Thursday May 23, 2024 06:51 pm

Takings from and Makings of Central Bank Digital Currency

Transforming the Paper Money to Digital

🕐 2023-08-06 01:01:54

Transforming the Paper Money to Digital


Dr. Jamaluddin Ahmed

This paper introduces the background and motivation for the CBDC.  This includes the form of money throughout history, the roles of money as a means of payment, store of value, and commercial bank money. Central bank money is a liability of the central bank, while commercial bank money is the digital form of money commonly used by the public. Since the 1940s and 50s, public money was in the form of cash. However, the FinTech revolution has given birth to payment services such as Google Pay, AliPay, Samsung Pay, bKash, M-Pesa, WeChat, and Transend, transforming and revolutionizing the payment industry. The term Central Bank Digital Currency (CBDC) refers to granting universal, electronic, 24x7 national currency-denominated and interest-bearing access to its balance sheet or any electronic, fiat liability of a central bank that can be used to settle payments or as store value. Some view CBDC as electronic narrow money and, in some senses, already existing in the form of central bank reserves. In a nutshell, CBDC will provide faster, more reliable, and cost-effective services such as security settlement for capital markets, cross-border payments, instant domestic payments, instant peer-to-peer wallet transactions, large value transactions and settlements, programmable money, MSME lending, and offline payments. The CBDC could be useful in addressing the consequences of the decline in cash. CBDC covers three paradigms of money: accounts-based retail CBDC without DLT, value-based retail CBDC without DLT, and retail CBDC based on DLT and wholesale CBDC based on DLT. The first are being tested by the central bank of Sweden. The CBDC should also cover three paradigms of money, such as value-based money, fiat money, and decentralized money. When issuing CBDC, common public policy objectives allowing common principles to be agreed upon should be kept in mind. These objectives are identified as not impeding a central bank in carrying out its mandates, co-existing with cash and robust private money, enabling innovation and efficiency, and following three fundamental principles: do no harm, co-existence, and innovation efficiency. Examples of CBDC projects include CBDC technology considerations, the current landscape of digital currency, comparisons of CBDC with physical cash and alternate private digital money, currencies launched CBDC pilots, and research stages. The CBDC feasibility overview for developing and emerging economies and by regions, criteria enabling environment priorities, design priorities with demand infrastructure and supply availabilities, have been placed. We should bear in mind that the concept of CBDC has been conceived of considering the state to conduct monetary management running by a sovereign-state conducting through the economic nucleus named the central bank. In order to achieve the above objectives, this paper is structured into seven sections, which are listed with a short description presented in the following paragraphs.

The Economic Rationale and Concerns for Central Bank Digital Currency
This section presents an overview of the economic justifications for achieving the most efficient, fastest, and least costly way. It explains how CBDC reduces the transaction costs of the prevailing payment system and enables financial inclusion at a faster rate, reducing tax evasion, money laundering, and illegal transactions. CBDC creates the possibility for the central bank to reduce the risk of transportation and the cost of carrying cash, and aims to eliminate cash from the money supply to reduce crime by introducing widely available retail CBDC. The paper discusses the efficiency gains, competition from private money, cross-border payment efficiency, ensuring financial stability, increased seigniorage revenue, enhancing the competitiveness of the banking system, and improving financial inclusion. In addition, the paper identifies the key feasibility and operational challenges, legal considerations, issues of money laundering, combating finance of terror concerns, privacy concerns, and cyber security. It also explains concerns related to central bank overstepping its role, unknown factors, effects on monetary policy and commercial banks, effects on the payment system, and security.

CBDC for Transforming of Informal Economy into Formal
The informal economy is pervasive in most economies and has a negative impact on many aspects of a country and society. It obscures a country’s real economic value and output. This section emphasizes the use of CBDC to help reduce the size of the informal economy. It identifies the dark side of cash, which enables the informal economy, and explains available measures to reduce it by introducing digital payment policy measures, financial inclusion measures, tailored financial products, broader reach, financial literacy, and impact analysis of digital payment measures. The section also presents the macroeconomic consequences and monetary policy implications of CBDC, as well as the SWOT analysis of CBDC. Attention is drawn to the unprepared legal aspects and private crypto-assets competition that require policy makers’ attention.
Key Drivers, Economic Impact, and Risks of CBDC
This section explains the needs for CBDC, which are driven by the push for faster payments, rapid digitization, and better mitigation of clearing and settlement risk. There is a demand for cross-border value transfer and financial inclusion. This section discusses the different drivers and the need for trust, efficiency in the financial system, improved financial access and inclusion, and enhanced monetary and fiscal policy support. It also covers global benchmarking and country projects related to CBDC. The key considerations for CBDC for different stakeholders have been elaborated, including the technologies and access options. The choice between retail and/or wholesale CBDC has been described, and different approaches to the issuance and circulation of CBDC have been presented and explained. The section also discusses CBDC use cases and their impact on different financial service players, including a forward-looking view. A 10-focus country profile with a sector legend is included in this section.

Technical Design Choices for CBDC
This section presents the proposed technology and design mechanism that would be required to achieve the expected economic benefits of transforming traditional paper-based central bank currency into CBDC. It details the participants’ transport layer, whether it is less intermediated or more intermediated, the roles of financial intermediaries, who has access to the payment system technology, and at what level. The transport layer of a CBDC system determines whether a third party is needed to facilitate transfers between two parties, and if so, who the third party or parties are. The benefits and drawbacks of each design choice are described. Interoperability is discussed, specifically, the level of technical interoperability with other systems. Governance, specifically, permissioned vs. permissionless, is also discussed. Access tiering, by user accounts, transition, counterparty, or none, is highlighted. Identity privacy, whether known to the central bank, intermediary, or none, is discussed. Remediation, on-ledger, and off-ledger are analyzed. Design choice benefits and drawbacks are described. Secure hardware, whether more hardware-based or more software-based, is brought to light. Transaction signature, whether no signature, single signature, or multi-signature signing, is highlighted. Transaction privacy, whether more observable transaction or layering, is documented. Offline transactions, transaction programmability, data model, account balance, ledger history, holding limit, and adjustment on the transaction are analyzed.

The Legal Issues to be addressed before implementing the CBDC
Since the creation of the sovereign state, central banks have been responsible for monetary management, including currency. As business and economic activity has grown, transaction volumes and costs, as well as the risk of doing business, have increased substantially. Economists, central bankers, banking experts, and the business community all agree that technology should be utilized to enhance the national payment system, including the introduction of a central bank digital currency, for faster, more secure, and less costly for financial inclusion, and to curb money laundering, tax evasion, illicit money transfers, and reduce the informal economy and black money creation. 

Central Bank Digital Currency in Progress and Comparative Analysis        
This paper addresses the required changes needed in the relevant clauses of laws, which need to be adjusted for CBDC, as they were originally crafted based on paper money. It identifies relevant sections that needed to be changed in line with the new situation for the customized implementation of CBDC. The section reviews the experiences of countries that have already started CBDC or are progressing at the project phase. Central banks moving towards digitalization need to rearrange their regulations to align with the technology-driven system adjustment to avoid future confusion. This section draws attention to the reform of central bank law, monetary law, monetary unit reform, and legal tender status, which need to be allowed for CBDC. Private law privileges and general law protection should be accommodated in the system before the adoption of CBDC.
The structure of this section is as follows: first, it describes the design of the current survey and explains how it differs in focus and coverage from other surveys.  Second, the section then proceeds to present the key results and attempts to enhance the findings by reviewing selected country case studies. Third.  this section distills some crucial lessons for those countries on their journey in this field. Finally, it concludes by providing insights and considerations for the way forward.
The development of digital payment systems in the private sector, thanks to the technological revolution in the payment service industry, has led to more secure, trusted, cost-effective, and faster transaction processing. This has added significant economic value across the globe. Initially, many countries were reluctant to shift from traditional payment systems, especially developed countries that had promoted, sponsored, and developed traditional payment systems. However, Sweden in the EU and China, with its command economy, have been exceptions, as they have pursued a cashless society and introduced central bank digital currencies, leaving behind the old paradigm of paper currency and cash-based society. They have also leveraged the benefits of technological advancements in the payment service industry for better monetary management.
Innovative types of cryptocurrencies are being used in the private sector, each with specific benefits and limitations that are subject to control by the central bank, which acts as the sovereign authority. Political scientists refer to this control as sovereign state control, which is typically carried out through independent central banks in each country. This paper aims to define the core functions of central banks in the introduction. With the ongoing digitization of the economy and the rapid technological advancements in the payment industry, the way people make payments is changing. There is a growing demand for e-money and a decreasing demand for cash. As a result, the system under which currencies and money are used is changing. From a system perspective, the growth and decline of payment methods are leading to a competitive environment. The same is true for currencies and money, where a key paradigm is the assumption that good money, especially money that enjoys consumer trust, will prevail over weaker forms of money.
History provides evidence that public money was strictly in cash up until the 1950s. Even for researchers, it was difficult, if not outright impossible, to imagine that within less than 60 years, the monetary system would work worldwide and that transactions to the other side of the world would be frequent, necessary, and instant. For consumers, the rise of manifold applications, such as Google, Alipay, bKash in Bangladesh, M-Pesa in Kenya, and many others, has brought benefits to the payment service industry through digitalization. This has led central bankers and policymakers worldwide to openly debate the implementation of central bank digital currencies (CBDCs). The acceptance of CBDCs would imply that the central bank becomes a financial intermediary in the economy and becomes involved in maturity transformation.
Thus, a CBDC is simply the digital form of a country’s fiat currency. This paper presents four proposals on CBDC, three paradigms of money, issuing a CBDC, three fundamental principles, updates on CBDC initiatives, examples of CBDC projects, public vs. private money, the potential impact of a fully electronic currency system, design choices for CBDC instrument design, ledger design, and incentive design. The paper also discusses the current landscape of CBDC and its early state of play, as well as the inevitability of CBDC. It compares CBDCs with physical cash and alternative private currencies, and documents countries where retail CBDC/digital currencies have launched, are being piloted, or are being researched. The paper also reports on the combined macroeconomic impact of CBDCs and digital currencies on LDCs, as well as the unbanked communities that are on the frontline for maintaining currency sovereignty. Finally, the paper considers global considerations for shadow banking and COVID-19.
This paper presents the economic rationale and concerns for CBDC, including ensuring legal tender availability, efficiency gains, competition from private money, improving cross-border payment efficiency, ensuring financial stability, combating illegal activities, enhancing competitiveness of the banking system, and improving financial inclusion. The paper also details the key feasibility and operational challenges, legal considerations, anti-money laundering and combating the financing of terrorism concerns, privacy concerns, cyber security, and the potential for central banks to overlap their roles. The paper also discusses the unknown factors and effects of CBDC on monetary policy, zero to lower bound, helicopter money, inflation, seigniorage, private cryptocurrencies, effects on commercial banks, funding of non-interest bearing CBDCs, interest-bearing CBDCs, and the possible changes for commercial banks, including raising deposit rates, higher lending rates, changes in bank lending, cost reduction, higher risk, bank runs, lender of last resort, deposit insurance, private innovations, financial inclusion, stronger and more resilient banks, and mintettes. The paper also examines the effect of CBDC on payment systems, including immediate settlement, peer-to-peer payment, cross-border payments, cost reduction, and increased volume of migrant remittances. Finally, the paper discusses the business case for CBDC in terms of cost reduction from correspondent banking systems, cross-border payment via mCBDC corridor networks, security in emerging economies, and technological leap.
CBDC has the potential to transform the informal economy into a formal one by reducing its size. Correlation analysis shows that cash enables the informal economy, but by providing measures such as financial inclusion, tailored financial products, and broader reach, CBDC can help reduce the size of the informal economy. Impact analysis of four digital payment measures has shown their impact on the informal economy, including Bangladesh’s trade-related illicit financial outflows, which deepen the dollar shortage and persisting losses due to money laundering. The amount of black money in Bangladesh is estimated to be over BDT 10 trillion. Additionally, the cost of cash handling in the UK is another factor that suggests the economic rationale for establishing CBDC. The macroeconomic and monetary policy implications of CBDC, as well as its political and monetary impacts, have been analyzed along with a SWOT analysis. Macro aspects of CBDC have also been examined, including its impact on cash, access to central bank money, retail payment services, access to government payments, financial inclusion, the retail payment market, monetary policy, control of monetary policy, financial intermediation stability, and financial integrity.
CBDC is driven by several key factors such as the need for faster payments, rapid digitization, and better mitigation for clearing and settlement risks. Its benefits include bringing central banks back to the currency creation and trust, increasing efficiency in the financial system, improving financial access, and enhancing monetary and fiscal policy. The Asia Pacific region is leading in the development and benchmarking of CBDCs. Countries such as Singapore, Cambodia, China, Japan, India, Australia, Thailand, Brazil, Hong Kong, Italy, Kenya, Nigeria, Poland, Russian Federation, and the United States are at different stages of CBDC implementation. The key considerations for CBDC implementation include regulatory frameworks, technology choices, access options, issuance and circulation models, user cases, and the impact on financial services players. It is also important to consider monetary implications for ecosystem players and to take a forward-looking view. Focus country profiles with sector-level analysis are also important, considering factors such as the size and drivers of the informal economy, the sector profile of the informal economy, measures against the informal economy, and the impact of digital payments. However, CBDC also comes with risks and challenges that must be addressed, including privacy concerns, cybersecurity risks, and the impact on financial intermediaries.
The technical design choices for CBDC have been analyzed, with a focus on the design choices that are likely to matter to policymakers. The analysis makes a few starting assumptions, such as the system being mostly permissionless from a governance standpoint. However, the design choice introduces a larger number of technical complexities and practical limitations that strongly suggest a sense for a system that has at least one trusted entity, which is the central bank. A CBDC system could be managed by a set of trusted entities, a network of system participants, or a combination of both. The participants in the transport layer could be less intermediated or more intermediated, depending on the economic rationale and policymaker decisions at the political level. The interoperability with other payment systems could be permissioned or permissionless. Governance could be managed by a set of trusted entities or a network of system participants, or a combination of the two. The access tiering could be by user account, transaction amount, counterparty, or none, depending on policy choice. 

Jamaluddin Ahmed FCA PhD is the Chairman of Emerging Credit Rating Limited and Tier 1 Solutions Limited, ex-President of ICAB, ex-member of the Board of Directors of Bangladesh Bank, ex-Chairman of Janata Bank Limited, and ex-General Secretary of Bangladesh Economic Association. Email: