Abstract

Central Bank Digital Currencies (CBDCs) are government-backed digital currencies that are issued by nations’ central banks and pegged to the value of their incumbent fiat currency. Over recent years, with the onset of blockchain technology and the proliferation of decentralized cryptocurrencies, nearly 80 countries have begun to conduct extensive research and development into CBDCs to discern the technical advantages they provide over traditional monetary instruments and the feasibility of implementing them from a legislative perspective.

This dissertation will dive into the current state of CBDCs, the technological improvements they bring, and the deeply polarized debate that is currently ongoing regarding the sociopolitical effects that their introduction into the global economy may render. In this first part, we provide a detailed introduction to the history and definition of CBDCs, the variations of CBDC concepts developed over recent years, and the benefits and drawbacks of CBDCs from an institutional perspective. The second part will concern the intriguing arguments that individuals and institutions have presented both for and against this new form of currency, dealing with issues of personal privacy, economic infrastructural reformation, and the existence of similar but alternative solutions such as stablecoins.

Introduction

Over the past year, central banks around the world have dove head-first into the research and development of their own Central Bank Digital Currencies or CBDCs. Not entirely a new technology, with the first rendition of a CBDC being invented back in the 1990s, CBDCs received a renewed wave of interest from national banks back in 2015 when the Bank of England coined the acronym. Much of the fervor around CBDCs since that time can be directly attributed to the onset of blockchain technology and the cryptocurrencies they facilitate. 

Today, a much larger conversation is being held regarding the potential benefits and risks of CBDCs as a new form of payment for both individuals and institutions. In fact, the conversation inevitably deals heavily with the relationship between the purview of government bodies and the individual rights of citizens around the world. Additionally, given that CBDCs inevitably will differ in their minute details depending upon which country they are present in, it is essential to understand what defines a CBDC, what benefits they promise, and what risks they impose.

What are CBDCs?

CBDCs as they are known today do not share a standardized set of sociopolitical or financial requirements. This is due to the fact that the inherent politicization of this tool by pundits on all ends of every spectrum has generated a multi-faceted debate on what the correct implementation should look like. However, there are a few technical features that all existing CBDCs or future projects share.

- CBDCs are denominated in a country’s national currency.
- CBDCs are non-cash monetary instruments, based entirely upon electronic records.
- CBDCs are central bank liabilities, meaning end users have a claim on the central banks.
- CBDCs must be widely accepted as a payment instrument since their original intent is to supplant physical cash.

Multiple central banks have released their own variations of a definition for a CBDC, and they range in their level of explanatory detail.

- IMF (2020): “A digital representation of sovereign currency that is issued by a jurisdiction’s monetary authority and appears on the liability side of the monetary authority’s balance sheet.”
- United States (2020): “A digital liability of the Federal Reserve that is widely available to the general public.” 
- Bank of England (2020): “An electronic form of central bank money that could be used by households and businesses to make payments and store value.”
- Banque de France (2020): “A digital asset that only the central bank may issue or destroy, that is traded at par against banknotes and reserves, that is available 24/7, that may be used in peer-to-peer transactions and that circulates on digital media that are at least partially different from existing media.”

In practice, CBDCs can be implemented in two ways:

- Wholesale CBDC: Access to CBDCs is limited to a select group of commercial banks and clearing institutions that receive the currency directly via interbank systems accessible by the central bank
- Retail CBDC: Access to CBDCs is expanded to corporate businesses and generally across the economy to all individual consumers

How is this different from electronic money?

An important consideration in the discussion of CBDCs is how it differs from already existing electronic money or e-money. For all intents and purposes, this distinction is small but critical. According to the E-money Directive delineated by the EU, which has been accepted as the global standard, e-money is:

“Electronically, including magnetically, stored monetary value as represented by a claim on the issuer which is issued on receipt of funds for the purpose of making payment transactions, and which is accepted by a natural or legal person other than the electronic money issuer.”

While similar to CBDCs, a few differences stand out. The first of these is that e-money is issued “on receipt of funds,” which insinuates that these funds already belong to the issuer in another monetary repository, such as, but not necessarily, a personal checking account. In other words, e-money is pre-funded by its users. The second of these is that e-money is used “for the purpose of making payment transactions,” not anything else. A public transportation card such as the New York City Metro Card is an example of this. Users must top up these cards either on their phones, with credit cards, or with physical cash. Another example would be currencies within video game ecosystems that must be pre-purchased before they can be used. 

Notably, the definition of e-money is clear with regard to how e-money can be issued and how it can be utilized by people. The same cannot be said about CBDCs. For example, there is no evidence that CBDCs will function as a pre-funded monetary vehicle like e-money. E-money essentially exists as an extension of the money an individual already owns, whether this is as commercial bank money – digital money held in accounts at commercial banks – or as nonbank money – digital money held at nonbank financial service providers like Venmo, Paypal, Vanguard, Robinhood, etc. Here, the common thread between all the parties that manipulate e-money is that they are all non-governmental entities.

CBDCs, on the other hand, are strictly deployed by the central bank. As mentioned by the Federal Reserve, “Federal Reserve notes (i.e., physical currency) are the only type of central bank money available to the general public.” As such, oversight and monetary policy surrounding CBDCs could introduce a tidal wave of money-related changes that affect the daily lives of a country’s population. It is for these political, social, and philosophical implications that there is a roaring debate on whether CBDCs are an appropriate venture for countries to pursue. For the sake of this paper, this humanities-related discussion will be reserved for the second article in this series.

CBDCs Could Replace Cash

One of the main motivations behind the recent surge of interest in CBDCs as a potential new form of central bank money is the decline of cash usage around the globe.

According to FIS, globally, cash usage saw its biggest decline in 2020, “driven by pandemic-induced business closures.” By 2021, cash accounted for only 17.9% of total transaction value globally, representing roughly $8.3T USD in payments for that year. FIS predicts that this share will drop by nearly 10% in most regions of the world, with North America, Asia-Pacific, and Europe making the most drastic step away from physical money.

Another interesting phenomenon is that “card usage is increasingly shifting to pass-through mobile wallets.” Per the Global Payments Report for 2022, “credit’s share is projected to decrease to 22.4% by 2025 when it will represent over $13.2 trillion” while “mobile wallets’ share of global POS transactions jumped over 21% YoY in 2021” and is “expected to rise to 38.6% share (over $22.7 trillion) by 2025.”

Both the decline of cash usage and card usage gives credence to the notion that electronic or digital transactions will supersede physical transactions – perhaps even replace them entirely. As such, central banks are adamant about being prepared for this future transition, especially if it has the potential to increase the overall efficiency of payment for common citizens.

Additionally, credit card usage has also been in decline due to what is known as swipe fees. Despite the increased revenue that comes from accepting debit or credit cards at point-of-sale, some small to medium-sized businesses opt to reject card payments in their businesses to avoid these fees, which range from 2-4% of any transaction. According to the National Retail Federation, swipe fees alone account for over $100B in costs to retailers and their customers, drive up consumer prices by an estimated $900 a year per household in the US, and thus place upward pressure on inflation. The introduction of a CBDC could alleviate much of these fees, which are centrally price-fixed by major card companies like Mastercard and Visa, thus improving businesses’ bottom lines and accelerating the widespread adoption of CBDC payments.

Blockchain Technology

Another critical impetus of CBDC development today is blockchain technology. Prior to the recent fervor surrounding CBDCs, the concept of a centrally distributed digital currency was an unconventional area of financial research due to the lack of technology infrastructures that were available to support its desired functionality. Naturally, digital money itself has been around since the 1990s, and almost all money transferred between central banks and commercial banks became digitized.

The key differentiating factor between the technology at that time and the available technology today is the underlying format. Previously, account-based digital money become the gold standard of verifiable money transfers, as it permitted individuals to transfer money to businesses and government institutions after their identities were verified. Blockchain technology, on the other hand, introduced token-based digital currency, or a tokenization standard, by which digital currencies like Bitcoin, Ethereum, etc. are verified for their authenticity instead of the issuer of those tokens in any transaction. In other words, tokenization allowed for financial liabilities (i.e., real money) to be securely sent around the world from peer to peer without exposing users to risks of identity compromise, arbitrary and surreptitious restrictions by centralized actors like banks, and even the associated costs of exchanging one national currency to another. 

Cryptocurrency – Stablecoins

The provenance of cryptocurrencies as a result of blockchain technology advancements in recent years is simultaneously the cause for interest in CBDCs today as well as a potential solution for actualizing its existence in the future. Notably, CBDCs themselves are, at first glance, not unlike cryptocurrencies. In particular, stablecoins, which are cryptocurrencies pegged to fiat currencies, share a slew of similarities.

- Both are pegged to a fiat currency.
- Both are fully digital forms of payment.
- Both rely on tokenization, though some CBDC projects are exploring an account-based infrastructure, rather than a token-based one.
- Both are programmable money, “whereby different logics are wired within the definition of money itself and where rules in payments between multiple peers can be automated” (PWC). 

Beyond these similarities, though, lie a collection of differences between CBDCs and cryptocurrencies that generate more significant externalities both politically and financially. These are as follows:

The differences between stablecoins and CBDCs are numerous, but they essentially are corroborative answers to one common question: who is in control? For policymakers, private institutions, and individuals this question is at the crux of their determination of CBDCs' rightful (or wrongful) place in the global economic system.

Benefits of CBDC

To effectively determine whether CBDCs do more harm than good, it is necessary to delineate all of the benefits that CBDCs promise to bring before diving into the damages they could wreak, either intentionally or unintentionally. 

The first major benefit of a CBDC is that it broadens general access to digital money and reduces costs overall for all individuals and institutions. It allows individual consumers to connect directly with central banks, thus reducing requirements for larger infrastructure to provide money to people. That means that people who don’t have access to a personal checking account can have a means of transacting without bringing physical cash. Additionally, people who don’t use smartphones can be supplied with stored-value cards (pre-loaded) to use without a bank account. It also precludes the need for physical currency exchanges, thus reducing cross-border transaction costs by streamlining distribution.

An extension of this first merit is that CBDCs are free from credit and liquidity risk. Since CBDCs are a centrally distributed asset by a nation’s government, it is the central banks themselves that burden that liability just as they have with their own national currencies. In the case of the United States, the risk of owning CBDC would be akin to the risk of owning a US Dollar, which is minimal. In fact, CBDCs themselves remove the third-party risk of commercial bank failures or runs, since all token holdings or accounts are not only stored but programmed within the central banking system.

Another large benefit that CBDCs are foreseen to provide is a strengthening effect on a national currency’s international dominance. Applicable in particular to large nations like the US, CBDCs and their inherent accessibility are likely to increase their use around the world. For America, in particular, this expected benefit is one of the largest reasons for entering the proverbial “race to CBDC,” especially since China already has one. The prospect of being unable to compete in the political advances that may emerge from the use of CBDCs is one that the US cannot accept.

The following benefit may be argued to be more damaging than good, but CBDCs are programmable and trackable, thus allowing the central government to oversee and potentially intervene in circumstances of tax evasion and, more commonly in the web3 age, digital financial crimes. Given the slew of crypto-related hacks resulting in millions of stolen dollars in crypto, the newfound ability to observe the flow of money among citizens and across national borders is a natural and, frankly, unavoidable effort that governments will pursue.

Drawbacks of CBDC

The previously mentioned benefit of oversight is the crux of the huge debate that surrounds CBDCs and their implementation, and it is seen overwhelmingly as a greater drawback than a benefit. Increased oversight inextricably leads to a reduction in privacy – privacy that was held sacred with the use of physical cash. For many individuals, regardless of the legality of their transactions, cash was the only method of preserving privacy in their transactions, until cryptocurrencies came about. Since then, cryptocurrencies have served as an appealing alternative to cash transactions given the anonymity and international utility they preserve. CBDCs, unlike cryptocurrencies, are centrally governed and identify their users. As such, many fear that CBDCs could be misappropriated by the government to censor and prevent the inflows and outflows of money to various groups and individuals. The far-reaching grasp of the government as it pertains to CBDCs is an expansive discussion on its own, so further inspection of the topic will be reserved for the second part of this article series.

Another drawback of CBDCs deals with the infrastructural instability it could generate in the midst of cumbersome systematic changes required of institutional players. At present, banks are capable of providing loans due, in large part, to deposits from individuals and institutions who maintain their dollar liquidity in various accounts. In the case that CBDCs become endemic and are viewed as a suitable replacement for real dollars, then it could result in a massive reduction in total cash deposits into the commercial banking system. The resulting lack of liquidity could thus exacerbate bank funding expenses, reduce credit availability, and raise credit costs for households and businesses. Additionally, a CBDC that is interest-bearing would reduce the appeal of other low-risk investments like mutual funds, Treasury bills, and other short-term investment vehicles. A reduction in the use of these low-risk assets would also reduce credit availability. Simple solutions for this potential issue are already in consideration, including a non-interest-bearing CBDC as well as a central bank limit on the amount of CBDC that can be held by any end user.

A larger potential issue related to this is the potential for CBDC to be treated as an important safe haven during economic turmoil. Since CBDCs are so easy to convert or withdraw from commercial banks, it could exacerbate runs on financial firms to a point where traditional central bank measures to preserve commercial bank liquidity, such as prudential supervision, government deposit insurance, and flat-out reducing access to central bank liquidity may be insufficient to prevent massive outflows. While it is true that governments could then exert limits or control on CBDC withdrawals to prevent such outflows, it can be argued that such control borders on totalitarian censorship and could negatively impact those who would seek to withdraw cash if that is in short supply as well.

CBDCs would also require large changes to monetary policy, including increasing the central bank’s balance sheet to accommodate CBDC growth (or lack thereof). As of now, many central banks replicate the “ample reserves” monetary policy regime espoused by the American Federal Reserve, which does not require active management over the reserve supply of money. Simply put, the central bank in its current state is able to exercise control over the federal funds rate and other short-term interest rates without needing to know exactly how much money is in reserve. However, the introduction of a CBDC could greatly exacerbate the degree of reserves required to preserve the central bank’s reserve funds. If CBDC demand increases greatly over the long term, then the central banks will have to greatly increase the supply of CBDCs that are instantly disposable, which could spell huge repercussions on the inflation rates of international currencies.

There are some inequalities that CBDCs could create as well, in terms of access, though certainly fewer than the current banking system. The older generations, for example, may struggle to adapt to a CBDC-dominant economy due to difficulties with technological advancements. They may also be vulnerable to scam fishing calls or emails that could be pernicious and difficult to catch.

Additionally, CBDC dominance could result in the downfall of critical institutions – and even full-on economies – around the world. If CBDCs were to become commonplace and fully replace the need for commercial banks, then it is possible that those banks will either lose enough business and close down or be forced to pivot and provide a more sophisticated financial service like portfolio management or accounting provision. Likely, this will not be the case, as many governments are likely to dispense CBDCs through commercial banks in an effort to foster a larger ecosystem of financial institutions, but it could result in a loss for some smaller banks.

On the other hand, if, for example, an American CBDC becomes particularly powerful in the global order, a smaller country could run into the problem of its people resorting to the American CBDC instead of their own local CBDC or national fiat currency. Issues like high inflation, increasing interest rates, and even purely limited access during times of financial distress could all result in a huge dichotomy of financial and political power over smaller nations that could result in greater harm than good.

Finally, CBDCs, despite likely receiving significant technical support and human resources designed to mitigate such issues, will become a recurring target of cybercrimes. The technological nature of CBDCs, whether they adopt veritable blockchain infrastructure or slightly altered structures based on permissioned nodes, will welcome challengers who have become sophisticated in their malicious approaches, ever since cryptocurrencies and other blockchain-native projects became more prevalent around the world. A massive effort – and an equally large collective of anti-hack personnel – would be indispensable to safely implement a CBDC.

Conclusion

Upon close inspection, it is evident that CBDCs are the next evolutionary step of central bank money, and its development today is as opportune as it could be, piggybacking off of the innovation and infrastructural examples provided by blockchain technology. In the midst of decreased cash usage and the advent of a truly cosmopolitan infrastructure of exchange that is becoming as quotidian to average citizens as transacting with cash, it is no wonder that CBDCs are a likely future for countries all over. Governments are investigating the most appropriate implementation methods that suit the financial situation of their concomitant domestic economies, resulting in a plethora of CBDC models worth examining.

CBDCs promises a slew of benefits for both individuals and institutions, including greater access to central bank money, financial inclusion of underserved economic participants, improved cross-national payments, and most of all, a more efficient means of value transfer for all. However, they are not without their perceived drawbacks, privacy rights violations primary among them. On top of this, a predicted overhaul of financial structures globally, instability of the existing financial system, and negative externalities upon monetary policy are all macro-level anxieties that lack a confident means of resolution. To add insult to injury, CBDCs flat-out invite cybercrimes to a degree yet untold.

While complicated to reconcile these differences, in the second part of this M3TA Deep-Dive series, we depart from the strictly technological and financially-related facts of this topic and dive into various opinions shared on the sociopolitical ramifications of CBDCs. By doing so, we strive to walk you through an analysis of the positive and negative externalities of CBDC implementation and arrive at our own conclusion regarding how CBDCs should enter the global economic playing field.

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