From Bitcoin to Central Bank Digital Currency (CBDC)

In October 2020, seven major central banks¹ and the Bank for International Settlements (BIS) published a joint report laying out the key requirements for Central Bank Digital Currencies (CBDC). At the same time the European Central Bank (ECB) launched a public consultation on a digital euro² and announced it will decide in Q2 2021 whether to pursue the launch of a digital euro.

The recent report by the group of central banks establishes the first coordinated position of officials since crypto-assets became trendy.

Until now, central banks and regulators have published individual analyses and have occasionally taken disciplinary actions to protect consumers, but mostly did not interfere with innovation. A few initiated pilot projects (see below).

Vocabulary and concepts have evolved since Satoshi Nakamoto³ published in 2008 the famous 8-page Bitcoin white paper describing a peer-to-peer payment system based on decentralised ledgers and proof of work. Bitcoin and Blockchain marked paradigm shifts from traditional payment systems based on a central trusted third party.

The libertarian innovative wave spawned since 2015 a great number of self-proclaimed “cryptocurrencies” that were later more accurately labeled as crypto-assets.

Ultimately, a currency is the money of a country, or a group of countries. In its commonly accepted definition, money serves 3 purposes:

1. A means of payment, allowing easy transfer between economic agents. We shall easily agree that coins, notes, and bank transfers are easier to handle than the ancient Micronesian giant stone wheels described by Milton Friedman.
2. A unit of account. Pricing goods and services in units of currency made trade a lot simpler by creating a unique metric of value, sparing traders from publishing all the “cross rates” between bartered items.
3. A store of value.

An asset should entitle the owner to a tangible item or a stream of cash flows. From that perspective, crypto-assets have failed to reassure. Currencies ceased to be convertible into gold several decades ago⁴ and became Fiat money. Since then, a currency is solely a claim on a central bank. Therefore, the value of a currency depends on our trust in the balance sheet of a central bank and its ability to keep inflation under control. Thanks to their historical track records, central banks have earned the trust of the public while issuers of crypto assets still long for it.

Depending on national circumstances, central banks have various motivations to issue CBDCs. Common motivations are the diversification of payment methods as the economy becomes more digital, as well as increasing financial inclusion for remote regions where physical cash is difficult to obtain (reduction of number of bank branches or ATMs).

Several fundamentally different solutions are envisaged for the design of CBDCs and many questions remain to be answered

• Should CBDC be “cash-like” or “deposit-like”? Would it bear interest?
• If CBDC is similar to a deposit at the central bank, how to avoid the elephant in the room: the disintermediation of commercial banks?
• For resilience and availability purpose, CBDC should be usable offline, however, counterfeiting and fraud are more complex to mitigate in an offline world.
• Will a cap be imposed on individual holdings of CBDCs? In zero interest periods, would depositors prefer holding CBDCs or deposit money at commercial banks? In times of financial crisis, “runs to digital CB money” would be easier than withdrawing banknotes for ATMs, potentially destabilizing the system.

The various official reports points towards a two-tier approach where CBDCs would be issued by central banks to commercial banks and commercial banks would then distribute the currency to their clients.

To maintain the right balance between security and privacy, it is unlikely that CBDCs will be fully anonymous like cash, but rather provide some level of privacy. It should be reminded that Bitcoin and crypto-assets provide only semi-anonymity.

What have central banks tested so far?

The pioneer

Uruguay Central Bank was the first to test digital currencies in November 2017 with in a 6-month pilot where 20 million e-pesos temporarily replaced the equivalent number of traditional banknotes. 10 000 mobile phones owners used an e-Wallet. The scheme involved multiple established business partners. The technical specifications featured unique traceable bills preventing double spending and required a mobile phone connection (not an internet one). Banco Central de Uruguay described the experience as very positive and without technical incidents (source BIS). The prime motivation was digital inclusion and the reduction of transaction costs compared other payment methods.

The great wall

China imposed a ban on initial coin offerings in September 2017 and de facto kept a lid on the mania surrounding crypto-assets, showing concern over speculation, consumer protection and a willingness to control the future of the digital Renminbi.

A first pilot of a “Digital Currency Electronic Payment” – DCEP took place in Shenzhen in October 2020 where 50 000 randomly selected consumers received 200 digital Renminbi.

The second pilot is currently running in Suzhou where 100 000 residents received on 11 December 2020 digital “red envelopes” of 200 Renminbi. The Suzhou DCEP will be valid until 27 December 2020 through the official Digital Renminbi app.

Sweden, the cashless society

The Swedes are using less physical cash than their fellow Europeans. Sveriges Riksbank was long perceived as the most advanced central bank and designed a framework in cooperation with established business partners. The central bank announced it was testing the framework in a simulated environment.

Until recently, central banks kept a certain distance and let the private sector innovate. In recent months, we have seen the first steps of concerted moves towards CBDCs.

This change of attitude is welcome as it complements other private and public initiatives in the world of payments which is innovating at a greater pace than ever.

By moving forward, central banks – trusted and risk adverse organisations - are signaling to society that technological innovation is safe and can bring value.

Jean-Marc Servat
Chair
European Association of Corporate Treasurers

- - - -

^{1) Fed, ECB , Sveriges Riksbank, BOE, Bank of Japan, Swiss National Bank and Bank of Canada
2) The deadline of the digital euro consultation is 12 January 2021.
3) It is still unclear whether “Satoshi Nakamoto” represents a real person or a group of individuals.
4) The last nail on the coffin of the gold standard and Bretton Woods was the end of the US dollar convertibility into gold in 1971.}