Introduction
Central banks are pivotal institutions in a nation state’s economy, serving as the primary authority responsible for overseeing monetary policy, regulating financial institutions and maintaining economic stability. The independence of central banks is a crucial aspect of their effectiveness. Whilst central banks often operate independently from political influence, allowing them to make decisions based on economic rather than political considerations, they are still accountable to the public and government. This balance ensures that central banks can pursue long-term economic goals without undue political pressure, whilst remaining transparent and responsive to the needs of the economy.
Described by some as a solution in search of a problem, Central Bank Digital Currencies (CBDCs) have become an increasingly contentious topic, raising justifiable concerns about potential threats to individual liberties, privacy and the freedoms we have come to enjoy in western democracies. But is that problem, in the eyes of governments and central banks, the emergence of decentralised money and the tens of millions of citizens around the world who are taking responsibility for their own funds by adopting Bitcoin and other decentralised cryptocurrencies – becoming their own bank? In this article, I have defined and outlined the concept of the CBDC, explaining the rationale for their introduction and the various forms they could take, before highlighting a number of key concerns about the prospect of central banks and governments entering the realm of digital currencies.
CBDCs defined
A Central Bank Digital Currency, or CBDC as they are generally known, is a type of digital currency issued and backed by a central bank. A CBDC is designed to be similar to the traditional fiat currencies we all use today, in that it is legal tender in its country of issuance and has the full backing of the government. The difference between a CBDC and the money we know and use on a day-to-day basis is that instead of physical notes and coins, it exists in digital form. In short, a CBDC is a government backed digital currency denominated in a country’s national currency. However, unlike the majority of cryptocurrencies, which by design and ideology are decentralised, a CBDC is entirely controlled by one single authority – a central bank.
The concept of CBDCs
CBDCs are a relatively new concept within the broader evolution and development of digital currencies in the post-internet era. The concept has emerged from the evolving landscape of digital finance and the need for central banks to adapt to the rapidly changing global economy. The origins of CBDCs are closely tied to the rise of cryptocurrencies, the increasing digitisation of money and the wider challenges posed by private digital currencies, such as Bitcoin and stablecoins, which have achieved meaningful adoption globally. As Bitcoin and other cryptocurrencies have demonstrated the potential for decentralised digital currencies that operate independently of traditional financial systems and governmental control, nation states and central banks have been forced to respond to a number of associated challenges, such as volatility, regulatory concerns and the threat of undermining central bank authority over monetary policy. In response, central banks around the world began exploring the idea of issuing their own digital currencies. The People’s Bank of China was one of the first to take concrete steps, launching pilot programs for its digital yuan in 2020. Other central banks, including those in the Eurozone, the United States and the United Kingdom have followed suit, conducting research, consultations and pilot projects to assess the feasibility and potential impacts of CBDCs.
Categories of CBDCs
Central Bank Digital Currencies are generally considered to fall into two distinct categories: ‘Wholesale’ and ‘Retail’ CBDCs. Each serves a distinct purpose within the financial system, targeting different users and addressing specific needs. CBDCs could be implemented in different ways, including as a token on a blockchain, a digital version of the physical currency or a hybrid system. Whichever model is deployed in an instance of a CBDC, factors including privacy, security and the impact on monetary policy will be critical in implementation.
Wholesale CBDCs
Wholesale CBDCs are designed for use by financial institutions, particularly banks and other entities involved in large-scale financial transactions. These CBDCs are not intended for general public use but are rather focused on improving the efficiency, security and speed of interbank transactions and other financial market activities. The primary rationale for wholesale CBDCs lies in their ability to streamline processes in the wholesale banking sector, which includes activities like settling large-value payments, clearing securities and managing cross-border transactions. Traditional systems for these purposes often rely on outdated infrastructure, which can be slow, costly and prone to errors. A wholesale CBDC leverages digital technology to enable more direct, real-time settlement between financial institutions, reducing the need for intermediaries and minimising settlement risks. By using a CBDC, central banks can ensure that transactions are secure, transparent and settled instantly, enhancing overall financial stability and efficiency. This type of CBDC can also facilitate more effective monetary policy implementation by providing central banks with enhanced tools to manage liquidity in the banking system.
Retail CBDCs
Retail CBDCs are designed for use by the general public and would function as a digital form of cash that can be used by individuals and businesses for everyday transactions, such as buying goods and services, transferring money or saving. Retail CBDCs are typically intended to be as accessible and easy to use as physical currency but with the added features of digital technology. The introduction of a retail CBDC could theoretically promote financial inclusion by providing a digital payment option to people who may not have access to traditional banking services. In regions where cash usage is declining, a retail CBDC could ensure that people would continue to have access to central bank-backed money in a digital form, which is secure and widely accepted. The theory behind Retail CBDCs is to enable features such as enhanced payment security, reduced transaction costs and faster settlement times compared to traditional payment methods. Meantime, they would provide central banks with more direct control over the money supply and the ability to track economic activity in real-time, which can be useful for implementing and adjusting monetary policy.
CBDCs: the evolution of Money or a State Response to the emergence of Cryptocurrencies?
The concept of the CBDC is certainly an inevitable and evolutionary response to recent developments in financial technology, notably the increasing digitisation of money and privatisation of payment rails. The rationale for CBDCs stems from several key factors.
Efficiency and Cost Reduction
In leading G7 economies, where the day-to-day use of bank notes and coins is diminishing rapidly as a result of electronic cash payments, a digital fiat currency would make sense in many ways. This shift towards a cashless society has highlighted the need for more efficient, secure and cost-effective payment systems. CBDCs can streamline domestic and cross-border transactions, reducing costs and increasing the speed of payments. Of course CBDCs can also reduce the costs associated with printing, distributing and managing physical cash, as well as reducing transaction fees by eliminating intermediaries in payment systems.
Combating Financial Crime
Furthermore, in the fight against financial crime, CBDCs would offer improved transparency and traceability in financial transactions, making it easier to track and prevent illicit activities such as money laundering, tax evasion and terrorism financing.
Maintaining Monetary Sovereignty
As privately owned cryptocurrencies and stablecoins have gained traction over the last decade or more, central banks soon recognised the need to maintain control over their national currencies and monetary policies. A CBDC would allow a central bank to provide a digital alternative that is safe, stable and backed by the national government, ensuring that the official currency remains the primary medium of exchange.
Ultimately a CBDC would provide the central bank with more direct control over the economy, allowing them to track and regulate money flows more closely, but herein lies the dilemma and controversy surrounding the concept and prospect of Central Bank Digital Currencies – at least in their ‘retail’ form. A far-reaching initiative, such as the development and introduction of a retail CBDC, will inevitably involve a host of important considerations, both positive and negative, which impact economic, technological, political and social factors. CBDCs have the potential to reshape national and global financial systems significantly, but as much as they offer governments and central banks the benefits of technological and monetary innovation, in turn CBDCs pose a non-trivial threat to the rights and freedoms enjoyed by citizens of democratic nations across the world.
How might CBDCs impact individual liberties and pose a threat to privacy and freedom?
The prospect of CBDCs has become a topic of great interest, concern and controversy, particularly in western democratic societies. Many commentators and interested parties, in the wake of the rollout of China’s digital E-CNY CBDC, are raising concerns about the significant implications for individual civil liberties and how government controlled digital currency can pose a threat to privacy and freedom.
Increased surveillance
One of the advantages of physical cash is anonymity and an individual’s ability to make financial transactions anonymously, allowing engagement in certain activities without fear of persecution or discrimination. CBDCs could potentially enable increased surveillance and monitoring of financial transactions, as every transaction would be recorded on a centralised ledger. This could open up the possibility of governments or other entities being able to monitor and track individuals’ spending habits, giving the issuer the ability not only to see how we transact, but even to control how we transact and hence how we live our private lives. It is this risk of abuse of power in regard to CBDCs that has raised concerns over a government’s prospective ability to exert greater control over individuals’ financial activities. Design features and measures would need to be put in place to ensure that CBDCs are developed in a way that protects individual freedoms and privacy, whilst still achieving the desired benefits.
Programmable Money
The concept behind programmable money is that a CBDC can be coded with specific instructions that dictate how, when and where the currency can be used. This programmability could enable a wide range of advanced financial measures, for example mitigating against fraud by ensuring that funds are only used for intended purposes and enhancing monetary policy by enabling central banks to implement targeted interventions more precisely. Imagine a circumstance during an economic downturn when the central bank could issue a CBDC with negative interest rates or expiration dates to encourage spending; or when a government could issue a stimulus payment in the form of a CBDC that can only be spent on essential goods within a certain time frame. In a commercial situation, programmable money could allow a business to automate payments to suppliers when certain conditions are met, reducing administrative burdens and improving cash flow management. The digitisation of money opens up a world of possibilities in future.
However, whilst programmable money could introduce previously unimagined innovation in financial systems, it also raises significant concerns around privacy, ethics and the potential for misuse. Programmable money could be monitored and controlled, as explained earlier, giving central banks or governments unprecedented authority over how individuals and businesses use their money, and raising concerns about the imposition of restrictions on spending, purchasing limitations, direct taxation or even censorship and the confiscation of funds. The centralised control available in programmable money could be exploited for political or social control, by which governments could use programmable CBDCs to enforce compliance with laws or policies in ways that might be viewed as overreaching or authoritarian.
Wider Concerns about Financial System Disruption
Concerns have also been raised that the introduction of CBDCs could disrupt traditional banking models by reducing the role of commercial banks in money creation and deposit-taking, potentially leading to financial instability. In a CBDC system, the prospect exists that individuals and businesses might move the majority of their funds into digital wallets. In doing so, they would be bypassing traditional banks and this shift risks destabilising the wider banking system by reducing deposits and diminishing banks’ ability to lend and finance economic activities. By undermining the commercial banking sector and reducing financial intermediation, the introduction of CBDCs could lead to increased centralisation of financial power within central banks, with broader economic implications and reduced access to credit for consumers and businesses.
Looking to the Future
At the time of writing, the Bahamas, Jamaica and Nigeria have already introduced CBDCs and in China, the digital yuan is partially rolled out as part of a large-scale pilot. A further cohort of over 100 countries and currency unions are exploring the option of developing and introducing CBDCs. Meantime, in the US for example, a number of states are preparing anti-CBDC legislation. This is a complex topic which presents all sides of the dividing line with a broad array of opportunities and challenges. Whilst CBDCs could offer significant potential benefits, such as modernising payment systems and reducing central banking costs, they also raise critical concerns about privacy, civil liberties, cybersecurity and the wider stability of the financial system. Careful consideration, rigorous testing and inclusive dialogue with all stakeholders will be essential to ensure that any prospective implementation of a CBDC is designed and managed to mitigate potential risks. In technological terms alone, the difficulty of ensuring security, scalability and interoperability of CBDCs poses complex technological challenges. Meantime, in countries with weaker currencies, the introduction of CBDCs by larger economies could lead to a ‘digital dollarisation’, by which local populations favour the use of foreign CBDCs over their national currency, undermining monetary sovereignty. Balancing risks with any benefits will be crucial as central banks and governments consider the implementation of programmable features in CBDCs. Critically this will require careful consideration of legal, ethical and technological safeguards to ensure that programmable money serves the public good without compromising individual freedoms.
