The Rundown on CBDCs

Everyday there is a news report about a country that is "exploring" or "studying" the possibility of developing a central bank digital currency (CBDC). In the past few days, I've read articles about Rwanda, Israel and France looking to pilot programs with CBDCs. And yesterday, the Bank of International Settlements announced its backing of the development of CBDCs. With approximately 80% of central banks around the world taking a closer look at CBDCs, now is as good a time as any to learn more about them.

What Are They?
A central bank digital currency is exactly what it sounds like--a digital currency issued by a central bank. In the same way our central bank, the Federal Reserve, issues the U.S. dollar, it would similarly issue some official U.S. digital currency ('digital dollar'). This is pretty much where the simplicity of it all ends. Things get really hairy (really fast) when central banks have to figure out how CBDCs fit into a traditional financial system in which many intermediaries (e.g., banks) play a significant role.

The Bahamas launched its CBDC last year. Known as the Sand Dollar, this currency is a digital version of the Bahamian dollar and exists in an ecosystem that closely resembles the traditional financial system. The central bank is responsible for minting Sand Dollars while authorized third parties offer a host of services to ordinary people, including wallet and custodian services. These third parties also bear responsibility for conducting AML/KYC checks on their customers that wish to carry a Sand Dollar balance over a certain amount. In the Bahamas, telecommunications and internet services can be disrupted for significant periods of time by hurricanes. The Sand Dollar wallet applications (available on mobile phones and smart cards) are designed to transact without an internet connection and incur relatively low transaction fees.

The National Bank of Cambodia launched Bakong, a quasi-CBDC, last year. The currency is referred to as a quasi-CBDC by many because it is not centrally issued by the central bank and it is backed by a fiat currency. The Bakong supports transactions in Cambodian riel or USD and those transaction occur on a permissioned blockchain that is controlled by the central bank. Commercial banks (and some other financial institutions) comprise the ledger's nodes, issue Bakong, and record the blockchain's transactions. Every wallet is connected to a financial institution, transactions are settled within seconds, and there are no transaction fees.

The Bahamas and Cambodia are the only two countries to officially launch CBDCs but there are some very interesting pilot programs taking place now (including one that involves random airdrops of digital currency that can be used with online retailers). We're sure to see some interesting announcements in the near future.

Why Are Countries Considering This?
There are many policy motivations behind central banks' interests in CBDCs. One motivation stems from the desire to bring more people into the traditional financial system. The numbers tend to vary but approximately 1/3 of the global adult population is unbanked--meaning these individuals do not have an account at a financial institution. There are a myriad of reasons why people are unbanked but many view digital currencies (centrally-backed or otherwise (DeFi)) as a path to increase access to financial services more generally. The idea is that many of these unbanked people either have or can obtain mobile devices that are able to serve as as a point of financial connectivity.

Another important motivation is the rapid rate of progress by non-state actors (namely, Big Tech) in the digital currency space. When Facebook announced the Libra initiative a few years ago, central banks were concerned, to say the least. There is a lot more that goes into (and comes out of) monetary policy than the printing of currency, and many policymakers and economists have expressed a range of concerns over a private corporation gaining too much traction with its own currency. This same range of concerns applies to those decentralized currencies, too (looking at you bitcoin). There are implications for monetary sovereignty, stability of fiat currencies, drastic reductions in bank reserves, tax avoidance, money laundering, etc. With that, central banks feel pressured to accelerate their efforts and they should.

What Are The Challenges?

The tension that arises from CBDCs has been characterized as the "store of value vs. means of payment"debate. Many government officials are much more comfortable with CBDCs as a means of payment because that is most akin to how cash operates in our financial system. Moreover, digital currencies that are treated as a store of value tend to experience a lot more volatility. So one challenge will be the creation of an ecosystem that encourages the use of CBDCs as a means of payment in a world where Doge millionaires are minted every quarter. As alluded to earlier, the other tricky part is going to be the design/architecture and the preservation of the role of those more traditional financial institutions as intermediaries. As annoying and predatory as they may seem at times, they play an important role in efficiently directing financial traffic and in innovating financial products/services. Like we see in the Bahamas and Cambodia, the rollout of CBDCs is likely to entail public-private partnerships in many places.