Central Bank Digital Currency
Its the most talked about, soon to be the 3rd form of money……
According to voxeu.com, surveys indicate that 80% of central banks are engaging in work on the topic and over 30 central banks have already launched research or design reports. Central Bank of Sri Lanka is also working on a CBDC, this information is solid thanks to the RIT act. (Yes I personally inquired and CBSL was kind enough to respond)
Recent advances in cryptographic and distributed ledger techniques have opened the door to the widespread use of digital currencies. While private initiatives such as Bitcoin, Ethereum, and Libra have led the introduction of these currencies, researchers and policymakers have explored the possibility that central banks could also issue digital currencies, and make them available to the general public.
CBDCs could become a new, third form of central bank money, alongside physical cash (accessible to the public) and central bank reserves (accessible to many financial institutions).
Lets get to know the existing two forms of money.
Understanding the fiat money system in place in important for a better understanding of CBDC. Today, to promote safe payments central banks issues central bank money to the public as cash and to banks through reserve and settlement accounts. This is the mandate CBs has for monetary and financial stability. This money acts as a means of payment, unit of account and store of value for jurisdiction. In a way almost all largest and smallest payments in the economy is carried out using central bank issued money.
Central bank has a direct liability on Cash/Coins. What does this mean? It means that if you have a cash note with you, then the central bank will 100% guarantee the existence of that note. In no point of time you need to be worried because its issued by the central bank.
Then we have central bank reserves, which are in digital form. Commercial Banks act as an middle layer(intermediary) layer when granting access to the reserves. This is actually the current electronic money. Which is a intermediary representation of money but unlike Cash, CBSL is not fully responsible for that. The commercial bank which you are holding your bank account is responsible for the money saved in the account. In other means, you need to go that exact bank to use that money.
Bottom line is, reserve money or current electronic money does not exactly represent cash. The key consideration for issuing a retail CBDC is that current electronic retail money represents a claim on an intermediary(commercial banks), rather than functioning as the digital equivalent of cash. This raises several issues, as the intermediary might run into insolvency, be fraudulent, or suffer technical outages. A CBDC to be unaffected by financial crisis must be a cash-like direct claim on the central bank.
Below image will show the liability difference between ,Cash and electronic money in today’s two-tier monetary system.
Figure 1 : Explanation- Cash is a direct claim on the central bank, while deposit accounts are claims on the commercial bank. Commercial banks back some of these claims by holding reserves at the central bank, but such value backing is never full.
What are we trying to solve with CBDC, that digital form of money doesn't support?
Households and firms have long held digital money balances, in addition to notes and coins. Banks have issued digital money, demand deposits for decades. And central banks have done likewise, issuing reserves, but only to commercial banks.
What has changed in recent years is the ease with which users can access their money and spend it. FinTech and Big Tech have led the way (and banks have followed) towards more transaction convenience, at the cost of sacrificing personal service and privacy. Moreover, blockchain-based technologies which decentralize the storage of information and its trustworthy transmission increasingly allow to cut out the middleman.
Also we know that commercial banks as the intermediary might run into insolvency, be fraudulent, Not meet the reserve rules and issue more currency to the public or suffer technical outages.
What is central bank digital currency?
As you have already read above, addition to banknotes and other liabilities, central banks issue digital money reserves but only to a select group of financial institutions which we call as commercial banks. With the CBDC concept, households and firms also should have the possibility to acquire reserves directly from central banks without an intermediary. More like Cash!. Then again. The innovative part of CBDC is not its digital nature, but broad access. A more fitting name would be ‘Reserves for All’.
Possible CBDC Architecture
These considerations bring to the fore the issue of how a CBDC can live up to central banks’ mandate to provide a universal means of payment for the digital era, while at the same time giving the private sector the primary role in the retail payment system. Only some of the numerous proposed CBDC architectures can achieve this feat.
Currently there are three main architecture designs are being discussed.
- Direct CBDC
- Hybrid CDBC
- Indirect.
I will share an figure below which will detail out the differences of the three concepts.
Direct CBDC : A retail CBDC allows consumers to hold a direct claim on the central bank. Central bank handles all payments in real time and keeps a record of all retail holdings. No intermediaries needed. This is more like Cash. Central bank will have to provide infra and resources to handle all transactions and consumer accounts.
Hybrid CBDC : incorporate a two-tier structure with direct claims on the central bank while real-time payments are handled by intermediaries. The central bank could either retain a copy of all retail CBDC holdings or only run a wholesale ledger . Consumer accounts and transactions will be handled and managed by the intermediaries but central bank will also notified of the transactions taken place.
Indirect CBDC : fully backed payment accounts that feature intermediaries who need to have fully backed account holdings at the central bank. I don’t see any difference in this model and the existing digital money.
Central Banks Readiness
As central banks play a key role in payment systems, both the declining use of cash and related private sector developments may require them to step up and take a more active role. If a central bank were to issue a CBDC, record-keeping, integrity protection and establishment of the necessary level of consistency can also be delegated to the private sector, which might either be allowed to use proprietary technology or be required to run open protocols specified by a standardization body. (Hybrid)
The need for technical supervision emerges as soon as the central bank is shielded from some retail transactions, which a fraudulent or technically compromised payment service provider could use to appropriate customer funds. Maximum supervision is required when the central bank has the conceivable minimum information set. Payment supervision must happen at a high frequency perhaps even in real time.
All this pinpoints a novel trade-off for central banks in the digital era: they can operate either complex technical infrastructures or complex supervisory regimes. There are many ways to do so, but all will require the central bank to develop substantial technological expertise.
Next we will talk about CBDC issues and concerns and the problems CBDC will help resolve in the existing monetary system..
End of part 1.
References : https://voxeu.org/article/cbdc-architectures-financial-system-and-central-bank-future
