As the world embraces a cashless approach in the wake of the Covid-19 pandemic, Central Bank Digital Currencies or CBDCs have started taking center stage. The idea of the CBDC is to have a digital form of fiat money that can be used as legal tender and is generated by the country’s central bank. Several countries around the world are working on their CBDC projects. So, in this guide, we are going to be:
- Looking into the potential of CBDCs.
- Promising CBDC projects around the world
Design framework of CBDCs
Vox did an interesting article some time back, which detailed five particular questions that central banks must ask themselves while creating a CBDC.
- Should CBDC payments go through an account held at the central bank? Or should it directly connect the payer and payee?
- Should central banks completely move ahead from the traditional paper currency?
- Should CBDC have a constant, nominal value like cash and coins? Or should it be interest-bearing, or indexed to an aggregate price index?
- How will CBDCs change the monetary policies of central banks in the future?
- How does CBDC change the interactions between Central Banks and various fiscal authorities?
So, upon asking these questions, Vox defined the characteristics of a well-designed CBDC as such:
- It should be a costless medium of exchange.
- It should be a secure store of value.
- It should be made widely available to the public.
- It should be relatively price-stable.
What are the advantages of CBDC implementation?
- The cost of managing cash can vary wildly, depending on geography. Eg. Countries made of several secluded islands usually experience a very high “cost of cash.”
- In traditional financial systems, the intermediary costs can go through the roof. A centralized digital currency mitigates the need for having several intermediaries.
- CBDC could provide a very valid method of financial inclusion. The fact remains that there is a large percentage of unbanked people around the world. According to the World Bank, around 80% of people in Indonesia, the Philippines, and Vietnam, and 30% in Malaysia and Thailand, are unbanked. In Myanmar, only 23% of people have a legit bank account. In a world where cash use is decreasing, using CBDC can include them in a financial system.
- CBDC can make the global payment system a lot more resilient. Currently, the payment system is concentrated in the hands of a few large companies. Using a DLT-based coin can have a very positive effect here.
- According to IMF, a properly executed CBDC can counter new digital currencies. Privately-issued digital currencies can be a regulatory nightmare. A domestically-issued CBDC which is, denominated in the domestic unit of account, would help counter this problem.
- One of the biggest problems with cryptocurrencies is its price volatility. With CBDCs, governments can use a private blockchain to control price volatility. While this will compromise on decentralization, it can help increase the widespread usage of blockchain technology.
- Speaking of widespread usage of blockchain technology, utilizing CBDCs can help banks experiment more with Distributed Ledger Technology (DLT). Some central banks are considering the option of providing CBDC only to institutional market participants in order to develop DLT-based asset markets.
- CBDCs can increase the economy’s response to changes in the policy rate. For example, during a period of prolonged crisis, CBDCs can theoretically be used to charge negative interest rates.
- CBDCs can help encourage competition and innovation in the financial sector. New entrants can build on the tech to enter the payments space and provide their own solutions. It will also reduce the need for most smaller banks and non-banks to run their payments through the larger banks.
- As electronic and digital payments take over from physical cash, the central banks will look to replace physical cash with its electronic equivalent, i.e., CBDC. Doing this will increase the proceeds from creating money, aka, seigniorage, earned by the bank.
What are the disadvantages of CBDC implementation?
While there are some distinct advantages, we should also look into the challenges to get a balanced view.
- CBDCs can cause central banks to charge higher interest rates on loans or experience a compression of margins. This is mainly because people could be tempted to withdraw deposits from the banks and hold on to their coins. In times of crisis, people may move on from their deposits to CBDCs.
- If the demand for CBDC does grow, it can increase the balance sheet pretty considerably. Plus, central banks may be forced to provide emergency liquidity to local banks that experience rapid and massive funding outflow. This means that central banks would take on additional credit risk.
- There are many hidden costs and risks associated with CBDCs that the central banks should factor in. Central banks will need to be active across several channels such as payments value chain, customer interfaces, building front-end wallets, maintaining the extensive technology, monitoring transactions, and taking care of AML and anti-terrorism policies.
CBDC solutions around the world
Now, we have a basic idea of how CBDCs work, let’s looks at some of the implementations around the world.
#1 SOV – The Marshall Islands
SFB Technologies will partner with Algorand blockchain to provide the Marshallese sovereign (SOV). Algorand is an open-source, pure proof-of-stake blockchain protocol that enables the development of scalable blockchain-native solutions for real-world use cases.
Jim Wagner, co-founder and CTO of SFB Technologies, explained why Algorand was chosen as the underlying protocol:
“Algorand was selected after extensive market research among the leading protocol options. The company has already powered several mainstream use cases and thanks to its unique features the platform has the functionality required to issue, manage and distribute the SOV on a global level. This partnership ensures that the SOV will be built on a scalable and secure platform.”
The government of the Marshall Islands will closely oversee the SOV project. Kenneth Kedi, Speaker of the Marshallese Parliament, said:
“I am excited about the technological partnership with Algorand. With it, a strong alliance is forming to develop the SOV project. This is another milestone towards developing the Marshall Islands financial services industry.”
The SOV supply will be algorithmically fixed to grow at 4% each year to keep the inflation in check.
#2 Digital Yuan – China
A spokesperson for the People’s Bank of China (PBOC) revealed on the China Central Television that pilot tests are currently underway for its new digital currency, aka DC/EP (digital currency/electronic payment). The tests are presently being carried out in the cities of Shenzhen, Suzhou, Xiongan new area, Chengdu, and the future site of the winter Olympics. However, the bank also made it clear that the pilot tests don’t imply that the CBDC has been greenlighted for future public usage.
“The current closed test of Digital Yuan will not affect the commercial operation of listed institutions, nor will it affect the RMB issuance and circulation system, financial market and social economy outside the test environment.”
The DC/EP is being tested as a part of a transport subsidies scheme for government and domestic enterprise workers.
Digital Yuan – Underneath the Hood
The representative also revealed the following technical and design details about the digital currency:
- It has a two-layer architecture and a two-tier delivery system.
- It utilizes “dual-offline” technology to ensure that transactions will still get processed even if China’s online banking and other virtual payment platforms go offline due to poor network signal strength.
- DC/EP works independently from China’s existing banking system. It isn’t tied or dependent on the users’ bank accounts.
- The Digital Yuan will be issued directly by the PBOC, making it different from other cryptocurrencies.
- The Digital Yuan will be backed by the nation’s credit to ensure price stability.
#3 Project Inthanon – Thailand
The Bank of Thailand’s CBDC implementation – Project Inthanon – is in its third phase. Inthanon is a collaborative project between the central bank and financial institutions. It aims to develop and test a proof of concept for domestic wholesale funds transfer using CBDCs. Currently, they are testing out interoperability among ledgers for cross-border funds transfer. The bank will collaborate with the Hong Kong Monetary Authority to explore this interoperability.
Before this, during Phase II, the bank successfully tested out the efficiency of bond trading and repurchasing activities with DLT, including interbank outright trading and repurchase transactions. Along with that, the bank explored how DLT can help facilitate the banks’ reconciliation of customer accounts and money transfers in compliance with regulations to reduce error and associated compliance costs.
#4 RSK and the Central Bank of Argentina
The Central Bank of Argentina (BCRA) is currently working on a proof-of-concept (PoC) that’s powered by RSK technology and allows for the end-to-end traceability of account debit claims. The PoC is within the framework of the 2019 Financial Innovation Roundtable of the BCRA and will be built by the Blockchain Group, which comprises of IOV Labs, Sabra Group, Banco de la Provincia de Córdoba, BBVA, ICBC, Banco Santander, BYMA, Interbanking, and Red Link.
Rootstock (RSK) is a smart contract platform that is connected to the Bitcoin blockchain through sidechain technology. Rootstock was born to be compatible with Ethereum’s applications (the web3/EVM/Solidity model) but using bitcoin as the underlying cryptocurrency. The idea behind the creation of RSK was to give the Bitcoin blockchain smart contract functionalities.
This PoC requires a collaboration between the different actors like banks, clearinghouses, financial agents, and various technology providers. The main thing that the BCRA wanted to test out is Inter-entity Messaging. Through practical experimentation, BCRA, through RSK, seeks to help the financial industry to understand blockchain technology and its potential benefits better. Ultimately, it is hoped that the technology could be used to develop more straightforward and more efficient alternatives to the current clearing systems and could also set the foundations for central bank digital currencies in the future.
Even though CBDCs are indeed being explored by many different countries, many people will prefer decentralized stablecoins. RSK has also being exploring that aspect with the MOC and RIF On Chain projects.
Other notable CBDC projects
- Bahamas: The “Sand Dollar” currently has pilot programs in two of its largest island chains.
- Barbados: A blockchain-based version of the Barbadian dollar was released in 2016.
- France: The central bank of France officially announced a program of experiments to test the interbank integration of CBDCs.
- Saudi Arabia and the United Arab Emirates: The central banks of the two gulf powerhouses are jointly issuing a CBDC called “Aber.” The goal is to increase interbank trading opportunities and boost financial co-operation.
- Sweden: The Riksbank, Sweden’s central bank, started the E-krona project in 2017 to study the need and possibility of a CBDC. In February 2020, the bank announced the launch of a year-long pilot project of the CBDC.
- Turkey: Turkish President, Recep Tayyip Erdogan, has mandated the development of the digital Lira to finish by the end of 2020.
- Uruguay: The E-peso was successfully piloted from Nov. 2017 to Apr. 2018.
CBDC has the potential to disrupt the landscape of global finance positively. Electronic payments replacing physical cash-based transactions seems like CBDCs are now a question of “when” and not “if.” There are so many exciting implementations around the world, that you should definitely keep an eye out for. There are several problems with the current financial system, which can be elegantly remediated by CBDC. The challenges faced in its implementation will change from country-to-country. This is why the central banks need to work on an implementation that provides the maximum amount of value, specifically to their country.