Why Central Banks are considering CBDC

Central banks around the world are accelerating their research and pilots around Central Bank Digital Currencies (CBDCs) concentrating in three use cases: wholesale, cross-border and retail. Their objectives are to remove large painpoints in these parts of the financial system increasing efficiencies and access, and to maintain monetary sovereignty. Given the financial stability consequences CBDCs can generate, their characteristics must be carefully studied through public-private collaborations. However, as the IMF has announced the impact of COVID has put the world in a new Bretton Woods moment and the promises that CBDCs could deliver are worth to be explored.

Central banks around the world are accelerating their research and pilots around Central Bank Digital Currencies (CBDCs). The three main uses looked at are wholesale, cross-border and retail. Wholesale is any transaction among corporations, cross-border are transactions among countries, and retail is any transaction in which one individual is involved. These are very different use cases but reflect the some of the largest pain points of the current financial sector.

Central banks around the world are accelerating their research and pilots around CBDCs concentrating in three use cases: wholesale, cross-border and retail

Normally, all banks within a country have access to a settlement system to make payments. These systems are Deferred Net Settlement Systems (DNS) or Real Gross Settlement Systems (RTGS), and are normally managed by the central bank. Every participant has an account in the system and the central bank makes adjustments to reflect payments from one entity to the other. In the case of DNS, the adjustments are made at the end of the day in net terms, while in the case of RTGS, the adjustments are made immediately in gross terms.

RTGS require more funding to operate because the banks need to pay each other gross amounts, but reduce the risk that final settlement will not happen as expected at the end of the day. Normally RTGS have been used for enterprise payments, while DNS have been used for retail payments (that is why a cashless payment for an individual may take a couple days). However, recently some countries have developed fast payment systems (FPSs) that offer real time payments for individuals close to 24/7. Also, the programmability that blockchain promises could be achieved in a similar way through APIs[1]. Therefore, depending on the degree of development of the payment system of each country, CBDCs will bring more efficiencies or less.

Depending on the degree of development of the payment system of each country, CBDCs will bring more efficiencies or less in domestic wholesale settlement systems

However, the evolution of securities towards tokenization is pushing the most advanced central banks to consider CBDCs for domestic settlement as well. The settlement of securities often requires the coordination of two separate entities: a securities settlement to transfer the securities and a payments settlement to transfer the funds[2]. This allows the Delivery-versus-Payment (DvP) mechanism which allows that the securities change hands only when the payment is done. If blockchain brings large efficiencies in the settlement of securities and derivatives due to the removal of pre and post manual processes, it may not make sense to leave the payment leg unchanged. In addition, one of the current problems for the development of the market of tokenized securities is the lack of an accepted payment token.

However, the evolution of securities towards tokenization is pushing the most advanced central banks to consider CBDCs because it does not make sense to tokenize one leg of the transaction and not the other

Cross-border payments are one of the more complex payment types. They rely on the correspondent banking system, which is an arrangement by which one bank in one country puts deposits in another bank in another country and vice versa. These accounts are called nostro and vostro and allow the movement of money from one country to another. The problem is that if the bank wants to send money to a country where it does not have an account opened, it needs to rely in a third bank that makes the connection. Adding a third bank decreases transparency and increases the length of the process. To circumvent this system, some money transfer operators, such as Transferwise, have funded accounts in many countries reducing the complexity of moving money cross-borders to debits and credits in their accounts. However, funding those accounts means having large amounts of capital parked in many countries, which requires scale for the business to operate.

Facilitating international payments is an area that is catching the attention of the most advanced central banks. Apart from removing the pain points, central banks are interested in maintaining their financial sovereignty and potentially strengthening the international role of their currencies, as the European Central Bank (ECB) mentions in its report on the Digital Euro. A more widespread use of a country’s currency gives the country and its banks more power internationally as the main suppliers of the currency. In addition, once international trade contracts are written and agreed in one currency, there is friction to change them.

Apart from removing the pain points in cross-border payments, central banks are interested in CBDCs to maintain their financial sovereignty and potentially strengthen the international role of their currencies

Finally, central banks are studying CBDCs as a mean to reach the unbanked. COVID exposed the difficulties of getting stimulus checks to the hands of those people that needed them the most. In the US, some of the stimulus checks arrived late or were mistakenly returned creating unnecessary stress for the recipents[3]. The believe is that CBDCs could be hold in an account without minimums and maintenance costs, and therefore become a vehicle to distribute wealthfare government payments. This idea is not new and it actually made it to a bill, which foresees the creation of a Digital Dollar Wallet in the US back in March. In contrast, for people that are currently banked, CBDCs will only add another means of payment to the current options: cash, e-money and debit/credit cards.

Central banks are studying CBDCs as a mean to reach the unbanked

The creation of CBDCs however must be carefully studied and piloted. Future wholesale payments need to be as resilient and safe as current systems. Consequently, the new architecture needs to take into account the standards that nowadays are applied to the financial market infrastructures that handle payment settlements. In addition, CBDCs in retail payments have the potential to disintermediate banks, specially in times of stress, given that the Central Banks will not go bankrupt (in contrast with banks). Also, they could decrease the supply of credit if depositors decide to keep their money in CBDCs instead. This is one of the reasons why the ECB is thinking of limiting the amount of CBDCs that people can hold. As the Bank of England Deputy Governor Jon Cunliffe pointed out, it is not their job to protect the banks[4], however, central banks have a duty to ensure financial stability.

CBDCs must be carefully studied and piloted to create payments systems as resilient as current systems, and not to generate financial stability problems

Furthermore, there are still open questions on how CBDCs should be. Some proponents are interested in having a CBCD that accrues interest to remove the lower bound of policy rates at 0% and allow negative interest rates, improving the effects of monetary policy. There are also discussions on how to respect privacy of transactions while at the same time allow an efficient monitoring of anti-money laundering and terrorist financing risks.

Two of the most debated characteristics for CBDCs is how they will treat privacy and whether they should accrue interest

In conclusion, it is clear that CBCDs will be a reality in the near future, however, there are still many questions to be resolved both technical and policy-related. This is the reason why Central Banks are calling for public-private collaborations to reach to a solution that evolves the current monetary and financial system for the better. As the IMF Managing Director Kristalina Georgieva, COVID has put the world in a new Bretton Woods moment[5] and technology innovation and policy rethinking may be the way.

[1] https://www.bis.org/cpmi/publ/d190.pdf [2] https://www.bis.org/publ/qtrpdf/r_qt2003.pdf [3] https://www.washingtonpost.com/business/2020/04/16/coronavirus-cares-stimulus-check/ [4] https://www.reuters.com/article/us-britain-boe-cunliffe/boes-cunliffe-not-our-job-to-protect-banks-against-digital-currencies-idUSKBN27T1ZR

[5] https://www.imf.org/en/News/Articles/2020/10/15/sp101520-a-new-bretton-woods-moment