Central Bank Digital Currencies: Demystifying the Next Evolution of Money

In line with the ever-shifting demands of individuals, businesses and societies, innovation in money and payments is constant and inexhaustible. The end goal is fast, cheap, and frictionless value transfers, that serve the needs of the parties enmeshed in the exchange. For decades, the wider private sector has been actively pursuing this vision with innovations such as E-money, Fintech, NeoBanks, and Cryptocurrencies.

Yet, economic events of the recent past, such as the financial crisis of 2008, the European debt crisis, and the COVID-19 pandemic, have aggravated the need for even more radical changes in the economy, and an ultimate shift towards systems that produce socially beneficial outcomes that are free of systemic risk. Despite this need, and until now, central banks have largely remained monolithic and true to their mandate of facilitating for financial stability and economic growth, a role they served with varying degrees of success.

Central Bank Digital Currencies or CBDCs, are promoted as a medium for remedying fundamental issues with modern economies and societies. If successful at their premise, they will also mark a new era of more involved and relevant Central Banks in the wider economic affairs.

Despite the important mandate of CBDCs, and their prominence in academic literature and public discussion, their definition and premise remain ambiguous to uninitiated observers.

While many concepts that relate money, economics, and finance venture into the arcane, others, such as money creation, are so simple that, to paraphrase John Kenneth Galbraith, “the mind is repelled”. CBDCs comfortably fall into the latter category.

The recent report of the EU Blockchain Observatory and Forum aims to demystify CBDCs by providing concrete definitions, laying out their desirable characteristics, and shedding light on other surrounding topics. This article provides a brief overview of some of the topics discussed in the report.

What are CBDCs and why are they important?

Monetary policy, inclusion and financial stability:

Central Bank Digital Currencies, as the name suggests, are digital forms of money to be used by the private sector, meaning businesses and households, that are issued by the central bank. Their novelty and potential impact will rely on two factors: first, the extent to which they will be made to end-consumers, besides banks and financial institutions, and secondly, the technology behind them, and the new possibilities that it might enable.

The 2008 financial crisis showcased the inefficiencies of commercial banks and their reliance on central banks for their rescue. By making CBDCs available to all, central banks will extend their protection and guarantees to the wider economy, meaning businesses and end-consumers. As such, a potential insolvency of commercial banks would no longer be as detrimental to the economy. In the same spirit of protecting the economy, CBDCs are to further financial inclusion. With COVID-19 accelerating the digitalisation of work, communication, and even money, all signs point towards the declining use of physical money for transactions. CBDCs are promoted as the digital alternative of cash to mitigate financial exclusion and ensure that end-consumers and businesses still have access to a central-bank medium of exchange.

Within the last 10 years, cryptocurrencies, stablecoins, and private solutions such as Facebook’s Diem emerged in an attempt to meet consumer needs for fast, frictionless, and beardless payments. The vast networks that they developed were perceived as potential threats to financial sovereignty by regulators. Thus, CBDCs are also promoted as a medium for ensuring the relevance of the central bank and strengthening the financial sovereignty of a country against threats of the private sector, or foreign actors.

Advances in payments and new possibilities:

In terms of technology, innovations such as Fintech, Neobanks, and especially blockchain, showcased the benefits of money and financial systems suited for modern needs. In many cases, the speed, efficiency, and user experience of private and decentralised solutions are unmatched by traditional payment systems.

By drawing from innovations from the open blockchain space and private sector, CBDCs might also constitute the next evolution in today’s payment systems, facilitating for advancements in payment speed and efficiency. Moreover, the digital nature of CBDC is likely to enable additional novel concepts. Indicatively, programmable digital money can be used for more targeted and effective monetary policy.

As an example, the COVID-19 pandemic, and inefficiency of instruments such as quantitative easing, necessitated fiscal policies in the form of stimulus checks. Yet, in the face of uncertainty, many consumers opted to save instead of spending. As a result, stimulus checks might prove less effective than desired. A digital and programmable CBDC could render stimulus checks more effective by programmatically ensuring that they are spent within predetermined timeframes, or even in specific areas of the economy. Additionally, the digital nature of a CBDC might also prove helpful in eliminating the zero-lower bound, freeing up additional options for conventional and unconventional policy levers.

European Blockchain Observatory and Forum (EUBOF)

As approximately 90% of central banks globally are exploring the issuance of CBDCs, the design choices that will facilitate their most desirable characteristics are still under debate. The EU Blockchain Observatory and Forum, under the academic guidance of the Institute for the Future (IFF) at the University of Nicosia, released a new report that identifies and evaluates eight (8) alternative design architectures for the digital euro.

This large-scale research aims at contributing to the ongoing debate to develop the digital euro, highlighting the following dimensions:

• How the digital euro will differ based on whether it functions similarly to today’s bank deposits (an account-based digital euro) or similar to today’s physical cash (a token-based digital euro).

• What are the differences based on the underlying technological infrastructure of the new currency, specifically choosing between implementing it atop existing euro zone-wide payment rails (such as the TIPS) or atop novel technological architectures, such as blockchain.

• Explores whether the ECB, as well as the Eurozone banking system and European citizens, would be better off if the digital euro was exclusively coordinated by the Central Bank or if it was distributed and managed in collaboration with Europe’s commercial banks and other financial institutions.

• Addresses additional considerations related to technology (interoperability and programmability features of the digital euro), regulatory aspects (traceability, compliance, and AML/KYC enforcement) and end-user experience (fund custody, digital wallet design and user interfaces).

• Identifies and studies several implications of the digital euro to areas such as financial stability or the operation of the European banking industry

Also published on: https://irishtechnews.ie/central-bank-currencies-next-evolution-money/