Central Bank Digital Currencies: Reshaping the financial landscape

The traditional financial landscape has undercome drastic changes in the past; the future looks the same - - the central bank-issued digital currency is the first step towards it! Digital money started off with the launch of Bitcoin, and hos now multiplied rapidly. The market is highly diverse, with different portfolios for different people. The apex of graduation from the margins into the mainstream, however, can perhaps be understood as the way that central banks are now embracing the technology. Central Bank Digital Currencies (CBDCs) are part of active pilot programs of many central banks across the globe. Sveriges Riksbank - Sweden’s central bank - has announced a project for a digital version of its currency, especially for retail use. The bank is naming the currency as e-krona. The People’s Bank of China, on the other hand, has embarked on its own “digital yuan” project! This list is only going to expand in the coming future. In addition to these, the Bank of England, the Bank of Japan, the US Federal Reserve, and the European Central Bank are all looking to dive deeper into the use of CBDCs. Meanwhile, the so-called “central banks’ central bank” -- the Bank for International Settlements -- has been discussing CBDS in detail and recently announced that amid the current pandemic, contaminated bills may be the catalyst for central banks to deliver a digital cash alternative for payments. What can be other reasons that compel the heart of the economic establishment to take a plunge in technology with such radical and revolutionary roots? To be fair, they have been responding, in part, to challenges posed by the private sector businesses - such as Libra by Facebook. However, CBDCs go beyond this and even offer substantial benefits for general use, which makes them all the more attractive in their own right.  Specifically, the motivations could include: 

• Providing a much-needed cash alternative.
• Implementing a strict monetary policy.
• Promoting thorough financial inclusion.
• Modernizing payment for an overall digital economy.
• Increasing profits. 
• Linking payments to identity. 

The most interesting aspect of the recent models is the collaborative approach that many have been observed taking - with a little help from private sectors. For instance, the Bank of England has been researching what it calls the “platform model,” in which the bank is the only entity allowed to create or destroy a token while leaving payment interface providers (private sector operators) to communicate with end-users. This proposal gives payment interface providers the responsibility to maintain KYC checks while providing additional services to allow customers the freedom to differentiate themselves. Other central banks have even gone a step further. IMF researchers have recently coined the term “synthetic CBDC” to describe a model in which a non-central bank entity, such as a commercial bank can issue a stablecoin backed by central bank reserves.

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Digital Currencies for Global Payments is not that rare. The term “digital currencies” generally indicates the ever-increasing range of private-sector alternatives to traditional currencies that are coming to life as a part of the ongoing fintech revolution.  Indeed, cryptocurrencies such as Bitcoin and Ethereum are digital currencies and can be used for international payments. We don’t think of national currencies as a digital currency. But still, the Bank of England points out that central banks have been issuing digital currencies. However, this is done only to banks and not individuals. Electronic bank reserves are essentially digital currencies that are used as the final step of settlement between various banks. In essence, they can be understood as the banks’ digital currency that is eventually used for global payments.  Moreover, it’s not just the central banks that follow this process - even commercial banks do. Anyone having a deposit account is ideally using digital currencies issued by that bank, which the bank has guaranteed to be exchangeable at par for the central bank’s digital currency or its notes-and-coins equivalent.  Doing this ensures that a dollar in a bank account is worth the same as a physical dollar bill. The bank’s guarantee is backed by government deposit insurance, which is fixed up to a limit. Above that limit, the government doesn’t routinely guarantee convertibility to central bank money, whether digital or notes and coins. Though outliers exist to even this - as we saw in 2008, governments might temporarily guarantee convertibility far above that limit to prevent a systemic meltdown. The vast majority of the money that is in circulation today is actually digital currency issued by commercial banks - as is the majority of money issued by central banks. If we keep aside the physical transaction that takes place (in notes, coins, paper checks), all global payments are now being made using digital currency. This may be a combination of the central bank and commercial bank digital money or maybe an actual digital currency, like bitcoins. Eventually, we will surely encounter a lot more variety in the use cases CBDCs in the retail space, and a number of different researches and implementations. These advancements will then pave the way for the benefit of a wide variety of institutions, from corporate treasury departments to payment networks open to the general public.  The distinctions between currently evolving retail CBDC models and previous projects that used wholesale CBDCs are slowly blurring. Through examples, we have already realized that CBDCs are great at the wholesale level, and the various applications can teach us a lot about the prospects they bring to retail. For instance: 

• Project Ubin - the Monetary Authority of Singapore - teaches that a blockchain-enabled CBDC supports more efficient complex payment workflows. This also includes a decentralized liquidity savings mechanism.
• Project Inthanon - the Bank of Thailand and the Hong Kong Monetary Authority - taught us that a blockchain-based CBDC allows for a simple cross-border corridor; it has enabled FX price discovery; and has facilitated atomic PvP.
• Project Jasper - the Bank of Canada and the Canadian stock exchange - made us realize that a blockchain-based CBDC leads to operational improvements — such as 24/7 access to the payment system and T+0 settlement — more effectively than legacy financial architecture can provide.

Blockchain technology is pivotal for enabling the tokenization of these assets, allowing P2P transactions, and offering distributed custody. Further, the blockchain tech enables atomic transactions - which facilitate any delivery versus payment, in real-time, without the risk of one leg being executed before others.  Blockchain tech also lays the foundation of the architecture for a more secure payment system, in which there is no centralized point of failure nor honeypot for hackers to attack - thereby taking security up many notches. It also allows connectivity into a growing tokenized financial ecosystem with global integrity. Looking at the future, we can definitely imagine a completely new architecture for money. This new architecture will be as significant to our financial landscape as was the invention of credit cards. It will be blockchain-based and will work on a system of records, and rely on central banks’ diligence in providing robust governance frameworks. Increased access to CBDCs will be an important factor for central banks to fulfill their mandate of offering modern payment solutions. Further, it will also catalyze the connectivity among the general public, corporations, and the financial industry, with parallel innovations currently being built out by firms leveraging blockchain technology in non-payment-related areas. At this point, central banks hold tremendous power and opportunity to orchestrate and offer purchasing power to this ecosystem!

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