Inching towards the Central Bank Digital Currencies (#24)

Also: third BIS survey, plans for offline payments, and other CBDC Developments

Feb 14, 2021

The world has had its fair share of crazy in the last few months. Reality-defying equity rallies, meme-stocks, dramatic elections, billions in institutional bets on bitcoin. And the list is long. These are unusual events and their occurrence within a few months was highly unlikely. There is another, more lasting, change that has gained pace behind the scenes.

I refer to the development of Central Bank Digital Currencies (CBDCs) here. I wrote on the topic four months back and was fascinated by the pace at which central banks were moving towards CBDCs.

But this is the decade of 20s. Four months is a long time here. So, let me highlight a few critical developments on the topic since October.

The Central bank of Bahamas did a nationwide roll-out of Sand Dollar (website) digital currency, positioning it as an alternative to cash / Bahamian Dollar (B$)
Reserve Bank of Australia announced a wholesale CBDC project, built on an Ethereum-based platform
Cambodia’s central bank launched Project Bakong, a quasi-CBDC (pre-funded), and became the first Asian central bank to do so, while Turkey is also slowly moving towards the launch
Bank of Russia sounded optimistic about Digital Ruble, seeing it as a means to reduce the dollar dependence, similar to the argument laid for Digital Euro, and lately
Reserve Bank of India rang the bell for a digital currency opportunity, while PayPal can’t wait to distribute CBDCs

I have picked some selective arguments above, but the point remains that multiple influential central banks are confidently moving towards a digital currency system today. I firmly believe that this might be one of the most significant developments of the 20s.

In this article, I deliberate further on the purpose and implementation strategy that we are seeing from central banks. This will mostly reference the third survey by the Bank for International Settlements (BIS), interviews from central bankers, and some of my personal views.

Before, let us revisit the basics.

What are Central Bank Digital Currencies (CBDCs)?

CBDCs are the digital equivalents of the national unit of account (E.g. US Dollar for the United States or INR for India), issued and backed by the central banks
There are two types of CBDCs: retail and wholesale.
- Retail CBDCs are CBDCs for use by households or businesses as a digital equivalent of cash. This sounds similar to the cashless money you hold in digital wallets, cards, banks. However, the key distinction is that CBDCs are a direct claim on a central bank and not a liability of private financial institutions.
- Wholesale CBDCs, instead, are intended for restricted access by financial institutions – particularly to settle large interbank payments or for transactions with the central bank.

But, do Central Banks find CBDCs interesting?

BIS surveyed 65 central banks in the last quarter of 2020 to measure such sentiments. Of those surveyed, a significant 86% are now exploring the benefits and drawbacks of CBDCs. The figure of 65 may sound middling, but these countries (21 advanced and 44 emerging or developing) represent ~72% of the world’s population and 91% of the economic output.

The rise in exploration is of 6 percentage points (from 80% to 86%), with the focus shifting towards retail applications of CBDCs. The number of central banks working only on wholesale CBDCs has instead fallen in number. But the most important metric in the above graph is that ~74% of these banks are now in the experimentation / proof of concept or development / pilot phase of their research, up from ~52%.

Takeaways: banks are showing greater urgency to bring the digital equivalents of cash to people / businesses over the last year. This is likely due to a combination of pandemic revealing the inefficiencies of cash and a fear of missing out against the likes of China that is going all-in with Digital Yuan and the private cryptocurrencies / stablecoins. Similar to an arms race, this would not only empower those within but also signal monetary superiority to the outsiders.

Let us go deeper into the views of central banks from the survey.

What is driving the development of retail CBDCs?

In the emerging economies, financial inclusion has become the top motivator over the last year. This is enforced more due to the hardships faced in transferring cash to people and transacting with it during the pandemic. Bahamas’ Sand Dollar sticks out as an example of CBDC for financial inclusion, highlighted in the report and launched for the 390K population spread out over 30 islands in the country. Not only does it make the Bahamian Dollar distribution easier across islands, but the wallet would also provide a record of income and spending to the people, which can then be used as supporting data for providing them micro-loans.

Financial inclusion is also becoming an increasingly important motive for advanced countries as a means to provide access to central bank money without commercial banks coming in the way.

Next, payments safety and improved efficiency due to digital currencies act as motivators across both emerging and advanced nations. Efficiency would include the ability to provide faster settlements, as payments through digital currency get immediately settled through one wallet to another with real-time payments infra to support. Although payment through cash is also immediate, the costs of maintaining and storing cash can be significant.

Moreover, the government and central bank find more comfort in being able to track digital currencies over cash, which can frustratingly be used for money laundering, counterfeiting, or other illicit ends.

Finally, the survey also highlights the ability to directly reach the (digital) wallets of the public as a strong motivator, especially in emerging economies. This would be particularly beneficial in handling the monetary supply in the economy, where the central bank could monitor the cash usage, distribution in the economy and introduce cash easily through commercial banks to millions in the wallets.

Financial stability and monetary policy are, however, less important motivations for retail CBDCs in advanced countries. Instead, the need to maintain monetary sovereignty in the face of “digital dollarization” and/or the threat of private cryptocurrencies are forcing many to act.

Takeaways: The motivations for developing retail CBDCs remain tightly tied to the local circumstances in the country, incl. the level of payment infrastructure development, monetary policy efficiency, and the degree of financial inclusion. Moreover, combining the safety of central bank money with the convenience of an electronic payment method, CBDCs provide central banks a tool to monitor the money flows and act as safeguards against the emerging private cryptocurrencies and stablecoins. This is important since there is great likelihood that the big tech companies, starting with Facebook’s Diem and even Amazon, will become competitors in this domain.

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Making Digital Currencies a Reality

With more central banks seeing the merit of CBDCs, there is a shift in focus towards moving onto the pilot or implementation phase. For hypothesizing how consumers will access the digital currencies, we have the pilot of Digital Yuan and the roll-out of Sand Dollar as examples. Both have mildly different methods to issue these digital currencies. Let me detail out what their standard framework looks like.

Medium of Use: In the Bahamas, the central bank on-boarded financial institutions and authorised their e-wallets or the central bank sand dollar e-wallet to hold and issue the digital currency. The usage of a mobile phone is not necessary, however, as people are afforded the ability to use a wallet-based card as well. Similarly, in China, Digital Yuan is being piloted on wallets issued and designed by big banks and is building a Wallet Card option that would allow payments akin to any debit / credit card without the need for Wi-fi or mobile connection.

Distribution: For Sand Dollar, the individual / businesses would then download the authorized e-wallet, complete the KYC process (without linking the bank account), and then be able to hold Bahamian dollars up to a certain limit. In contrast, the Digital Yuan is planned to be adopted through a two-tiered system, wherein commercial banks distribute the digital currency to users and they then must deposit the same amount of reserves with the PBoC as the Digital Yuan they distribute. On the front-end, both are expected to work similarly. Important to note that unless the fintech companies such as Alipay, PayPal become a part of the distribution, a nationwide rollout of the CBDC wallets poses a threat to the wallets of private fintech companies. This is perhaps why PayPal wants to be on the distribution side of CBDCs since the central banking would make the user acquisition easier – similar to how the stimulus distribution during the pandemic has aided certain applications.

Mode of Payment: QR codes and wallet-based cardsare preferred online and offline modes of payments, respectively, for both Sand Dollar and Digital Yuan. Besides, the Sand Dollar can also be transferred by simply entering a custom name of the recipient. To simplify, custom names are similar to social media usernames in that everyone would have a unique name, which should be entered carefully inside the application to avoid wrong transfers.

The earlier mention of digital wallets raises one underlying issue that is key to solving for financial inclusion: offline wallet payments. This implies transfers of digital cash from one wallet to another without the use of the internet. This is particularly crucial for economies with limited internet availability, and this consumer segment likely overlaps with the population excluded from any financial services.

We are seeing offline solutions being built around Near-Field Communication (NFC) or Bluetooth technology with the card or wallet as the medium of payment. One such is suggested by Visa, which released a technical paper in December that highlighted an approach for offline point-to-point transfer between two devices. The offline payment system (OPS) protocol ideated in the paper would allow digital money to be directly downloaded onto the device, and stored on secure hardware inside the device. The hardware would be authorized by a wallet provider (e.g. a bank), and CBDCs can then be transacted offline across devices using Bluetooth or NFC.

In India, likewise, as the talks of a digital currency move forward, there are already startups working under the guidance of the central bank to bridge the offline payments gap for the underserved.

Questions also remain on how people would be convinced to convert their cash holdings into digital cash, which can be a logistical nightmare. Moreover, it remains crucial to get the buy-in of the public to use digital cash instead of physical, especially where there are alternatives such as A2A transfers allowing people to earn interest rates on their holdings. And where businesses and households rely entirely on cash for day-to-day expenditure.

Final few words

Digital cash has the potential to marginalise the borders between people, businesses, and banks by making settlements cheaper, safer, traceable, and instant. And the survey estimates that roughly 1/5th of the world’s population would be exposed to a digital currency within three years.

As the benefits are better understood and certain standard protocols tested, expect more central banks to issue digital currencies to give way to a more controlled central bank money system. The competition for alternate modes of digital currencies will likely heighten up as stablecoins, such as Facebook’s Diem, and private cryptocurrencies become medium of exchange. In such cases, getting the right banks and stakeholders on board for ensuring the public buy-in will be crucial for those planning a CBDC rollout.

We have seen attempts previously to replace cash with more digital forms of payments, but I believe - in CBDCs - the central banks have found a method with lower friction than other digital forms of payments while maintaining the convenience. Adoption becomes more promising.

Going ahead, CBDCs are likely to become a platform over which more targeted services are built, with direct benefits and subsidies being the most obvious use cases. Moreover, the next ten years will be crucial in deciding the role that CBDCs play in the monetary policy and in including billions in a safer and faster financial system. And with the developments to be, expect to continue hearing a lot more on the CBDCs.

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