51 minute read
The conceptual framework of central bank digital currencies
Péter Fáykiss – Anikó Szombati
The actual catalysts behind the increasingly serious discussion about the introduction of a central bank digital currency (CBDC) included technological progress, the rise in electronic payments as well as the appearance of the private solutions addressing the anomalies in payment systems. The way how the different countries introduce it, however, will vary considerably. It will depend largely on the particular problem that a CBDC can resolve, its relationship with monetary policy and the extent to which the central bank wishes to involve market participants in the operation of the new payment system. Besides, potential users’ needs and the differences and options between the available technologies have to be taken into consideration so that a completely new money-type can function alongside cash as used today, while ensuring that the targeted user base actually uses it. This chapter presents and categorises the public policy, economic and technological considerations that need to be taken into account when deciding about the introduction of a CBDC.
1. The main reasons and purposes of introducing a CBDC
A little bit more than ten years ago, the concept of central bank digital currencies (CBDC) was linked to financial transactions between central banks and their direct counterparties, i.e. commercial banks and other professional financial service providers with access to the central bank’s instruments. The idea that the digital currency embodying a direct claim on the central
bank’s balance sheet may appear in the transactions between financial service providers, or even in those between households and companies, is primarily due to technological progress and the spread of digital payment solutions. Nevertheless, the decision on the everyday use of a central bank digital currency beyond research, testing and pilot projects (Figure 1) should be based on a strong social consensus, and it should be carefully considered to protect the central bank’s reputation.
Figure 1: International CBDC researches and pilots
Retail research and wholesale project Live retail Retail research Ongoing retail pilot Completed retail pilot Wholesale projects
Source: BIS, central banks’ websites. Status as of 30 April 2021.
1.1. The possible social and public policy considerations leading to the decision to introduce a CBDC
To move the issue of a CBDC from central banks’ research teams to policy teams or even the implementing technology team, central banks should have an underlying motivation that nudges them from theoretical examination towards the
decision on implementation. The review of international central banking practices shows that there are four main considerations, phenomena or driving factors facilitating the introduction of a CBDC:
– Potential cost savings and reduction of market frictions: the most widely considered aspect is the reduction of the costs arising from the financial and environmental toll of cash usage.37 However, the costs of cash management go hand in hand with the social costs that arise from exclusion from, or partial access to, modern, bank account-based digital payment solutions in the case of certain social groups or an even broader section of society. The CBDC can support financial inclusion by providing these groups with access to quick, cheap and secure digital payment solutions, which entails stronger digital skills, increased capacity to promote interests, greater security and more freedom in entrepreneurship for the society at large. In other words, the CBDC can complement cash for the social groups who currently have no access to the electronic payment infrastructure. Overall, it can promote the development of a socially more efficient payment system, which also involves the reduction of cash usage.
– Rise in alternative forms of payment, preserving monetary
sovereignty in spite of the appearance of stablecoins: within the continuous innovations affecting technology and payment systems, one announcement stood out from the rest: in 2019, the Libra Association, established by Facebook, proclaimed that it was developing a payment solution building on the global Facebook user community and offering fast, cheap and accessible service that can also be utilised in cross-border payments. The proposal drew a barrage of regulatory criticism because it would have created an alternative payment system and thus constrained monetary sovereignty in the affected
37 Based on a survey by Central Banking from February 2020.
countries, and it would also have entailed financial stability risks by enabling an exit from the domestic financial system. Also, the portfolio allocation decisions of the collateral holdings backing the payment system would also have introduced a major uncertainty to bond and FX markets. Besides the regulatory pressure, the need to maintain control over local payment systems boosted local CBDC projects in numerous countries.38 Although the Libra, and later on Diem Association’s ideas have changed profoundly, Facebook’s initiative was probably a huge catalyst to the appearance of a CBDC in everyday payments within a reasonable timeframe.
– Creation of an instrument suitable for targeted stimulus: the COVID-19 pandemic and the resulting constraints led to a massive economic slump all over the world. To mitigate the social impact of the significant amount of lost income and unemployment, fiscal entities decided to provide extraordinary, immediate and universal allowance in several countries. However, it was far from straightforward that this would actually get to those in need in a fast and targeted manner, and for example the US administration started distributing cheques. By contrast, in China WeChat Pay and Alipay, the two super-apps, were used to distribute digital coupons in an easy, fast and targeted manner, and the recipients contributed significantly to restarting the economy when they spent those coupons. A universal CBDC widely available to households could be a solid basis for implementing fast and targeted stimulus measures necessary in such situations. Based on this, the creation of a digital payment solution operated by a central player has become part of the potential public policy objectives. However, it must be noted that in addition to providing a payment channel and the digital assets to households, a system
38 To name only the major central banks, they included the previously sceptical
European Central Bank, the Fed and the PBoC, too.
for remote identification of citizens and record-keeping also needs to be designed and operated. – Designing a new platform for innovative services: although the existing payment systems meet the current electronic payment needs, several market innovations have targeted this area, since the pricing and efficiency of completing orders, especially in cross-border payments, needs to be improved considerably. As these solutions can only be successful in the long run when a large number of users adopt them, beyond a certain point, the appearance of new service providers limits innovation that is based on the current payment structure. Therefore, taking into account long-term development opportunities, central banks increasingly believe39 that a brand-new payment system is needed that can even manage smart contracts. It could complement the current system and gradually embrace new payment solutions and the new business solutions built on them.
1.2. Market failures potentially triggering the introduction of a CBDC based on the international literature
Central banks can only be expected to make public policy intervention and a public commitment to a new, unprecedented central bank digital currency solution, if a clear market problem, failure or public policy consideration can be identified that provokes thinking outside the box and a new way of central bank action.
According to the examples in the international literature, CBDC projects can be catalysed by the below social objectives and unresolved market frictions and failures:
– Reduction in cash holdings, cash logistics costs and the entailing environmental impact: cash is a central bank
39 For example the ECB, the Bank of England or the Monetary Authority of
Singapore.
commodity with a strong brand backed by central bank credibility, and central banks are stipulated by law to provide it. At the same time, the rise of digital payment solutions has intensified the demand for a digital payment instrument that is issued and guaranteed by the state, universally accepted just like cash, and able to fulfil the means of payment function in digital form. When this becomes widely used, most of the costs associated with collecting, handling, guarding and redistributing cash as well as replacing the necessary amount can be slashed thanks to an appropriately efficient CBDC system, and this is also reflected in the reduced environmental impact related to production and transportation.40 – Improving access to financial services and enhancing financial awareness: despite the rise in the access to bank accounts, about one-third of the world’s adult population have no access to basic financial services, and approximately 1 billion people do not even have an ID (World Bank 2020) that could be used to enter into a relationship with a bank. Therefore, it is in society’s best interest to reduce cash use in these social groups and provide an option for conducting financial transactions on more secure digital devices, mainly smartphones, that offer the possibility of greater awareness and access to other services. A cheap, universally accessible, secure and fast electronic payment system operated by a central bank can fulfil this mission. – Operating a robust payment instrument and system and ensuring access to them even in a crisis: in advanced countries, where card usage and electronic payment solutions
40 Nevertheless, further analysis of the social costs entailed by the establishment of a CBDC system is necessary to prove this. Moreover, it is not expected to completely eliminate cash in the foreseeable future, as it cannot provide all the features (it offers anonymity, it is tangible and can be physically counted and therefore managed better) that make many people prefer cash in Central Europe, for example in Germany, Switzerland and Austria. CBDC can represent a realistic social advantage in the countries (East Asia, Central
Africa) where cash distribution is difficult to organise.
are on the rise, cash is increasingly likely to disappear from everyday transactions in the near future. However, this could make countries or communities vulnerable to malfunctions in the existing financial infrastructure, partly linked to the private sector, resulting from the uncertainty surrounding the business decisions of infrastructure providers, cyberattacks, a general outage or a natural disaster. A backup system may have to be established and maintained to ensure uninterrupted digital payments in everyday life, and this obviously has to be implemented by a central player, for example the central bank. This system would include a universally accepted and widely accessible digital payment instrument, which would be cost- and risk-free similar to cash.
– Developing the market for financial services and fostering competition: the current electronic payment solutions are mostly card-based, and they create a sense of instant payment among users, while the actual settlement for stores and service providers may take days, and there is also a substantial fee payable to the card company (Bank of England 2020). A CBDC acting as an alternative to payment services could be a good starting point for promoting the establishment of a competitive market in this field as well as truly instant payment platforms with low costs. Such a platform can also support other developments and technological innovations, for example through smart contracts related to payment transactions, which allow users to initiate further processes after the payment is made, for example in connection with land registry entries or duties office records. – Reducing the shadow economy: the efforts to reduce cash transactions facilitate cost reduction related to cash management, transportation and guarding, and also the combating of the shadow economy, especially in developing countries. A CBDC framework could be a useful tool in exploring the transactions conducted tax-free or even illegally in the informal sector and enforcing the mechanisms to prevent these. This does
not necessarily mean that the central bank or government authorities have direct access and control over citizens’ financial transactions, as in itself the digital form of transactions can partly guarantee the reduction of illegal payments.41 – Fostering economic growth, increasing the effectiveness of monetary policy: for monetary authorities, one of the main attractions of a generally accessible CBDC is that the interest paid on households’ central bank deposits ensures an immediate and direct transmission of the interest conditions determined by the central bank. However, this theoretical premise may not necessarily be implemented in practice. First, fast and complete transmission requires that a substantial share of retail deposits be held with the central bank. This would make it difficult to fulfil commercial bank functions, i.e. the quantitative, risk and maturity transformation, which also hampers the operation of other monetary policy channels and may pose financial stability risks. Second, especially in the context of the near-zero or negative interest rate environment seen in several regions in today’s economic situation, the implementation of negative interest rates through the CBDC may most likely be hindered by the opportunity to flee to cash. Accordingly, in the current economic climate, the introduction of a CBDC for monetary policy purposes is more likely when it is intended to reduce a special market friction or anomaly, such as a credit rationing problem arising from the procyclical behaviour of the banking sector, when commercial bank lending to major sectors and players in the economy may be constrained or temporarily suspended. For example, SMEs constitute such a sector. – Leading by example: improving the acceptance of innovative technologies and testing such technologies: the central bank’s innovations prompted by the introduction of a CBDC as well
41 It should be noted that besides a central bank digital currency, this can also be ensured by central records on all payment transactions kept by the tax authority.
as the innovations in payments, transactions and other areas fostered by the new platform may be important catalysts in the digitalisation of the financial sector and the economy as a whole. This could improve the efficiency and competitiveness of the national economy and thus indirectly support economic growth. The central bank’s commitment to modern technologies and the comprehensive testing of various technologies may also be used in public administration as stepping stones towards new initiatives, paving the way for new technologies, for example systems based on distributed ledger technology (DLT). Estonia already has extensive experience in this. Besides the financial sector, these technologies can also appear in process automation, record-keeping and numerous other areas. Finally, society’s openness and awareness can also be improved through the commitment of a credible and established institution, such as the central bank, to new technologies.
2. Foundations and expectations in connection with a planned CBDC system
Central banks have been providing reliable money to the public for decades, or, in the case of certain institutions, centuries (e.g. the Swedish Riksbank). Therefore central bank money has an important public good function: (i) first, it is a uniform unit of account for determining the prices of products and services in a given jurisdiction, (ii) second, it has a store of value function, so it can be used by economic actors and individuals for amassing savings, (iii) and finally, it is also an important medium of exchange, as it can be universally used for purchasing goods and services.
Although this is hardly reflected in general public thinking, central banks actually offer some access to the liabilities side of their balance sheet by providing money. Currently, there are two main types of central bank money: one of them is cash, which appears directly and widely at households and companies alike, and the other one is electronic central bank deposit money, comprising the funds held on the reserve and nostro accounts used by a small group of eligible counterparty financial institutions. In addition to these, there is commercial bank deposit money, held on the commercial bank accounts.
However, cash usage has recently declined considerably in several countries, digital payments have been on the rise, and several new factors and other possible motivating forces have appeared (for more on those, see the previous subchapter) that may encourage central banks to issue central bank money in a new, digital form, perhaps even universally. Although there is still no generally accepted definition of central bank digital currencies, the present study mainly uses the definition by the BIS (2020). Consequently, a central bank digital currency is a digital form of central bank money that is different from balances in traditional reserve or settlement accounts (CPMI-MC 2018). It is a digital payment instrument denominated in the domestic currency and a direct liability of the central bank. In this sense, a central bank digital currency is a third type of central bank money, which can exist alongside cash and central bank deposit money. It can support the establishment of an even more resilient financial and payment system and provide an opportunity for fostering related innovative services through its digital nature, which the current payment and cash infrastructure cannot do or only to a limited extent.
2.1. The basics of establishing the conceptual framework for a CBDC
It must be underlined that it should be up to the independent decision of individual countries and central banks when and how they introduce what type of central bank digital currency, because the conceptual framework and the specific operating framework depend largely on the given country’s legal, social and economic environment and financial system. During the development of the operating framework, decision-makers are faced with several trade-offs and path dependence arising from decisions related to certain aspects, and the potential benefits and drawbacks need to be continuously evaluated, so there is no optimal solution for designing a central bank digital currency. Despite this complexity, certain general principles and basic expectations can be determined in relation to central bank digital currencies. The below five basic principles stand out according to the international literature (see, for example, Kahn et al. 2018, Riksbank 2018, Brunnermeier et al. 2019, Adrian–Griffoli 2019, Auer et al. 2020, BIS 2020, ECB 2020):
– The introduction of a CBDC has to come with the appropriate public policy motivation. An important premise is that a CBDC should not be introduced for its own sake, it should improve social welfare as much as possible, either by addressing a clearly identifiable market failure or by mitigating market frictions in certain areas.
– It should not threaten the central bank’s main monetary and financial stability objectives. While designing a CBDC, it must be borne in mind that the appearance of the new central bank money should not have a negative impact on overall monetary policy or the stability of the financial system, and it should not hinder the central bank in fulfilling these mandates. First, the ‘unity’ of the currency should be ensured (the CBDC should be freely convertible to other types of money), and second,
the conceptual framework should be designed in a way that addresses any negative effect of the CBDC on monetary and financial stability objectives. – It should be complementary. The introduction of a CBDC is a completely new challenge to central banks. It should be designed to have a complementary, parallel nature alongside the already available other types of central bank money, including cash, in other words it should not drive those out, and it should work in a supplementary system that works in parallel to the existing types. In particular, the public’s access to cash must not be compromised. – It should improve efficiency. An important principle in designing the conceptual framework of a CBDC is that it should improve social welfare, either through increasing the efficiency of payment solutions (by offering a competitive payment alternative to cash and other forms of payment), or through other positive externalities (for example the reduction of tax evasion or money laundering risks). – It should support innovation. Finally, another important element of the introduction of a CBDC is that the concept should foster innovation in some form, by the technology used, by strengthening digital skills and competences, or by providing a platform for the introduction of new innovative services. Of course, considerations other than the five listed above may also have to be taken into account when designing a CBDC concept. Nevertheless, these are general principles that are applicable for a wide range of CBDCs, and they help make the introduction and operation sustainable and successful over the long term.
2.2. Expectations identified in connection with a planned CBDC system
Besides the basic principles described in the previous section, some core functional expectations can also be identified in connection with a CBDC concept. These expectations should be classified along three main dimensions: (i) central bank expectations for a CBDC system), (ii) customer needs and (iii) market considerations. 16 basic functional expectations can be identified along the three dimensions (Figure 2): i. Central bank expectations: From a central banking perspective, the CBDC payment system is expected to be resilient and secure, and the currency should be convertible to other forms of money in line with the central banking functions. Another important aspect is scalability, in other words there should be an option to gradually expand the system depending on the intensity of demand, and it should be able to handle considerably greater volumes and transaction numbers.
Central banks also expect the design of the CBDC to be in line with the legal environment on issuance and every other related legal requirement (e.g. anti-money laundering and counterterrorist financing and data processing rules). ii. Customer needs: Customers expect several features from a CBDC; however, the critical nature of these expectations depends largely on the potential user base. First, customers wish to use a fast, user-friendly, easily accessible and cheap (cost-effective) service. Second, the service should be available on a 24/7/365 basis, relatively easily. iii. Market considerations: Those designing a CBDC should be mindful of market considerations, too, because this enables the creation of a framework that is interoperable, flexible and suited for encouraging the development of new innovative services. In other words, the CBDC should operate in a system that is interoperable with other payment systems, flexible
and modularly expandable. Furthermore, it should exploit comparative advantages and foster competition in auxiliary services.
It should be noted that even though these basic functional expectations are generally applicable, their importance, dominance and critical nature obviously depend largely on the CBDC’s entire design framework, especially the user base. For example in the case of a CBDC with a primary wholesale focus, resilience, security and scalability are crucial, while costeffectiveness and user-friendliness are not necessarily vital, albeit important aspects. By contrast, in a CBDC system mainly geared towards households, the significance of the expectations about user-friendliness, inclusivity and modularity may increase.
Figure 2: Basic functional requirements for a CBDC system
Central bank expectations
Customer needs
Market considerations
• Resilient • Secure • Scalable • Convertible • In line with legal requirements (legal authorization, GDPR, AML, etc.)
• Fast • User friendly • Cost-efficient • 7/24 availability • Easily accessible and inclusive within given multitude • Transparent
• Exploits comparative advantages • Increases competitiveness • Interoperable • Flexible • Modularly expandable
Source: own edit based on BoE, ECB, BIS
According to the international literature, there are seven distinct decision steps that should be considered while designing a CBDC (Figure 3). It should be noted here that some of the decisions can be made relatively independently, while others may involve
decisions options that are already partly determined by earlier decisions:
I. The fundamental goal, which can stipulate the motivation for the CBDC’s introduction, i.e. the market failure that it is intended to be mitigated. II. Accessibility, which determines which economic and social actors will have access to the CBDC.
III. Monetary policy nature, which should lay down the key monetary framework, i.e. whether the instrument is active, neutral or flexible from the perspective of monetary policy, as well as any constraints (e.g. on the amount held on an account, transaction size or number).
IV. Form of the CBDC, which should include the form of money (cash or deposit money) it is equivalent to, and the functions it can have accordingly. V. Operating framework, which determines the players that take part in the operation as well as the central bank’s functions. VI. Anonymity, namely whether anonymous transactions can be conducted and the framework for that (account-based or token-based approach). VII. The technology used, i.e. whether the system would operate using the traditional infrastructure, or a new system, possibly one based on distributed ledger technology, should be developed.
Figure 3: Decision ‘steps’ in designing a CBDC
VII. TECHNOLOGY
VI. ANONYMITY
V. FRAMEWORK
Is it feasible on traditional infrastructure? Is the use of blockchain/DLT justified?
Are anonymous transactions enabled? Account-based or token-based operation?
What actors are involved in the operation? What functions does the central bank perform?
IV. FORM
III. MONETARY POLICY NATURE
What form of money does it replace? Cash or bank money?
Deliberately effective, neutral or flexible?
II. ACCESSIBILITY
Who is able to transact with it?
I. FUNDAMENTAL GOAL
What is the basic purpose?
Source: Authors’ work.
Partially determined
Independent decision
The cascaded structure shows that these decision points build on each other to a great extent. On the three first ‘steps’ (the fundamental goal of the CBDC, accessibility, monetary policy nature), there is considerable freedom to choose along the dimensions, however, once the decisions are taken, the form, the framework, anonymity and the technology to be used may be partly determined.
3. Potential user groups of a CBDC
An important question in connection with the introduction of a CBDC is which user groups should have access to it. In the design stage of a CBDC project, after the fundamental goal of the introduction is determined (reduction of market frictions, other public policy objective), the group of economic and social actors having direct or indirect access to the CBDC should be carefully considered.
– Households or a special retail segment: Similar to cash and commercial bank deposit money, one option is to give the entire public access to the CBDC. In such a universal scenario, all citizens would get access to the liabilities side of the central bank’s balance sheet in addition to cash use. Another option is to grant access to a specific group rather than the entire population.
This may be warranted in cases where a market failure can be identified in connection with a specific, distinct social group, and it can be mitigated with the introduction of a CBDC. For instance there is a massive share of households in several developing countries that never or only rarely use financial services, and their financial inclusion can be implemented with a CBDC designed for this purpose. In such a case, access does not have to be granted to the entire population, but rather only to the particular social group. Within the general household group, a separate segment may comprise non-residents, for example those who arrive to the given country as tourists.
Since here quantitative restrictions may also be applied to maintain monetary sovereignty, such a decision requires independent reflection and an assessment of how this relates to the fundamental goal of the introduction. – SMEs: In connection with the introduction of a CBDC, there may be a market failure for SMEs that could be mitigated by the introduction and the appearance of the services related to that.
Of course, access does not have to be exclusive, it can be granted to other social groups, too. With SMEs, the market friction or failure that could be mitigated with the introduction of a CBDC may primarily arise in connection with the services related to lending and cross-border payments, and some new, innovative solutions may emerge enabled by the CBDC framework. – Corporates: In the case of corporations, there are two main considerations in connection with CBDC access. First, similar to SMEs, the introduction could be an innovative solution in cross-border payments, and obviously this works best if
a specific group of the central banks concerned participate. Second, innovative corporate solutions can already be identified that cannot be implemented in the current infrastructure, or only with difficulty. Examples include smart contract solutions related to corporate bond issues, or stock financing also implemented in a smart contract framework. An appropriately designed CBDC solution could provide a platform for this purpose, which can be used by the existing financial institutions to develop new services. – Payment service providers: As indicated above, payment service providers typically have access to central bank funds through the electronic central bank deposit money, which refers to the reserve and nostro accounts applicable to a small group of actors, mainly eligible counterparty financial institutions. The introduction of a CBDC can mainly affect this group by allowing them to develop new, innovative services on the resulting platform (e.g. download-based micropayments), thereby improving the efficiency and competitiveness of the financial system. – Other, non-payment institutions: Generally, other, nonpayment institutions (e.g. insurers and pension funds) currently have direct access to cash and commercial bank deposit money.
In their case, similar to corporates, access to a CBDC system can mainly represent value added in connection with cross-border payments and the establishment of a platform suited for the development of innovative services. – Municipalities: Similar to most economic actors, municipalities currently have direct access to cash and commercial bank deposit money. Therefore, it should be considered whether to grant municipalities access to a potentially introduced CBDC.
This may be warranted if a CBDC becomes widely used in the economy, for example on account of widespread access among households, or if a major market friction can be identified in the case of the financial services provided to municipalities in the
given country (for instance smaller municipalities may find it more difficult to access financial services). Of course, the goal of the CBDC’s introduction should be borne in mind when determining potential users. However, this is typically not a major constraint, it rather stipulates the group that should be definitely granted access. For example if a central bank plans to introduce a CBDC to address a market problem mainly seen in the retail segment, it may of course grant access to other actors (e.g. SMEs or even municipalities) besides households.
Figure 4: Relevance of each design dimension based on accessibility
Households or special retail segment Monetary policy nature Converti bility
Offline operation Crossborder usage
Additional services, involving market players Anonimity Technology
SMEs
Corporates
Payment service providers
Other, non-payment institutions
Municipalities
Note: In the figure, design dimensions are marked as follows: relevant – full circle, medium relevant – half full circle, less relevant – empty circle. Source: Authors’ work.
Of course, the relevance of the design dimensions presented above varies considerably, depending on the economic and social actors that have access to the CBDC. For example the monetary policy nature of the CBDC is a very important dimension for
households and companies, but less so in the case of financial institutions, most of which already have access to central bank funds. In a similar fashion, anonymity and offline operation can be important dimensions with a CBDC focusing on households, but it is completely irrelevant with a central bank money available to corporations and payment service providers. All in all, the central bank and decision-makers in a given country should design the operating framework for a central bank digital currency by identifying the social goal related to the CBDC introduction, using that to determine the group that has potential access, and taking into account the country’s legal, social and economic environment as well as the features of the financial system.
4. Questions related to the form and operating framework of a CBDC
While designing the conceptual framework for a central bank digital currency, the establishment of the fundamental goal(s) and accessibility should be followed by decisions on the monetary policy nature, form and operating framework of the CBDC. The monetary policy dimensions are discussed in a separate study, so here only two key aspects are mentioned briefly: (i) quantitative restrictions and (ii) interest.
i. Quantitative restrictions: These constraints can be general or determined along various dimensions. For example, quantitative restrictions can be calibrated for the amount of money held on an account, transaction size, the volume of transactions per month or the size of offline transactions, even at the counterparty level. In the latter case, counterparties need to be identified individually, which also affects the structure of the whole system. ii. Interest: Interest is one of the most crucial monetary policy aspects in designing a CBDC concept. It can be used by the
central bank to influence the demand for the CBDC fairly directly, and it also partly determines the whole system, for example by excluding anonymity (when interest is paid, anonymity may be difficult to ensure because tax is payable on interest). With interest, the CBDC would be more like commercial bank money, while without it, it would be more like cash.
4.1. Determining the form of a CBDC as a type of money
The form of the CBDC can be partly constrained by the decisions taken by the central bank about the fundamental goal, accessibility and monetary policy nature of the CBDC to be introduced. Of course, these constraints should be taken into account when designing a particular CBDC, because it is especially true about central bank digital currencies that there is no one-size-fits-all approach, and the framework of the given CBDC depends largely on the country’s legal, social and economic setting and financial system. In connection with the CBDC’s form, decisions must be taken along the following dimensions: – Convertibility: A crucial aspect is whether the central bank wants to allow full convertibility with cash, commercial bank deposit money or both. If cash can be converted to CBDC, the central bank needs to implement major infrastructure developments and ensure availability (e.g. establishment and maintenance of branches and/or ATMs), which may significantly increase the costs of introducing a CBDC. – Offline operation: Offering offline operation for a CBDC (allowing it to be used everywhere, under all conditions) can be considered a convenience service, or it can be seen as a vital feature of a backup system used alongside cash. Countries or communities could become vulnerable to malfunctions in the existing financial infrastructure, and to cyberattacks,
a general outage or a natural disaster. A backup system has to be established and maintained to ensure uninterrupted digital payments in everyday life, and an important function would be its ability to handle offline transactions under certain conditions (e.g. a given number of transactions or maximum transaction size).
– Access by non-residents: When designing a CBDC, central banks and decision-makers probably focus on residents, but besides local operation, it may be considered whether the central bank should offer access to non-residents. This may take the form of providing access to non-residents in the given country (e.g. tourists, non-resident workers) or, with an even larger scope, allowing the CBDC to be used abroad or in crossborder transfers. Of course this issue is rather complex, and most central banks are not expected to treat it as a priority during the introduction of a CBDC, so only gradual ‘easing’ is expected in this field (exceptions include the central banks whose currency (USD, EUR, CNY or even CHF) is already used widely abroad, either as cash or as deposit money, therefore their central bank digital currency should also support the current role of the traditional currency in international payments or its more widespread use in the future).
4.2. Potential operating framework of a CBDC
The main question regarding the operating framework of a CBDC is which institutions should participate in its operation, and how these institutions are linked to the system as a whole. Three main models can be identified when it comes to operating frameworks: (i) the direct, (ii) hybrid and (iii) indirect models (Figure 5, see, for example, CPMI MC 2018, Auer-Böhme 2020, Auer et al. 2020, ECB 2020).
i. Direct model: In this operating framework, customers directly deal with the central bank, and they have claims on the central bank. The CBDC is issued by the central bank, account
balances are recorded there and the various payment services and other financial services, if any, are used there, too. This requires major development and operating expenses from central banks (account-keeping system, mobile application and internet banking platform, remote customer identification tasks related to AML requirements, fraud prevention etc.), and, depending on the size of the group with access to the CBDC, this could exert a substantial effect on the market. ii. Hybrid model: In the hybrid model, the claims are still on the central bank, but an intermediate service provider is added to the scheme to allow some operational tasks to be outsourced to one or more market participants. This payment service provider (PSP) may provide the mobile application and the internet banking platform, customer service, it can even handle the remote customer identification tasks related to AML requirements, and it may take over fraud prevention functions as well. In this model, the competitive market is preserved in some sense, since the players can compete with each other in the quality of services and through the incorporation of new services. Nevertheless, the development of a sustainable business model for market participants is a major challenge, as customers may not necessarily be willing to pay a large service fee in addition to banking service charges. iii. Indirect model: In the indirect model, the claims are on a market participant rather than the central bank. Here, the market participant holds liquid assets as collateral to cover all the amount of CBDC held with it by customers, preventing itself from the ability to create money, unlike in today’s banking model. In such a scenario, the model would be practically similar to today’s electronic money institutions, the only exception would be that the institutions would hold the liquid collateral of the CBDC with the central bank. In the indirect model, most of the operational tasks are delegated to market participants, and the central bank is mainly left
with recording stock outstanding and collateral as well as controlling the money supply. Since in this model the claims that arise are not against the central bank, some experts do not even consider this form of money as CBDC (for more details, see BIS 2020).
Figure 5: The possible role of the central bank and the market players in the operation of the CBDC
Direct model Hybrid model Indirect model
Issuance Central bank
Account
Payment service
Households and enterprises
Direct claim on the
central bank
Central bank
PSP operator Central bank 100% collateral
Financial institutions
Direct claim on the central bank
Direct claim on the market player
Source: Authors’ work based on BIS, IMF, BoE, ECB, Riksbank.
Besides the basic structure of the operating model presented above, there may be several supplementary dimensions in connection with a CBDC. One question is whether external parties (either supervised or non-supervised institutions) can develop additional services on the platform that constitutes the CBDC’s framework (provided, of course, that the technology of the given platform enables this). Just like services, the issue of infrastructure is also important. The infrastructure of central bank–market participant relations should be determined (e.g. traditional relations, dedicated API access to certain elements
of the system). These questions are relevant, all the more so because the level of services offered by the central bank and the associated parties (the channels through which it can be accessed, the convenience services offered by the central bank, typically in the form of commercial banking services, whether new, innovative solutions can be integrated into the platform, whether it can manage smart contracts etc.) influences the extent to which the CBDC is used, which could have monetary policy and financial stability implications. Finally, an additional topic needs to be mentioned in connection with operation, namely lending. The current international literature discusses this in less detail (see, among others, Auer et al. 2020, Adrian−Griffoli 2019, ECB 2020, BIS 2020), but it should be addressed because of certain public policy objectives and central banking and market effects. Lending through the CBDC practically enables certain market actors to access not only the central bank’s liabilities side (similar to cash) but also, to some extent, its assets side. This is partly true even today, one only needs to think of the current central bank bond purchase programmes, but with a CBDC, that instrument could be much more direct, faster and even cheaper. With respect to lending, the operating model can be direct, hybrid or indirect (Figure 6). In the indirect model (A), the central bank only manages a quasi-credit account for the participants, while in the direct and hybrid models (B), it has more varied tasks (e.g. scoring and credit rating, collateral valuation, disbursement and repayment records, workout, portfolio management).
Figure 6: Possible role of the central bank and market players regarding a CBDC with lending function
Credit register
Loan disbursement
A) Central bank manages one single credit account
Commercial banks’ mobile bank and internet bank
Account management
B) Direct Access
Mobile bank and internet bank
Source: Authors’ work.
5. Considerations related to the anonymity of transactions and account balances
5.1. The necessity of anonymity and the aspects to be considered
The retail CBDC scheme available to the wider public should enable widespread use through its simplicity, attractive cost level and functionality. When an alternative to cash transactions is sought, transactions should be simple and smooth as well as anonymous, and the latter can largely determine the popularity of a CBDC.
Although the anonymity of cash transactions was a matter of course until the 2000s, the global regulatory focus in the wake of the 2001 terrorist attacks resulted in tighter rules for customer identification in the case of larger transactions (KYC) to reduce money laundering (AML) and terrorist financing risks to a minimum, which affected both cash and electronic transactions. These control mechanisms would obviously apply to CBDC transactions, too, beyond a certain amount, to prevent the new payment solution from facilitating illegal transactions. However, a system operated with such mechanisms is highly complex and requires continuous control from the operator, which is compounded by the burden related to processing and storing the obtained data as well as maintaining steady one-toone relations with customers. Since such systems are operated by already existing payment service providers and commercial banks, several central banks (BoE, ECB, PBoC etc.) plan to fulfil this role with the cooperation of the private sector in the long run. So, an important decision point when designing the CBDC scheme is whether to allow anonymous, uncontrolled transactions, and whether different limits can be integrated into the system to distinguish riskier transactions.
5.2. The levels and extent of anonymity, and conceptual (multi-stage) frameworks
At one extreme of the theoretical framework, there are fully anonymous transactions, which replicate the fast and unconditional experience of cash transactions (Figure 7). In this case, customers do not need to have an account under their name, they can initiate payments among each other from their digital wallets. These are referred to as token-based systems, because the digital wallet or storage platform can be a mobile application or digital transmitter, for example an anonymous bank card. The existing AML rules only allow such schemes with strict
constraints. In the EU, the 5th Anti-Money Laundering Directive42 limits anonymous balances to EUR 150, with a requirement to subsequently check the cardholder’s transactions. However, placing quantitative restrictions on anonymous transactions should not only be considered to eliminate illegal dealings, it is also important in enabling the traceability of offline transactions. This is because in order to facilitate the legal authorisation of the transactions conducted during any interruption in the link between the clearing system and the counterparties providing the payment platform, the number and size of such transactions should be limited to the absolute minimum that allows legitimate use even under extreme conditions (e.g. in the event of a natural disaster). At the other extreme of the theoretical framework is full customer due diligence and identification, which is already compulsory for payment service providers and commercial banks in the case of electronic payment transactions. In this case, the requirement to complete due diligence on customers when they enter the system and even after that at regular intervals, coupled with continuous transaction monitoring, places a considerable extra burden on all system operators, which may include central banks here. At the same time, users also have to acknowledge that their CBDC transactions are constantly monitored and recorded, and may even be suspended in suspicious cases. The social acceptance of such a system can depend on how citizens feel about central registers. Therefore, striking the right balance between the opportunities
42 Directive (EU) 2018/843 of the European Parliament and of the Council of 30 May 2018 amending Directive (EU) 2015/849 on the prevention of the use of the financial system for the purposes of money laundering or terrorist financing, and amending Directives 2009/138/EC and 2013/36/EU (Text with EEA relevance).
offered by technology and customers’ need for anonymity is key to the success in any retail CBDC system.43
Figure 7: Possibilities of anonymous transactions and customer identification in CBDC models
Identified transactions Controllable anonymity Anonymous transactions
Complete customer due diligence
Unlimited number and volume of transactions
~ commercial bank money Multilevel customer due diligence
Multilevel restrictions
~ PBoC DC/EP No customer due diligence
Limited number and volume of transactions
~ cash
Increasing money laundering risks
Increasing data handling burdens
Source: Authors’ work.
A possible implementation of the middle ground between the two extremes is offered by the so-called controllable anonymity used by the PBoC’s Institute of Digital Currency,44 which assigns pre-determined, gradually tightening due diligence requirements to the transactions increasing in size, thereby ensuring a sort of graduality to find the sweet spot between smooth transactions and the growing administrative and data processing burden arising from the increasing money laundering risks. There are three grades, with gradually increasing limits on account balances and
43 The ECB’s household questionnaire on this topic also seeked to learn more about these preferences. (https://www.ecb.europa.eu/euro/shared/files/
Questionnaire_on_a_digital_euro.pdf) 44 https://www.bloomberg.com/news/articles/2019-11-13/pboc-wantscontrollable-anonymity-in-china-s-digital-currency
individual transaction sizes, depending on whether the account holders identify themselves with another bank account, a copy of their ID or a transaction from another bank account. The system distinguishes between the accounts held with a payment service provider and those held with commercial banks, and of course only the latter can have full functionality and the highest limit. This allows transactions in everyday life to be simplified and extended to a wide range of service providers, while more unusual and complex transactions come with stricter identification requirements.
The two, radically different versions of CBDC are the wholesale type used among financial institutions, and the widely used CBDC available to the general public. Since technological challenges are mainly faced during the preparation and introduction of the latter due to the number and considerable diversity of users, this chapter focuses on the questions and main parameters related to this. Nevertheless, where relevant, the technological issues tied to a CBDC used among professional financial actors will also be pointed out and discussed.
6.1. Presentation of the potential participants in the ecosystem
In the case of a widely used retail CBDC, cooperation between several partners and ensuring an uninterrupted service are required for the establishment and operation of the system. The members of the smallest ecosystem by functions:45
45 Of course, more than of these functions may be fulfilled by the entities.
– Central bank: the conceptual designer of the system, owner of the decisions and responsibility. – Operator(s): operator of the physical underlying system and any service units and functions, the actor in charge of technical operation. – Payment service providers: depending on the model, they are responsible for user registration and interaction, the continuous operators of individual KYC and AML procedures, main points of contact towards users and the sources and users of potential new innovations. They may comprise commercial banks, payment service providers or even tech firms to maintain the possibility of market innovation and market diversity. – Banks: besides the functions described at payment service providers, they ensure convertibility between the CBDC and the money issued by commercial banks, possibly even for foreign
CBDCs.
In a broader sense, the supporting ecosystem may also include the suppliers of the physical devices that are part of the physical infrastructure and necessary for retailers and users, the developers of services and apps, or even the external suppliers taking part in data analysis and communication.
6.2. Design considerations related to the technology used during the introduction of a CBDC
As described above, the decision points related to the design of the CBDC system motived by public policy goals affect several other design dimensions. Therefore these can be considered predetermined features when choosing the technology to be used. Nonetheless, the currently available technologies obviously limit the choice, just like the absence of reliable testing experience that would pave the way for their robust and large-scale application.
6.2.1. Expectations from the technology to be applied The technological challenges posed by a widely used retail CBDC system are definitely new compared to earlier systems, because a very large user base needs to be served in almost real time, continuously, without errors, and the system has to be deployed relatively quickly after the decision is taken, without the adjustment opportunities available in earlier, evolutive processes. Therefore, there is a special focus on feedback and testing at the design and implementation stages. The theoretical requirements to be considered during the design stage are as follows (BIS 2020): – Convenient and accessible: the system has to provide the already available user experience, in physical and online shopping alike, as well as during peer-to-peer transactions.
Depending on mobile penetration and the number of phones in use, tap-to-pay can be achieved with mobile phones, wearables or portable digital devices, for example stored-value cards. Some of these devices need to work offline as well. The old and the disabled should also be able to conduct payment transactions. – Resilient and secure: the system has to ensure full protection against unauthorised access, attacks and phishing on both the clearing system and the user side. Advanced and continuously developed cryptographic procedures need to be provided to record transactions and user balances in real time. The recordkeeping system has to be highly resilient, which may require system redundancy in the case of central clearing, or enhanced protection at the nodes in the case of distributed ledger solutions. – Fast and scalable: the system should be able to simultaneously complete transactions for a huge number of users at reasonable costs, i.e. its throughput has to be large. Moreover, the technology should also ensure that even if the initial number of transactions surges, the system will not reach full capacity
soon, since innovative solutions may considerably boost user demand, for example with the rise in micro payments related to media consumption. – Interoperable: the system obviously has to function at all the players taking part in its operation and in maintaining customer relations, both online and offline, and it has to provide a link to the existing payments infrastructure, for example in the form of convertibility to commercial bank money or cash. Furthermore, it should enable the connection to platform-based business models and new, CBDC-based developments. Users should also have the option to switch between service providers, because that is the only way to ensure a customer-driven approach and continuous innovation.
– Flexible and adaptable: the system has to work in line with the current and future functions of money, while adequately responding to the often conflicting requirements. It should be flexible by design and remain so.
6.2.2. Path dependence and innovation opportunities When deciding on the technology to be used, the continuous and uninterrupted operation of the existing payments infrastructure should be ensured until the deployment of the new system, and the operating costs and environmental impact of the final system or systems should remain acceptable.
Figure 8: Possible directions of a CBDC infrastructure development
Increasing complexity New system in an innovative approach
(e.g.: DLT-based)
New system on traditional basis
Expansion of current
Increasing development requirement
Source: Authors’ work.
Based on the time required for implementation and the project’s complexity, the least amount of effort is required when the existing systems are expanded, enabling them to manage individual retail accounts (Figure 8). In this case, capacity requirements may be reduced if some of the clearing and account management functions are outsourced to authorised payment service providers or commercial banks.
However, beyond a certain number of users, the time required for the development and the need to ensure uninterrupted operation may call for designing a new system based on the traditional infrastructure. This leaves more doors open to establishing new connections with new service providers or to widen the user base, possibly even abroad, without compromising the reliability of the technology. However, if the CBDC project was motivated by the need for the new platform to enable the development and propagation of innovative services, smart contracts and programmable functions,
the traditional technology may have to be surpassed. Distributed ledger technology (DLT) offers market participants an opportunity to link the clearing and settlement of payment transactions to further automatic and real-time transactions, registrations and other operations, the completion of which can be verified by all the parties controlling the ledger system, validating it on a majority basis. If the ledger is controlled by a low number of special clearing nodes, the negative experiences regarding the time required for clearing usually cited in connection with the distributed ledger technology may not be relevant, because the system’s throughput may be greater than today’s systems’ by orders of magnitude.46
Figure 9: Possible long-term targets for the design of the CBDC core system
I. The new system replaces the existing system(s) II. The new system supplements the current infrastructure
After a successful pilot period, the old system will be phased out The old and the new systems run in parallel with different functionality and focus
III. Back-up system alongside the traditional infrastructure
Source: Authors’ work.
When a new system is set up as the core CBDC system, the longterm relationship between the existing and the new system should also be considered (Figure 9). The new system may be required to supplement the existing one, ensuring the new functionality while the old system reliably operates. The new system may also have
46 For example see nanopay’s nanorail ledger system, which can complete up to 50,000 transactions per second (TPS). (www. nanopay.net)
to be able to take over the functionality of the existing system in a crisis (e.g. cyberattack, natural disaster, extensive power failure), and be able to ensure the uninterrupted operation of the digital payments infrastructure.
6.2.3. Considerations when deciding between a centralised and a decentralised core system The appearance of bitcoin in 2008 marked the emergence of an early forerunner to central bank digital currencies, as it sought to popularise a new, digital means of payment without any central clearing system or records, where transactions are finalised and cleared with the approval of the majority of verified participants or nodes. However, this comes at a price: the finalisation of transactions requires time and energy, so this technology is not really suited for the digital version of cash transactions in terms of the customer experience. Bitcoin’s features mentioned above and the fact that it is not backed by any government or economy that would ensure the stability of its value basically exclude it from among the public blockchain solutions to be considered when designing a CBDC. However, the distributed ledger technology itself should not be dismissed at all.
This is because when clearing occurs with many parties, the process does not necessarily have to rely on the common judgement of a large number of players that are difficult to identify. So-called private blockchains with a distributed ledger solution can be created where writing and validation rights can be distinguished, and where these rights are distributed among a low number of verified actors (Figure 10).
Figure 10: Main differences between private and public blockchains
Public Private
• Many, unknown participants • Reading and writing rights • Platform dependant consensus mechanism • Limited number and known validators • Centralised writing rights • Public or restricted reading rights • Multiple algorithms for consensus
Source: Authors’ work.
A special implementation of private blockchains is the so-called centralised ledger technology (CLT), where a central actor is responsible for operating the system and storing data, while information is also recorded and transactions are validated at the limited number of other participants in the blockchain. Due to the distributed ledger nature, this preserves simultaneous and multiple validation and greater recovery capacity, while transactions can be processed and completed in real time without major compromises. Another big advantage of the CLT technology is that it can ensure offline operation for a limited time, since the transactions recorded by the distributed nodes are protected from external manipulation with cryptographic tools and can be recorded in the central ledger when the online connection is restored.
The option for multi-actor, simultaneous validation and for the linking of payment transactions with other settlement obligations stipulated in a smart contract make distributed ledger technology on a private blockchain especially attractive when implementing so-called wholesale CBDC solutions among financial institutions. Several central banks (SNB, BdF, Bank of Canada) have made great progress in experimenting with the development and deploying of such solutions. Besides simplifying and accelerating money and capital market transactions, this solution may greatly facilitate cross-border wholesale payment transactions and real time settlement. Numerous central banking projects have been set up in international cooperation (e.g. Project Stella, Project Inthanon-LionRock) to implement this.
Table 1: Technology features of centralised and partially decentralised systems
Core system architecture
Accessibility
Speed
Settlement finality
Security, resilience
Major risk factor
Expansion of current infrastructure
Supplementary to the current system, complex Moderately complex Lower complexity
Closed, permissioned
Closed, permissioned
Closed, permissioned, but certain parts can be opened
New system on traditional basis
High (transaction) Low (value chain) High (transaction) Low (value chain) High (transaction) Medium (value chain)
Well-defined, well-interpreted legally
Well-defined, well-interpreted legally Depends on the exact operational model, can be well-defined
Single point-offailure, but the vulnerabilty of the central actor is critical Single point-offailure, but the vulnerability of the central actor is critical More resilient on an ecosystem level
Older core system can be a risk
Longer term sustainability is questionable
Risks of technology are partly unknown
CLT, private blockchain
Source: Authors’ work.
During the introduction of a widely used retail CBDC, when the underlying system needs to be chosen, the solutions based on a private blockchain should also be considered, because, mainly on account of the low complexity and the resulting lower operational risk and vulnerability, this may have a huge advantage over centralised solutions (Table 1). Nevertheless, the novelty of the technology and the scant experience about using it in everyday payments make most decision-makers vary, and no major central bank has publicly committed itself to this technology yet. In itself, the introduction of a CBDC does not require new technology, it can be implemented through the extension of the existing infrastructure or by placing the latter on a new footing. According to the international literature, the opportunities offered by the new technologies are explored in most projects to ensure that conscious decisions are taken on the system’s limits and the options for further action offered by the system’s structure.
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