Central Bank Digital Currencies are transforming the…

They say that opposites attract. But central banks, the historic pillars of society very rarely flirt with innovation. Except, the tide is changing. Central banks exploring the future of money are taking inspiration from cryptocurrencies by introducing their own digital currencies.

Technological innovations and the COVID-19 pandemic have transformed consumer spending habits as cash is being replaced by contactless credit cards. This cultural shift is driving banks to future-proof their systems and offerings for an increasingly digitalised economy.

Central Bank Digital Currencies (CBDCs) are a digital form of a nation’s fiat currency. They will be issued directly by central banks themselves. They’re different from cryptocurrencies which are typically supported by corporations or not backed at all. Like cash, CBDCs are backed by the issuing government and pegged to the value of the national currency.

If you think central bankers are apprehensive, think again. Intimated by cryptocurrencies eliminating their economic control, 87 countries representing over 90 per cent of global GDP are already exploring CBDCs. Some countries have gone live. The Bahamas has introduced its US-dollar pegged CBDC ‘The Sand Dollar’ and the Eastern Central Caribbean Central Bank is piloting ‘DCash’. The European Central Bank is gearing up towards a 2025 release.
CBDCs could revolutionise all corners of society

CBDCs are being marketed as alternative forms of retail focused payments. CBDCs are cheaper, more robust and offer faster instruments to complete global payment transactions than traditional forms. They’re as safe, and as free of credit risk as physical cash and provide a new means of convenience for household and commercial payments.

Access and inclusion for the most vulnerable

CBDCs could open-up banking to more people, enabling those who usually fail to meet banking requirements to participate in the digital economy. The e-naira in Nigeria introduced tiered permission structures to allow access without IDs or formal addresses. For the nearly 2 billion unbanked across the world, these accounts could serve as entry points for building personal credit.

But not everyone has a smartphone. For those requiring additional hardware, CBDCs could be a barrier to entry, especially for the unbanked, elderly and less tech-savvy. Although devices and education can be provided, these hurdles could limit uptake. Further, if central banks distribute CBDCs directly to customers, they could end our reliance on retail banks to manage our money. With high-street footfall plunging, CBDCs would require a substantial support network to assist CBDC customers.

Central banks need to determine both current and future needs for all users. They must analyse different market segments, personas and identify customer journeys that will help shape their future design. By segmenting the market, central banks will understand different payment use cases that their solution might be used for, identifying questions that will need to be addressed. By examining different user groups, and understanding different needs, the priorities for each demographic will appear.

Exciting new value propositions come with data privacy concerns

CBDC could be an opportunity for central banks and payment interface providers to develop new customer facing propositions. By using smart contracts, CBDCs could introduce automated programmable payments, where transactions can carry out predefined functions or follow specific sets of rules. An example being electric cars negotiating directly with charging points to pay for the electricity used without human intervention. Also, digital audit trails can simplify financial compliance, particularly for small businesses.

But transparency raises question marks around data privacy concerns. Just 54 per cent of people would trust a digital currency issued by their government or central bank. From managing ‘know your customer’ data, third party data sharing and tracking illegal activity across billions of transactions, central banks will need to find the balance between customer privacy and the monitoring of illicit activity.

By collaborating with other payment service providers within their end-to-end network, central banks can begin to determine the role of domestic banks and fintechs as deposit takers and intermediaries. By determining the different touchpoints required to raise and complete a payment, each theme will help central banks to raise questions of what their requirements should be. By working with others early, centrals banks will be able to identify compliance, information security and data privacy requirements and integrate them into their programmes from the start. This will allow them to understand various risk types, legal-entity data sources and alignment and the reporting required for compliance.

CBDCs monetary control could promote economic stability

For maximum security from a future financial crisis, individuals and businesses could seek to store their money in the central backed liability rather than in private sector accounts, which is the norm today. Nightmares of the 2008 nationalisation of British bank Northern Rock will haunt many with current regulations only protecting personal savings of up to £85,000.

There are concerns that CBDC could make digital bank runs more frequent and severe. Today, most central banks establish control by ensuring they meet banks’ demand for central bank reserves. But cash deposits placed into CBDCs will channel reserves from the system. That could reduce monetary control if it causes banks to bid up for reserves resulting in short-term market rate increases.

Plan sharing with other central banks undergoing similar transitions is key for synchronising approaches, discussing pain points, and determining timelines. To successfully implement CBDCs, central banks need to understand complex technology requirements. Distributed ledger technology as the infrastructure for CBDC is commonplace with the most advanced CBDC pilots. Although this technology is new for many central banks, engaging with others could help determine the best approach moving forwards. Similarly, to fully understand the impact of CBDCs on the dynamics of monetary and global financial stability, central banks must engage detailed behavioural and socio-economic research.

The core success of CBDC hinges on end-user acceptance

For CBDC to work, its functionality must be viewed as a better and more stable medium of exchange in comparison to existing options. To anticipate and understand the needs of future retail consumers and merchants, central banks must balance public demand, privacy, and economic usefulness within their design.

CBDCs won’t be a complete silver bullet for financial inclusion, but they’re a valuable new type of central bank liquidity able to support those in need. If designed with the public at its heart, CBDCs could offer a new financial system that serves more people, at any time, in any location.