Central Bank Digital Currencies (CBDCs) are so hot right now. Nigeria’s launched in October. India’s launches in April. China, South Africa, Saudi Arabia, Sweden, and Jamaica are testing small amounts of CBDC. More still are in the research and development phase, such as the U.S. where the Federal Reserve solicited comments on a United States CBDC in January. It’s rare to see such a diverse block of countries move towards the same policy goal so quickly, but the benefits offered by a Central Bank Digital Currency justify the haste. This post will first briefly define CBDCs before contextualizing that definition by looking at the current state of well-functioning National Payment Systems (NPSs) such as those in the U.S. and E.U. Not all countries have such well-functioning systems, so we then turn to the problems inherent in poorly functioning NPSs, before returning to what a CBDC is, how it ameliorates the problems in both good and bad NPSs, and how it allows nations with poorly-functioning NPSs to leapfrog ahead to a NPS which is on par with or better than the systems in well-developed countries. Finally, we conclude with problems that are inherent in CBDCs and the current state of CBDC development worldwide. So what exactly is a CBDC, and why are so many countries pursuing it?
Succinctly, a CBDC is a digital liability of a central bank. It is a fiat currency, with value derived from its issuance by the state. Compare this with a coin in your pocket. The coin is also fiat currency, and it is also a liability of the central bank. The distinction between that coin and a CBDC is that the CBDC is digital. While this distinction sounds trite, it is in fact the heart of what makes CBDCs so attractive to governments.
This currency digitization is significant because presently it is not performed by the government. Instead, third-parties, predominantly commercial banks, turn physical currency into other forms of money when transferred into the institution. In the case of commercial banks, the fiat money becomes “commercial bank money” when deposited. This is referred to as an intermediated National Payment System (NPS). Rather than being able to deposit and withdraw money from the central bank — which would be non-intermediated — a currency user must deposit and withdraw money from a commercial bank, which in turn is able to exchange money with the central bank.
Some countries, such as the United States, presently have a digital currency which is only available to large institutions for transfers of large amounts of funds. A digital currency only available to large institutions is sometimes referred to as a “wholesale CDBC,” as opposed to a “retail CBDC” which is available to all or nearly all citizens of a country. The genesis of CBDCs post-dates the use of “digital money” by a central bank, so the term CBDC nearly always refers to a retail CBDC. Getting into the weeds of financial history as to why the term CBDC typically does not refer to central bank digital currency held by large financial institutions is beyond the scope of this article. The short version is that as banks grew, they needed access to large amounts of currency and the ability to transfer that currency between banks so that they could serve their basic function: providing access to lines of credit by using the money placed in their accounts by depositors. Expediting transactions with a central bank made transactions faster and less risky, making the economy in general run faster and with less risk. The high frequency, large quantity, and high dollar amount transactions engaged in by large financial institutions justified the government incurring those costs in the name of economic prosperity. The U.S. is the financial epicenter of the world partly because of the efforts the government has undertaken to expedite transfers with the central bank and among commercial banks. However, for countries without well-functioning and well-established financial institutions, that cost was not justified: there simply were not enough players engaged in large enough transactions at a high enough frequency to establish a similar National Payment System. That is, until modern technology made the creation of a CBDC cheap and relatively easy.
To see how a CBDC would improve the current state of affairs, we have to see how a NPS functions in a best-case scenario. Let’s take a look at how the U.S. NPS works during an average transaction. Your friend picked up the tab at the bar, and you need to reimburse them (at least if you want them to still be your friend). How do you give them the money? Option 1) hand them money. Option 2) write a check. Option 3) send a wire transfer. Option 4) send the payment via a nonbank payment system such as Venmo. Each carries different levels of risk and liquidity. Option 1 is most secure because you are directly transferring fiat currency. As legal tender, it is required to be accepted as payment in the issuing country, making it extremely liquid. Option 2 and 3 are less secure because the bank may go out of business in the time it takes for your friend to deposit the check or the time it takes for your bank to wire the money to your friends account (if you both have deposit accounts at the same bank, the transfer would be nearly instantaneous, but we will assume you use different banks). That commercial bank money is less liquid because paying with bank funds requires writing a check or an Automated Clearing House transfer (ACH, the U.S. electronic funds transfer system). Option 4 is the riskiest of all because nonbank financial institutions are not subject to the rules and regulations of commercial banks, giving less recourse to people with funds wrapped up in the service if the nonbank institution fails. They are also less liquid, as the nonbank money must be transferred to a commercial bank before it can be converted to fiat currency. A financial panic could lead to runs on these institutions where money is withdrawn faster than it is replaced. In that event, the nonbank issuer closes up shop and those with money in the issuer are stiffed. While the user may have recourse in the legal system, the issuer may be insolvent and unable to fully repay. Banks face the same issue, but with FDIC insurance and other regulations, depositors know they will get something if the bank goes belly up. The government is most secure because as long as the government remains in power, you will be able to use your dollar.
Despite the higher risk and lower liquidity, banks and payment apps provide real benefits. First and foremost, both offer physical security for your money. Although you may lose money if the institution becomes insolvent, you need not worry about robbery or theft. As to the specific institutions, bank depositors earn interest on their funds because banks use those deposits to lend, while fiat currency stays stagnant. Your $100 bill will always be worth only $100, but deposited in a bank, you will be able to grow that $100 into more. Also, deposits give less risk and more liquidity than other sources of passive income such as securities. Payment apps compensate for their high risk and low liquidity by allowing easy signup for accounts and fast transfers on their network. With no minimum deposit requirement and no regulatory requirement that deposits are backed by assets, they are more accessible people with low incomes and able to make faster transfers than a bank. Likewise, with no need to access an ATM, the app is more accessible to people with few nearby banking outlets, and the app is able to make faster transfers than when using fiat currency.
Not all people have access to those benefits, however. 7% of the US population is unbanked, partially due to availability of financial services. Other nations have less well functioning systems, making the problems inherent in fiat currency, commercial bank money, and nonbank money that much more severe. In China and India, 20% of the population is unbanked and. Russia is 24% unbanked. Nigeria has 60% of its population unbanked. Without a bank, a person’s alternatives are to keep your money in cash or to use alternative payment systems. Cash presents issues of theft and high transaction costs, as mentioned above. Governments also prefer people don’t use cash because it makes policing money laundering, terrorist financing, and other criminal acts significantly harder. Storing money in the bank gives the state a regulatory target, meaning that the government can require the bank to report and investigate suspicious transactions, which reduces the cost of the government performing that oversight themselves.
Without banks as intermediaries, more people turn to nonbank financial services like payment apps and cryptocurrencies. Lack of access to banks means that people are forced to look to riskier and more expensive options for lines of credit and have difficulty saving money. Those people are typically poor and disproportionately women. If you use an alternative payment system and they go out of business, those with money in that system may find themselves deprived of their money and with little recourse. In the example above, Venmo likely isn’t going down soon, and indeed many payment apps in the U.S. are now also banks, but what about a riskier payment app?
Simultaneously, governments don’t like alternative payment apps because the store of value which underpins the transfer are often cryptos which can be both a trap for users who are unaware of their volatility and a destabilizing force because cryptos do not directly rely on the government for their value. For citizens of countries with rapidly depreciating currencies or civil unrest, using cryptocurrencies provides more stability than their fiat currency. This can be seen most recently in Turkey, where President Recep Tayyip Erdoğan’s policies have cratered the value of the Turkish lira, prompting citizens to buy up cryptocurrencies, specifically stablecoins. Although fiat currency is typically most secure because it is backed by the state, if the state is weak, that currency is also weak, hence why crypto usage is highest in developing countries. This is one reason why the launch of CBDC projects often accompany other measures such as the ban on crypto mining in China and a 30% tax on crypto imposed in India. The idea is that the CBDC will fill the demand for a digital currency which is currently directed to cryptocurrencies.
Moving value into cryptos further destabilizes and undermines the power of the state by making it more difficult to police crime, as noted above. Wide acceptance of cryptocurrencies also undermines the state’s monetary policy. A state controls their economy primarily through their control of their fiat currency. When citizens are storing value in cryptocurrencies rather than fiat currency or easily convertible commercial bank money, the state’s control over the economy is necessarily attenuated. Cryptos’ ability to transfer value across borders more easily than fiat currency and commercial bank money further exacerbates these problems. There are further implications of a state’s citizens moving away from fiat currency and towards cryptocurrencies, but those issues are beyond the scope of the discussion here — for instance, cryptocurrencies undermine the economy’s development of financial institutions such as banks, decreasing the availability of credit, but this may be offset by the creation of crypto deposit institutions — but the takeaway is the same: cryptocurrencies pose a threat to state issued money.
To recap, even in the best National Payment Systems such as those in the U.S. or E.U., there are frictions between competing goals of financial security and transaction speed. Institutions in those systems do not serve the needs of all citizens, and countries with less well-functioning systems fare even worse, with large shares of their populations unable to transfer money safely and quickly. Simultaneously, a lack of those institutions encourages consumers to put value in currencies with no direct ties to the state, threatening the state’s ability to police financial crimes and undermining the state’s monetary policy.
A retail CBDC addresses these issues by allowing the central bank to establish bank accounts for every citizen. That centralized store of value reduces transaction costs, gives a banking option to the unbanked, allows for more direct oversight of the financial system, and reasserts the power of the government as the issuer of currency. For nations with underdeveloped NPSs, like Nigeria whose eNaira currency launched last year, the benefits of a CBDC are immense. The 60% of their population who were unbanked and had to hold physical stores of currency now have the option of depositing it in their central bank account, reducing the threat of theft. It formalizes their economy, providing a record of transactions between people which would otherwise go unrecorded. This record gives the government a more complete picture of their economy, specifically GDP and employment, which in turn allows them to better tailor policies to the actual goings on of the country. This formalization reduces tax avoidance, allowing the government to generate more revenue, as well as making it easier to monitor crime. Well-functioning NPSs rely on intermediary financial institutions for this formalization. Up until recently, a developing country’s only option to ameliorate the woes listed above was to try and stabilize their economy and build financial intermediaries for their citizens. But building institutions takes time, nevermind the time it then takes for institutions to achieve widespread adoption and buy-in from the constituencies they are intended to serve. A CBDC is therefore an economic wormhole, allowing countries to bypass decades of work building financial institutions.
But it’s not all upside. A CBDC benefits countries by disintermediating the NPS but poorly designed, this could undermine long term growth of the economy. First, intermediation between the central bank and consumers has real benefits. Banks draw on their deposits to fund lines of credit, and if given access to attractive central bank accounts, people may withdraw their funds from commercial banks to store within the central bank. This could decrease the availability of credit and increase the cost of obtaining it. Modern industries are by-and-large reliant on debt financing for growth, so higher credit costs could translate to a slowdown in the nation’s economic growth. Similarly, one of a CBDC’s greatest draws is its record-keeping function, which allows for increased economic formalization. However, that surveillance ability can be abused. The ability to monitor nearly every person’s financial transactions could give countries an easy tool to clamp down on dissent.
Luckily, these risks can be mitigated by effective CBDC design, which is sufficiently technical to be outside the scope of this blog. In the United States, the Federal Reserve requested comments on a CBDC in January, indicating that they are in the research phase of developing a currency. Simultaneously, however, the Boston Fed is pursuing CBDC design by partnering with MIT’s Digital Currency Initiative. “Project Hamilton,” as the collaboration is called, released a whitepapaer on CBDCs and open-source code for a hypothetical CBDC in early February. It’s notable that the countries slowest to adopt CBDCs are those with the best functioning National Payment Systems. A CBDC’s ability to dramatically improve a country’s NPS is less dramatic in countries which are already ahead.
This only scratches the surface of CBDCs. In the coming years, more and more governments around the world will be concerned with their CBDC and the policies it serves. It will let money in developing countries flow in ways heretofore unseen. It will be used, in some places, to crush dissent. Simultaneously, it may be another nail in the coffin of American hegemony. The US is currently the financial epicenter of the world because of the status of the dollar, a status owed in large part to our financial industry and NPS. That centralization makes US sanctions particularly brutal. Effective or not, those sanctions have been an oft used foreign policy tool in recent decades. If those sanctions are less effective, it may put the US and its allies in a position where they must use more direct means of confrontation.
CBDCs are coming to every country, sooner or later, in one form or another. How they will be used and how they will be used, however, remains to be seen.
Author Biography: Evan Conner is a Moderator of the International Law Society’s International Law and Policy Brief (ILPB) and a J.D. candidate at The George Washington University Law School. He has a B.Mus. in Sound Recording Technology from University of Massachusetts – Lowell.Tweet