How central bank digital currencies will take over the world

This is the year of central bank digital currencies.

Twelve years on from the launch of bitcoin, six years after the launch of Tether – the first stablecoin backed by US dollar reserves – and just eight months since Facebook’s announcement of the Libra cryptocurrency project, central banks are suddenly getting set to launch their own new forms of digital money.

For now, live pilot projects are still mostly restricted to emerging markets such as the Bahamas, the countries of the Eastern Caribbean Currency Union (ECCU) and Cambodia, where central banks are responding to excessive dependence on physical cash that burdens businesses and individuals with high handling costs.

Announcing the test phase of a digital Eastern Caribbean dollar to run over a private permissioned blockchain on IBM’s Hyperledger Fabric last year, Timothy Antoine, governor of the Eastern Caribbean Central Bank, noted that 80% of payments in the ECCU are expedited through cash and cheques. “When we survey our payments landscape, we cannot help but conclude payments are too slow and too expensive.”

This is central bank digital currency at the cutting edge, with the governor asking local banks and credit unions to help test it with small businesses, such as supermarkets and garages, in the hope of lowering charges that can amount to 5% to 15% of their operating costs. These expenses come not just in the form of bank fees and costs of securing and transporting cash but also the manual checking of till receipts against notes and coins.

The digital EC currency (DXDC) test project is not designed to replace physical cash but certainly aims to reduce its use. The ECCB sees the digital currency as part of a broader modernization of the economy and hopes it will boost its growth trajectory.

These emerging market central banks are also addressing financial exclusion. More people have smartphones than have bank accounts in many emerging countries.

Another motive for the National Bank of Cambodia, which launched its blockchain based Bakong system last year for peer-to-peer domestic transfers between certain banks’ customers, is dollarization. The Cambodian riel is overshadowed by US dollars circulating in the local economy. The central bank has lost some control both of money supply and monetary policy, and hopes a central bank digital currency may address this. It also aims to improve tax collection as the country progresses to the lower tier of middle-income status and loses access to some concessional lending.

More to come

At the opposite end of the scale, Sweden, a developed market economy where use of physical cash is declining markedly – as it is across Scandinavia – is set for the Sveriges Riksbank to launch its e-krona project by the time Euromoney goes to press. This will run through to the end of 2020 and develop a technical platform that enables, for instance, payment with central bank e-krona directly from a mobile phone, a card or watch. The platform will contain simulations of payment service providers, retail outlets and other parts of the Swedish payment system.

While the Sveriges Riskbank has not yet taken a final decision on moving to a central bank digital currency, it has made clear its worry that physical cash may soon be so marginalized that it becomes difficult to use as a means of payment. Retailers are close to the point where it is unprofitable to accept notes and coins. An e‐krona, which individuals might eventually deposit in accounts at the central bank, but which in the first test phase they will store on phones or cards, could ensure that the general public still has access to a state-guaranteed means of payment.

There’s a lot suddenly happening and much more to come.

In January the Bank for International Settlements (BIS) reported results of a survey of 66 central banks, covering 75% of the world’s population and 90% of its economic output. It found that 80% of central banks are currently engaged in some form of work on central bank digital currency (CBDC). That is up from 70% a year earlier.

And this work is now going far beyond research, with 40% of central banks engaged in experimental proofs of concept and 10%, mostly in emerging markets, already running pilot projects.

Some are looking closely into wholesale versions of central bank issued digital currency that might be used primarily to drive efficiency in markets such as interbank payments and securities settlement and to which access would be restricted.

The test designs are often token-based and built on private, permissioned blockchains.

But at least half of the central banks are also looking into so-called general purpose digital currencies that might be opened up at the retail level to whole populations. The design question many are grappling with is whether any such system should also work in tokenized form, as a central bank-backed version of blockchain based cryptocurrencies, or through some variant of traditional bank accounts.

For now, this may still all sound quite theoretical and far away. But headlines and announcements will soon be coming thick and fast. The BIS finds that central banks collectively representing a fifth of the world’s population are likely to issue a general purpose CBDC in the next three years.

Big unknown

The big unknown is how soon the People’s Bank of China (PBoC) will launch its digital currency and how far and how fast it will push it. No launch date has been set, but the expectation is that this is now imminent. In a country where more than 600 million people already use WeChat and Alipay, it seems likely that a digital renminbi on people’s smartphones will win rapid and widespread acceptance, overcoming fears that it will give the PBoC and the government complete central control of money and oversight of every transaction by every citizen.

Big brother looms large over central bank digital currencies.

Cash is anonymous. It leaves no digital footprint. Hardly anybody uses it in shops and restaurants anymore, but some Euromoney readers no doubt use cash to pay the person who tends their garden or who cleans the house and does the ironing. It’s even possible one or two pay cash for recreational substances more stimulating than vintage Burgundy or to cover the travel and accommodation expenses of a dinner companion for the evening.

Once central bank digital currency supplants physical cash, then governments could have the power – if not the legal right in many countries – to view and even control and censor who can use their own money – Meltem Demirors, CoinShares

There are big questions whether central bank digital currency would remove those privacy protections. “The US dollar bill is a tool of free speech, an extension of the bill of rights,” says Meltem Demirors, chief strategy officer at digital asset management firm CoinShares. “It is important that money remains open, permissionless and censorship resistant.

“One of the most fundamental questions is over civil liberties,” says Demirors. “Once central bank digital currency supplants physical cash, then governments could have the power – if not the legal right in many countries – to view and even control and censor who can use their own money.

“Criticize the government on social media and it might cut off access to your digital wallet and stop you buying a train or a plane ticket.”

If that all sounds a bit ‘Handmaids Tale’, Demirors points out: “Alibaba and Tencent are already licensed as official credit bureaus in China, with social media and online behavior impacting access to credit. Governments like control. We saw this with the withdrawal of high-value notes in India, where part of the motivation was to drive 300 million people onto the national identity registry as a condition of access to the banking system.

“There is a whole narrative in emerging markets around CBDC as a means of enabling more inclusive access to financial services at lower cost. But the other reason governments may want this is to link digital identity and financial data,” she says.

Federal Reserve chair Jerome Powell, responding to questions about a digital US dollar before Congress in February, listed three major risks to such an undertaking: cyber risk, fraud risk and privacy risk.

For any country, putting central bank currency in digital form would offer a very attractive target for cyberattacks and give malign actors – including perhaps state actors – an obvious platform on which to focus their efforts. Protection against fraud, especially in real-time transfer of digital money across borders that bypasses intermediaries, raises the already high bar for identity authentication.

Privacy rights don’t seem to be a worry holding up anyone in China, however.

In late January, Deutsche Bank reported a survey of 3,600 customers in China, France, Germany, Italy, the UK and the US on attitudes of different age groups to cryptocurrency and digital currency. No surprise that a large majority of millennials think cryptocurrencies are good for the economy and that they envision using a purely digital sovereign currency.

More interestingly, the survey shows that citizens in advanced economies are more worried about privacy than people in emerging economies. According to the Deutsche Bank survey, Americans (22%), British (21%), French (29%), Germans (42%), and Italians (19%) reported concerns about anonymity and traceability. Only a tenth of Chinese reported similar concerns.

Changchun Mu, director of China’s Research Institute on Digital Currency and the driver of the project while at PBoC, said in a lecture last year that: “The new digital currency will spot certain behavioural patterns using big data and identify the users.” The vision is to replace physical cash with a digital version using technology that can: “Help the government crackdown on money laundering, tax evasion and financing terrorist groups.”

China’s Digital Currency/Electronic Payments initiative has been in development since 2014. It is likely to be rolled out to the population through the country’s largest banks and phone companies.

Jerome Powell, chair of the Federal Reserve

High-level geopolitics

The big question exercising US policymakers is not the impact on civil liberties in China but rather whether its use might spread outside China, for example through trade and payments in Belt and Road countries, and whether the digital renminbi might eventually challenge the supremacy of the dollar as both the dominant global reserve currency and the unit of account for large volumes of world trade.

Without the removal of capital controls, such a challenge may seem unlikely; but internationalizing the renminbi is a policy goal for China and the launch of a CBDC may work in its favour.

Appearing in front of the US Senate in mid-February, Powell agreed that: “We do have to ask what it would mean if China had a digital currency that gained fairly wide adoption, including to other countries.”

“One possible extension of China’s Belt and Road Initiative, which is financing infrastructure in more than 68 countries, might be to extend China’s monetary regime to these countries using digital renminbi,” Demirors tells Euromoney. “If China should take the new digital renminbi and extend it to, say, west Africa, where some economies have been dollarized, that might be an interesting test of whether the dollar will remain unchallenged as the currency of the world.”

Consideration of the relative power of national currencies and the control of international payments rails takes the technical debate over design of central bank digital currency and puts it straight into high-level geopolitics.

Apexx Global is a payments aggregator that offers its merchant customers access, through a single application programme interface (API), to 200 methods for accepting customer payments around the world. Alternative payment methods are proliferating, many of them quite national in character.

Peter Keenan, co-founder and chief executive of Apexx Global, and a former banker at HSBC, tells Euromoney: “Clearly the technology is already here to have a credible digital currency operate globally at scale. The hold-up on taking that into the real world has been fitting the technology into a regulatory framework that satisfies governments and central banks which manage the money supply as well as monetary policy. Yes, central banks want all the KYC [know-your-customer], AML [anti-money laundering] and CFT [combating-the-financing-of-terrorism] controls that they fear don’t work for cryptocurrencies, but they also want to control the money supply. If they can do that, then governments themselves might be big initial users for central bank digital currency through inter-governmental payments, then moving down one level to wholesale interbank payments and payments between large corporations and eventually to the population.”

Looking at how geopolitics plays into this, Keenan points to recent experience in Russia. “Partly thanks to the dominance of the dollar, of US global banks and payment companies like Mastercard, and also of the country’s giant technology companies that are mostly owned and controlled by US shareholders, the US appears to have the advantage in all this.”

Keenan notes how fast the MIR card has developed in Russia since 2015, partly as a response.

“Mastercard and Visa is used everywhere around the world, a position it has built over 60 years. But because of geopolitical tensions that have arisen recently, the concern arose in Russia at what might happen if the US government ever told Mastercard and Visa to just turn Russia off from their network. From fewer than five million users in 2018, the MIR card has 60 million today. It is essential to have access to it as means of payments acceptance for any e-commerce company selling to Russian customers. But it only works in Russia and some neighbouring countries,” he says.

“It has grown so fast because the Russian government insisted that anyone receiving money from the government, whether that be salary or social security or whatever, must have a MIR card attached to their bank account.”

There are two insights here. First, a struggle for dominance in advanced technology is now underway, largely between China and the US but also involving Russia, in which central bank digital currency could be a new battlefield. Second, governments could drive adoption of central bank digital currency very quickly if they believe it is in their own interests.

Most money is already digital. Is this a lot of fuss about nothing?

Sceptics might wonder whether central banks have just caught up in the blockchain hype cycle, rather like commercial banks did from roughly 2015 to 2017, when it looked like the classic technology solution in search of a problem. Central bankers may be worrying that, with many now at or close to the zero bound on monetary policy and with extraordinary measures seemingly unable to revive growth, their power and influence are set to wane. They could be indulging in a little showmanship.

Are we seeing just innovation theatrics here, perhaps with quiet requests attached for budget to accommodate these experiments in the future of money?

After all, as recently as May 2018, Lael Brainard, a member of the board of governors of the Federal Reserve, appeared to dismiss the prospects for a Fed Coin, when she pointed out that: “Most consumers and businesses in the US already make retail payments electronically using debit and credit cards, payment applications, and the automated clearinghouse network. Moreover, people are finding easy ways to make digital payments directly to other people through a variety of mobile apps. As such, it is not obvious what additional value a Fed-issued digital currency would provide over and above these options.”

It helps with something so new and different as blockchain for an exogenous event to shock the system – and the central banks – into action. Libra was that shock – Todd McDonald, R3

What has changed? And how fast are central banks’ experiments with digital currency likely to progress into live production?

“Central banks tend to move purposefully but not quickly and for good reason,” says Todd McDonald, co-founder of R3, the enterprise blockchain software company that began as a bank consortium and has since built the Corda platform. “But lots of work has already quietly been done to build a foundation for central bank digital currencies. We have worked with the Bank of Canada, Monetary Authority of Singapore, the Hong Kong Monetary Authority, Bank of Thailand and we are also working on other projects subject to non-disclosure agreements, which will be announced soon.

“What has picked up recently is the pace. It helps with something so new and different as blockchain for an exogenous event to shock the system – and the central banks – into action. Libra was that shock. Central banks had been trying to define the concepts around digital currency. Libra injected new urgency.”

Central banks had for years felt free to study bitcoin as an academic exercise, an interesting piece of math that never set out to fit within a regulatory framework and never threatened them or their mandates. The lack of scalability of the bitcoin blockchain, the extraordinary volatility in the price, suspicion of market manipulation by early bitcoin billionaires, high friction costs and periodic hacks of bitcoin exchanges, all meant it would never become a widely-used means of exchange or unit of account.

Libra, in contrast, offered the promise – or the threat – of a brand new global currency not under the control of any central bank, yet kept stable by the backing of reserves in their fiat currencies, potentially operating almost immediately at scale between 2.4 billion users and across borders. It raised the prospect of a private company (strictly speaking a group of private companies) suddenly exercising control over a significant portion of the world’s money.

Jerome Powell told Congress in February that: “Having a single government currency at the heart of the financial system has served us well. It’s a very basic thing that hasn’t really been in question. And before we move away from that, we need to really understand what we’re doing. Preserving the centrality of a widely accepted and trusted currency is an enormously important thing. Whether a digital currency moves us along that path or not is an open question. Technology has now made this possible. Every major central bank is taking a deep look at this. That is our obligation. It is incumbent on us to understand the costs and benefits, the trade-offs associated with a possible digital currency.

“Frankly, Libra lit a fire under that. It was a bit of a wake-up call that this is coming fast. And it could come in a way that is quite widespread and systemically important fairly quickly.”

Digital sovereign

Digital sovereign currency and the concept of close-to-immediate exchange of value peer to peer, like sending a text and without going through multiple intermediary banks, is no longer the hobbyhorse of renegade crypto libertarians.

In January, J Christopher Giancarlo, former chair of the Commodity Futures Trading Commission (CFTC), along with venture capitalist Charles Giancarlo and former CFTC chief innovation officer Daniel Gorfine, announced the Digital Dollar Project to advance exploration of a central bank digital currency in the US.

“The digital 21st century is underserved by an analog reserve currency,” said Giancarlo. “A digital dollar would help future-proof the greenback and allow individuals and global enterprises to make payments in dollars irrespective of space and time. We are launching the Digital Dollar Project to catalyze a digital, tokenized US currency that would coexist with other Federal Reserve liabilities and serve as a settlement medium to meet the demands of the new digital world and a cheaper, faster and more inclusive global financial system.”

The Federal Reserve is certainly engaging now.

In early February, Brainard, who has been working on the FedNow service – its first new payments rail for 40 years, which is designed to build faster, close to real-time retail payments infrastructure in the US – spoke again on central bank digital currency and what now is at stake. This time, her tone was different.

“The prospect for rapid adoption of global stablecoin payment systems has intensified calls for central banks to issue digital currencies in order to maintain the sovereign currency as the anchor of the nation’s payment systems,” said Brainard at payments conference in California.

Since Facebook announced Libra, the question of whether some other kind of private currency could ever challenge the dollar or change hands at scale alongside it, no longer seems quite so ridiculous.

Lael Brainard, member of the board of governors of the Federal Reserve

“Given the dollar’s important role, it is essential that we remain on the frontier of research and policy development regarding central bank digital currency,” said Brainard. “Like other central banks, we are conducting research and experimentation related to distributed-ledger technologies and their potential use case for digital currencies, including the potential for a CBDC. We are collaborating with other central banks as we advance our understanding.”

“Everyone knew the Fed had moved beyond just research but, even though the emphasis is still clearly on FedNow, this was a first on-the-record discussion by a leading Fed figure of the prospects for a digital dollar on blockchain,” one banker tells Euromoney.

In 2018 Brainard had said there was no compelling demonstrated need for a Fed-issued digital currency. Now she appeared keen to discuss the design and policy issues: whether a new form of digital central bank liability might reduce payments complexity, improve end-to-end processing, simplify record keeping and take some recent breakthrough innovations from the private sector, while also reducing operational vulnerabilities.

She also pointed to potentially profound implications for the entire financial system from such a simple sounding step as a digital dollar.

Early research into the concept of central bank digital currency at the Bank of England, for example, quickly identified the potential for a great disintermediation. Would retail customers suddenly have accounts at the Bank of England as well as or instead of at conventional banks, which today create money through extending loans.

A financial system has evolved over centuries intermediated by banks but ultimately backed by national central banks at which only those private commercial banks maintain reserve accounts.

Visitors to the Bank of England back in 2015 recall high minded discussions of democratizing access to the central bank. Would central banks provide a good user experience to retail customers, however, or be adept at extending credit? There’s no good reason to think they would.

The key benefit often touted for central bank digital currency is the ability to exchange payments at high speed, close to real time, and at very low cost by going directly between counterparties in a decentralized system rather than via each party’s intermediary bank.

But there are some benefits to slow speeds and protections that come from retail customers paying those middlemen. Banks have invested a lot in spotting and combatting fraud, halting payments that look unusual for a given account, querying them, recompensing payments sent by identity thieves and resolving more innocent errors.

Would all that be lost?

Marion Laboure and Jim Reid, macro strategists at Deutsche Bank, published a report on the future of payments in January. They suggest that while payment cards may disappear in the digital revolution, physical cash is likely to survive, perhaps in combination with central bank digital currency, which would be issued by a central authority but exchanged in a decentralized system.

They suggest CBDC would in fact reduce the risk of identity theft. “Today’s intermediated digital payment systems allow too much private information to be revealed to third parties (e.g. commercial banks). Distributed-ledger technology would alleviate the problem.”

Potential advantage

For central banks, there is another potential advantage. If physical cash is no longer hoarded and widely used and especially if more companies and individuals hold deposits in interest bearing accounts at central banks, then monetary policy transmission through changing interest rates becomes more immediate and effective.

Interest rates don’t apply to physical cash.

Of course, if they did apply to digital cash that raises the risk for all individuals of being charged negative rates on their money – a charge now being rolled out in Europe mainly to the deposits of high net-worth individuals, but which could potentially apply to everyone.

The gathering momentum for CBDC, now evident around the world, raises fundamental questions about the whole financial system.

“In light of considerations of privacy and guarding against illicit activity, issuance of a digital currency would raise important questions about what kinds of intermediaries might provide CBDC transaction accounts for consumers,” noted Brainard. “While some proposals are centered on commercial bank intermediaries, others propose new types of intermediaries that might develop with a narrow focus on payments. New types of intermediaries in turn could create a need for new types of accounts and new forms of oversight.”

McDonald at R3 believes that the world’s central banks are now setting out the road map for this journey towards digital currencies.

In January, the Bank of Canada, Bank of England, Bank of Japan, European Central Bank, Sveriges Riksbank and Swiss National Bank, together with the BIS, created a group to share experiences as they assess the potential use cases for central bank digital currency in their home jurisdictions. This will also consider economic, functional and technical design choices, including cross-border interoperability.

Private sector participants are also getting involved.

“The real action is likely to be in Europe, where the overriding concern is to head Libra off at the pass, and in Asia, where there may be more experimentation to help modernize financial markets and perhaps more focus on general purpose retail central bank digital currency for financial inclusion,” says McDonald.

“But from the very first position papers we have worked on with central banks, the last thing they want is to do away with commercial bank money.”

Financial stability

Related to this, the design of any central bank digital currency needs to address important questions surrounding financial stability. Brainard pointed out that: “A variety of approaches have been put forward to address the potential run risk associated with the ability to convert commercial bank deposits into CBDC with a simple swipe.”

In a broadly adopted CBDC system, at the first sign of anything resembling a re-run of the 2008 financial crisis, every corporate, retail and financial depositor would empty their accounts – even at highly rated banks – and have all their money sitting at the Federal Reserve, the Bank of England or the ECB before you could say synthetic sub-prime mortgage-backed CDO.

And the same would happen around the world.

Central banks would no longer backstop the banking system. They would be the banking system.

That would be an extraordinary outcome for what to most people initially sounds like a simple step. Money, after all, is already received and sent digitally. It has been for generations as Chris Wittenborn, director of strategy and business development at fintech company Velocity Markets, an aggregator of cryptocurrency liquidity pools, tells Euromoney.

Will the dollar remain the dominant currency of the world if it can’t be exchanged in five minutes on a Sunday evening but other leading currencies can? – Chris Wittenborn, Velocity Markets

“If I transfer $100,000 from my Chase account to yours at HSBC nobody is shipping $100,000 of bank notes. And well over 90% of equity and debt securities now exist only in digital form. But a complete modernization of the financial world now needs to happen. If trade and commerce carries on 24 hours a day seven days a week, it becomes an issue if goods and services can be bought, sold and exchanged in five minutes on a Sunday evening, but the associated transfer of value – of currency – cannot move so fast,” says Wittenbourn.

“Will the dollar remain the dominant currency of the world if it can’t be exchanged in five minutes on a Sunday evening but other leading currencies can?”

What is in play now is central banks’ fear of being left behind and their desire to remain competitive. The US is behind the curve in payments technology. People in China don’t use cash or cards to pay for things. They use their phones. And that may be enough to promote the first central bank digital currency-lite.

If that fear and competitive instinct brings distributed-ledger technology to the heart of central bank digital currency, the libertarian technologists who gave the world the bitcoin blockchain might see that technology turned against them.

“The blockchain usage in bitcoin is extremely transparent and there are forensic tools being used to help regulators weed through millions of transactions in an effort to put context behind the ‘who, what, when and where’ of bitcoin movement,” says Wittenborn.

Now If the central bank can see every dollar that goes in and out of every CBDC wallet, that is potentially very powerful. Think what the tax authorities might do with that.

How will this all unfold and which central banks will take the lead?

“There are roughly three groups of central banks progressing on digital currency,” says McDonald at R3. “The People’s Bank of China, the Federal Reserve and ECB are focused on how digital currency impacts their role and status as a reserve currency in global markets. The rest of the G20 central banks, such as the Bank of Japan and Bank of England, are pushing ahead from a payments and settlement perspective. Central banks in emerging markets are looking at digital currencies as a tool to enable financial inclusion and have a bigger role in international trade and policy.

“These efforts combined are moving the needle for central bank digital currencies on a global scale.”

What matters most for the future of central bank digital currency is what that first group does. All the signs are that the PBoC is ready to move. “The US and the Federal Reserve are more methodical on all this than the ECB and the Bank of England. The Fed is still committed to FedNow but is at least asking if it can incorporate digital currency and whether, if it ignores it, it does so it at its peril,” says McDonald.

Different objectives

The Federal Reserve is slightly unusual among leading central banks in that it does not regulate national payments systems directly even though it oversees the banks that intermediate them. “The Fed sees the risk of ‘Venmo-ization’ of payments, of more Americans opting into payments system outside the scope of FDIC insurance and dispute resolution,” says McDonald.

The various members of the G20 have different objectives, but in Europe they are generally leaning towards potential early application of central bank digital currency in capital markets and global trade; asking whether central bank digital currency might reduce risk and increase efficiency, for example in delivery versus payment in equity and debt markets.

In Asia financial inclusion is more of a theme. The Bank of Thailand and the Monetary Authority of Singapore are also looking at the potential for central bank digital currencies to enable cheaper and faster cross-border payments.

It is almost impossible to predict when central bank digital currency might achieve mass adoption. No one Euromoney speaks to sees a sudden shift from physical cash to digital, so any changes are likely to be carefully phased and may not feel dramatic. The BIS suggests one fifth of the world could be living with CBDC in three years’ time.

What about the US?

“I anticipate it will take 10 years for basic design and implementation and potentially much longer to harness the full potential of realizing synergies through multiple organizations within government,” says Wittenborn.

But everyone in financial markets is also aware of adoption curves, when nothing seems to happen for several years until suddenly the new technology hits critical mass apparently overnight and it is hard to remember that it wasn’t always this way. Think of contactless payments.

Some people may already be voting with their money. The price of bitcoin has been rising all year, starting at just under $7,000 in January and passing $10,000 in mid-February. Perhaps all the talk about central bank digital currencies – and the thought of national authorities soon having an overview of every financial transaction – is spreading anxiety.

Before central bank digital currency even arrives, the mere prospect of it might be giving the decentralized and pseudo anonymous cryptocurrency markets one last boost.