Central Bank Digital Currencies
Next: CDBC Example
Central Bank Digital Currencies are a way to implement money in completely digitalised format. The CBDC can be implemented in multiple ways.
There is a lot of activity today in many countries to implement CBDCs partially due to competition from cryptocurrencies and partially to upgrade financial systems to be more suitable for the digital age.
So let see what they are. Central banks have not been too open about how the current trials have been technically implemented so the posts in this part are somewhat based on guesses.
Central Bank Digital Currency (CBDC)
Today commercial banks have an account at the central bank and clear the flow of money when transactions happen between two different commercial banks as discussed in a previous post. Central bank money is used to settle those transactions and commercial banks lend it from central bank. For this lending they pay interest that is called discount rate or policy rate.
Retail CBDC simply means extending the scope of those who can have central bank money to the general public. I.e., you would have an account at the central bank in addition to having an account at a commercial bank.
The more modest variant called wholesale CDBC just means digitising the current way banks access central bank money.
A CBDC can be implemented in a centralised database at the central bank or in decentralised format for example via some blockchain variant.
There has been a lot of innovation around Ethereum ecosystem during last years to speed up the ability to handle large transaction volumes and similar improvements have happened via lightning network on bitcoin side as well. The web3 technology is starting to be ready for handling massive traffic at affordable costs.
The CBDC account is accessed using wallet software that runs on users’ phone or other smart device. The wallet contains users private keys and signs each transaction before it is submitted to the payment system.
The money itself can either be stored in the central bank database in accounts or in decentralised manner on a blockchain.
The blockchain variant can be made to allow people to do peer-to-peer payments even when there is no network connection. This would happen by sending signed transactions between wallets via local network like Bluetooth or WiFi. However the settlement does not happen until network connection is restored (i.e. there is some vulnerability of double spending).
CBDC variants
There are three different variant CBDC discussed.
In Direct/Retail CBDC you have an account at the central bank and it handles payment transactions. This means that every transaction gets recorded at CB. Central bank creates a wallet that users use for payments. We’ll focus mostly in this alternative here.
Hybrid CBDC. Banks and other financial institutes handle customer facing operations like checking customer identities when you open an account and you’d use the banks app for services. All CBDC transactions are still recorded at the central bank level.
Wholesale/Intermediate CBDC where central bank provides a wholesale ledger to commercial banks. Banks use the CBDC to clear transactions between themselves. This is very similar to current setup except the interbank settlement infrastructure is modernised.
Such central bank money means great loss of power to commercial banks and deposit outflows but central bank can steer this with their deposit rate. One risk of this is decrease in bank loans and thereby macroeconomic activity.
Why are central banks suddenly thinking about introducing CBDCs?
The planned introduction of digital payment methods of large tech companies like Facebook (now renamed Meta) was the trigger that caused central banks to consider central bank money in a speeded up fashion. The idea itself is decades old.
Would large Internet companies have a large foothold in payments, central banks would run a risk of losing control of monetary policy in their own country.
Another reason is the general move towards cashless society. For people who do not have a bank account today this could mean access to financial services, as Central Bank could offer an account to people who commercial banks view as non-profitable.
Third reason is that the cross-border payment infrastructure is old fashioned and it takes days to make money transfers. Fees can be very large – from 10% upwards. For migrant workers this means that they work one month every year for the bank just to transfer money to their beloved ones in their home country. Big tech companies were looking to fill this gap as they have customers all around the world and their platforms are major media for advertisers – why not evolve platforms where millions of people spend their time to also buy and pay on the same platform?
This increasing concentration of a large share of payment services to a few large global companies would create risks and vulnerabilities to nation states and also create barriers to entry for competition and stifle innovation
Further threat comes from blockchain based payment tokens like Bitcoin and the multitude of other cryptocurrencies.
Putting all the pieces together central bank were running a risk of losing their ability to control price stability in their respective countries.
Features
When CBDCs are implemented, they offer a number of new features to central banks.
CBDC allow immediate delivery of relief funds to people and companies during exceptional times like pandemics.
CBDC mechanism might also allow direct tax payments based on VAT-% of each transaction.
As programmable money, CBDCs could add specific policies to it. Large depositors might have negative rate incentivising them to spend money boosting economic activity. In some countries treating different citizens differently may be against the constitution (for example in Finland) so this might apply to organisations only.
The number of policies that could be applied is likely to grow with time as people invent new ways to add policies (program) money. As another example relief funds could have an expiry date forcing to spend it within time allotted. This way central bank could ensure all money handed out is spent in short time to boost the economy. Aid money could also be tied to specific types of purchases.
And CBDCs come with risks and mixed bags
CBDC allow also easily to implement universal basic income (UBI) schemes. UBIs are government programs for giving every adult citizen a set amount of money on a regular basis.
On the downside they remove the need to get employed. Most if not all people have a built-in need to have a feeling that their life matters and that they contribute to the society. UBI takes that away. Their zombification effect of UBI is similar to what Quantitative Easing (QE) does for companies. Individuals on UBI can spend in physical comfort their unique life at home gaming or on social media. Those who still seek employment spend their days at companies producing products and services that are not needed while QE keeps the company rolling. Transformation to a postmodern society will be then have been completed.
UBI is thought to solve the problems resulting with increasing automation replacing workers in many industries both in blue- and white-collar sectors. Someone still always owns/controls the robots and automations and this party will have complete power over society. For a person on UBI this means that they cannot politically afford to disagree with power holders.
Autocrats can use the CBDC concept to punish people who voice criticism or speak publicly about democracy or support freedom of speech. Post something authorities do not like and you no longer can access money in your CBDC account (first for a set period, then indefinitely) or you won’t receive stimulus payments or you will suddenly have a negative interest rate. This is especially easy with the Direct CBDC model but can be implemented also with Hybrid CBDC if additional interfaces are required from banks (the know-your-customer procedure is performed by retail banks so each customer is known)
And not only autocrats, during covid crisis in Canada demonstrators accounts were frozen and in UK a politician has been kicked out of bank due to political opinion
Having access to ledger and knowing identities allows the CB and ultimately the government to have access to complete list of members in all organisations (political parties, associations, clubs) based on membership fees and all the places where they make purchases (which bookstore they frequent, where they purchased an apartment etc.)
Autocrats can also use their CDBC abroad if their CDBC becomes available as a compatible means of payment there. When their nationals set up companies abroad, they could extend infinite zero-rate credit with their CDBC to loyal people who then can drive competition out. This way they win economic influence practically everywhere where this is possible. Also, it may allow to complete transactions without host country tax office having any information if both buyer and seller have account on the same CBDC. This means skipping taxes, an additional competitive advantage.
https://www.banque-france.fr/sites/default/files/media/2021/11/09/rapport_mnbc_0.pdf
As a final validation on dangers of CBDC, lets consider how important being able to have banking services is to human rights, Human rights allow people to free speech, assembly, religion and so on. All of these incur costs. With free speech you may publish your opinions in print format, travel somewhere for demonstrations, set up web sites and so on. Freedom of religion includes renting spaces for activities, paying salaries for subcontractors or employees, food and consumables at gatherings etc. Free assembly requires travel (tickets, hotel bills etc.,) to meet like-minded people.
Freezing bank accounts, takes these rights away, And this can be done in a sneaky way. Banks may be required to close “high risk accounts” and then indirectly or through back channels indicated who should be affected. If issues surface, the politicians/regulators can always claim that the bank overreacted and the requirements was just to apply “due care”.
Benefits to Central Bank – Closed-loop Control
Today the monetary system is largely open loop. Central banks can affect the flow of money in the economy through a few mechanisms such as raising interest rates (discount rate), increasing or decrease the reserve requirements or via open bank operations (purchasing government bonds etc.).
The effect of these operations are seen in the central bank indirectly on key indicators from the economy (interest rates lenders pay, employment rate etc.) with a delay.
CDBC allows central banks real time, accurate and fine-grained information from their operations. This direct feedback creates a closed-loop system. For the Central Bank this is beneficial, as it allows better control. But it comes with the risks described above and history is full of examples where such misuse risks realise sooner than later.
Next: CDBC Example