By Stephen Ptohopoulos ACIB, CCBI*

Disclaimer: Views and opinions expressed are those of the author and are not necessarily those of his employer.

The objective of this article is to discuss some of the key features and designs of CBDCs that are being considered.  This article will not provide a detailed technical analysis; this is best left to experts with a more detailed theoretical and/or working knowledge of the subject matter, such as those working in technology firms, academic institutions and central banks.

CBDCs are in the design or testing / pilot phases at many central banks around the world, e.g., those of The People’s Republic of China, U.S.A., Japan, Canada, U.K., Sweden, Hong Kong, Singapore and the Russian Federation.  With respect to the eurozone the European Central Bank (ECB) is actively considering issuing its own CBDC (‘digital euro’) and has recently published the results of a public consultation on a digital euro.

Some of the reasons why central banks are actively working towards issuing CBDCs include:

• Migration to the digital economy; growth of e-commerce
• Competition between economies and financial systems e.g., China vs. USA, USA vs. Eurozone, etc.
• Competition from substitutes issued by non-sovereign economic actors including digital cryptocurrencies (like Bitcoin) and stablecoins (the Libra / Diem initiatives from Facebook)
• Desire to maintain a monopoly on the ability to issue money
• Open up possibilities for new monetary policy tools (pertinent in an age of negative interest rates)
• Innovation, potential interoperability with other technologies such as the Internet of Things (IoT), Digital Ledger Technologies (DLT)/Blockchains, smart contracts and programmable money

So, what is a CBDC?  It is not a digital cryptocurrency (like Bitcoin).  Bitcoin is a private, decentralized (distributed) computing network.  While deposits (sight accounts) held by households and firms in commercial banks are a type of digital money, which can be withdrawn or transferred without requiring prior notice, they however represent claims against a commercial bank.   The depositor is prepared to bear a credit risk (default by the commercial bank), as reflected in terms of the financial institution’s credit rating.  In the context of the eurosystem, TIPS (TARGET Instant Payments) is set to build on and ultimately replace TARGET2, with the latter being a RTGS (Real Time Gross Settlement System) operated by the ECB.  While it can be argued that payments executed in TARGET2 are electronic, cleared funds representing ‘central bank money’ TARGET2/TIPS however are not a CBDC.  Instead, a CBDC can be thought of to be the digital equivalent of cash (physical coins and banknotes), in other words a digital financial asset with cash-like features.

On the premise that a CBDC is to fulfil the same sort of functions as present day physical money, below is a ‘wish list’ of the features that are likely to be desired for a CBDC:

• Accepted as legal tender.
• Accessible for use by all the general public
• Tangibility
• Convenience and ease of use
• A ‘bearer’ financial asset
• Privacy / anonymity
• Fungibility – basically a digital euro held by X is no different from a digital euro held by Y, in much the same way as there is no difference between a genuine physical EUR 5 banknote from any other another genuine physical EUR 5 bank note, i.e., they are interchangeable
• Make instant payments
• Efficient way to make low value payments (micropayments)
• Can be transferred at no cost
• Can be transferred from the holder/bearer (payor) direct, without having to use/be routed through intermediaries to the payee i.e., peer-to-peer (P2P)
• Can function outside the banking/financial system
• Able to function ‘offline’ – at the very least for a short while – in the event of a general power supply or IT systems outage 

Looking at a CBDC from the perspective of the monetary authorities / central bank, I would speculate that they would want it to support objectives such as:

• Monetary policy – ability to exercise control over the money supply
• Stability of the financial system
• Financial inclusion* – target those groups within society that do not have a bank account / unable to access banking and financial services (the ‘un-banked’ population)
• Resilience – built-in ‘duplication’, enabling uninterrupted retail funds transfers, retail commercial payments and capital flows in the event of a failure of the inter-bank payments system
• Prevent ‘bad’ actors from using the financial system
• Ecological issues / impact on the environment, in terms of the use of natural resources and energy consumption i.e., minimise ‘carbon footprint.’

*It needs to be kept in mind that in many countries there is likely to be a demographic which is not comfortable with technology and transacting digitally. Given this, the monetary authorities will need to consider how to mitigate likely negative impacts of the rollout of a CBDC if this is concurrent with the withdrawal/removal from circulation of physical coins and banknotes. While CBDCs could help to increase financial inclusion, at the same time there is a need to avoid worsening another form of economic marginalisation, in what has been described as the ‘digital divide’ within societies.

It is apparent that at least some of the above objectives are mutually exclusive to the desired features of a CBDC.  To take just one example, it would appear to be difficult to reconcile privacy/anonymity, being the digital equivalent of a ‘bearer’ financial asset and P2P transactions with the imposition by the regulatory authorities on financial institutions to adhere to KYC/CDD and AML/CFT requirements.

The design of a CBDC is important because this will determine if and to what extent it meets the desired features and objectives outlined above.

Direct vs. Indirect

In a direct (‘centralist’ design) CBDC the general public hold a financial asset which represents a direct claim on the central bank.  It could be argued this is a ‘true’ or ‘pure’ CBDC.  The central bank has a direct relationship with members of the general public who are holders of the CBDCs they issued.  While this design might appear to be the obvious choice and appealing, one of the many implications is that the central bank would essentially enter the business of retail financial services (incurring the costs of building the infrastructure as well as the administrative costs).  Another implication could be financial disintermediation, threatening the business model (indeed the very role / raison d’etre) of the commercial banks.

A CBDC indirect (‘federalist’) design would in many ways resemble the banking system, as we know it today.  The public would have a relationship with a commercial bank, with the former placing/lodging funds with the latter.  These funds in turn could be fully backed (i.e., 1:1) by CBCDs held by the commercial bank with the central bank.  With this model, in terms of balance sheet accounting the CBDC would be a liability of the central bank but would be an asset (claim) of the commercial bank.  Arguably, this design violates one of the key tenets of a CBDC, possibly undermining its acceptance and take-up by the public, especially if there is a low level trust in the banking system.

A variation on the indirect CBDC is what could be described as a ‘hybrid’ design.  In this design while the CBDC held by the public could be a direct claim on the central bank, the central bank sub-contracts the administration and customer relationship management to the commercial banks (including customer KYC/AML and CDD ‘on- boarding’).  This design has its merits since it could play to the respective strengths (areas of specialisation/division of labour) of the central and commercial banks.

Accounts vs. Tokens

Another design parameter is in terms of evidence of ownership.  With an account-based design holdings of CBDCs, along with transaction history are recorded in a database.  Accounts are associated with identity, whereby funds/balances are strongly tied to an identity (of the holder/owner).  This would not be much different from existing bank accounts, in which balances and transactions are recorded in a ledger of a bank.

With a token-based design, as its name implies, proof and control of ownership is exercised by means of tokens.  The object (token) is the asset – a useful physical analogy is a casino chip.

One final point with respect to the accounts vs. tokens debate is that, as expert commentators have remarked, it is not always clear-cut; there are ‘grey’ areas.  In the context of cryptocurrencies which are typically token-based (e.g., Bitcoin) the native tokens (UTXOs) are often stored on e-wallets – with the latter resembling accounts.

RTGS vs. DLT/Blockchain

A third design parameter is the ledger infrastructure.  As alluded to previously (in the context of the eurozone) there is an existing RTGS infrastructure (with TIPS superseding TARGET2).  Incidentally, the financial systems of many of the world’s advanced economies also have RTGS e.g., CHAPS (UK) and CHIPS (USA).   Given this, there are merits to adopting a RTGS design for a CBDC.  However, there are likely to be drawbacks in terms of functionality, scope for innovation and futureproofing with the question of interoperability between the CBDC and applications native to the other technologies such IoT and DLT/Blockchain (including smart contracts).   Not least for this reason, a DLT/Blockchain infrastructure should be given serious consideration.

CBDCs from the perspective of a commercial bank

As mentioned previously with the rollout of a CBDC the commercial banks may face having their business model disrupted and there is the potential threat of disintermediation (although to what degree is likely to depend on the design of the CBDC).

On the liabilities side of the balance sheet (i.e., customer deposits) in normal times, customers may prefer to hold a larger proportion of their liquid assets (‘cash’) as CBDCs as opposed to bank deposits.  This phenomenon will be compounded in times of distress (in which there is a loss of trust of customers in the banking/financial system) when there are likely to be attempts on mass scale to convert deposits into CBDCs i.e., in essence a form of a bank run.

Let us now look at the assets side of the equation (i.e., loans/advances).   Should there be a reduction of retail deposits in relative or absolute terms by customers (due to a preference for cash holdings in the form of CBDCs) the impact could be that lending by the commercial banks is reduced.  The commercial banks could see a contraction in their balance sheets and ceteris paribus (in terms of reserve ratio requirements) this will manifest into constraints in their capacity to lend.

A healthy financial system / financial stability is typically one the stated goals of a monetary policy.  Therefore, it can be expected that the monetary authorities / central bank will anticipate the likely impact of a CBDC and have in place measures to mitigate risks.  Such measures might be:

• Imposition of a ‘cap’ on the amount natural and legal persons can hold in CBDCs.

• Tiered interest rates e.g.,

– holdings of CBDCs from EUR 0 – EUR 1.000 to bear a positive interest rate that is lower than the equivalent rate applicable to bank deposits**

**reflecting the lower credit risk of CBCDs vis à vis bank deposits and to incentivize the public hold their surplus funds in the form of deposit accounts with the commercial banks

– holdings of CBDCs from EUR 1.001+ incur a negative interest rate

• In times of distress the central bank compensates the commercial banks in full for customer deposits withdrawn / converted into CBDCs (i.e., act as a ‘lender of last resort.’)

It is the author’s view that while the issuance of CBDCs may not happen any time soon, it is nonetheless inevitable.   It is difficult to see how the migration to a digital economy can be considered complete while physical coins and banknotes are still in circulation and widely used. Having discussed the likely desired features, objectives as well as design aspects, it is clear that some compromises and trade-offs will be inevitable.  A likely rollout of a CBDC would pose certain challenges for both the monetary authorities and the commercial banks.  Finally, it is the author’s view that the risks are outweighed by benefits including productivity gains, financial innovation and (possibly, hopefully) greater financial inclusion, all of which should contribute towards long-term economic growth.

*Knowledge worker and analyst.  Stephen follows developments in a range of topics including the digital economy, digital banking, DeFi, DLT/ Blockchains; finance and economics; international trade finance and supply chain finance; the political economy and international relations.  Stephen is an Associate member of the London Institute of Banking & Finance; holder of the Certificate in Bank Strategy, Operations and Technology professional qualification (and Certificated member) of the Chartered Banker Institute