I have written before about the process of adoption of blockchain technology, and how it needs a combination of domain, or commercial, expertise and technical expertise. If you have these two together then you have the ability to create something new, and the question then becomes where you create it. I argued that the answer to where you create it is the ‘void’ –the blue water into which your venture can launch. Currently in banking, the voids are not being filled. Rather, we are seeing commercial banks adding blockchain based elements onto their existing business models. For example Investec in South Africa has announced the launch of digital asset custodial services.
Voids are hard to spot because you are looking for gaps, and are often hampered by a mental model that is founded on the current paradigm. One void that looks like being addressed fairly soon is that of a central bank digital currency, or CBDC. CBDC is digital money that is issued by the central bank, and backed with government assets. It is different from cash in that it is electronic, and it is different from commercial bank money in that it is backed by the central bank.
Why CBDC? Why now?
There is currently great interest in this topic, with the Bank for International Settlements Quarterly Review from March 2020 listing seventeen retail (as opposed to wholesale) CBDC projects around the world, including here in South Africa. The sudden interest can be understood from both a proactive and a reactive perspective. From the positive side, central banks see that technology – mainly but not exclusively blockchain – enables things that were not before possible, and so are duty bound to investigate. Central bank mandates relate to the implementation of monetary policy, and it could be argued that any central bank that does not investigate new tools is at best complacent, at worst negligent. Another positive is that the addition of CBDC to an economy potentially enables large improvements in financial inclusion. This is a social imperative, and explicitly part of some central bank mandates, as well as having the fortunate side effect of being good for the economy. Finally, adding CBDC into a financial system creates a new set of tools with which to innovate, and all the positives that that implies.
Balanced between positive and negative reasons for implementing CBDC is a big one: the removal of cash. Central banks tend to be ambivalent about cash: while it is good for financial inclusion, it also facilitates crime. As a physical thing, I can steal it from you, and – unless you memorise the serial numbers – you can’t prove that what I now hold used to be yours. Then it’s expensive to make and replace, a cost that central banks have to bear. Its use is declining significantly in many countries.
From a more cynical or pragmatic perspective, the reasons for pursuing CBDC can all be traced back to a version of “what if someone else does it first?”. The most likely threats are bitcoin, another central bank, payments firms, or Facebook. The concerns with all of these are effectively the same: that something else takes the place of the national currency, and thereby changes the landscape in a way that is deemed to be bad. To examine these, it helps to go back to those old favourites, the three functions of money. As you will know if you’ve done any reading on this stuff, money serves as a store of value (remaining stable over time), a unit of account (for defining the value of things) and a medium of exchange (for facilitating payment).
The Swedish Riksbank, who are working with an economy where use of cash has declined sharply, have said that their interest in CBDC comes from a concern that payments come to depend on private companies. This is a concern that something else becomes the medium of exchange.
If that something else was a payment token issued by a global network with billions of users, then citizens might start keeping their funds in that token. If that token was denominated in US dollars, or if it became a currency in its own right, then the power of a central bank is diminished. The global network is, of course, Facebook, and the project that may become a currency is Libra. They have recently talked about what is effectively a dollar stablecoin rather than the original proposal which was for a basket of currencies. If I pay for a lot of things in Libra, or dollars, then I might as well keep my money in that currency, especially if it is more stable than the fiat alternative. Something else has thus become the store of value.
The combination of the means of exchange and the store of value leads to a critical mass of people and businesses using a foreign currency for daily life, and pretty soon goods and services are priced in dollars, or Libra. This is already the case for things like oil, or scarce services in countries with weak currencies. Once this happens, something else has become the unit of account.
This brings us to another scary topic: dollarisation. For some non-US economies, like Zimbabwe, the US dollar is part of daily life; for others, the power exerted by the Federal Reserve - via the dollar’s status as a global reserve currency - is undesirable. The People’s Bank of China has announced its intention to create a CBDC at least partly for this reason. With the growing trade influence - especially in Africa - of China, Renminbisation (?!) is a possibility, especially if trade is facilitated by the features of the Chinese CBDC.
I think it’s fair to say that the central banks have more to lose if their currency is usurped than they have to gain from increasing financial inclusion, competition, or monetary policy leverage. We should therefore give more weight to the fear factors than to the others when considering what happens next.
Where do we go from here?
Central banks could conceivably conclude separately or collectively that CBDC is a bad idea, and agree between them to keep the genie in the bottle. That would not remove the threat, however, from either a central bank who breaks ranks and launches a CBDC anyway (as China have already said they will), or from the changes wrought by new means of payment like Libra: “an incredibly important catalytic event” according to the head of the Riksbank. If we project from the above factors, then CBDCs seem inevitable. If that is the case, then what happens next?
A lot, as ever, depends on timing. Technology changes rapidly, but regulation and human behaviour are always much slower to shift. Given this, and the long development cycles, the impact of CBDC is likely to play out over many years. It absolutely makes sense for central banks to be investigating this topic now as there is a lot of learning to do. Assuming, then, that multiple central banks do launch CBDC, there are some interesting possibilities.
One I find particularly interesting is how these CBDCs will compete with each other. Currencies have always competed, with exchange rates being influenced by macroeconomics and by demand for the currencies. When currency is software, though, we have the ability for different CBDCs to compete on features. It may be the case that the digital Euro works better for payments, the Yen CBDC enables me to programme its use in more ways, or the e-krona provides an anonymity that I need in some contexts.
Central banks may choose to optimise their CBDC for features that are most valuable in their local or regional context, but they must do so in cognisance of the broader implications of their decisions. As an example, a degree of privacy is desirable in some contexts, but must be set against the need to counter criminal activity. For this reason, the Department of Justice in the US recently equated coin mixing – obscuring the details of crypto transactions – with money laundering. If a country’s CBDC came with some anonymity as a feature, would that make it illegal in the US?
There is a multiplier effect on getting the features of your CBDC right as well. More desirable features will lead to higher adoption, which in turn should make the currency more valuable. The imperative for central banks is obviously to think very carefully about what the target market is for their CBDC, who they would like the users to be, and therefore what features to optimise for. This is the kind of thinking a startup does when seeking product market fit, and so most central banks are likely to need skills that they haven’t needed before.
A further benefit to getting it right as a central bank is that you will, as a side effect, bolster the CBDC related industries in your country, as entrepreneurs come to test their ideas. In the same way that crypto businesses have launched in friendly jurisdictions, CBDC related businesses (and there is some overlap with crypto) are likely to seek out the most friendly environments. This can also be expected to be self sustaining as critical mass builds in the local financial industry.
And how do we get there?
A necessary step in reaching a situation where CBDCs compete is each CBDC being available outside its national borders. This is another design parameter. The central bank issuing the CBDC may decide to limit who can hold it. For wholesale CBDC, used in a limited context such as inter-bank settlement, this may be possible. Experiments like Project Khokha in South Africa or Project Jasper in Canada are built around ‘invitation only’ permissions networks. Once a CBDC is available to everyone – retail CBDC – the restriction becomes harder.
The CBDC will be held in some kind of digital wallet. This would be attached to a specific identity, which could be corporate or individual. The issuer of this wallet could be the central bank or deputised commercial banks. The central bank could restrict ownership to locally based companies or citizens, but what about multi-nationals, foreign residents or tourists?
Supposing I am in the UK and want to buy the e-krona, then I need some kind of digital wallet to hold it. This will probably be issued by a Swedish institution, either the Riksbank itself, or endorsed by the Riskbank. What I would need to do would be to establish my identity to the satisfaction of the Swedish authorities. Perhaps there is a local branch of a Swedish bank where I live, maybe there is a local correspondent bank who could provide that service, or maybe there is a global business with a base in my country and Sweden and who could facilitate it. Maybe I just show an ID in my local Ikea.
Once CBDCs become globally useful in one or more of the three functions of money, then behaviour and economies start to change. One view is that we end up with a single global currency, and one day look back on the nation state with its fiat currency as a historical curiosity. A more likely scenario is that we end up with a few regional currencies which will settle into relatively stable exchange rates, and we use different currencies for different uses, depending on their features – probably including cryptocurrency alongside CBDC. In some regions, we may end up with duopolies, e.g. Southern Africa could end up with a CBDC dollar and a CBDC rand, with the former facilitating international trade, and the latter designed with regional needs in mind.
The winning central banks in this context will have visibility of money usage at a global scale for their currency. This will enable terrific insight, but comes with surveillance concerns and creates a systemic risk. The degree of independence of central banks from the governments they serve varies throughout the world. Mitigating the risk of something going wrong is a good argument for decentralisation of the currency. But that’s a topic for another article.
Comments