Looking at both sides of the coin: a technical view of CBDCs
by Carlos Leon, Director of Financial Market Infrastructures & Digital Currency Solutions at FNA
A recent Crypto AM Industry Voices guest column presented the case against Central Bank Digital Currencies (CBDCs), arguing they are a one-way ticket to trouble, an Orwellian nightmare. It highlighted some commonly cited reservations surrounding the adoption of CBDCs while portraying Bitcoin as a solution to all the problems a CBDC could not solve, or even cause. However, when discussing CBDCs and bitcoin, it didn’t sufficiently address both sides of the coin.
CBDCs are, at this stage, a broad concept. They come in hundreds of different shapes, sizes and flavours, and the flavour each central bank chooses will ultimately determine whether a CBDC will work for the people, or not. To briefly counter last week’s guest column:
- CBDCs do not use blockchain technology per se
- Not all CBDCs will be programmable
- CBDCs won’t be marketed as better for the environment and the solution to inflation; most cited motivations are monetary sovereignty, transactional efficiency, financial inclusion, and the robustness of payment systems
- CBDCs are not intended for every citizen using digital wallets instead of bank accounts; in fact, one of the most delicate parts of CBDC design nowadays is how to avoid deposit migration because central banks are well aware that it could impact financial stability
- Most central banks are designing intermediated CBDCs, with banks and payment system providers as the distributors of CBDCs; this way, not only are the central banks not willing to crowd out the payments ecosystem, but central banks could have similar (limited) access to data as with payments based on commercial bank money and e-money.
READ MORE: CBDCs – the future of banking or an Orwellian Nightmare?
All in all, the design of a CBDC is the key to bringing this broad concept to life and to succeed as a new form of money. After one year, the slow adoption of CBDCs in the Bahamas and Nigeria suggests that the use case is unclear and that central banks have to work harder to understand consumers’ and merchants’ needs. Likewise, after more than a decade, bitcoin and alike have failed to turn into money–they remain as assets to invest or bet, with no clear case for medium of exchange, store of value, or unit of account, even where declared as legal tender (El Salvador, for example). For both, CBDCs and cryptos, the use case is in the making – but only CBDCs have some flexibility as most of them are currently being studied, designed, or piloted.
CBDCs are not a silver bullet, and while they indeed have their flaws, they also have significant advantages. As industry leaders, it is our responsibility to educate the market on the facts. I believe it is imperative that when making the case for or against CBDCs, at a time when more than 90 central banks are looking to introduce them in the near future, we present a balanced argument for and against.
It is the motivations behind the design and adoption of CBDCs that need to be better understood and clarified. As before, CBDCs will not be marketed as better for the environment and the solution to inflation, nor is it accurate to imply that a prime motivation among governments is to inflict ultimate control over societies through a form of social engineering. This could be said of any fiat-based payment system in place today. In fact, the CBDC architectures currently being discussed do not necessarily involve having access to all the details of how, when or where people are using CBDCs.
A tiered anonymity architecture, with anonymity depending on the value of the transaction, could favour privacy while complying with anti-money laundering (AML) and combating the financing of terrorism (CFT) mandates—similar to what we have today with cash transactions at commercial banks. If banks and payment system providers are the distributors of CBDCs, this could work even better.
We must focus on championing the responsible and proper design of CBDCs to alleviate the fears associated with the unknown. We need a discussion on technical grounds that outlines the facts rather than makes presumptions based on broad negative sentiment—what bitcoiners usually call spreading FUD (fear, uncertainty, and doubt).
Let’s look at the pros, to begin with.
- CBDCs provide a practical alternative to the decreasing use of cash on a global level. The European Central Bank revealed cash was used for 59% of point-of-sale transactions in 2022, down from 72% in 2019. CBDCs will give people across the world the option to keep using a public form of money, if or when cash becomes used less and less.
- Everyone should have an accessible option to use a form of public money for online and offline transactions, as opposed to having no choice but to use private forms of money, i.e., bank deposits, e-money, and stablecoins. CBDCs would ensure that everyone has direct access to central bank money, which is ultimately good for the people.
- CBDCs are a way to make local payment systems more robust and secure. It would mean we are not completely dependent on foreign payment rails (e.g. Visa and Mastercard) and will not be reliant on unreliable, unregulated, and unsupervised infrastructure providers, which includes bitcoin, because we have no guarantee that bitcoin nodes will run forever and that developers will act on behalf of the users.
- Encouraging the increased use of CBDCs will decrease the extent of tax evasion and money laundering in sizable transactions. It will allow the enforcement of anti-money laundering (AML) and anti-terrorism regulations, albeit countered by potential implications around consumer privacy, which we will address shortly.
- If properly designed, CBDCs have the power to increase financial inclusion among those who do not wish or can’t have a relationship with banking institutions, e-money issuers, and stablecoin issuers. With cash transactional use declining in several jurisdictions, a CBDC is one feasible way of providing people with access to another form of central bank money, to complement (not replace) the use of cash, without the need for a bank account. This is also a matter of monetary sovereignty and resilience of the payment system.
On the other hand, there are some drawbacks to consider.
- One recurrent argument against the use of CBDCs is the impact on society’s privacy. Consumer protection legislation and the judicious work of all authorities, congress, prime ministers, and society is the key. Currently, China is usually portrayed as an example of what to fear when governments could use CBDCs as tools for conducting surveillance and political and social control. To preserve the integrity of CBDCs while minimising threats to privacy, a tiered anonymity model with banks and payment system providers as CBDCs distributors could be convenient.
- If CBDCs become highly successful and widely adopted, they could potentially crowd out private forms of money, negatively affecting commercial banks and the economy as a whole by means of disintermediation and higher cost of funding. However, all central banks are attempting to design CBDCs in a way which will ensure this does not happen; central banks pursue a sweet spot between poor adoption and massive adoption that will depend on the design features, the use case, and the intricacies of each jurisdiction.
- There are potential financial instability issues. In addition to the potential impact of CBDC in benign conditions, during crisis periods a CBDC could be perceived as a safe haven, making bank deposits more flighty and thus increasing the risk of bank runs. To counter this, most central banks are studying caps on CBDC balances. Again, no central bank wants its CBDCs to be overly successful to a certain extent.
- CBDCs could speed up the replacement of cash within society—in my view, a negative outcome for the society. However, central banks including the Bank of England and the US Federal Reserve, have publicly committed to ensuring the continued safety and availability of cash, considering CBDCs as a means to expand safe payment options, not to reduce or replace them. In fact, it is the financial industry that has spurred the war against cash–not the central banks–and for their own profit, of course; paradoxically, the war against cash driven by financial firms has pushed central banks to rethink public money provision via CBDCs, which they now fear will affect their business as usual.
- Of course, banks will always be vulnerable to operational failures in the payment system, which would have negative implications both reputationally and for the functioning of the economy. This potential risk isn’t exclusive to CBDCs, however.
As we have seen in this technical discussion, the key to the success of CBDCs comes down to the proper design of these digital currencies, and the core motivations and use case behind their implementation. To alleviate concerns and reservations that exist, central banks must have a clear understanding of the pros and cons, backed up by a clear vision for how a CBDC will be adopted based on the multiple design options available to them.
Going back to Orwellian nightmares, it is true that a CBDC could be mismanaged by a government, either democratic or authoritarian. Likewise, it is also true that other forms of money could be misused, including cash–did you know that some ATMs are capable of reading serial numbers on bank notes?
But, Bitcoin can be misused for Orwellian purposes too. Not long ago, a Latin American country gave Bitcoin legal tender status and offered U$30 worth of Bitcoin to people to download and register to Chivo, the government’s mobile wallet; to me, giving a bait equivalent to almost three days’ minimum wage to force people to surrender personal and transactional information to an app that is owned and managed by a government which has been accused of authoritarianism is pretty Orwellian.
In the wrong hands, even the pseudo anonymous and allegedly decentralised bitcoin could turn against the public.
Perhaps the payment instrument or the form of money is not what we should fear. It is payment instruments’ design and their potential misuse by governments and central banks. Adequate consumer protection, regulation, and oversight of the payment system is always needed for any form of money (or technology!) to work for – not against – the public.