Manu Choudhary, CEO of Definity Markets, explores some of the big challenges that lie in front of the central bank digital currency project.
Arguably we have had BDCs or bank digital currencies for over 50 years in the UK, which is the money in your accounts, created by commercial banks. One key distinction between CBDCs and traditional digital currencies lies in the centralisation of control.
While digital currencies have been in use for decades, with banks issuing deposit entries as digital currency, CBDCs are proposed as a centralised form of digital cash. Central banks, like the European Central Bank (ECB) and the Bank of England aim to offer CBDCs as a response to the growing popularity of cryptocurrencies. However, this move poses significant risks to the existing financial system and could entirely disintermediate commercial banks.
There are 2 elements to CBDCs, wholesale and retail.
• Wholesale CBDCs are designed for use by financial institutions and serve as a digital representation of reserves held by banks with the central bank. They could be used to improve payments and securities settlement efficiency, as well as to reduce counterparty credit and liquidity risks.
• Retail CBDCs can be directly held by citizens and corporates as a digital form of cash as a complement to paper money with accounts at the central bank.
What will the benefits and risks of CBDCs be?
There are tangible benefits of using wholesale CBDCs, however it is not quite as clear cut when it comes to retail CBDCs. Whilst I think there are huge benefits for emerging market economies, where there is a lack of traditional banking infrastructure and a fragmented payment system, but a high prevalence of smart phone usage, central bank digital currencies could genuinely be a wonderful tool to promote financial inclusion. Moreover, it would help to remedy the fragmented payments infrastructure and speed up the payment process.
In the UK or Europe, however, you have to ask yourself the question, why do we need retail CBDCs? In the UK about 3% of the population is unbanked; this number is marginally higher in the EU, but still only 4%, and if I want to make a faster payment to UK bank accounts it is virtually instant or SEPA payments within 30 seconds 24 hours a day, 7 days a week.
When you ask the central banks what the real purpose of retail CBDCs are in the developed world, the explanation, is to be able to combine monetary policy (interest rates, price stability employment) and fiscal policy (taxation and spending) and be able to execute it in real time. I find this logic a little troubling.
In the West there seems to be no convincing need for CBDCs, as existing digital currencies already serve the purpose efficiently. I really have to question the necessity of retail CBDCs.
There are some quite material technical challenges, such as the reliance on functioning technology and potential vulnerabilities, which in my mind raise doubts about the resilience of retail CBDCs. Perhaps most crucially, the issue of trust emerges as a significant concern, certainly for me. I was deeply troubled with how authoritarian that apparently democratic and free counties like the UK became in 2020 and having lived through that once makes me a little concerned that governments and central banks might use retail CBDCs to monitor, control, and restrict transactions, eroding privacy and individual freedoms. Most worryingly this introduces an element of conditional currency, where individuals must seek permission from central authorities to utilise their own money.
Who are the main players in this space, why are they getting involved, and how do their approaches and interests align or differ?
The major players in the space from a central bank perspective are the BIS and its 66 central bank member firms. The major players in the developed world from a central bank perspective are, the Swiss National Bank, the Bank or England, the Banque De France and the Fed and the ECB.
These central banks are getting involved because they are concerned about the growth of private crypto currencies. One thing to understand however is that of the half a dozen central banks I have spoken to, every single one is using their own (permissioned) private derivative of a public blockchain, Stellar, Algorand, or XRP. Which then requires the building of bridges to interface with other CBDCs and further bridges to interface with public blockchains.
The SNB (Swiss National Bank) recently announced that they are no longer pursuing a retail CBDC and they will focus solely on a wholesale CBDC.
The BoE have stated that they may opt for synthetic CBDCs rather than retail CBDCs, which I think is a much smarter idea. However, the BoE intends to use narrow money rather than my idea of using bonds from the BoE balance sheet as collateral.
What challenges do regulators, banks and governments currently face in developing and implementing CBDCs?
Most central banks are rightly concerned about the growth of stable coin use and the potential for systemic risk it creates. It is my belief that rather than more regulation, what we actually need is greater participation from the Bank of England.
The Bank of England currently has about £808 billion in UK Gilts, acquired principally through its QE programs, on its balance sheet, which constitutes ~30% of all UK Sovereign debt.
If the Bank of England were to allocate ~5% of these bonds notionally to collateralise a stable coin, let’s call it ‘BritCoin’, issued by the Bank of England in partnership with a financial institution, it would be able to dominate the stable coin market overnight. As an added bonus this mechanism of creating a synthetic CBDC does not increase money supply.
Infrastructure – what should it be? Who is going to build and run it? Who is going to own it?
In an ideal world, central bank digital currencies would all run on the same public blockchain, but that’s not how it’s going to work. Every single CBDC is using a private version of a public blockchain. The infrastructure already exists and is owned by the central banks, but currently there is no interoperability.
How could retail central bank digital currencies shift market structures and impact the financial services sector?
If we continue down the current path, we could disintermediate commercial banks and destroy economic growth. Banks are not financial intermediaries; they are key to the creation of money. When a bank lends, that money doesn’t come from its reserves, that money is created. When that money is lent to businesses it is additive to GDP and does not create inflation. When that money is used to create asset bubbles, such as real estate lending, it does create inflation.
