Authors

Ignazio Angeloni^[1]Senior policy fellow, SAFE (Frankfurt) and non-resident fellow, IEP Bocconi.

 

1. The longest decision ever

The preparation for the digital euro moves on. In November 2023 the ECB launched a new and final 3-year program of exploration of the technical features. Barring a postponment, at the end of this phase a decision on the actual launch will be made.

Before any consideration of substance, one should commend the opennes with which the central bank is conducting its work. The ECB keeps the public regularly informed. Stakeholders are being consulted. Outside experts are in a position to understand what is going on and form their views. In preparing for a possible digital euro, the ECB is abiding to high standards of transparency.

As mentioned, the final decision about launching a digital euro has not been made yet. The preparation process started in 2020 with a 3-year “investigation phase”. The current “preparation phase” should end in 2026. During this time the central bank is “browsing the daisy”, suspended between a “yes” or “no” decision. If, after a “go” decision, some more time passes before the digital euro enters our pockets, its gestation will have taken more time than the euro itself (1992-1999), let alone the euro banknotes (1999-2002) and the ECB banking supervision (2012-2014). That’s not necessarily bad, given the uncertainties involved.

While the process unfolds, however, the rest of the world is moving fast in two related domains: payment technology and geo-politics. Developments in both areas influence what happens around the world with regard to the possible introduction of central bank digital currencies (CBDCs).

The digital payment industry moves fast. Tech giants on both sides of the Pacific (China and even more California) relentlessly introduce more advanced digital payment applications, leveraging on the synergies with handheld devices. A recent example is Tap-to-Pay, the new P2P solution by Apple (Forbes, 2024b). P2P functionalities already exist on PayPal, Revolut and other platforms, but Tap-to-Pay does more: it promises to invade B2P, sending Point-of-Sale technology into retirement. Prepare for a time in which a portable phone will be all a shop manager needs to do business, including comply with accounting and tax obligations. More innovation will come after AI takes hold and combines with payments. Central banks which in the meantime have decided to become suppliers of their own retail digital payment products will find themselves in a fast moving, fiercely competitive business environment, in which they are unlikely to have the upper hand but are relegated to a “follower” position, constantly catching up. Not an enviable situation.

Geo-politics is also moving. After the Russian invasion of the Ukraine and amid the new expansionism of China, international relations and the global security situation have worsened. Monetary and financial arrangements, including the international use of currencies, are affected. Cyber threats affecting the financial sector are rampant. The traditional role of the US dollar as main reserve and vehicle currency may come under threat as a number of “non aligned” countries look for alternatives. CBDCs are increasingly becoming battleground of international currency competition. As discussed more extensively below, China appears to be using its digital currency, the e-CNY, as a lever to increase the attractiveness of the yuan as an international transaction and reserve currency among neighbouring countries and beyond, undermining the established roles of the US dollar and the euro.

Amid this complex set of factors, the purpose of this paper is twofold. First, in Section 2, we revisit the main arguments in favor and against the adoption of a digital euro, focusing on the design choice chosen by the ECB, namely, a retail instrument available to the generality of citizens, producers and retailers. The conclusion here is that uncertainties regarding the underlying motivation for this type of instrument remain; they have been limited by the preparatory work but not fully dispelled. In Section 3 the focus is broadened to developments outside the eurozone. One takeaway from this overview is that there is an extreme variety of views and orientations regarding the rationale of CBDCs, their purpose and design, and more fundamentally the advisability of introducing one and in what form. Another one is that, whereas in Europe and in developing countries the goal of creating a new secure retail payment means prevails, in the United States that of improving the efficiency of wholesale and international payments is gaining ground. Section 4 concludes with some tentative indications for future work on the digital euro.

 

2. Revisiting the arguments

This section briefly revisits the arguments in favour and against the prospective introduction of a retail digital euro, along the lines of an earlier paper (Angeloni, 2023a), considering whether those arguments are still valid in light as preparatory work progresses. The discussion is divided into six headings: Market reception; Effects on bank intermediation; Consequences for monetary policy; Consequences for financial stability; Financial inclusion; Privacy.

 

Market reception

The simplest and most down-to-earth question that must be answered as one ponders the possible launch of a retail-based digital euro is: Do people need it? The answer to this question determines whether the digital euro has a chance of succeed in the marketplace or instead risks being a flop.

The critical fact here is that the ECB would offer a new payment instrument to a large base of customers, in competition with private providers of similar products. Traditionally, central banks offer their products and services on a monopolistic basis (for example, when they print banknotes), or to specific subjects they regulate and supervise, as deposit and settlement services offered to commercial banks. The digital euro puts the ECB in a wholly new situation, where it is not protected by monopolist power and market rejection is possible. Today users have countless digital payment options, largely similar to one another, all efficient, safe and cheap. If rejected by the market, the digital euro would involve reputational and other costs for the central bank. A related consideration is that the central bank has regulatory powers in the payments industry, which generates a conflict of interest. The central bank may be tempted to use those powers to prop up its own product, distorting competition and hampering innovation. China’s example, discussed below, where the government promotes the digital yuan as an alternative to Alipay and Tencent, is not directly applicable but not irrelevant either.

Market analyses conducted by the ECB (for example, Kantar Public, 2022) have not aswered that question definitively. People say that they like efficient and safe digital payment, but consider the existing options quite satisfactory. The extra safety consisting in the digital euro being a central bank liability is not regarded as important. Moreover, people are attached to physical cash because it has unique characteristics: tangibility and absolute privacy. All these considerations together raise the question of whether there is a market niche for the digital euro. More analyses would be needed to clarify this question.

 

Effect on bank intermediation

The main question surrounding the introduction of the digital euro regards its impact on bank intermediation. If the new instrument is sufficiently attractive, a shift will take place away from other instruments. It is unlikely that this will impact the demand for paper currency in a significant way, because cash has specific characteristics the digital euro is unlikely to reproduce. More likely is a decline in the demand for bank deposits. This is particularly the case because the ECB has decided to outsource all front-end functions relating to the digital eiro to banks: onboarding and offboarding, KYC and AML checks, and all services associated with deposits – online banking, payment cards, apps, etc. There will be strong synergies between opening a bank deposit and a digital euro deposit – same process, same information, same forms to fill. From a user perspective, there will be no difference between opening a digital euro account or a normal deposit.

The digital euro therefore is likely to imply a decline in the balance sheet of the bank and an increase in the balance sheet of the ECB, of a size hard to quantify ex-ante. Aware of the risks involved in a disintermediation of banks, the ECB plans to set strict limits on digital euro balances. In its latest progress report (ECB, 2024), it announced work on a methodology to quantify these limits. The nature and the extent of these limits is one of the important open issues that will determine how the prospective digital euro may look like and the impact it may have on the financial sector.

 

Consequences for monetary policy

The digital euro was never intended as a monetary policy instrument, but may have unintended effects on the way monetary policy impacts the economy. As just mentioned, the likely shift away from bank deposits would shrink the balance sheet of banks. Bank liquidity would decrease, with a contractionary effect on lending: banks would tend to restrict credit to households and businesses. The amounts are uncertain and could be macroeconomically relevant. The central bank may compensate the liquidity squeeze by offering more refinancing operations. However, banks usually do not regard central bank funding as a perfect substitute for deposit funding, which is traditionally more stable.

It is sometimes argued that a digital euro is needed to preserve the role of central bank money as a “monetary anchor” in an increasingly digitalized financial sector. This idea is misleading, however, because it overlooks that the existing monetary control processes are already entirely digital. Bank liquidity, the crucial variable for the transmission of monetary policy, takes the form of electronic deposits at the central bank. Open market operations affecting bank liquidity are digitalized, as are the ensuing settlement operatins. Cash, physical or digital, plays no role in the conduct of monetary policy.

 

Consequences for financial stability

Depositors may not appreciate the difference between commercial bank and central bank money in normal conditions, but that distinction becomes crucial in a banking crisis, when they perceive their bank may fail. In the EU bank deposits are guaranteed up to 100.000 euros: beyond that, deposits are at least partially at risk. The digital euro would offer depositors a convenient, instant and costless channel to “run” their bank, shifting from bank deposits to a riskless liquid asset. This would risk exacerbating a banking crisis. This risk is compounded by the fact that the eurozone lacks an area-wide deposit insurance scheme.

The practical relevance of this problem depends on the design of the digital euro. If holding limits were sufficiently strict, the danger would be reduced in the aggregate. The impact on each individial bank, however, may be significant, depending on its funding structure. Moreover, one shoud not overlook the risk that in a banking crisis the ECB may come under pressure to relax the limits, to shelter citizen from the losses. A banking crisis is always a painful and politically sensitive event; in certain scenarios, the idea of using the digital euro to shelter savers from losses may become politically attractive. Far from resolving the crisis, the relaxation of the limits would aggravate it and make it systemic.

 

Financial inclusion

A rationale often mentioned is that CBDCs can foster financial inclusion – the access of “unbanked” citizens to the financial sector. However, in the case of the eurozone such effect is unlikely to be important. Citizens that choose to remain outside the traditional banking channel and use cash instead do so because they are technologically unsophisticated or because they are wary of the formalities and complexities involved in operning a bank account. A digital euro involving the same steps and contacts with a bank is unlikely to change the attitude of those citizens.

A related issue is that of foreign workers’ remittances. Cross border workers often face extraordinary delays and costs in transfering money to their families at home. An increasing number of eurozone workers are immigrants. Facilitating money transfers for those workers would be a valuable service from an economic and social perspective. An active role of the public sector, central banks particularly, would be justified. Dedicated schemes for immigrant workers would require accords among the central banks of the countries involved. Alternatively, private initiative by banks and other providers of international money transfers could be facilitated and subsidized.

 

Privacy

As mentioned already, citizens consider privacy an important feature of payment means and regard cash as the ideal instrument for this purpose. Accordingly, the ECB is considering technical features that can deliver “cash-like” privacy. In its latest progress report, it states in particular its intention to “.. use state-of-the-art measures, including pseudonymisation, hashing and data encryption, to ensure it would not be able to directly link digital euro transactions to specific users.” (ECB, 2024).

While this may sooth some concerns, it is unlikely to solve the problem fully. Digital transactions can always be traced and will never be equivalent of exchanges of cash, at least in the eyes of users. Offline functionality, foreseen by the ECB, helps but it is of little relevance: today’s prepaid cards are not extensively used. Moreover, privacy is a blessing in certain respects but a curse in others. Money launderers, drug dealers and all-purpose criminals are very interested in efficient and confidential payment means. Traditionally they used to fill briefcases with cash; today they increasingly use digital alternatives, including crypto-assets. A digital euro with guaranteed privacy would not escape their attention. Another source of reputational risks for the central bank.

 

3. Looking beyond the eurozone borders

The eventual decision on launching a digital euro, the way it will be designed and what purpose it will be supposed to serve, are likely depend to a significant extent on what happens elsewhere in the world. The complexity and risks involved are such that a “do it alone” choice is hardly advisable. Especially among the highly integrated and interdependent Western bloc, cross-border coherence can make country-specific choices more credible and robust. “Interoperability” among different CBDCs is an important oft-quoted requirement. Moreover, what happens outside the Western bloc is also important: in particular, China is exerting first-mover influence on the Unites States and other countries as well.

At present, however, what happens around the world is far from clear. Most central banks are conducting studies but few have made definite decisions. The future is open for the digital euro as well: on the one hand, the passage of time and the cost and investment sunk in the project increase the probability that “something” will be done eventually. On the other, one cannot ignore the persistence of arguments and views to the contrary, especially with regard to a retail CBDC.

What follows is a high-level selective overview of initiatives and debates outside the eurozone. It focuses on initiatives, decisions and official statements that are relatively recent and can signal future trends at national or international level.

 

China

China deserves first mention for two reasons. It was the first country to launch an CBDC project in 2017, and to start experimenting with it three years later. The second reason is that what happens in China can influence opinions and orientations in the United States. The choices made by China can have an important indirect global influence.

The e-CNY experimented by the People’s Bank of China (PBoC) is a retail instrument. It was made available initially in four cities in 2020 and later extended to several regions, although not yet to the whole country (Atlantic Council, 2024). There are different types of e-CNY available, from the simplest ones and most limited in size and functionality, to the more extensive ones, subject to stringent disclosure requirements. The Chinese government is proactively promoting the instrument, granting for example discounts and concessions to holders. Private providers like Alipay and Tencent, already massively present in the country, have integrated the e-CNY, facilitating its circulation.

In spite of strong official promotional activity, the digital yuan has had a slow start. Data – unfortunately very scanty – suggest that the uptake so far is limited, because of strong competition from very efficient private applications. There are reportedly 260 million e-CNY wallets open, around 18% of the population (Atlantic Council, 2024). As of mid-2023, some 950 million transactions had cumulatively taken place. Over a 4-year horizon, this amounts to an average of 2 transaction per wallet per year, a negligible number. Over the last year for which data are available, the average number of transactions per second was about 20, against some 120,000 reported by Alipay alone. The outstanding stock of e-CNYs in 2023 was just about 0.13% of the currency in circulation.

The modest domestic uptake of the digital yuan is confirmed by other sporadic sources. An interesting “test drive” conducted by a journalist in Guangzhou (the fourth-largest Chinese city, otherwise know as Canton), in restaurants, hotels and other places of public accommodation, concluded that the e-CNY was little used and even known, except in public transportation and other government-owned facilities (Quinn, 2024).

 

Other Asian countries

While domestic penetration of the digital yuan remains limited, China is promoting its international use of among Far- and Middle-Eastern countries. eBridge, a China-led multiple country platform started in 2021 in collaboration with the BIS, has associated the Hong-Kong Monetary authority and the Bank of Thailand and the central bank of the United Arab Emirates. eBridge works as a multi-central bank platform among participating central banks and commercial banks, on a distributed ledger allowing fast cross-border payments and settlement among the participating entities. Recently, Saudi Arabia has joined; an important extension. It should be noted, however, that the attitude of individual countries toward CBDCs varies. The Bank of Thailand, for example, while a member of eBridge has recently stated that it has no intention for the moment to issue a retail CBDC (Bank of Thailand, 2024).

The tense geo-political situation followed following Russia’s invasion of the Ukraine has increased the interest in initiatives like eBridge (Atlantic Council, 2024), and in general in payment platforms that allow to avoid mainstream financial channels dominated by the US dollar (Ku, 2024).

A survey conducted by the International Monetary Fund on work conducted by Middle-East and Central Asian countries revealed that most of them are exploring the possibility of launching a CBDC (IMF, 2024), whereas a smaller number of countries expressed no interest. In most cases, the involvement is driven by domestic considerations: financial inclusion, enhancing financial and technological literacy, and promoting efficiency and competition.

Japan has explored the potential of an electronic yen, most recently launching a pilot and an opinion survey. The activism of China likely contributed to Japan’s interest. Recently, however, a statement by the central bank governor suggests caution (Ueda, 2024). The governor mentions a scarce awareness by the population and emphasizes the benefits of physical cash (tangibility, proximity of the transacting parties, privacy), calling for more experimentation involving the public.

The Reserve Bank of India has launched pilots of tokenized CBDC instruments for bank wholesale and retail transactions in 2022. While the government has adopted measures to help the success of the initiative, its prospects are still unclear.

 

Russia

Given the geo-political relevance of CBDCs, some attention to what happens in Russia is due. Putin’s Federation has not been active on CBDCs at first, but this is changing. In early 2024, the central bank governor informed on ongoing initiatives to launch a national CBDC (Ledger Insights, 2024). The Duma has passed legislation and first trials have started in 2023. Some 25.000 transactions have taken place since then, mostly P2P transfers, a very small number, which may be due in part to the recent start of the trial. A “second wave” involving large banks will be started after the central bank has fixed a number of bugs. Technical features of the digital rouble are quite sophisticated, including dynamic QR codes, smart contracts and programmable money. The goal of building something that is state of the art and attractive internationally is quite evident.

 

United States

The Federal Reserve started explorations years ago, but is still sitting on the fence, neither supporting nor excluding the idea. Staff analyses tend to be sceptical, rather emphasizing the risks (Carapella et al., 2024). Christopher Waller, a Board member, famously dubbed the CBDC “a solution in search of a problem” (Waller, 2021). Subsequent statement by Fed policymakers moderated the tone a bit, but in substance were on the same line, emphasizing rather the advantages of FedNow, a different type of Fed-sponsored instant money transfer. In a recent statement, another Board member, Michelle Bowman, concluded: “From my perspective, there could be some promise for wholesale CBDCs in the future for settlement of certain financial market transactions and processing international payments. When it comes to some of the broader design and policy issues, particularly those around consumer privacy and impacts on the banking system, it is difficult to imagine a world where the tradeoffs between benefits and unintended consequences could justify a direct access CBDC for uses beyond interbank and wholesale transactions.” (Bowman, 2023)

Outside the Fed, discussions tend to be dominated by geo-strategic competition with China. In 2002, the Hoover Institution, a Republican-leaning think tank, assembled a high-profile team of experts to examine challenges that digital payments in China pose for the US. The report takes the view that the e-CNY will effectively promote China’s financial system and currency, making them more attractive and undercutting the position of the US dollar. The report calls for the US government and the Fed to be more active in developing a strategy on digital payments.

Politics in Washingtin moves in a different direction. Conservative circles criticise the Fed for the opposite reason, namely keeping the digital dollar option open. The republicans majority in the House of Representatives recently promoted an amendment to the Federal Reserve Act banning the creation of a digital dollar (Forbes, 2024a). Trump himself has called it “very dangerous”. Political maneuvering is in flux, partly directed against the independence of the Fed. Chairman Powell has repeatedly stated that the Fed will not go ahead if not explicitly mandated by the legislature. In a recent testimony he was quite vocal against a retail CBDC: “People don’t need to worry about a central bank digital currency, nothing like that is remotely close to happening anytime soon”, adding that “… the last thing the Federal Reserve would want would be to have individual accounts for all Americans.” (Reuters, 2024).

 

United Kingdom

The Bank of England has been preparing for a digital sterling since 2021, with the UK Treasury. The model is much along the lines of the ECB, namely, a retail instrument available to citizens and companies. The central bank seems quite open to the prospect, although a definitive decision has not been made (Cunliffe, 2023). Bank of England communication conveys a rather favourable picture, mentioning possible benefits for innovation, consumer choice, and privacy of information. Legislators will need to issue primary law before any launch is decided. Recently, the UK Parliament’s Treasury Committee Chair has stated that the instrument will not be launched before 2030, and holding balances will be limited.

 

Switzerland

The Swiss National Bank’s most recent digital payment initiative, Helvetia III, launched in December 2023, is a pilot aimed at offering to commercial banks central bank deposits in tokenized form. Offering full integration between central bank money and the Swiss exchange for tokenized financial assets, SDX, the project makes commercial bank transactions more efficient. The scheme is strictly reserved to commercial banks and based on central bank settlement.

On the option of a retail CBDC, The chairman of the Swiss National Bank, has recently stated that “The SNB currently sees no need in Switzerland for such digital central bank money for the general public, also known as retail CBDC. Consumers and businesses already have access to a wide range of efficient and innovative payment instruments offered by the private sector. Retail CBDC could fundamentally alter the current monetary system and the role of central banks and commercial banks, with far-reaching consequences for the financial system. From a Swiss perspective, the risks of retail CBDC currently outweigh its potential benefits.”(Jordan, 2024)

 

The African continent

The African continent provides a fertile ground for CBDCs and digital payments in general. It lacks, in many countries, a developed banking infrastructure with traditional channels – branch networks, ATMs, etc. On the other hand, handheld telephony is quite widespread and digital transformation, while still backwards, is progressing fast (World Bank, 2024). Money laundering and terrorist financing are a risk in some places. This calls for close monitoring and control, something a CBDC can potentially facilitate.

A recent survey shows that out of 54 African countries, only 4 possess payment system infrastructures that could potentially support a CBDC. 14 countries have made official expressions of interest towards issuing the instrument, and are involved in research and technical exploration of such possibility, whole the others have not expressed an interest (Ozili, 2023).

Two digital payment instruments launched in recent years in Africa have attracted global attention: M-Pesa and the e-Naira. M-Pesa, the largest digital payment instrument in Africa, counts over 30 million users in ten countries. Introduced in 2007 in Kenya, it allows to deposit, withdraw and pay through text messages sent via smartphone, using retail stores as banking agents.

M-Pesa is not a CBDC – the funds are not on the central bank balance sheet – but a money transfer technology relying on a branchless network of quasi-banks. Research has shown that M-Pesa had a positive economic effect, by removing constraints to consumption and reducing poverty (Suri and Jack, 2016).

By contrast, eNaira is a CBDC. Launched in 2021 in Nigeria, the largest African country, it operates via a distributed ledger. Nigeria’s population is relatively highly sophysticated digitally: a large fraction of the population has mobile phones but no bank account, and there is a thriving high-tech sector. The main stated purpose of the eNaira was to provide financial services to the unbanked, leveraging on the high level of digitalization. Another reason is to combat corruption and tax evasion, since eNaira transactions are traceable.

In spite of careful preparation and official measures to prop up the instrument, the e-Naira was a flop. Uptake is limited, with 1 million wallets according to recent information (Nigerian population is 200 mn). The few wallets are rarely used, and the volume of transactions represents a negligible share of the money supply. By contrast, over one-half of the Nigerian population is trading in cryptocurrencies, confirming that technology is not a barrier. (this and some other information on CBDCs mentioned here is drawn from a coauthored forthcoming book: Angeloni and Gros, 2025).

 

Latin America and the Caribbean

Most Latin American countries, including “island” Caribbean economies, have expressed interests in CBDC and are conducting analyses. Crypto-activity is extensive in the area, and digital expertise is widespread. Actual experiences vary, however. In Brazil, an efficient digital payment infrastructure, Pix, was introduced in 2019. While sponsored by the central bank, Pix is not a CBDC but a digital money transfer based on bank balance sheets. The system allows for instant, convenient, safe and low-cost payment functionality; as such, it caters for the main needs of retail users and reduce the potential scope of a CBDC.

A case that attracted worldwide attention years ago is that of the Bahamas. With its tropical climate, tax-exempt system and lax financial supervision, the Commonwealth of the Bahamas attracts tourists and hazardous financiers alike — most prominently FTX, the infamous crypto exchange that went bankrupt in 2022. In 2019, it was the first country to introduce a CBDC, called the “sand dollar”. Its main stated aim was to help financial inclusion and facilitating monetary transactions across a collection of islands subject to frequent disruption because of hurricanes. In spite of its fame, the experiment was not successful. As of recently, the sand dollar balances represented a minor share of central bank money in circulation and transactions were negligible.

Other cases of Latin American countries exploring the potential introduction of CBDCs (none of which have made decisions yet) are reported in a recent survey by the International Monetary Fund (IMF, 2023).

 

4. Conclusions

For several years now, the ECB has been engaged in preparatory works for the introduction of a central bank digital currency, the digital euro. This work has advanced our understanding of the complex issues involved and has contributed to a line of research actively pursued in many parts of the world.

After revisiting the pros and cons, this paper concludes that, all in all, the rationale of introducing an ECB-sponsored digital euro for citizens, retailers and producers, is not solidly established. Today’s highly dynamic, innovative and efficient digital payment ecosystem does not require such instrument, which would unavoidably duplicate existing applications and probably struggle matching private innovation.

The paper also offers a short survey of international experiences regarding CBDCs and alternative digital solutions. What strikes in this overview is the extreme diversity of orientations. Developong countries are interested in promoting financial inclusion and literacy, bypassing their lack of developed physical banking networks. Emerging countries either take different directions altogether (Brazil), or experiment with pilot CBDCs (India). China stands out in being fully committed to a digital yuan, clearly – though not explicitly – motivated by internal control and geopolitical expansion. In spite of extensive public intervention, however, the e-CNY has not attracted so far much favor among the population, amid fierce competition from private competitors like Alipay and Tencent.

The US Federal Reserve seems oriented towards exploring wholesale central bank-based digital solutions to improve the efficiency of the international payments system. A retail-based CBDC seems for the time bing ruled out. Switzerland, a country whose financial sector has a small but significant international role, has undertaken moves in the same direction.

Whereas the ECB has so far placed its bets on a retail CBDC, in our view would be well advised paying attention to other options as well. The need of improving the functionality of the international payment system is long-standing and solidly established. CBDCs can help in this regard. The ECB should actively join the Fed and other central banks in studying a wholesale, interoperable multi currency version of CBDC capable of making the international large-value payment system more efficient and safer. More generally, it is important that in conducing its preparatory work the ECB coordinates with other Western central banks. In a highly interdependent global monetary and financial system, a situation in which the main central banks take markedly different decisions on CBDCs is hardly advisable.

 

References

Angeloni, I. (2023a). Digital euro: when in doubt, abstain (but be prepared). Report submitted to the European parliament, April.

Angeloni, I., and Gros, D. (2025). Money in Crisis, Cambridge University Press, forthcoming.

Atlantic Council (2024). Central Bank Digital Currency Tracker.

Bank of Thailand (2024). Pilot Program Retail CBDC Conclusion Report, March.

Bowman, M.W. (2023). Considerations for a Central Bank Digital Currency (Georgetown University, Washington DC, 18 April 18.

Carapella, F., Chang, J.W., Infante, D., Leistra, M., Lubis, A., and Vardoulakis, A.P. (2024). Financial Stability Implications of CBDC. Finance and economics discussion paper 2024-21, April.

Cunliffe, J. (2023). The digital Pound. Speech at UK Finance, 7 February.

ECB (2024). ECB publishes first progress report on digital euro preparation phase, June.

Forbes (2024a). The House Bans The Fed From Building A CBDC Like The Digital Yuan, May.

Forbes (2024b). Apple Tap To Cash Excites, But The Real Payments Innovation Lies Elsewhere, June.

International Monetary Fund (2023). Interest in Central Bank Digital Currencies Picks Up in Latin America and the Caribbean, While Crypto Use Varies. Country Focus, June.

International Monetary Fund (2024). Central Bank Digital Currencies in the Middle East and Central Asia, DP n. 4, April.

Jordan, T. (2024). Towards the future monetary system; Introductory remarks at the SNB conference, 8 April.

Kantar Public (2022). Study on New Digital Payment Methods, March.

Ku, L. (2024). Could China-led wholesale CBDC fuel de-dollarization? Euromoney, June.

Duffie, D., and Elizabeth Economy eds. (2022). Digital Currencies: The US, China, And The World At A Crossroads. The Hoover Institution, March.

Reuters (2024). Powell says Fed not “remotely close” to a central bank digital currency, 7 March.

World Bank (2024). Digital Transformation Drives Development in Africa, January.

Ozili, P. (2023). “A Survey of Central Bank Digital Currency Adoption in African Countries”, in “The Fourth Industrial Revolution in Africa: Exploring the Development Implications of Smart Technologies in Africa”, David Mhlanga ed., Springer.

Quinn, C. (2024). I just gave China’s digital yuan a test drive — how did the world’s biggest CBDC perform? DL News, March.

Suri, T., and Jack, W. (2016). The long run poverty and gender impact of mobile money. Science 354, 1288-1292.

Ueda, K. (2024.) What to know about central bank digital currency, remarks at the Fintech Summit FIN/SUM 2024, Tokyo, 5 March.

Waller, C. (2021). CBDC: A Solution in Search of a Problem? Speech at the American Enterprise Institute, August.

Authors

Dhamodharan Dhamodharan^[1]Executive Vice President, Blockchain & Digital Assets at Mastercard.

 

Introduction

Central banks around the world have rapidly accelerated their exploration of central bank digital currencies (CBDCs), conducting in-depth economic analysis, technical proofs-of- concept, and even large-scale pilots to understand the role that a CBDC could play in achieving their economic and policy objectives. As part of this exploration, central banks are carefully considering the feasibility of retail CBDCs^[2]References to CBDCs in this paper are referring to retail CBDCs unless otherwise specified. as they continually strive to strengthen and grow their economies with greater innovation and efficiency. To do this, they will necessarily have to engage an ecosystem of participating banks, payment service providers, data service providers, payment networks, and a variety of technology resources. Collectively, it will be critical that there is active public-private collaboration to consider the impact that CBDCs may have on the future of payments and how best to safeguard the interests of consumers and businesses.

Exploring the promise of new technology and the potential efficiency gains that adoption could bring has been an essential part of the modernisation journey. Innovative new solutions have been the drivers for sustainable and inclusive economic growth that benefit everyone, everywhere. However, the success of innovative payment solutions has always been contingent on whether they fundamentally address any perceived gaps in the market that existing solutions and services do not already adequately serve. It also depends on whether consumers and businesses believe that new payment innovations are superior to the (digital) solutions already available.

Importantly in case of CBDCs, it will also be contingent on who is best placed to provide this innovation. Unlike commercial payment solutions offered today, retail CBDCs raise the more fundamental questions of whether central banks should be in the business of providing retail payments to customers and the broader implications this may have on competition. There are also problematic assumptions made in relation to retail CBDCs that relate to their need to mimic cash-like convenience, which has a direct impact on business models, distorting market dynamics and risking instability.

This paper challenges the motivations and the assumptions made by central banks on how retail CBDCs would be delivered under so-called “two-tier” intermediated models. Section 1 explores the motivations outlined by central banks, and questions whether retail CBDCs are intended to act as “monetary anchors” for stability or, whether they are instead being designed as central bank-led market solutions. Section 2 then discusses the notion that a retail CBDC would be delivered under a two-tier intermediated model, highlighting the vast gaps between how the roles of industry participants for retail CBDCs are envisaged and how the current intermediated financial system operates today. Section 3 then delves into the commercial model for delivering a retail CBDC, which for many central banks, is expected to be offered free of charge to customers just like their cash equivalents. The paper concludes with the principles that will be needed for CBDCs to successfully address user needs, and importantly how the market can help deliver and distribute CBDCs.

 

Central bank digital currencies: Monetary anchor or market solution?

Today, there are 134 countries & currency unions, representing 98 per cent of global GDP, exploring both wholesale and retail CBDCs.^[3]See the Atlantic Council’s CBDC Tracker at https://www.atlanticcouncil.org/cbdctracker/ Central banks’ motivations for exploring CBDCs vary across jurisdictions. Key goals often cited by central banks include creating a digital substitute for cash in an increasingly digital society, improving control over monetary policy, achieving geopolitical and strategic autonomy, enhancing resilience, increasing the speed of payments, reducing their cost, and facilitating financial inclusion. Above all, central banks want to ensure that central bank money remains an anchor of monetary and financial stability.^[4]There are numerous references made by central banks that CBDCs would reinforce central bank money as the anchor of the monetary system, as well as acting as an anchor of financial stability. For … Continue reading

Design choices for the successful rollout of any new product will always place the needs of end-users at the centre of solution development. Ultimately, CBDCs will only meet their broader policy and systemic objectives if users believe that their value improves on, and is superior to, existing market solutions and there is widespread adoption. To determine whether CBDCs ultimately meet their objectives will therefore require central banks to clearly articulate the economic or market problem that exists in today’s payment system, how the CBDC addresses or solves this problem and what “success” looks like. This should be based on use cases that are informed by market assessments of current and future payment needs. This means that user segments are clearly identified, the value-added benefits of the CBDC are clearly understood by all parties in the payments ecosystem and that existing payment infrastructure and technical know-how are leveraged to help rollout and delivery.

However, as is the case for many CBDC initiatives around the world, the motivations expressed by central banks are predominantly focused on policy and systemic objectives, rather than being primarily driven by specific customer needs, requirements or benefits.

Macroeconomic, financial policy and international considerations will likely fail to resonate with end-users who – particularly in highly advanced payments systems – already have fast, safe and efficient ways to make everyday payments. Paradoxically, if CBDCs are also overwhelmingly successful and achieve substantial adoption and usage, this may mean that they have displaced other types of payment instruments and deposit accounts, materializing the risks of disintermediation, deposit substitution and financial instability. In such a scenario, “success” may also mean that central bank money no longer acts as an anchor of monetary and financial stability, but rather becomes the cause of market disruption and instability.

Currently, the design choices being explored for many retail CBDC projects replicate payment features and functionalities already offered by the private sector. They are based on the delivery of a means to hold and fund retail payments in CBDC (e.g., digital wallets), the infrastructure needed to enable those CBDC payments (e.g., online, point of sale and offline capabilities) and finally, a scheme (e.g., like the ones operated by domestic and international card networks and digital public infrastructure). While the underlying value being transferred with a CBDC is a central bank liability rather than a commercial bank liability, this distinction is largely inconsequential for the average consumer. The form factors needed will also be indistinguishable from current retail payment products.

It will be critical therefore that the intended benefits of CBDCs over existing payment solutions in terms of their novel application be clearly articulated to users. To ensure its longer- term viability, central banks should also outline the incremental value that CBDCs create that exceed the significant costs associated with their development, delivery, and operation. Market participants will find it challenging to invest in new infrastructure unless there is a strong commercial business use case for doing so. Above all, CBDCs should avoid replicating market solutions in pursuit of domestic, geopolitical or macro-financial policy goals when highly advanced market solutions already exist. To do so could cause competitive distortions and inadvertently threaten the efficiencies that already exist in today’s highly evolved payments systems. It remains to be seen whether it is the role of the central bank to be direct providers of digital retail payments.

Instead, central banks can ensure that central bank money remains a monetary anchor by “doing what only central banks can do”^[5]In the House of Lords debate on the Economic Affairs Committee’s Report, Lord King of Lothbury cautioned against expanding the Bank of England’s responsibilities with a retail CBDC, noting that … Continue reading). Central banks are important regulators of payment systems and they are there to ensure the smooth functioning of the financial system. Central banks are pivotal for providing the necessary regulatory framework to foster safe innovation and supporting market innovation, e.g., in the nascent form of commercial bank tokenised deposits, which could play an important role in driving new payment solutions for the future digital money landscape (Oliver Wyman and JP Morgan, 2022). Importantly, tokenised central bank reserves in the form of wholesale CBDCs, together with tokenised deposits, would maintain the strong two-tier monetary system and provide the necessary monetary anchor to ensure the “singleness of money” in an evolving digital payments age (BIS, 2023).

 

Delivering digital public money: the “two-tier” distribution model and interoperability

Central bank proposals for CBDCs recognise that digital innovation in payments is best served under a public-private partnership, which is critical to ensuring an open and competitive payment ecosystem. This approach is aligned with the existing allocation of public and private responsibilities within the financial system, and by extending a broader set of capabilities to the private sector, it would also provide a more robust platform for the development of value-added innovations. In the context therefore for CBDCs, a truly intermediated retail CBDC model could provide a secure, fast, and resilient technology environment that avoids the unnecessary expense of parallel infrastructure and ensures that compliance requirements remain primarily with industry. This approach also ensures that the central bank retains institutional governance over core monetary infrastructure, while relying on private sector competition to drive innovation, efficiency, and a diversity of offerings.

Importantly, in a well-designed two-tier approach, intermediaries would continue to play a critical role in creating trust, meeting the needs of users, and enabling the successful adoption of a CBDC. As is the case for the current ecosystem, a two-tier model is based on the central bank issuing the currency and relying on market intermediaries to determine the modalities of distribution. These intermediaries then compete to attract customers through better and more efficient products and services and develop these based on market dynamics and commercial considerations. Therefore, if the CBDC intends to promote choice and competition in a two-tier model, the modalities of distribution and acceptance should be left to intermediaries and merchants and be based on market and commercial considerations rather than regulatory solutions.

Intermediated models for distributing retail CBDCs nevertheless appear to fall short of such an arrangement in emerging retail CBDC proposals. Two-tier models, such as the ones that are being considered in Europe, require intermediaries to fulfil the role as distribution agents on behalf of the central bank, which are required to carry out these functions based on legislative mandates. This means that intermediaries do not necessarily exercise agency over whether they distribute and how they can offer CBDC products based on commercial considerations. Similarly, they will not be given the freedom to choose the means through which they would be able to distribute retail CBDCs. While interoperability is cited as a key objective for CBDCs, emerging proposals seem to indicate that they would need to be distributed using only central bank run-payment rails, operating separately under their own scheme.^[6]See the Digital euro package https://finance.ec.europa.eu/publications/digital-euro-package_en

A CBDC has the potential to serve as a foundation for innovative and value-added financial products and services developed by competitors within the private sector if there is a

genuine desire for a CBDC to act as a digital version of central bank money. Open and competitive payment ecosystems are critical to enabling access, adoption, and use of payment options that serve a wide range of user needs, preferences, and financial inclusion. Moreover, ongoing payments innovation and the efficiency of national and international payment flows all depend on CBDCs being interoperable with existing payment schemes to ensure seamless consumer adoption, avoid siloed ecosystems and monetary fragmentation. For a CBDC, interoperability with other stores of value (e.g., commercial bank deposits, e-money etc.) would play an important role in strengthening the domestic payment ecosystem and reinforcing the role of central bank money at its core. Sustained collaboration between the central bank and private sector participants will be critical to delivering this interoperability.

A CBDC must be usable for a variety of in-person and digital transactions to provide value as a payment mechanism. However, enabling acceptance points is a prominent challenge to driving mass adoption of any new payment solution. Consumers will be more likely to adopt a CBDC if it can be used on existing acceptance infrastructure and is supported by known and identifiable payment form factors (physical and remote) linked to the user’s existing devices and accounts. Requiring CBDCs to employ new payment rails would on the other hand create artificial barriers between the CBDC and commercial bank money, causing unnecessary friction between payment means and overcomplicate access and distribution. This would generate confusion and ultimately go against the ambition of an integrated payment market.

Proposals that seek to mandate acceptance and impose regulatory models of distribution call into question a true two-tier model, which could result in unintended market fragmentation with implications for competition, stability, security, and innovation within the broader payment system. CBDCs will be more competitive, innovative, resilient, and better equipped to meet various policy objectives, as well as the evolving demands of the consumer, where the project works to actively encourage the participation of all payments market stakeholders. A ‘two-tier’ model that is based on market-led innovation is best placed to provide a secure, fast, and resilient technology environment that avoids the unnecessary expense of parallel infrastructure and ensures resilience.

 

Ensuring a sustainable and competitive payment ecosystem

Many central banks envisage CBDCs to operate functionally as a version of “digital cash”. This logic assumes that cash has characteristics that can be easily replicated by a digital equivalent. At a minimum, this means that users should have access to CBDCs at no additional cost, that it should be available at any time – with or without internet connectivity –, be accepted as a means to purchase goods and services and to be able to exchange it peer to peer. Importantly, it should also be available to everyone, to ensure inclusion and equity.

However, unlike the relatively simple infrastructure that is needed to print and distribute cash, building new wallet solutions, integrating with new payment infrastructure, developing offline solutions, and enabling the various links in the payment value chain are all costly and

complex activities. Sustainable digital payment ecosystems are dependent on a delicate balancing of incentives between those stakeholders who bear the costs of enabling payments and those who benefit from payment services. For a central bank’s CBDC infrastructure to sustain a vibrant and competitive ecosystem of payments innovators, incentives will need to exist that allow payment service providers to generate an appropriate return on their investments.

Compensation models therefore need to consider the potentially significant new implementation and running costs that merchants and intermediaries will need to incur to offer CBDC services. These include, but not limited to, adapting front and backend systems, customer onboarding processes, operational and other security upgrades. Many central banks are also discussing the possibility that CBDCs could run on entirely new technology, such as distributed ledger technology (DLT). Others are also considering the need to adopt state-of-the- art privacy enhancing technologies, which are promising but have yet to be run and operated at scale. Accordingly, compensation models also need to factor in the feasibility for industry to adopt such new technologies. New teams of expertise would be needed with detailed knowledge of this new technology over the lifecycle of their development, leading to potentially high operational costs and excessive complexity for some payment intermediaries.

Thought should also be given to how well existing regulation is equipped to address downstream applications of a CBDC via new technologies. Regulatory guidance in this area would be essential to help participants apply existing rules to innovative payment services involving a CBDC according to whatever technological form it is designed to function. For example, if parallel DLT infrastructure is required to support a CBDC that will function offline

– consideration will need to be given to any additional regulatory requirements applicable to the use of this technology.

Another key area of risk that is often given limited consideration is the enormous complexity and costs of mitigating fraud and cyber-risk across a retail CBDC ecosystem. The cost to the global economy of cybercrime is expected to grow by 15 percent per year over the next five years, reaching $10.5 trillion USD annually by 2025.8 A retail CBDC will inevitably face sophisticated fraud and cyberattacks from both private and state-sponsored actors. CBDC users must trust that the system will be accessible and operational where and when it is needed; that their funds, accounts, identity, and other data are secure; and that they will be protected in the event of fraud.

Importantly, unlike commercial means of payment, end users will hold the CBDC to a much higher standard given that it will be compared to its closest equivalent – the physical banknote. Users will also assume that as it is issued and backed by the central bank (often cited as the key benefit of a CBDC) it would be more secure than commercial alternatives. Should the CBDC therefore suffer from any vulnerability due to weak end-points, the underlying credibility of the CBDC and implicitly the central bank may be impacted as a result.

The premise of CBDC innovation and scalability is built on the ability of intermediaries to offer consumers new digital services to enhance the convenience and utility of their CBDC accounts. If the cost to intermediaries and service providers for the provision of the CBDC is greater than a comparable digital means of payment, industry will not be incentivized to provide high-quality CBDC services, which may affect the success of the CBDC. The same competitive conditions should therefore be applied to CBDC and comparable payment services. Likewise, if central banks propose mandatory acceptance, intermediaries and merchants must not be constrained by regulated levels of compensation or, the payment rails through which they distribute and accept a CBDC. Instead, they should be given the choice to determine the most appropriate and cost-effective way to recuperate the costs being imposed as well as deliver commercially viable solutions to their customers.

From a business perspective, while merchants are applauding CBDC initiatives in the hope of reduced costs, CBDCs risk disintermediating banks in the distribution of money and constraining existing private payment solutions. The risk of endangering competition and innovation due to excessive central bank’s intervention is high. This is why it is crucial to strike the right balance between public intervention and private sector initiative in regulating CBDCs. Above all, a CBDC should be financially self-sustaining, i.e., operate without any public subsidies on investment or operational costs. Otherwise, there is a risk that the CBDC will have the unintended consequences of reducing the diversity, competitiveness, and resilience in the payment landscape.

 

Conclusion: principles for an open, competitive, and innovative payment market using CBDCs

It is essential that governments and central banks adopt specific measures to ensure an open, competitive, and innovative payment market using CBDCs. These actions should focus on creating a level-playing field for all payment solutions, encouraging private sector participation, and fostering technological advancements. By doing so, central banks can support a dynamic financial ecosystem where multiple payment methods coexist and compete, ultimately benefiting consumers through increased choice and improved services. By focusing on ensuring a well-functioning market, central banks can drive improvements in efficiency, innovation, and service quality to the benefit of consumers and thereby remaining an anchor for monetary and financial stability.

While the motivations driving central banks to explore CBDCs differ, there remains a common set of principles that all CBDC initiatives should support. These tenets will best serve the needs of consumers, preserve the health of the financial system, and ensure that consumers continue to have access to a robust and innovative array of payment options (McWaters, 2024).

• Promote Mutual Trust and a Global Approach to Payments. Encouraging a global regulatory framework that supports multilateral initiatives ensures that sovereignty and geopolitical goals do not create barriers to competition and investment. Strengthening the elationship between jurisdictions is essential to prevent race-to-the-bottom scenarios where national champions are favored over foreign competition. This collaborative approach will uphold the commitment of advanced economies to an open free market economy. CBDCs should be designed to integrate with existing payment solutions, promoting unity rather than exclusion in the global payments landscape.
• Foster Genuine Public-Private Cooperation. Establishing open and ongoing dialogue between regulators and private market participants ensures that CBDC projects are aligned with market needs and have the best chance of success. Clearly delineating the roles and responsibilities of the central bank and private entities ensures that the central bank does not encroach on market activities that are more efficiently managed by private parties. Private sector innovation can be encouraged by avoiding overly prescriptive, top-down regulation that may stifle creativity and adaptability. This collaborative approach will leverage the strengths of both public and private sectors, fostering a dynamic and innovative payment ecosystem.
• Ensure a Level-Playing Field. Implementing regulations that allow CBDCs and private payment solutions to compete on fair terms will ensure a level playing field. This includes avoiding undue advantages for CBDCs from both a business and regulatory perspective. To achieve this the following guidelines should be followed:
  • Mandatory acceptance. If CBDCs are granted mandatory acceptance by merchants, they would have a significant advantage over private payment solutions, which take years to scale up merchant acceptance. Careful consideration is needed to balance this.
  • Market-Driven Compensation and Pricing. The compensation and pricing for CBDCs should be in line with the market (ie based on market analysis, established market impact assessments and pricing regulation) to ensure fairness. Above all, public subsidies should be avoided. The cornerstone of an open market economy is based on vibrant competition which drives better consumer outcomes.
  • Regulatory Impartiality. As the issuer and regulator, the central bank should not exploit its privileged position to disadvantage competing payment methods. Regulatory measures must be impartial.
  • Consistent Regulatory Standards. Apply the principle of “same activity, same risk, same regulation” to ensure that CBDCs are subject to the same regulatory requirements (e.g., oversight and AML checks) as private payment solutions.
• Create Interoperability: Designing CBDCs to integrate seamlessly with existing national and international payment systems is critical. This means relying on widely used standards and technologies to minimize costs and implementation burdens for intermediaries, service providers and merchants. Focusing on interoperability, rather than building a new infrastructure, would increase resilience and promote innovation by allowing the industry to build new services based on existing ones, thus reducing time-to-market. Ensuring compatibility with a wide array of solutions, including traditional banking, stablecoins, and potentially other CBDCs, is essential.

By taking these positive actions, central banks, governments and legislators can create an environment where both CBDCs and private payment solutions thrive, driving competition, innovation, and improved financial services for all users. Partnerships between the public and private sectors will be key to successfully ushering in transformational change, drive adoption, and create the best end-user experience. Ongoing payments innovation, expanded financial inclusion, and the efficiency of national and international payment flows all depend on vibrant private sector competition. If a CBDC is the right path for a central bank to reach its objectives, the private sector can help central banks bring their vision to life and realize their goals.

 

References

McWaters, J., Wann, J., Baert, C., De Matteis, A., and Cuccuru, P. (2024). Regulating Digital Currencies: ensuring an efficient and competitive payment market. TechREG CHRONICLE, June 2024. Available at: https://www.pymnts.com/cpi_category/techreg-chronicle-june-2024/.

Panetta, F. (2021). Central bank digital currencies: a monetary anchor for digital innovation. Speech by Fabio Panetta, Member of the Executive Board of the ECB, at the Elcano Royal Institute, Madrid. Available at: https://www.ecb.europa.eu/press/key/date/2021/html/ecb.sp211105~08781cb638.en.html.

Rehn, O. (2022). Beyond Crypto-Mania: Digital Euro as Monetary Anchor. Panel at University of California, Berkeley. August 23, 2022. Available at: https://www.suomenpankki.fi/en/media- and-publications/speeches-and-interviews/2022/governor-olli-rehn-beyond-crypto-mania- digital-euro-as-monetary-anchor/.

Jordan, T. (2024). Project Helvetia III – The Swiss National Bank’s pilot for wholesale CBDC. BIS Innovation Summit 2024, Basel, 6 May 2024. Available at: https://www.bis.org/review/r240506e.htm.

Villeroy de Galhau, F. (2024). Innovation by central banks – the sooner the better. BIS Innovation Summit 2024, Basel, 6 May 2024. Available at: https://www.bis.org/review/r240506d.htm.

Bank for International Settlements (BIS) (2023). Stablecoins versus tokenised deposits: implications for the singleness of money. BIS Bulletin 73. Available at: https://www.bis.org/publ/bisbull73.pdf.

Oliver Wyman and JP Morgan. (2022). report on Deposit Tokens. A foundation for stable digital money.

Available at: https://www.jpmorgan.com/onyx/documents/deposit-tokens.pdf.

 

Authors

Sebastian Infante, Kyungmin Kim, Anna Orlik, André F. Silva and Robert Tetlow^[1]Board of Governors of the Federal Reserve System. The views expressed in this paper are those of the authors alone and should not be attributed to the Board of Governors or any of its staff. All … Continue reading

 

Abstract: The rising popularity of online transactions, and the associated decline in the use of physical currency, is driving cash toward obsolescence. Thus, one could argue that a central bank not introducing a digital version of cash—a central bank digital currency, or CBDC—is making a choice to eschew direct involvement in the shaping of the modern payments system. The burgeoning academic literature on CBDC identifies many potential benefits, as well as risks, that vary depending on the design features of the CBDC and the environment into which the CBDC is introduced. Of these features, the level of remuneration paid on CBDC holdings, if any, is the most important. Carefully designed, a remunerated CBDC has the prospect of returning a net benefit to the society, with limited downside risk.

 

1. Introduction

Economies the world over are in the midst of rapid digitization, particularly in retail payments. Fewer people make payments with physical currency, and many choose not to carry significant cash balances. Debit and credit cards have long been supplanting cash in most developed economies, but even they are now being displaced by mobile payments. It seems clear that today’s youth will grow up with little experience of ever using cash, or any physical token, in their daily routines. The coming obsolescence of cash furnishes an argument for introducing a public digital version of cash that does not rely on physical tokens such as paper bills and coins.

The academic literature identifies many economic benefits from the introduction of a CBDC, as well as some noteworthy risks.^[2]See Infante et al. (2024) for a review of the literature focused on the implications for the banking sector and financial stability. To its proponents, CBDC has the potential to improve the allocative efficiency of the payments system by reducing the market power of banks and other payments system providers and by expanding access to digital payment services to people who are underserved. As a byproduct, CBDC could also transform economic rents that accrue to incumbent service providers into consumer surplus. In particular, a CBDC could generate social benefits by directly competing with bank deposit accounts. The increased competition would curb banks’ market power, raise deposit rates and thereby could improve allocative efficiency and increase consumer surplus (Chiu et al., 2023, for example). The resulting cost reductions could, in turn, broaden access to digital money—whether bank deposits, stablecoins, or CBDC—improving financial inclusion. Section 2 summarizes aspects of the design features of CBDC and how they affect adoption.

To its detractors, the disruption of the business model of the banking sector is a not a feature of CBDC but rather is a drawback. The competition between CBDC and bank deposits may improve allocative efficiency, but the concomitant bank disintermediation is perhaps the most salient risk associated with CBDC. Section 3 discusses this topic. The implied changes in banking could, in some circumstances, also be a source of diminished financial stability, but not always, as discussed in section 4. Others ask what market failure or inefficiency the introduction of CBDC is intended to address (see, for example, Waller, 2021). They argue in part that the forces of technical progress in finance—for example, blockchain technology, stablecoins, and DiFi—are already obliterating the economic rents that a CBDC would purport to capture for the public.

Ultimately, the net effect of a CBDC is not determined solely by its introduction. CBDC is an asset that would be held by a variety of economic agents which could affect the distribution of central bank liabilities throughout the economy. This means that the central bank’s balance sheet policy is an integral part of the general equilibrium effects, as argued in section 5. Section 6 considers some implications of the seemingly inevitable decline in the use of currency. Section 7 sums up and concludes.

 

2. CBDC take-up, remuneration, and other design features

The social and economic benefits of CBDC vary directly with take-up by businesses and households. The greater the take-up, the more the network externality associated with the joint, unquestioned use of a common currency accrues to society. The design of CBDC affects its attractiveness as store of value, which in turn determines its likely take-up and usage.
One possibility is minimal take-up, allowing the CBDC to quietly serve as a back-up digital payment mechanism, with scant repercussions for the current financial system. But take-up could be more substantial, depending on the design features of the CBDC, particularly its remuneration (Whited et al., 2023). All else equal, adoption by individuals and businesses of a CBDC would rise with the rate of remuneration. As noted below, high take-up could have significant implications for the financial system, especially through its effects on the banking sector; however, other aspects of design could mitigate those implications.

Setting aside remuneration, a CBDC could have features that distinguish it from cash, depending on its design. For example, CBDC may not provide the same degree of anonymity as cash, and thus might face resistance from those who are concerned with potential breaches of privacy. On the other side of the ledger, less anonymity could be a beneficial feature insofar as public authorities are able to curtail the illegal activities such as money laundering that reliance on cash allows. Regardless, concerns regarding privacy would not be a deterrent for those who have already willingly adopted card- or mobile-based payment platforms that make no promise of anonymity and are often subject to government reporting requirements.

There may also be benefits from the flexibility to choose the remuneration rate on CBDC. It could strengthen the transmission of monetary policy by directly affecting the interest rate that households earn on money holdings, rather than relying on partial passthrough of money market rates to deposit rates. In addition, if the introduction of a remunerated CBDC were to lead to further diminished use of cash, it could expand the space for monetary policy by decreasing the effective lower bound on nominal interest rates, possibly to a substantially negative rate.

At the same time, it is noteworthy that central banks generally appear reluctant to embrace paying interest on CBDC, with experiments to date mostly paying zero interest and public communications about possibilities of introducing CBDC frequently ruling out the paying of interest. One reason for this reluctance to pay interest on CBDC may simply be inertia, a legacy of physical currency, which pays zero interest. Paying interest on CBDC would not be a fundamentally new kind of operation; many central banks already pay interest to financial institutions on their holdings of central bank reserves.^[3]If there were large-scale conversion from currency to an interest-bearing CBDC, one (gross) cost would be a decline in seignorage revenues. However, provided that paper currency remains in … Continue reading

 

3. CBDC and bank credit provision

A risk associated with CBDC that is commonly invoked is the potential for bank disintermediation. A CBDC, particularly if it were remunerated, would be a source of competition for funding for banks, which could increase banks’ cost of funding, possibly resulting in a reduction in bank lending. If it paid interest, a CBDC could be an attractive store of value for a wide range of would-be depositors, meaning the displacement of deposits could be sizeable. Views differ on whether the implied disruption to bank business models would be welcome.

Banks would, naturally, be expected to react to the introduction of CBDC by changing the terms offered on deposits. Indeed, to the extent that the market for bank deposits is monopolistic, the post-CBDC equilibrium—especially if remunerated—would feature higher deposit rates, possibly along with higher deposit balances (Andolfatto, 2021). In this way, a CBDC could serve as the public option for digital payments that would establish a minimum standard in retail payments through its influence on industry competition. The increased competition would curb banks’ market power, improving economic efficiency. At the same time, the potential disruption to deposits as a funding source for banks could restrict the provision of bank credit to businesses.

Suppose a CBDC were introduced that paid no interest. In that case, its take-up and usage would be determined by the convenience it provides relative to money-like alternatives. If the same transactions could be carried out using bank deposits, the demand for the unremunerated CBDC would be limited. Indeed, the literature suggests that, irrespective of the level of competition in the banking sector, an unremunerated CBDC need not have material effects on bank funding costs and therefore on lending (Andolfatto, 2021; Keister and Sanches, 2023; Chiu et al., 2023).

Now suppose the CBDC is remunerated at a rate that is relatively high; that is, close to the monetary policy rate. The value of the CBDC now extends beyond serving as a medium of exchange, as in the unremunerated case, into one as an attractive store of value. As such, it would pressure banks to offer higher rates on deposits. This, in turn, could induce banks to raise lending rates to restore net interest margins. In theory, whether this all leads to a reduction in both deposits and lending depends on the competitive structure of the banking industry and of adjacent players in financial markets. Depending on the structure of the deposit market, even if the CBDC interest rate were low relative to policy rates, it could still elicit competition in the market for deposits, resulting in an increase in deposit rates paid by banks. In this scenario, and assuming banks have significant market power in deposit markets, the CBDC rate would set a floor on deposit rates, with the increased competition inducing banks to offer more favorable contracting terms to depositors.^[4]See, Van Hoose (2017), Drechsler et al. (2017) and Carletti et al. (2024) for evidence on, and implications of, imperfect competition in banking. As noted above, the resulting increase in deposit rates could even result in an expansion of the deposit base (Andolfatto, 2021; Chiu et al., 2023).

Next, suppose that following the introduction of a CBDC, funds were to indeed flow out of the banking system. Even so, deposits are not the only source of funding for banks. Banks could react to a contraction in deposits by relying more on wholesale markets for funding, at least in part. In this regard, Whited et al. (2023) estimates that a CBDC with remuneration set equal to the policy rate would capture 32 percent of the U.S. deposit market, with less than a fourth of the impact on deposits passed through to lending. Increased reliance on wholesale funding for banks has its own implications, not all of which are appealing, but substantially reduced volumes of lending need not be one of them.

 

4. CBDC and financial stability

The introduction of a CBDC would likely have implications for the stability of the financial sector. It is useful to parse those implications into the effects at times when markets are functioning normally and the effects in times of financial market stress. In normal times, a CBDC could crowd out financial firms’ use of private short-term debt as a source of funding, which would enhance financial stability, all else equal. In times of financial stress, however, CBDC could be an attractive place for funds to migrate to—that is, a source of run risk—which would undermine financial stability. The remuneration of the CBDC is an important factor in both cases.

During normal times, a CBDC that pays interest at rates close to prevailing money market rates could discourage financial firms from relying on short-term funding instruments, which are prone to runs. To see this, consider an environment with strong demand for safe assets that have money-like benefits. Financial firms could (and do) provide these benefits to investors by issuing private-label short-term funding instruments.^[5]Private repo is common in the United States, for example. Also, there was widespread issuance of private-label mortgage-backed securities (MBS) in the U.S. in the 00’s. Those securities came to be … Continue reading All else equal, this reduces the cost of short-term debt and encourages more issuance; the downside is an increase in financial firms’ reliance on risky short-term private funding.^[6]The mechanism operates through the crowding out effect of government debt (see, for example, Greenwood et al., 2015). While the literature on crowding out typically focuses on how governments … Continue reading In this context, a CBDC with a remuneration rate close to short-term market rates could put an effective floor on financial firms’ funding rates, reducing those firms’ reliance on private short-term debt, potentially improving overall financial stability. That said, the net effect on financial stability depends on the riskiness of banks’ alternative funding sources. If, for example, higher costs induce banks to substitute away from funding from retail deposits, which are regarded as “sticky,” towards funding from wholesale deposits, which tend to be more sensitive to market conditions, the implications for financial stability become ambiguous.

During times of financial stress, a remunerated CBDC could be an attractive investment option that may encourage investors to “run to” if they came to doubt the stability of the financial sector. Here too, the strength of the mechanism rises with the competitiveness of the remuneration rate on CBDC. If the CBDC were unremunerated, its attractiveness would be limited—at least when prevailing market rates are materially greater than zero. But if the rate paid on CBDC were comparable to its alternatives, and if financial frictions were negligible, even small doubts of stability could manifest in large financial flows. The problem is exacerbated if CBDC were elastically supplied, as that would allow hit-and-run entry and exit of financial positions for a wide range of investors, jeopardizing the stability of the sector as a whole.^[7]Similar concerns were raised in the design of the Federal Reserve’s overnight reverse repo facility (ON RRP), in which eligible non-bank counterparties can deposit funds via repos with the Federal … Continue reading Given this description, it is probably not surprising that the academic literature on this topic has focused on alternative design features, such as caps on holdings or restrictions on convertibility, that amount to introducing financial frictions. These design features would either ameliorate the risk of a surge in CBDC take-up in times of financial stress or curb the extent of one. But these (gross) gains are not costless. They reduce the ex-ante attractiveness of CBDC as a store of value, which would presumably reduce uptake and thus limit the welfare gains to society that are associated with the widespread adoption of a common publicly supplied digital payments medium.

The presence, or absence, of a digital means of payment, other than bank deposits, has implications for banking regulation. The introduction of CBDC has the potential to reshape the banking system—for example, by reducing the banking sector’s reliance on deposits—especially if CBDC were remunerated. Significant changes in the banking system, in turn, would likely affect the regulatory landscape and the balancing of trade-offs associated with ensuring the system’s soundness. And because CBDC, like cash, would be a means of payment the viability of which would not depend on the soundness of the banking system, it could reduce the expected social cost of banking crises (Williamson, 2021).

 

5. Recycling of CBDC

The foregoing noted the possibility of CBDC displacing deposits in the banking system. It also noted the prospects for wholesale sources of funds serving as alternatives to bank deposits; in short, that funds do not simply disappear if they are not held at banks. In a similar fashion, private funds held as CBDC on the central bank’s balance sheets also do not disappear. The hypothetical risks associated with the issuance of a CBDC highlight the importance of the central bank’s balance sheet management policy—and in particular, the recycling of CBDC—as a critical determinant of the aggregate effect. The central bank’s decisions regarding asset holdings backed by CBDC on its balance sheet interact with individuals’ and businesses’ investment decisions, which can mitigate or eliminate potential adverse effects (Infante et al., 2024).

Two choices appear to be particularly relevant: Whether, and by how much, to expand the central bank’s balance sheet in response to conversions from deposits to CBDC and the resulting drain of central bank reserves; and what types of assets to hold on the central bank balance sheet. With regard to the latter, in many jurisdictions, the choice has been traditionally confined to government securities, but holdings of privately issued bonds or direct lending to private borrowers is possible in some jurisdictions and have been employed at times.^[8]For example, some central banks purchased privately issued assets or lent to the private sector directly in response either to the coronavirus pandemic, or the market functioning issues associated … Continue reading The manner in which a central bank recycles an inflow from CBDC has implications for the degree of bank disintermediation and the financial stability risks associated with a surge in CBDC usage in times of financial stress. For example, if a central bank opts to redistribute an increase of CBDC directly to banks (through lending), the consequences of the potential associated drain in deposits would be ameliorated, albeit with potentially significant distributional implications. Overall, such a choice would have to be consistent with the central bank’s operating framework, which could influence how extensive a role the central bank plays in the financial system. In any event, the upshot is that the debate about introducing CBDC is not simply whether it should be done; rather, a complete assessment is contingent on the central bank’s policy regarding recycling CBDC and managing its balance sheet.^[9]See Infante et al. (2022) for a discussion of various potential outcomes of the central bank’s policy.

 

6. CBDC and the future

The declining use of cash and increasing importance of privately issued means of payment imply reduced direct involvement of central banks in the monetary economy. In theory, there is nothing special about paper money or fiat currency backed by government promises.^[10]For example, Andolfatto et. al. (2016) studies how the use of a privately issued currency backed up by shares of a broad stock market index could replace publicly issued fiat currency. However, in the world of competing private monies, a significant presence of money that is backed by the central bank might be necessary to ensure price stability. Fernández-Villaverde and Sanches (2019) shows that a purely private monetary system does not provide the socially optimum quantity of money and can deliver price stability only if some limit on the total issuance of private currencies is imposed. More broadly, Gorton and Zhang (2022) argues that governments should be wary of ceding to private actors their power over the issuance of money on the grounds that only government can ensure the underlying value of the assets that back them.

Ideally, the money and payments system of the future, with or without CBDC, will be more interoperable than is currently the case.^[11]Interoperability is the ability of systems to interact with one another quickly, seamlessly, and at a low cost. It can be divided into functional interoperability, meaning the ability to share data, … Continue reading But there are no assurances. Duffie (2020) discusses how electronic payments system providers may have incentives to fence off their services, sacrificing payments efficiency to raise customer switching costs and limit interoperability. The creation of payment services anchored by digital currencies issued by the central bank could mitigate these incentives. If these new digital payment services make and receive payments in a common, safe, and public digital currency, interoperability is more easily achieved.

In the international and historical context, Gorton (2021) emphasizes the importance of interoperability across different jurisdictions, drawing on the experience of the National Banking Era in the United States. Prior to the National Banking Act of 1863, interstate trade was expensive and inefficient because of the use of competing private bank notes as a means of payment. The Act introduced a uniform currency, which catalyzed developments in banking that increased efficiency and interoperability in the transfer of funds.

Continuing in the international context, developments may result in some countries coming to find they have a narrowing range of options. Suppose, for example, CBDCs are introduced by some countries, but not all. One consequence could be that it hinders the monetary policy autonomy of non-CBDC economies, depending on the design of the CBDC. The strengthened international spillovers created by the introduction of CBDC could also force non-CBDC economies to alter their monetary policy reactions to shocks (see, for example, Minesso et al., 2022). Finally, if some of the larger economies issued CDBCs, then to the extent those CBDCs were interoperable, they could become the preferred means to settle international financial transactions. In that case, households and businesses in the non-CBDC countries could end up bearing the incremental cost of international transactions with any profits earned accruing to foreign stakeholders.

In sum, the retail payments system is an essential part of an economy’s financial infrastructure. As such, there may be an intrinsic value for the central bank in maintaining an important role in payments. The dwindling use of cash points to currency becoming less useful as an “outside option”—a means for payments that does not rely on services, such as bank accounts, that are provided by the private sector. In these circumstances, CBDC can be viewed as a digital version of cash: a publicly provided means of payment that is also a central bank liability, and whose management is ultimately the government’s responsibility. It has the potential for generating efficiency gains, but with greater stability than private monies. As such, CBDC could assume the role of cash as the publicly provided outside option for making payments, especially retail payments.

 

7. Conclusion

Under the right conditions, CBDC has the prospect of generating many social benefits. It can improve the efficiency of the banking system and enhance financial stability. As with any substantive change, however, there are risks, especially those associated with bank disintermediation. But arguably, central banks have the tools to mitigate them. Among those tools are the design features of the CBDC itself. Remuneration is a CBDC’s most important design feature. A high rate of remuneration would induce more take-up of CBDC, which could be socially beneficial, all else equal. But that benefit would come at the likely cost of a disruption in the market for bank deposits. Restrictions on CBDC holdings, on remuneration of those holdings, or on rapid large-scale switching of balances, could mitigate the impact on banks. Viable alternatives to bank funding from retail deposits, or to banks as the source of lending, could also reduce the aggregate effects.

Finally, to the extent that one agrees that payments systems are part of the essential infrastructure for an economy and policymakers feel uncomfortable leaving that infrastructure entirely in private hands as the use of currency declines, the provision of a CBDC starts to look attractive.

 

References

Andolfatto, D., Berentsen, A., and Waller, C. (2016). Monetary policy with asset-backed money. Journal of Economic Theory 164: 166–186.

Andolfatto, D. (2021). Assessing the impact of central bank digital currency on private banks. Economic Journal 131 (634): 525–540.

Carletti, E., Leonello, A., and Marquez, R. (2024). Market power in banking. Annual Review of Financial Economics, forthcoming.

Chiu., J., Davoodalhosseini, S.M., Jiang, J., and Zhu, Y. (2023). Bank market power and central bank digital currency: Theory and quantitative assessment. Journal of Political Economy 131: 1213–1248.

Drechsler, I., Savov, A., and Schnabl, P. (2017). The deposits channel of monetary policy. The Quarterly Journal of Economics, 132(4), 1819-1876.

Duffie, D. (2020). Interoperable payment systems and the role of central bank digital currencies. Stanford Graduate School of Business Working Paper No. 3867.

Fernández-Villaverde, J., and Sanches, D. (2019). Can currency competition work. Journal of Monetary Economics 106: 1-15.

Frost, J.; Logan, L., Martin, A., McCabe, P.E., Natalucci, F.B., and Remache, J. (2015). Overnight RRP operations as a monetary policy tool: Some design considerations. FRB of New York Staff Report 712.

Gorton, G., and Zhang, J. (2022). Protecting the sovereign’s money monopoly. University of Michigan Law & Econ Research Paper No. 22-031.

Gorton, G. (2021). The Orkney Slew and central bank digital currencies. Working Paper.

Greenwood, R., Hanson, S.G., and Stein, J.C. (2015). A comparative‐advantage approach to government debt maturity. Journal of Finance 70(4): 1683-1722.

Infante, S., Kim, K., Orlik, A., Silva, A.F., and Tetlow, R. (2022). The macroeconomic implications of CBDC: a review of the literature. Finance and Economics Discussion Series paper no. 2022-076 (November). Washington: Board of Governors of the Federal Reserve System.

Infante, S., Kim, K., Orlik, A., Silva, A.F., and Tetlow, R. (2024). Retail central bank digital currencies: implications for banking and financial stability. Annual Review of Financial Economics. Forthcoming..

Keister, T., and Sanches, D. (2023). Should central banks issue digital currency? Review of Economic Studies 90(1): 404–431.

Marimon, R., Nicolini, J.P., and Teles, P. (2003). Inside–outside money competition. Journal of Monetary Economics 50(8): 1701–1718.

Minesso, M.F., Mehl, A., and Stracca, L. (2022). Central bank digital currency in an open economy. Journal of Monetary Economics 127: 54-68.

Nicolaisen, J. (2017). What should the future form of our money be? Speech delivered to the Norwegian Academy of Science and Letters.

Van Hoose, D. (2017) The industrial organization of banking: bank behavior, market structure and regulation, 2nd edition. Cham: Springer.

Waller, C.J. (2021). CBDC: A solution in search of a problem? Speech delivered at the American Enterprise Institute, Washington, D.C.

Whited, T.M.; Wu, Y. and Xiao, K. (2023). Will central bank digital currency disintermediate banks? Institute for Advanced Studies working paper 47.

Williamson, S.D. (2021). Central bank digital currency and flight to safety. Journal of Economic Dynamics and Control,142: 104146.

Authors

Richard Holden^[1]Richard Holden is Professor of Economics at UNSW Business School. e: richard.holden@unsw.edu.au. Many parts of this article are based on my book “Money in the Twenty-First Century: Cheap, Mobile, … Continue reading

 

Introduction

Central bank digital currencies (CBDCs) are going to be widespread. It’s just a matter of time. Already 130 countries, representing 98% of global GDP have begun trials of a CBDC. 64 of these countries are deemed to be in the advanced stages of such trials. 11 countries have already launch a CBDC.^[2]https://www.blockchaintechnology-news.com/2024/06/blockchain-firm-ripple-expands-apac-presence-with-japan-and-korea-fund/

That said, there are important design questions that need to be answered. Will CBDCs be retail or wholesale? Will they fully replace cash? Will they be held on a centralized or a decentralized ledger? How will they interact across countries? What will happen to the commercial banking system in countries which adopt them?

These are fundamental questions, and they will shape not only the form and functionality of these digital currencies. They will shape the future of money, and with it the future of our economies.

It is easy to dismiss the importance of CBDCs by thinking that they are simply part of the payments system. Perhaps they’re a little more efficient that existing methods of payment, but how big a difference can this make to real economic activity? The answer is: quite a lot, actually.

This paper proceeds as follows. I first outline the imperative for the established of CBDCs—especially for the United States. I then discuss my proposed design for a U.S. CBDC, based on my recent book “Money in the Twenty-First Century” (Holden, 2024). Finally, I highlight some of the critical issues which this design raises—in particular for the conduct of monetary policy and the role of the commercial banking system—and how these issues can be resolved. I conclude with some brief remarks about political challenges.

 

Competing with China, and Mark Zuckerberg

Diem

In 2021, Facebook (as it was then known) looked poised a private digital currency it called “Diem”. Federal Reserve Chair Jay Powell was in favor, but ultimately the U.S. government refused to support the trial.

The argument for a Diem trial went as follows. If there was going to be a private, global cryptocurrency then it would be better for it to be controlled by an American company like Facebook. That way the U.S. government could play a role in establishing the rules of the game. In any case, Facebook just wanted the go ahead for a trial of Diem. What harm was there in that?

The answer to that question, and the argument against, goes as follows.
First, digital currencies involved network externalities—the more people who used Diem the more attractive it would be for other consumers to adopt it. This phenomenon leads to winner-take-all markets where one firm ends up with huge market share. Google in search. Uber in ridesharing. Amazon in retailing. And, not incidentally, Facebook in social networks. Was this “just” a trial for Diem, or the first step on an inexorable march to market dominance?

Second, would Facebook really “control” the digital currency? The animating premise of the blockchains on which digital currencies like Bitcoin are built is that they are decentralized and anonymous. This was why a surprisingly large number frozen yoghurt shops in New Hampshire accepted Bitcoin and other digital currencies like Ether. The digital currency movement was born in 2008 out of a distrust of centralized authority in general and government in particular.

Third, cryptocurrencies might have virtues, but they also came with vices. Tax evasion, money laundering, lubricating the arms and illicit drugs trade. These were realities already.

But just because Diem died that summer, doesn’t mean that another large technology company couldn’t pull off a similar thing. Amazon, Apple, and Google are all companies that could plausibly do so. And the best way to prevent that is to outcompete them rather than regulate them.

 

China
The e-CNY Rollout

China is miles ahead of any other country in the race to a CBDC. The People’s Bank of China (PBOC) began moving to establish the Chinese digital currency (the “e-CNY”) in 2014. It created a task force to study issuance, technological requirements, and international experiences. Two years later the PBOC established a “Digital Currency Institute” which developed a prototype digital currency. A year later the PBOC began testing the e-CNY—and gave it that moniker—in partnership with commercial financial institutions.

The e-CNY and the paper yuan are exchangeable at a one-to-one rate, and ATMs that convert the e-CNY into cash have already been trialed. Users simply scan a QR code at the ATM using the digital yuan wallet.^[3]See https://www.theblock.co/post/95266/beijing-digital-yuan-cash-atm The digital currency itself can be purchased through China’s six big state-owned banks, as well as through Tencent and Ant Financial/Alibaba.

The e-CNY network follows a model that has been described as “one coin, two databases, three centers”. The idea of “one coin” is fairly straightforward—it’s the single, government-issued coin or token. The “two databases” are comprised of the PBOC’s centralized ledger and the ledgers that are maintained by the lower-tier banks in the network. The “three centers” are data centers that supposedly: (i) holds a database of the true identities of digital wallet holders; (ii) tracks transactions; and (iii) analyzes financial risks and monitors illicit transactions (Greene, 2021).

In March 2022 the PBOC announced that the rollout of the e-CNY would be expanded Chongqing, Tianjin, Hangzhou and Guangzhou, having already been trialed in several cities, including: Beijing, Shenzhen, Shanghai, Suzhou, Xiong’an, Chengdu, Hainan, Changsha, Xi’an, Qingdao and Dalian. Already the Chinese government had used financial incentives for consumers, thereby spurring adoption. This strategy is familiar among Silicon Valley firms in markets with network externalities. And a statement by the PBOC made clear that they will focus on continued further adoption.^[4]See reporting in the South China Morning Post, available at https://www.scmp.com/tech/policy/article/3172885/china-digital-currency-e-cny-rollouts-expand-hangzhou-and-chongqing

Policies must be designed to stimulate creativity and enthusiasm among the banks, technology firms and the local government in the development, promotion and proliferation of the digital yuan

Perhaps an even greater indication of the PBOC’s intentions are the plans to trial the e-CNY in global financial center Hong Kong. Eddie Yue Wai-man, head of the Hong Kong Monetary Authority (effectively Hong Kong’s central bank) said in February, 2022 that “The pilot testing of e-CNY will be an important move for Hong Kong to strengthen its role as an international offshore yuan trading centre.”^[5]See reporting in the South China Morning Post, available at … Continue reading And there has been a significant expansion of hiring of data and infrastructure at the PBOC’s Digital Currency Research Institute (DCRI) for hundreds of data and infrastructure engineers.

It is entirely plausible that China is intent on moving to a full-fledged, retail central bank digital currency. Indeed, the best reading of statement by the PBOC suggest this is the likely intent of the government. For instance, they have said that the e-CNY is designed to “create a new form of RMB that meets the public’s demand for cash in the era of digital economy. Supported by a retail payment infrastructure that is reliable, efficient, adaptive and open, the e-CNY system will bolster China’s digital economy, enhance financial inclusion, and make the monetary and payment systems more efficient.”

It is not hard to imagine a scenario where, over the course of a handful of years, the PBOC manages to orchestrate a transition to a fully digital retail e-CNY that displaces private providers. Once the e-CNY rollout has covered most of the major cities in China the PBOC could move to increase the attractiveness of their digital currency. One natural way to do this is to pay interest on balances in e-CNY wallets. This contains a number of risks. It would make the CBDC more attractive than deposits and could damage the banking sector.^[6]As the PBOC (July 2021) has noted: “Some believe that retail CBDC is more attractive than deposits and may lead to financial disintermediation, narrow banking, and credit squeeze, while others … Continue reading

But it would certainly create an incentive for people to hold the digital fiat currency rather than the physical RMB. It would be possible to preserve the stability of the banking sector. Alternatively, the PBOC may decide that the “full retail” model where the public all have individual accounts with the PBOC and the banking sector is largely cut out of the picture may end up being more attractive. Certainly, if they decided to go in this direction, it would be unclear what the value proposition of private digital payments companies would be. And it is also unclear what, if any, political or legal recourse they would have.

 

Competing with the e-CNY

Any analysis of how Fedcoin—or the existing physical U.S. Dollar—would compete with the e-CNY has to start with the functionality of these different currencies. Start with the scenario that China turns the e-CNY into a full-fledged retail currency while the U.S. sticks with the current, physical U.S. Dollar. That is, China basically continues the current rollout plan, squeeze out Alipay and WeChat Pay, and accommodate their domestic banks as planned, while the U.S. makes no serious or effective move toward a CBDC. Meanwhile China probably overtakes the U.S. as the world’s largest economy in terms of total output.

This would give China an efficiency advantage in their payments system, and it would improve their ability to crack down on tax evasion and illicit activities. It would also put the e-CNY in prime position to be at the center of a wholesale CBDC settlement regime along the lines of an expanded mBridge. Recall that the PBOC is already a key player in that project. And, without even a wholesale CBDC, the U.S. simple couldn’t participate, nor organize a competing network. This would leave China with the most high-tech, highly functional modern domestic currency. And it would make it a considerably more convenient currency with which to settle international foreign exchange transactions. In short, it would be an economic moment which could help catapult the e-CNY into the world’s global reserve currency. That would have considerable, negative consequences for the United States, and arguably the world more broadly.

A different configuration of competing currencies might involve China adopting the full retail model, as just described, while the U.S. adopts a wholesale CBDC. This might be enough to forestall the rise of the e-CNY as the global reserve currency, while leaving the U.S. with a less modern, less functional domestic currency. It would still be preferable to simply ceding currency leadership.

A third currency configuration is that the U.S. adopts Fedcoin as proposed in Chapter 5, and the PBOC successfully rolls out the e-CNY, but some time ahead of Fedcoin’s eventual establishment. This is, in my view, the most likely outcome. It is also the best outcome for the United States. It would give the U.S. a strong—perhaps overwhelming—chance of retaining its status as the global reserve currency. It would have significant domestic benefits in terms of financial inclusion, improve transactional efficiency, and cut down on a range of illicit activities. It would also effectively foreclose the possibility of a private digital currency, preventing all the possible ill effects and loss of policy sovereignty that would arise from such an occurrence.

Now, we shouldn’t fool ourselves into thinking that the development of Fedcoin will be costless. Quite apart from what is essentially the research and development program behind it, there will be the transition costs. And, beyond that, there will be running costs of a Fedcoin system. Of course, we shouldn’t forget that there are quite substantial costs—spread all throughout the economy—of running a payments system with physical cash. And after a complete transition to a digital currency like Fedcoin these costs will be avoided, which is good news.

But the question of just what the ongoing CBDC system—both in the United States and in other jurisdictions—will cost is an interesting one. On the one hand it will necessarily involve blockchain technology and we already know that operating decentralized ledger technology is expensive. This is seen most starkly in the energy use of the Bitcoin network. Of course, Fedcoin would run on a centralized ledger, rather than a decentralized one. And there are other consensus protocols than proof-of-work. Will return to this issue in the final chapter and argue that the cost of running the Fedcoin network—purely in terms of running costs—will be small relative to the private equivalent.

Designing a U.S. CBDC: Towards Fedcoin It would be easy enough to enumerate the various different design dimensions of a CBDC (e.g. wholesale versus retail, centralized versus decentralized ledgers). To tackle this more directly I now propose a specific model for a U.S. CBDC which I call “Fedcoin,” and then discuss the pros and cons of this design.^[7]This section drawn verbatim from Holden (2024), but I do not use quotation marks simply for expositional reasons.

 

Design Principle 1: Customer Competition

The different models we have already laid out highlight the fact that there are customer-facing activities that are important, in which the Federal Reserve is currently not involved, and which the public benefits from competition among providers. A first point of principle is that competition in the customer-facing aspects of retail banking should be preserved. That does not mean that in a world of both mobile and digital money that there will be a lot of market power or large rents in these activities—but that competition and consumer choice are valuable ends in themselves. Right now, that means preserving retail banking by the Fed not directly competing with those banks on the customer side.

That does not mean necessarily mean preserving the economic power of those retail banks. In an environment where retail banks and payments companies like Square compete to provide terminals to merchants, and where customers largely only need a mobile phone on the payments side, retail banks are unlikely to earn significant revenues from being involved in these activities. Yet at the heart of a govcoin model that involves the public having bank accounts with retail banks, those financial institutions will still take deposit from and have relationships with customers. Importantly, this will give these financial institutions access to the data of those customers in terms of spending patterns, account balances, and more. This is valuable information and can confer on these institutions certain advantages in terms of making loans and providing other financial products to those customers. As is currently the case—in a world without the digital money being contemplated here—there is great social value in giving customers ownership over their personal financial data and making it easy for them to switch between retail banks.

This is sometimes called “open banking”—and it is similar to the idea of local-number portability with mobile phone or other telecommunications providers. In that case telcos, and in this case retail banks, should be prevented from erecting artificial barriers that make it costly and time-consuming for customers to switch providers. This, in turn, gives customers more bargaining power, and reduces the fees and charges that a bank can extract from them.

 

Design Principle 2: Fedcoin as the Backbone of web3

To properly fend off a private digital currency, a Fedcoin needs to have as much of the functionality of a proposal like Libra or Amazons. A central part of this is that what Etherium achieved by having a Turing-complete programming language and digital currency on a single platform must be replicated by Fedcoin. Thanks to Buterin’s development of Etherium, we know this is possible. Indeed, because of the open-source nature of Etherium, it is replicable in a technical sense provided that Fedcoin can take the place of Ether in the analogous ecosystem. This requires that Fedcoin adopt a token-based rather than account-based approach.

The difference between these two approaches—something that has been much debated in central bank digital currency pilot programs—is somewhat semantic (Armelius et al., 2020).^[8]A very helpful discussion, on which the following treatment draws heavily, see Armelius et al. (2020). But it is important. Tokens are what is known as “bearer instruments”. They entitle the bearer of them to something of a certain monetary value. Banknotes are also a bearer instrument. By contrast, in an account-based approach to Fedcoin would involve a monetary balance, of Fedcoins, in an account at a retail bank.

Another distinction between tokens and accounts is how verification works. For tokens, verification is done by the person receiving it, whereas an intermediary is required to verify the identity of an account holder. For instance, a payment from a traditional bank account is deemed to be valid if the bank confirms that the person making the payment is, in fact, the account holder and not some other party. If the bank makes an error in this verification task then the bank has to return the funds to the true account holder. In this sense, the bank is the residual claimant on verification errors. Under a token-based system, by contrast, what has to be verified is the authenticity of the token itself.

Now tokens—since they are bearer instruments—raise the issue of double-spending. Remember, Satoshi Nakamoto’s great innovation was developing a way to prevent such double-spending of tokens using a decentralized ledger. Similarly, a tokenized Fedcoin would involve all transactions being recorded in a ledger to prevent double spending. In principle, that ledger need not be centralized (i.e. held solely by the Federal Reserve).

Notice that this ledger provides a record of what Fedcoins have been used for a by which account holders. This is no different than a credit or debit card—but it is different than cash. It is less anonymous than cash. Now we discussed earlier how some (but certainly not all) of the applications of blockchain technology using smart contracts make use of anonymity to prevent renegotiation in ways that can increase economic efficiency. For instance, this can help avoid the efficiency loss from “hold-up problems”. This could still be achieved with a tokenized Fedcoin—even with KYC rules. Knowledge of the “real world” identity of a customer could be walled off from smart contracts and even aspects of the legal system by statute. This way, the true identity of customers could be used to track and prevent the use of Fedcoins for illicit activities such as trade in illegal goods and tax evasion, while still permitting full functionality of smart contracts.

And tokenized Fedcoins would allow for more mundane but very valuable uses of smart money and smart contracts. For instance, conditionality can be built into the exchange of tokens so that actual exchange of the Fedcoin would only occur when certain conditions are satisfied. We’ve already seen that this is important is simultaneous exchange of currencies (so-called “payment versus payment” exchanges) and the risks that come with this not occurring as planned (this is known as “Herstatt risk”). It is also very useful in securities trading, which relies on the simultaneous exchange of a security and the “liquidity leg” (also known as “delivery versus payment” exchanges). In fact, once one starts thinking about it, this problem arises in all spot contracting. I hand over payment of one form or another and a coffee-shop owners hands me a skim latte. You hand me a cashier’s check and I give you the keys to my car, and so on. Some of these exchanges are backed by legal rules about theft or fraud, and others (or additionally) by social norms. But this raises an intriguing question: how much mutually beneficial spot contract doesn’t occur because of exchange risk? This type of risk can be avoided using a tokenized Fedcoin together with smart-money or smart-contracting apps.

Of course, people have been grappling with the issues to doing with secure exchanges for important trades like securities for a long time. And, if there is a trusted third party, trade can be made securely. If not we wouldn’t have a stock market! For instance, in securities trading this is known as a “central securities depository” and in foreign exchange as “continuous linked settlement”. But important innovation in decentralized finance—or DeFi—is happening using distributed ledgers and tokenized payments precisely because of the issues to do with third parties and the frictions created in the process. Thus, a suitably design Fedcoin could help foster this innovation, while also providing little rationale for an alternative purely private-sector solution.

 

Design Principle 3: A Centralized Ledger

A core consideration in the design of a govcoin is whether the central bank maintains a centralized ledger or not. It is important that this ledger is indeed centralized.

It is certainly possible to have a tokenized govcoin with a decentralized ledger. Indeed, Sweden has piloted such an approach with its “e-krona”.^[9]Armelius et al (2020) offer a useful description of how this would work in a system with both a regular currency and a tokenized CBDC. As they put it for the Swedish setting with an e-krona: … Continue reading The distinction here is twofold, but they are connected. These are: (i) whether there is a single core ledger of transactions that is owned by the central bank; and (ii) whether the central bank has a direct contractual relationship with the ender user of the govcoin. Why does this matter? The simple answer is control over illicit activities. Maintaining a core ledger would mean that the Fed would not need cooperation from retail banks in order to take action against bank customers who are engaged in illicit activities. Now this might sound like a moot point when it comes U.S. banks, who would already be strongly inclined to cooperate. But it is far from moot when thinking about non-bank institutions or a fully private digital currency and the provider of that currency.

Thus, under Fedcoin, the U.S. Federal Reserve would provide a “core ledger” where all Fedcoin holders would have digital wallets in which all transactions would be recorded.

 

Design Principle 4: International Neutrality

While it is reasonable for the U.S. create Fedcoin and seek to maintain its status as the global reserve currency, that should not imply the loss of monetary authority for other countries. In particular, could a Fedcoin mean that a country like Japan could lose control over their monetary policy? Without one important design feature, it could.

To see how imagine that Fedcoin became a popular medium of exchange in Japan. Being a digital coin in a digital wallet it would be hard for Japanese authorities to enforce a law saying that the Yen is the only currency that can be used in Japan. If the network externality flywheel got going—as it easily could—Fedcoin could wind up implicitly replacing the Yen for a meaningful part of the Japanese economy. This would make it borderline impossible for the Bank of Japan to set interest rates in the country.

This could be prevented, however, by the U.S. insisting that its commercial banks—responsible for interfacing with customers and enforcing KYC rules—only issue Fedcoin wallets to U.S. nationals. That way, no Japanese citizen could have a Fedcoin wallet and use the coin in Japan. For foreign travelers needing to use Fedcoin in the U.S., they could be issued with time-limited wallets that could only be filled with transferred foreign currency (like Yen).

An alternative would be to have the Fedcoin digital wallet be “region coded”, so that it could only be used in the United States and its territories. Either way, an international treaty to ensure that all countries maintained monetary sovereignty would be important for the legitimacy of Fedcoin, and for the U.S. not imposing potentially large costs on other countries.

 

Implications for Monetary Policy & Commercial Banking
The Fed

Fedcoin would return the way the Fed influences interest rates to the way it was done during the term of Paul Volcker as Fed chair in the late 1970s and early 1980s. When Volcker took over as Fed chair the Federal Funds Rate was managed by increasing or decreasing the amount of reserves in the banking system. The Fed would create a shortage of reserves when they wanted to push official rates up and would create a surplus of reserves when they want to push the rate down. Volcker changed this in a meeting on October 6, 1979. Volcker instituted a change where the quantity of growth in money supply (in reality, bank reserves) would be set and the interest rate would adjust to equilibrate supply and demand. This was consistent with conservative economist Milton Friedman’s doctrine of monetarism which held that inflation was very closely linked to growth of the money supply—captured in Friedman’s aphorism “inflation is always and everywhere a monetary phenomenon (Friedman, 1970).”

There is one important way in which Fedcoin would expand the toolkit of central bankers. It would permit them to set arbitrarily negative interest rates in a simple way. Because Fedcoin is a direct claim on the Federal Reserve—and because it is a digital coin—it can exist in fractional form. It would be straightforward for the Fed to declare that, over the course of a year, each Fedcoin would become worth (say) 0.98 Fedcoins. This would effectively implement a negative interest rate. And because commercial banks would not be creating their own money—by acting as intermediaries—this would apply to all money in the system.

 

Commercial Banks

Where would this leave the banking sector—not being able to create credit, but simply involved in interface with customers? On the deposit-taking side nothing would really change. Commercial banks would still provide services to customers, they would be responsible to verifying their identity (KYC rules) and matching it to account/digital wallet codes. And they would still performance the valuable function of making loans—determining credit quality, to whom to lend, and the interest rate on the loan. Banks just wouldn’t “create” money—that would be done purely by the Fed.

This loss of credit creation would have one negative impact on commercial banks—seignorage.

How would Fedcoin affect seigniorage? Clearly it wouldn’t affect it for the Fed—other than it may be the case that the costs of issuing digital money might be cheaper than issuing paper (or polymer) money and having to replace it when it wears out. But since commercial banks would no longer be creating credit they would lose the seigniorage that they implicitly earn in their current money-creation activities. This could simply be compensated for by the government in any number of ways.

 

Political Considerations
What about privacy?

Matched against this are concerns about privacy. Now, it’s tempting to reprise the quip made by Sun Microsystems CEO Scott McNealy in 1999: “You have zero privacy anyway. Get over it.”^[10]https://www.wired.com/1999/01/sun-on-privacy-get-over-it/ But privacy is a much more important issue than that. And while the U.S. Constitution may not contain an express right to privacy, the idea lives in a series of amendments that make up the Bill of Rights.^[11]The First Amendment involves privacy of beliefs. The Third Amendment involves the privacy of one’s home (against demands that it be used to house soldiers). The Fourth Amendment concerns privacy of … Continue reading And privacy is, at a minimum, an important constitutional value in most liberal democracies.11 Would a Fedcoin system represent a meaningful threat to privacy?

On balance the answer to this is “no”. But it would be silly to dismiss privacy concerns too quickly. There is an important difference between private companies having access to our information and government having access to it. It’s true that technology companies have all kinds of personal details about us—including our browser search history. But those companies don’t have the coercive power of the state to use that information. By contrast, government has exactly that power, and it’s one of the reasons why there has been historical concern about government intrusion on our privacy.

But what information are we talking about here? All that is at issue is what people spend money on. For the most part this is incredibly uninteresting and liable to do absolutely no harm. Of course, some people spend money on good or services that they would be embarrassed to find its way into the public domain. So the incremental concern is that government might know that somebody buys pornography or some other potentially embarrassing item. For all practical purposes, government either has no interest in this kind of information, could already access it, and is in any case preventing from using it in most democracies by existing laws.

That is a minor incremental privacy cost to bear, which must be weighed against a meaningful reduction in tax evasion, illegal drug trafficking, and other socially destructive activities. Most people would agree that’s a worthwhile trade to make.

 

Distrust of Government

An additional—and nontrivial—obstacle to implementing Fedcoin is the significant distrust of government by certain sections of the U.S. public.

An example of this is the sleepy New Hampshire town of Keene (population 23,000) (van Zuylen-Wood, 2021). It is home to the “Free Keene” movement, which opposes state power in every guise. Not only are taxes bad, so are police, and even parking meters and the parking inspectors who monitor compliance thereby generating revenue for the government. Keene is also the birthplace of the Shire Free Church, whose unlikely mission is weaning its parishioners and their community off government assistance. New York magazine justifiably described Keene as “the per capita crypto mecca of the country.” It is a town where frozen yoghurt stores accept Bitcoin, where the merits are various different cryptocurrencies are hotly debate, and is home to the “Bitcoin Embassy,” which peddles crypto-themed T-shirts, programming manuals, and books about Austrian economics (van Zuylen-Wood, 2021).

Now Keene might be the extreme case—but there would be substantial political opposition to a U.S. CBDC. And it would likely take substantial inducements to win widespread public support. That said, the lower taxes that might be possible from cracking down on the tax evasion of the few could help. And it might be one of the most powerful tools in address the opioid epidemic, which would also likely be very popular.

 

References

Armelius, H., Guibourg, G., Johansson, S., and Schmalholz, J. (2020). E-krona design models: pros, cons and trade-offs. Sveriges Riksbank Economic Review 2020 (2): 80-96.

Friedman, M. (1970). Counter-Revolution in Monetary Theory. Wincott Memorial Lecture. Institute of Economic Affairs, Occasional paper 33.

Greene, Robert. (2021). What will be the Impact of China’s State-Sponsored Digital Currency? Carnegie Endowment for Peace. Available at https://carnegieendowment.org/2021/07/01/what-will-be-impact-of-china-s-state-sponsored-digital-currency-pub-84868

van Zuylen-Wood, S. (2021). Ian Freeman could have been a bitcoin billionaire. Instead he could go to prison for the rest of his life. New York. 25 August, 2021. Available at https://nymag.com/intelligencer/2021/08/bitcoin-ian-freeman-fbi-doj.html