Acentral bank digital currency (CBDC) is a currency issued by a central bank in digital form that could potentially be used as legal tender. A CBDC is fully backed by a central bank, as opposed to a cryptocurrency, which is privately issued and not supported and controlled by a central bank. CBDCs have gained interest in recent years due to advancements in financial technology (fintech) and, in particular, the advent of blockchain technology and cryptocurrencies. A survey by the Bank for International Settlements (BIS) showed that more than 80 percent of central banks (within a sample of 66 central banks) were working on CBDCs, including the European Central Bank (ECB), the Federal Reserve System (Fed) and the Bank of England (BoE), among others (Boar et al., 2020)1.
A retail CBDC is a digital currency issued by a central bank directly to all users. A retail CBDC accessible to all could definitely be an important development in today’s digital economy, where the use of cash is gradually declining. A different CBDC model is a wholesale CBDC, which is a digital currency issued by a central bank designed for use by financial institutions.
Currently, the public can hold only money issued by the central bank in the form of banknotes, whilst commercial banks can hold central bank money in the form of reserves held at the central bank. In the analysis that follows, I summarise digital money’s new status with the presence of retail CBDCs, the potential benefits and risks of retail CBDCs, and the questions central banks are still trying to answer with regard to the use of retail CBDCs as legal tender.
The new retail CBDC status
A retail CBDC would complement, not replace, cash and bank deposits, and it would be purely electronic money. Unlike reserves, CBDCs would be available to households and businesses, allowing them to make payments using this electronic form of central bank money. CBDCs would normally be denominated in domestic currency. For instance, €2 of CBDC would be worth the same as a €2 coin. It is expected that CBDCs will be fully convertible to fiat money and vice versa.
CBDCs will be a central bank liability as opposed to commercial bank money, which is a claim against a commercial bank. Consumers won’t need a bank account to obtain and use CBDCs. Holders of CBDCs would have claims on the central bank—a “direct CBDC model”—and, therefore, would not have to bear credit risks as is the case with conventional deposits at commercial banks, rendering retail CBDCs risk-free digital currencies.
A CBDC could be created in two different ways by central banks. First, the central bank could issue cryptographic tokens that share some common features with bitcoin and other cryptos. Second, a CBDC could be created by allowing market participants to open deposit accounts at the central bank and use them to make payments in the same way they use traditional deposit accounts at commercial banks (Mersch, 2020)2.
Potential benefits of retail CBDCs
There are a number of potential benefits of retail CBDCs for international payments, monetary policy and financial inclusion. CBDCs could facilitate faster and more efficient cross-border payments. As cross-border payments are more complex than domestic ones, CBDCs would help ease international payments by offering cheaper—lower transaction and storage costs—and more transparent and resilient payment solutions. CBDCs could also increase safety in payment infrastructures, enhance systemic efficiency and offer increased protection against money-laundering processes.
On a separate note, CBDCs could improve the channels through which monetary policy is conducted. For example, central banks would be able to apply varying interest rates for consumers and businesses and enhance the implementation of central banks’ policy-rate adjustments. Moreover, CBDCs could make the overnight market more efficient by allowing CBDCs to be lent or borrowed overnight and could enhance quantitative easing by eliminating the need for intermediation by commercial banks (Meaning et al., 2018)3. Finally, CBDCs could promote financial inclusion. People with no access to regular bank accounts will be able to access CBDCs to use in both domestic and cross-border transactions.
Potential risks of retail CBDCs
A negative consequence of CBDCs is the crowding-out effect or disintermediation effect (Evans and Browning, 2021)4. That is, funds can potentially be switched out of conventional deposits at commercial banks into deposits at central banks in the form of CBDCs. This could lead to a reduction in the commercial banks’ funding and subsequently to cuts in the number of loans banks could provide, potentially harming the entire economy. Any such development could substantially increase the commercial banks’ funding costs as they would be required to find alternative funding sources—both domestically and overseas—in the absence of bank deposits, which could lead to a banking crisis. It follows that there could be negative impacts on financial stability and monetary policy. In extreme cases, the introduction of CBDCs could trigger digital-bank runs (Broadbent, 2016)5. This is more likely to happen during crisis periods when people are looking for “safe havens”, both domestically and internationally, amid elevated risk aversion in the economy and would prefer risk-free central bank money over risky commercial bank deposits—a flight-to-safety effect. Thus, central banks should carefully design CBDCs to preserve financial stability. (There are a number of proposals in place on how to prevent bank runs—for example, by introducing maximum conversion limits for traditional money into CBDCs, applying flexible exchange rates between CBDCs and commercial banks’ deposits, and introducing varying interest rates on CBDC holdings.)
Another potential risk of retail CBDCs revolves around the inflated sizes of central banks’ balance sheets (and, correspondingly, the reduced sizes of commercial banks’ balance sheets) after the adoption of CBDCs that could negatively affect their risk exposures and profitability. Inevitably, central banks would have to obtain assets to be held against the CBDCs, something that could be tricky as central banks’ balance sheets have already been expanded via asset purchase programmes (APPs) aimed at mitigating the adverse impacts of the COVID-19 pandemic. These effects could be mitigated if the CBDC were not a perfect substitute for bank deposits (Meaning et al., 2018)3.
The introduction of CDBCs could create a concentration of power in central banks around the globe that is not in line with their current roles to preserve monetary and financial stability (Mersch, 2020)2. It is also very likely that cyberattacks will become increasingly common after the introduction of CBDCs that could threaten the viability of the CBDC project (Bank for International Settlements, 2020)6.
Unanswered questions about retail CBDCs
Some unanswered questions about retail CBDCs that central banks are trying to answer include the following. First, should a CBDC bear interest? That is, should CBDCs be used for lending purposes? It is expected that central banks would be reluctant to pay much interest on their CBDCs to avoid fragmenting the banking system to a large extent. Second, should certain limits be imposed on the amounts of CBDCs that individuals and businesses can hold? Third, should CBDCs be freely exchanged for fiat money without any restrictions? Fourth, what would be the optimal CBDC architecture central banks need to adopt—conventional or distributed ledger technology (DLT) infrastructure? Fifth, should CBDCs be anonymous? This could have implications for data-privacy policies. Sixth, what would be the optimal structure of legal claims that central banks need to adopt? According to Auer and Böhme (2020)7, central banks have to choose between an “indirect CBDC model”, a “direct CBDC model” or a “hybrid CBDC model”. The indirect CBDC model involves consumer claims on an intermediary, whereas the direct CBDC model entails direct consumer claims on the central bank. The hybrid CBDC model, on the other hand, combines elements from both other models.
To conclude, it remains to be seen whether retail CBDCs would be beneficial to our modern digital economies. Given their importance for financial stability and monetary policy, they should be carefully designed to mitigate potential risks. Thorough cost-benefit analyses are needed to quantify and compare the costs of implementing CBDCs against their perceived benefits.
1 Bank for International Settlements: “Impending arrival – a sequel to the survey on central bank digital currency,” C. Boar, H. Holden and A. Wadsworth, 2020. (BIS Papers Number 107.)
2 “An ECB digital currency – a flight of fancy?”, Y. Mersch, May 11, 2020. (Speech at the Consensus 2020 virtual conference.)
3 Bank of England: “Broadening narrow money: monetary policy with a central bank digital currency,” J. Meaning, B. Dyson, J. Barker and E. Clayton, 2018. (Bank of England Staff Working Paper Number 724.)
4 “Central bank digital currencies,” J. Evans and S. Browning, 2021. (Research Briefing Number 9191. House of Commons Library.)
5 Bank of England: “Central banks and digital currencies,” B. Broadbent (speech), 2016.
6 Bank for International Settlements: “Central bank digital currencies: foundational principles and core features,” 2020. (Joint report by the Bank of Canada, European Central Bank, Bank of Japan, Sveriges Riksbank, Swiss National Bank, Bank of England, Board of Governors of the Federal Reserve and Bank for International Settlements.)
7 BIS Quarterly Review: “The technology of retail central bank digital currency,” R. Auer and R. Böhme, March 2020.