Central Bank Digital Currency: Implications, Design Choices, and Global Developments

Abstract

Central Bank Digital Currencies (CBDCs) have emerged as a transformative force in the global financial landscape, prompting central banks worldwide to explore their potential. This report provides an in-depth analysis of CBDCs, distinguishing them from stablecoins and cryptocurrencies, examining the motivations for their issuance, exploring various design choices, and discussing their implications for monetary policy, financial stability, and the traditional banking system. The report also highlights recent developments, including the Bank of Korea’s collaboration with commercial banks on a second pilot test of its CBDC.

Many thanks to our sponsor Panxora who helped us prepare this research report.

1. Introduction

The advent of digital technologies has revolutionized the financial sector, leading to the emergence of various digital assets such as cryptocurrencies and stablecoins. Amidst this digital transformation, central banks have initiated the development of Central Bank Digital Currencies (CBDCs) to modernize payment systems, enhance financial inclusion, and maintain monetary sovereignty. This report delves into the concept of CBDCs, differentiates them from other digital assets, and explores their potential impact on the financial ecosystem.

Many thanks to our sponsor Panxora who helped us prepare this research report.

2. Defining Central Bank Digital Currency

A Central Bank Digital Currency (CBDC) is a digital form of a country’s official currency, issued and regulated by the nation’s central bank. Unlike cryptocurrencies, which are typically decentralized and operate on peer-to-peer networks, CBDCs are centralized and represent a liability of the central bank. They are designed to function as legal tender, serving as a medium of exchange, a unit of account, and a store of value.

CBDCs differ from stablecoins in several key aspects. While stablecoins are digital assets pegged to a reserve of assets (such as a basket of currencies or commodities) to maintain a stable value, they are often issued by private entities and may not be subject to the same regulatory oversight as CBDCs. In contrast, CBDCs are issued by central banks and are fully backed by the government’s monetary authority, ensuring a higher level of trust and stability.

Many thanks to our sponsor Panxora who helped us prepare this research report.

3. Motivations for Issuing CBDCs

Central banks are exploring CBDCs for several reasons:

• Financial Inclusion: CBDCs can provide unbanked and underbanked populations with access to digital financial services, promoting greater financial inclusion.

• Payment System Efficiency: By offering a digital alternative to cash, CBDCs can streamline payment processes, reduce transaction costs, and enhance the speed of transactions.

• Monetary Policy Implementation: CBDCs can offer central banks a more direct tool for implementing monetary policy, potentially improving the transmission of policy measures.

• Counteracting Private Digital Currencies: The rise of private digital currencies poses challenges to monetary sovereignty. CBDCs provide a state-backed alternative to maintain control over the monetary system.

Many thanks to our sponsor Panxora who helped us prepare this research report.

4. Design Choices for CBDCs

The design of a CBDC involves several critical decisions:

• Wholesale vs. Retail CBDC: Wholesale CBDCs are intended for use by financial institutions for interbank transactions, aiming to improve the efficiency and security of the wholesale payment system. Retail CBDCs are designed for use by the general public for everyday transactions, serving as a digital alternative to cash.

• Centralized vs. Decentralized Ledger: While CBDCs are inherently centralized, the underlying technology can vary. Some central banks are exploring the use of distributed ledger technology (DLT) to enhance transparency and security, though the centralization of control remains.

• Privacy and Anonymity: Balancing user privacy with the need for regulatory oversight is a significant challenge. Central banks must decide the level of anonymity to provide, considering potential risks such as money laundering and terrorist financing.

• Interoperability: Ensuring that CBDCs can operate seamlessly with existing financial systems and across borders is crucial for their adoption and effectiveness.

Many thanks to our sponsor Panxora who helped us prepare this research report.

5. Implications of CBDCs

The introduction of CBDCs carries several potential implications:

• Monetary Policy: CBDCs could enhance the effectiveness of monetary policy by providing central banks with more direct tools to influence the economy. For instance, they could facilitate the implementation of negative interest rates or enable more precise targeting of monetary interventions.

• Financial Stability: While CBDCs could improve the resilience of payment systems, they also pose risks. A rapid shift from bank deposits to CBDCs could lead to disintermediation, affecting banks’ ability to lend and potentially leading to financial instability.

• Banking System Dynamics: The issuance of CBDCs could alter the traditional banking model. Banks might face increased competition for deposits, leading to changes in their funding structures and business models. Additionally, the role of banks in credit creation could be impacted, as CBDCs might serve as a direct liability of the central bank.

Many thanks to our sponsor Panxora who helped us prepare this research report.

6. Global Developments in CBDCs

Several countries have made significant progress in developing and piloting CBDCs:

• China: The People’s Bank of China has been at the forefront, piloting the digital yuan (e-CNY) in several cities, with transactions reaching approximately $987 billion. The digital yuan aims to enhance payment efficiency and reduce transaction costs.

• European Union: The European Central Bank has initiated a multi-year digital euro pilot, focusing on exploring the potential benefits and challenges of a digital euro.

• India: The Reserve Bank of India is developing the digital rupee, aiming to digitize the economy and reduce reliance on physical cash.

• South Korea: The Bank of Korea has been actively involved in CBDC research and development. In October 2023, it initiated a pilot project to test both retail and wholesale CBDCs. The wholesale test focuses on the tokenization of bank deposits to facilitate interbank transactions within a CBDC network managed by the Bank of Korea, the Financial Services Commission, and the Financial Supervisory Service. The retail tests are expected to commence after the completion of the wholesale test, aiming to assess the feasibility of a future monetary system based on retail CBDCs. (koreajoongangdaily.joins.com)

Many thanks to our sponsor Panxora who helped us prepare this research report.

7. Challenges and Risks

Despite the potential benefits, CBDCs present several challenges:

• Cybersecurity: Ensuring the security of CBDC systems against cyberattacks is paramount. The Bank for International Settlements has highlighted the need for robust risk management frameworks to address information security and operational risks associated with CBDCs. (bis.org)

• Privacy Concerns: Striking a balance between user privacy and regulatory oversight is complex. Concerns about surveillance and data privacy have been raised, particularly regarding the potential for state control over financial transactions.

• Technological Uncertainty: The rapid evolution of technology presents challenges in selecting appropriate platforms and ensuring scalability and interoperability of CBDC systems.

Many thanks to our sponsor Panxora who helped us prepare this research report.

8. Conclusion

Central Bank Digital Currencies represent a significant evolution in the digitalization of money, offering potential benefits such as enhanced payment efficiency, financial inclusion, and more effective monetary policy implementation. However, they also pose challenges related to cybersecurity, privacy, and the potential impact on the traditional banking system. As central banks continue to explore and pilot CBDCs, it is crucial to carefully consider these factors to ensure that the implementation of CBDCs aligns with the broader goals of financial stability and economic well-being.

Many thanks to our sponsor Panxora who helped us prepare this research report.

References

• Bank for International Settlements. (2023). Central bank digital currency (CBDC) information security and operational risks to central banks. (bis.org)

• Federal Reserve. (2020). Central Bank Digital Currency: A Literature Review. (federalreserve.gov)

• Christodorescu, M., Gu, W. C., Kumaresan, R., et al. (2020). Towards a Two-Tier Hierarchical Infrastructure: An Offline Payment System for Central Bank Digital Currencies. (arxiv.org)

• Beer, C., Zingg, S., Kostiainen, K., et al. (2024). PayOff: A Regulated Central Bank Digital Currency with Private Offline Payments. (arxiv.org)

• Goodell, G., Al-Nakib, H. D., Aste, T. (2024). Retail Central Bank Digital Currency: Motivations, Opportunities, and Mistakes. (arxiv.org)

• Hupel, L., Rafiee, M. (2023). How does post-quantum cryptography affect Central Bank Digital Currency? (arxiv.org)

• Digital Euro – Prototype summary. European Central Bank. (en.wikipedia.org)

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• Financial institutions band together for Korean digital currency trial. Korea JoongAng Daily. (koreajoongangdaily.joins.com)

• Central bank digital currency momentum growing, study shows. Reuters. (reuters.com)

• The IMF’s central bank digital currency handbook. Axios. (axios.com)

• The benefits of CBDCs are too great to ignore. Financial Times. (ft.com)

• Even central banks are losing faith in CBDCs. Financial Times. (ft.com)