kept solely between banks.
A retail CBDC would be a digital currency available for the public and businesses to transact with, as it if were regular cash or deposits in a checking account. They would provide direct claims to the central bank while eliminating the intermediary risk to consumers of an insolvent commercial bank.
For its potential role in shaping the future of consumer payments, the US Federal Reserve is currently researching the use of CBDCs from a retail perspective.
Within retail CBDCs there are two different types to consider as well, account-based versus value/token-based.
An account-based system is analogous to the modern commercial banking system. Each individual/business would have a dedicated account on a ledger which would be monitored by the central bank. Under this system, whether or not a transaction is authorized would depend on verifying the identity of the party making the payment (i.e. entering a password/credentials to identify yourself).
The token/value-based system would be more analogous to cash as it would not rely on the verification of identities. Rather, what would matter is the authenticity of the actual currency/token itself. This system would issue digital currencies which could then be transacted with via a mobile application or pre-loaded card.
When debating which system would work best for a retail CBDC, a value-based CBDC is viewed as being simpler of the two to develop and implement, while a program-based CBDC holds more functionality and scalability at the cost of being far more complex and expensive to develop. A retail CBDC system does not have to exclusively account or value-based, as each forms hold their own benefits and use cases. Value-based CBDCs are stored offline on mobile apps or payment cards, and used via card-readers or other mobile applications as part of every-day spending (similar to how we use credit/debit cards). This would make it ideal for small payments which retaining a high level of anonymity, just as the case is with cash. An account-based system could be used to recreate the services commercial banks offer for our currencies, making it ideal larger, real-time payment, checking, and savings solutions. We will revisit this discussion on a potential working model for CBDCs further on in this essay.
How Could CBDCs Improve Our Current Systems?
It’s understandable the idea of adopting a CBDC as another form of currency may seem daunting at first, but believe it or not, the technology stands to address major problems we face in our current payment system.
The first, and most obvious, would be solving the declining use of cash. Currently, just ~$6T of the ~$40T of the wealth in the world exists in the form of cash (Federal Reserve). Cash has become more and more an inconvenient method of payment as we elect to pay with far more convenient and efficient methods such as with cards or via mobile apps. This is not to mention as well the sanitary concerns regarding cash which arose during the height of COVID-19. A decline in cash would also eliminate so much waste as we would no longer have to concern ourselves with printing, transporting, and verifying physical cash.
As CBDCs would exist on centralized ledger managed by a single entity, it would finally enable real-time, fiat transactions between parties, a major improvement on the delayed payment systems currently used today. It frustrates the public to no end that when one cashes in a check or wire-transfers a certain sum, there is always the few days wait in between where both banks must verify the transaction. It would only increase one’s aggravation if the payment was on a strict time crunch. Replacing this with a single ledger would allow individuals/businesses to make efficient, reliable payments instantly. Not to mention, a ledger system would facilitate cross-border payments as well. With CBDCs is possible for central banks throughout the globe to create an interconnected system where they link their domestic CBDCs to create a faster network of payments.
It would also help to promote financial inclusion, by providing a government-guaranteed financial system to the underbanked. An estimated one out of fifteen American households are unbanked, with one in six being underbanked (relied upon alternative financial services such as check cashing, payday loans, etc.). For these families, they spend approximately 10% of their annual income on financial services fees (Brookings). A chief reason among those who do not have a bank account is that they simply cannot afford one.
A CBDC system where everyone would have access to a free bank account provided by the government and verified by their identities, would do leaps in providing the underbanked a safe haven from the predatory fees associated with the existing institutions they are forced to rely upon.
In addition, a CBDC could increase the speed of aid payments to citizens from the government as well. During the COVID pandemic, “the U.S. government had sent paper coronavirus stimulus checks totaling nearly $1.4 billion to some 1.1 million people who were deceased. Delays were also rife” (Time, Campbell, 2021).
If each citizen were registered with an account at the central bank, the government would be far more efficient in distributing emergency funds to its citizens. In fact, “knowing the months of waiting many people would suffer before receiving their stimulus checks, in March 2020, Congress considered a proposal to issue every American entitled to financial relief a digital wallet” (Time, Campbell, 2021).
Another strong point is that CBDCs would provide an alternative method of storing wealth free of counter-party risk. While the FDIC currently insures balances of up to $250,000 per depositor, per each account in a FDIC-insured bank (FDIC, 2022), this demonstrates the reality that commercial banks are susceptible to insolvency. Under a CBDC system, this insurance guarantee would become unnecessary, as the entirety of your deposits would be held by the institution which guaranteed it.
Considering the recent failure of the stablecoin TerraUSD and Luna, CBDCs provide a more trustworthy payment service alternative. Though I consider it wholly possible certain protocols may offer better banking solutions than CBDCs, they would not be backed by the stability of the US Government.
Lastly, a digital currency would represent “programable money”, which could be designed to automatically perform or inhibit transactions given certain conditions are met. Applying this “programable” functionality to cross border transactions an example, it is possible to program reserves so that, “the transfer of CBDC in one currency is linked with a transfer of CBDC in another currency, in a way that ensures each transfer occurs if — and only if — the other does” (Bank of England). To illustrate another feature of programmable money, it is estimated that during the pandemic, “around $50 billion of taxpayer money was paid to bail out U.S. airlines and prevent huge layoffs. In reality, $45 billion was spent on buying back stock to artificially prop up share prices and the linked bonuses of executives.” (Time, Campbell, 2021). Through digital currencies, not only is it possible to track far more easily where each of these government payments were spent, but also to program the disbursement so that they could only be used for intended purposes, such as the salaries of staff.
What Risks Involved in Transitioning?
On the other side of the room, the main risk surrounding CDBCs are how they would adversely affect our commercial banking systems. Upon introduction, the massive transfer of wealth which could ensue from commercial bank accounts into government-controlled digital currency ledgers could shock the financial system (we will come back to this point when discussing how CBDCs would affect existing financial infrastructure).
A more ideological downside to consider, which may disappoint cryptocurrency enthusiasts, is that CBDCs do not solve the problem of centralization. While certain financial intermediaries would be eliminated, there would still be the singular authority of the Federal Reserve in charge of managing the system, defeating the purpose of a cryptocurrency. As we have seen with the currency debasement as a result of rampant inflation, governments can be very fallible when it comes to monetary policy.
In addition, there are also large privacy concerns surrounding CBDCs as well. Under an account-based system, it is far easier to trace transactions through the digital record, yet this means the government would have immediate access to every financial record of every citizen instantaneously.
How Would This System Be Implemented?
As of now, the Federal Reserve has made no decision on whether to pursue or implement a CBDC, but are exploring their risks and benefits, in addition to how they could improve the current US domestic payments system.
If tomorrow, the Federal Reserve announced it would be adopting CBDCs, what would be a viable way to introduce this system to the general public?
Economists at the Bank of England have proposed a solution referred to as the “platform model”. Under this model, the central bank would provide the core infrastructure (i.e. the central ledger) and allow regulated third party developers to add functionality and overlay customer-facing services on top of this base layer. Basic functions such as deposits and transfers would be managed by the Central Bank, while leaving it up to the market to decide which additional services would be requested. This would help improve innovation in the space by allowing independent parties to introduce their payment solutions, while also freeing the Central Bank from the direct responsibility of interfacing with and managing clients.
This system would be in opposition to a vertically-integrated chain where the central bank would assume total responsibility in developing and maintaining the core platform itself, as well as all services built on top of the platform, i.e. payment authorization, customer service, etc.
To retain the privacy elements of using traditional cash, it also may be comforting the public to supplement this account-based system with a value-based token intended for small offline purchases. This token would carry the convenience and anonymity of using cash, without any of its issues. This dual-structure is similar to the model suggested by the “e-krona” from Sweden, whom believe the addition of this value-based token would “make the e-krona more accessible to groups that are unable or unwilling to have e-krona accounts” (Riksbank, 2017).
How Would This Disrupt Existing Systems?
The heaviest area CBDCs stand to disrupt are undoubtedly commercial banks such as Chase Bank, Wells Fargo, and Bank of America. As CBDCs would only succeed if individuals transferred wealth from commercial banks and into digital currency form, this new system would undermine the role of commercial banks as depository institutions, in a process called “disintermediation”. Not only would also place greater responsibility on central banks as a part of the overall financial system, but disintermediation could have numerous consequences on the economy if managed poorly.
In the case that CBDCs become widely accepted by the general public, this would overall shrink the size of commercial bank balance sheets and may force commercial banks to increase the interest rates on their deposits to retain customers. With the decline in deposits and rise in interest expense, this would increase the cost of funding for banks, which may translate to increased cost of credit for the overall economy, which would drive down lending volume.
As a result, during the introductory phase of CBDCs and during times of crisis, overly large inflows into CBDCs could contribute heavily to financial instability. If CBDCs and the central bank were viewed as a safe-haven asset during times of uncertainty, a widespread move from commercial deposits to CBDCs would equate to a run-on bank.
Despite the scary scenario described above, it is still unclear what the momentum would be in an initial shift into CBDCs by the average consumer. This and the concerns listed above would be determined and resolved by how the Federal Reserve chooses implement remuneration (interest) in their CBDCs as well as the amount and the structure of rates.
An unremunerated CBDC would not differ much from commercial deposits and would likely not cause much incentive for a massive shift towards CBDCs. Yet, a significant monetary precedent it would introduce is the elimination of sub-zero interest rates. Rates on sovereign bonds can fall below zero due to the costs associated with storing that physical cash. With a CBDC, there are no such operational costs associated. When introduced, the zero-rate CBDC would become the immediate alternative to negative yielding bonds, establish a zero-yield as the definitive lower bound for a return on asset (Brookings, 2020).
Accordingly, the rate on a remunerated CBDC would become the equivalent to a “risk-free-rate” for households, as the lowest possible return individuals as willing to accept on their deposits. This would in turn influence the deposit rates offered by commercial banks as well, who would have to adjust rates to remain competitive. By managing the rate of CBDCs, central banks could control the volume leaving commercial deposits, as well as the profitability and cost of capital offered by commercial banks. In addition, the central bank could also control volume entering CBDCs by setting limits on amounts an individual account is able to hold, as well as tiering interest payments to disincentivize higher account balances. This would be ideal in a retail scenario where the central bank intends CBDCs to be used for everyday payments as opposed to a savings vehicle.
So, while the risks of the Federal Reserve adopting a CBDC system into the US Financial System exist, the central bank would also have the tools to mitigate these concerns as well. For this, and the promotion of financial inclusion, shift away from legacy-cash towards a digital age, and the facilitation of financial transactions throughout the US and world, CBDCs are a technology which could prove to benefit society greatly and should face serious consideration for adoption within the US.