Central banks have overseen monetary policy for much of the last century. During that time, competition was scarce and innovation was slow.
But in the last decade, a three-pronged attack on the status quo has forced central banks to re-think their strategy.
It started when Bitcoin bypassed the entire global financial system with a digital, trustless payment network. It gave anyone the power to store, send and receive money across scale, space, and time.
Then, crypto stablecoins emerged as digital versions of fiat money on new payment rails, giving anyone with an internet connection access to their fiat currency of choice with no borders or transaction limits.
And in the last decade, a wave of digital-first financial apps like WeChat and Cash App have started to eat away at banking oligopolies, raising the bar for what people expect from their financial institutions.
In short, the entire global money supply chain is being disrupted, and nothing is exempt.
Not central banks, not local bank branches, not even the cash in your pocket.
In response, every segment of the traditional financial system is adapting. Banks are moving operations online and closing branches, merchants are improving online and in-person payment options, and central banks are studying digital currencies.
In this article we'll cover:
Central Bank Digital Currencies (CBDCs) are a digital extension of the cash in your pocket. There are a few important differences between CBDCs and cash, but 'digital cash' is a good starting point.
To understand what might make a 'digital cash' useful, let's start with the features that make cash useful. Because for decades, people all over the world have chosen cash as their preferred tool for buying and selling all sorts of goods and services. Why?
Cash has a few characteristics that make everyday payments possible:
But in addition to the features above, cash also has downsides for people and governments.
Some of the disadvantages of cash can be easily solved with credit cards and wire transfers, but those are specialized (and expensive) financial tools with their own sets of problems. That's not the point of a CBDC.
At a high level, central bankers know that cash usage is declining, but they also know how important it is to a functioning economy. So they're trying to build a stable and versatile digital currency that is just as accessible as cash, without the physical constraints of coins and bills.
A handful of central banks have already started working on CBDCs.
China was the first to act, possibly motivated by the prospect of achieving 'global reserve' currency status.
By launching a 'digital yuan' CBDC before the US launches a 'digital dollar' CBDC, China may be hoping to get other countries to trade in Yuan-denominated digital currency, rather than dollar-denominated money on traditional payment rails.
This 'dollarization of the world' has given America access to a massive pool of buyers for their debt, at lower rates than would be possible without being a 'reserve currency'.
Not an advantage the US wants to give up.
In 2015, The US Federal Reserve initially dismissed the idea of a digital currency, but has since changed their tune. They are actively researching the idea of a digital currency, along with a handful of other central banks around the world.
Below is a list of central banks that have made public statements about digital currencies, and the progress they've made so far.
On October 9th, members from seven central banks released a paper titled 'Central bank digital currencies: foundational principles and core features'.
So far, it's the most complete CBDC plan central banks have released, and it's a common framework that they all worked together on.
Participants included the Bank of Canada, the ECB, the Bank of Japan, the Swedish Central Bank, the Swiss National Bank, the Bank of England, and the US Federal Reserve. It's worth noting that China did not collaborate on this report, and seems to be content building their own system.
The report above explains why central banks are studying digital currencies, and what a central bank digital currency might look like if it were to be implemented. It also emphasizes that none of the seven central banks are ready to implement a CBDC yet.
Below are some of the motivations, potential use cases, and challenges that were highlighted in the CBDC report.
The report outlined three design principles that all seven central banks share as common ground.
To fulfill all the opportunities, challenges, and principles above, the report identified 14 features that a CBDC needs to have:
The CBDC report paints a rosy picture, emphasizing that digital currencies will be a tool for improving financial inclusion, cross-border payments, and direct stimulus efforts.
But the report also emphasizes that central banks are still just studying digital currencies, and lots of technical, monetary, and adoption-related challenges remain.
Below is a collection of other CBDC risks and concerns that have been highlighted by various economists, as well as some misconceptions and false narratives being spread by the public.
The proposal outlined by central banks makes a lot of sense. If implemented exactly as planned, it will be a net positive for the world. People need a simple way to make instant, stable payments to or from anyone at any time. It's 2020 already.
But implementing a CBDC system is easier said than done, especially for central banks.
Central banks are not in the technology business, they don't have teams of world-class engineers to build a system to their specifications, and they don't have any experience building or scaling consumer-facing products.
They will need to rely heavily on the private sector for the security, UX, and distribution, and marketing challenges they'll face.
If building a digital platform for billions of users wasn't hard enough, payments make it even harder. A CBDC app or portal must protect the hard-earned savings of billions of people from all sorts of cyber-attacks.
To solve their security challenges, central banks will need to rely on technology built by other companies and/or currency protocols, though it's not yet clear who they might work with.
One possible outcome, mentioned by Benoît Cœuré on Bloomberg's Odd Lots podcast, is that banks act as CBDC intermediaries. The idea here is that instead of central banks building a stand-alone CBDC app, they could work with all the banks to implement a new CBDC feature that works from within your banking app.
This way, central banks can leave security to the banks, and piggy-back on the existing installed base of bank app users to get the system launched.
It would still require integration with POS terminals and payment processors to enable "cash-like" commerce, but allowing people to keep using their existing bank account removes a huge security and adoption hurdle for central banks.
Of course, it also introduces a new problem. What about the people who don't have bank accounts, or don't know how to bank online?
A simple and free tool for making cross-border payments is a game-changer. It could radically improve the way we trade and remit money across national borders.
But national borders are essential for governments and central banks to enforce their own monetary policy.
What happens if people can freely move between currencies in seconds? Could it make currency exchange rates more volatile? Could countries with weak economic outlooks see exaggerated currency outflows into more stable currencies? Could unforeseen currency sell-offs interfere with a central bank's ability to enforce monetary policy? What other second-order effects might that cause?
Governments and central banks will need to think more about the impact that a border-less CBDC might have on their currencies and their economies.
For a CBDC to be useful as a cash complement, it needs to be useful to the people who want to use cash in the first place.
That means catering to the unbanked, the technology-illiterate, and those in the lowest-income tax brackets.
Some people don't trust banks, some don't know how to use phones, and some can't afford a phone. Bank integrations aren't helpful here, and leaving these people behind isn't an option.
I'd love to hear more central banks sharing ideas for onboarding these segments of the population. Because without their buy-in, a CBDC loses a lot of its power.
There is one final concern worth mentioning.
What if central banks aren't being totally honest with their guidance? What if a CBDC is merely their first step to eliminating cash, and exercising more and more control on people's spending habits?
Here's how one hypothetical scenario might play out.
Imagine a central bank launches a digital currency, calls it a 'cash complement' and proudly claims that they built a parallel payment system, while still giving everyone the right to use cash if they choose.
Mission accomplished, right? Not quite.
What happens if a central bank starts paying interest on CBDC savings? Or if a government wants to issue economic stimulus payments to people?
All of a sudden, anyone who wants those direct payments (whether that's a COVID stimulus check, UBI, interest on savings, or something else) now must use the CBDC.
From there, it's a slippery slope to becoming a tool for censoring or controlling how people spend their money. After all, a digital payment system means the anonymity and privacy of cash is lost.
To be clear, there's no indication that any central bank wants to try something like this. The most recent CBDC report specifically raises this as a risk to avoid.
But trust is something politicians and bankers don't have much of, and history is full of examples of central banks abusing their monetary policy powers at the expense of everyone else.
In the crypto industry, there's a well-known mental model for understanding how blockchains are forced to make design trade-offs. It's called the DCS Triangle.
The idea is that any distributed payment network can only pick two of the following three attributes:
Want near-instant settlements and a decentralized architecture? Better be a small network.
Want a decentralized system with billions of nodes? Good luck achieving consensus.
Central banks have a clear preference for near-instant settlements (consensus), and the capacity to serve billions of users (scale). In addition, a decentralized network might might actually hurt their cause.
If they want to retain control over monetary policy and modify past transactions should the need arise, they want a centralized network.
Central banks are building a currency that everyone can use as a complement to physical cash.
It must be fast and scalable, capable of handling hundreds of millions of instant transactions each day.
Bitcoin is a trustless system for high-powered transactions. It prioritizes decentralization and security above speed.
It must be stable and secure enough to move money of any size, to anyone in the world, at any time in the future.
Two different systems for two different purposes.
Central banks are starting to think seriously about implementing a digital currency, but many technical, political, privacy, and security questions remain.
Realistically, it seems like any kind of meaningful CBDC implementation is still a few years away. China may be the only exception.
Of all the global economic superpowers, they seem to be the furthest ahead right now, with a CBDC pilot program underway in four Chinese cities.
China is already intimately familiar with digital-first payment tools like WeChat, and they have the most to gain from establishing the Yuan as a digital currency before the dollar goes digital.
If anyone is going to jump the gun and launch a national-scale digital currency in the next 6-12 months, it will be China.
Increasing adoption of Bitcoin, stablecoins, or other digital payment systems could instil a sense of urgency in central bankers around the world, but rushing to launch a half-baked digital currency system creates a whole new set of potential problems for governments and bankers.
Overall, I'm optimistic about the CBDC strategies central banks have presented, but doubtful that all the proposed features will actually ship in an international digital currency.