WHY DO WE NEED A CENTRAL BANK DIGITAL CURRENCY WHEN MONEY IS ALREADY DIGITAL?
[Student IDEAS] by Paul Bédier - Master in Data Sciences & Business Analytics at ESSEC Business School & CentraleSupélec
The article aims to provide the reader with a better understanding of Central Bank Digital Currencies by giving them the required background to critically assess their usefulness and stakes. We explore the motivations behind these new projects, delve into the issue of public-private money balance seating at the core of their genesis, and provide different perspectives on possible implementations. Our view is that central banks should strive to chart cautious yet efficient paths towards CBDC.
Brand new acronym, same old idea?
CBDC: the new 4-letter acronym that will no doubt be the subject of heated disagreements for the years to come. It stands for “Central Bank Digital Currency.” For the average reader, the central bank rhymes with monetary policy and interest rates while digital currency would be associated with fintech companies and the crypto sphere. Confused? Let us attempt to clear the haze surrounding the buzz and jargon.
First, think about digital currency for a minute. Most people should be aware that an overwhelming majority of money already sits on digital ledgers: bank accounts. It is through a game of accounting entries that transactions are carried out. Tangible money like coins or bills is estimated to account for only 3 to 8%1 of the world money supply (with variations among countries). Why then do we keep hearing about digital currency as if it were this great transition we are on the verge of?
The answer is simple: central banks have been ramping up the communication about their Digital Currency projects, hence we are increasingly hearing about it. As of 2023, 130 countries2 (representing 98% of world GDP) are in the process of evaluating the launch of CBDC projects. Eleven countries have already launched theirs. What are these projects about? They can take different forms, but all revolve around the idea of transforming centrally issued banknotes and coins in a digital format and making them accessible to the public for transactions at its most basic level, or for savings and other financial operations at a more advanced level.
Here you might stop and say: “well how is that any revolution? I already have a bank account with digital money inside it and I use my credit card instead of bills to settle transactions”. It is indeed a subtle but undeniable revolution. The main distinction between what we have now and CBDCs is the same distinction that has always existed between private and public. The digital money you currently use through your credit card is issued by a private bank, while CBDCs would be issued by the central bank just like banknotes and coins. So, the definition of CBDC is simply the following: “A Central Bank Digital Currency is the digital form of a country’s fiat currency.”
After this explanation, you may feel a bit underwhelmed. We will simply have digital banknotes and coins now, why not. Does an old idea already materialized in our world really warrant a brand-new acronym?
Yes, it does, because the distinction raised above between private and public money is critical. Indeed, CBDCs are groundbreaking for two main reasons. First, the motivations behind them are numerous and diverse, and find their roots in questions of economic stability, financial efficiency, international geopolitics, and even sociopolitical objectives. Second, their mere implementation has the potential to be a can of worms and may compromise the financial stability they are meant to help with. By their nature of being digital currencies, they will intrinsically carry with them the potential for many advanced functions, through their programmability for instance, which might enter in direct competition with the private financial - and technological - sector. We will see that for these reasons, different countries have different plans for CBDCs.
Now comes the question we will strive to address in this article. Will CBDCs be useful to society? Are they necessary? The answer is not straightforward. Let us dig into this!
Motivations behind CBDCs, a tangled web
The idea of CBDC certainly is not new, and one tentative attempt at identifying its original author attributes it to Nobel laureate James Tobin3 who in 1987 already advocated for a public payment “medium with the convenience of deposits and the safety of currency”. Ignored for a long time, the proposal regained traction in the recent years, with central bank and public officials warming to it as a solution to rising issues: the decline of cash, exacerbated during the COVID crisis, and the relative spread outside of the traditional monetary system of cryptocurrencies like Bitcoin or, perhaps even more concerning, stable coins backed by tech giants such as Libra (Diem).
For Society and Businesses: Improve Financial Inclusion & Monetary Efficiency
On paper, motivations behind launching a CBDC could come from a genuine objective to better society and improve financial services. One of its most noble impacts would be to provide each citizen with a universal bank account at the country’s central bank, bringing basic and low-cost banking services to all. The positive repercussions of such a move, especially in developing countries with high unbanked rates, could be staggering.
Furthermore, CBDCs would bring with them a number of technological innovations, pushing efficiency upward for both individuals and businesses. Most of these innovations already exist, propelled by fintech companies, but they would take an even wider scale within the fiat currency infrastructure provided by central banks. With intermediaries such as commercial banks or clearing houses eliminated, real-time payments and settlements could take place, thus reducing financial risk, complexity and in turn lowering transaction costs. Proof of transaction in the form of a digital record located either on a distributed ledger (yet still centrally controlled) or a centralized database would foster trust and transparency in the financial system, making it more difficult for conflicts to arise and for fraudulent activities to take place. Finally, CBDCs would allow for easier programmability and bring with them a large number of beneficial features for the financial system. The best and most famous example is with smart contracts, which can be automatically settled and remove much of the counterparty risk usually involved in transactions.
Another motivation for CBDCs, and one that should please proponents of the neoclassical school of economics, is the heightened competition between private banks that would ensue a CBDC launch, as they would need to offer better services and interest rates to their customers for fear of losing them to the central bank. Now, this is a hot-issue topic and there is dissent among both central banks and public officials as some fear this could backfire. Indeed, they argue that by eroding the banking sector’s profitability and encouraging financial disintermediation, the consequences for the economy at large in terms of efficiency and innovation could be detrimental. Let us delve more into this issue later in the article.
For Central Banks: Regain Monetary Authority
Central banks have clear motivations behind CBDCs, which boil down to reaffirming their authority over money. Indeed, while they used to be fine relinquishing money issuance activities to private banks as long as it meant they could focus on monetary policy through their direct and indirect control - required reserves, policy rates, open market operations to name the main tools at the central bank’s disposal. In fact, this proved quite successful all things considered, as the commercial banks could compete with one another and innovate to win over customers, while the central banks essentially outsourced financial intermediation and credit issuance activities. The decline of cash - public money - to a baseline level was merely an accepted consequence.
However, this system is now being challenged from different sides with the spread of alternatives to fiat money: cryptocurrencies and stable coins. The former, coming from society’s underground, is a threat to the central bank’s authority and control over monetary policy and in their eyes a source of volatility arising from unregulated speculation and therefore a risk to global financial stability. However, cryptocurrency adoption remains low and its viability as a fiat money alternative is very debatable, as explored in the previous article of this series. The latter, coming from tech giants and the fintech industry, has the potential to become an even larger threat to central banks by short circuiting the established financial system. Finally, cash decline could now turn into full-fledged cash disappearance after the fintech industry filled the holes created by the COVID crisis, leaving our societies entirely reliant on private forms of money.
CBDCs could be the answer central banks are looking for, as they would intrinsically bring back public money in the economy, reaffirm their authority over the monetary system and even grant them new vectors of monetary policy. For the latter, this could simply take the form of direct transfers to the public with public money issuance, or so-called “helicopter money.” More refined approaches could involve programmability of money, say implementing expiration dates which would spur spendings and discourage savings – something that was assessed by China in their pilot program in Shenzhen. Finally, CBDCs could help central banks enhance financial stability by offering an alternative to fractional reserve banking and thus limiting the risk and impact of bank runs, and by avoiding a potential flight to unregulated and volatile cryptocurrencies or stable coins.
Now, of course the claim central bank’s authority was eroding to start with should be nuanced. In the last decade, institutions like the Federal Reserve of the United States of America (“Fed”), the European Central Bank (“ECB”), Bank of England, People’s Bank of China (“PBoC”), and many more have unleashed massive quantitative easing programs in the wake of the 2008 market crash, overflowing the market with liquidities in support of their respective economies. Recently, most of them have started a series of policy rate hikes to fight inflation caused by COVID crisis recovery and the Russian-Ukraine war supply shock. This would tend to show central banks are still very much in control of the monetary system and that their authority over the matter was not threatened quite as much as previously implied.
However, much can be told from how the central bank’s own stance on the matter shifted at the turn of the COVID crisis. Indeed, up to 2020, the consensus towards CBDCs was still fairly negative, or at least erring on the side of high caution. Now, the tone is a lot more positive, with central banks eager to communicate on their CBDC projects and deliberations. This is primarily the result from a better understanding of the impact of digital currency’s implementation on the existing financial system, and how it could be mitigated. But this is also due to renewed interest as central banks now would not reject an increase in the scope of their policies nor access to additional tools. Especially when economists are increasingly pointing out the risk of a decoupling between traditional monetary policy and the real economy.
For Sovereign States: Compete in the Monetary Arms Race
Sovereign states presumably act in their citizen’s interest and thus would be aligned with all the motivations listed above for individuals, businesses, and central banks. But they also have specific interests in the launch of Central Bank Digital Currencies. A domain in which they could be helpful to the state is the fight against illicit activities. Indeed, a digital repository theoretically makes them able to keep track of the exact location of each monetary unit of the currency. This could have repercussions for tax collection, making evasion more difficult through means of offshore banking or unreported employment via underground economies. It also makes it easier to spot criminal activities, track money laundering and reverse fraudulent transactions. Of course, all these benefits depend on the type of implementation chosen by the central bank, the amount of transparency in the system and the status of cash in the new system.
Another game is however at play here, with states fighting in the realm of geopolitics and international competition. Indeed, like any significant technological breakthrough – nuclear weapons, advanced semiconductor chips, artificial intelligence, the potential cost of not developing it may be too high and countries will get caught up in the infamous prisoner’s dilemma. You might ask: “what are the risks in the case of CBDCs, they appear harmless enough.” But this would be discounting the scale and significance of economic warfare. One of the risks to a country is simply to get overrun by the financial innovations provided by the CBDC of another country. This could manifest in increased capital flights, with investors flocking to the other country’s financial markets to benefit from increased efficiency and additional features, as well as individuals using the foreign CBDC as a safe asset. This in turn would have direct detrimental consequences on the economy, as the central bank would need to adjust policy rates in ways which might adversely affect the economy.
The highest and most critical risk waiting at the end of this path is an outright currency substitution. You may have heard of the concept of “dollarization.” which occurs when a country’s citizens partially or fully rely on a foreign currency (historically it often was the dollar, hence the term). Of course, this can have catastrophic consequences for sovereignty and economic independence, something that most countries want to preserve against. But even the simple erosion of a country’s monetary influence on the world can be perceived as a nightmare for said country. Imagine a world where the USA loses the dollar as the most influential currency and can no longer use it to write the rules of international trade (USD is currently estimated to represent 90% of total foreign exchange volume).4 CBDCs, with their highly efficient cross-border transaction settlement potential could displace the USD from this historic role. It does not take long to see how the US government might fight against this and feel obligated to pursue CBDC developments as a hedge against this risk. Consider also how China is part of the five countries who launched their CBDC pilot programs, while the US remains at preliminary research and deliberations, and you might sense uneasiness.5
Now that we have outlined the main motivations at play here, let us delve a bit deeper into the potential implementation of CBDCs and how they must find a difficult balance.
Public and Private money, a fragile balance
The Great Illusion
Central banks are great contenders for the title of most impressive magician out there. Not because they seemingly create money out of thin air or make it disappear just as easily, although that is certainly a neat trick. No, it is because they have created and maintained one of the longest running illusions in the history of humanity, on a wide scale. What is this illusion? We may call it the “illusion of one money.” Ask yourself, is there any significant difference between the currency you hold in your wallet and the one you hold in your bank account? If your answer is no, then you were successfully tricked. Indeed, as we have touched upon in the introduction, the former is public money issued by the central bank, while the latter is private money issued by a commercial bank. This subtlety is critical, as it stands at the core of the existing financial system.
How do central banks manage this? By their role as a “lender of last resort,” they guarantee immediate convertibility of private banks deposits into fiat – public – money. In essence, we collectively place our trust in this state institution and the result is that we can benefit from the private banking industry’s services on a scale that the central bank would not be able to offer on its own. To the point where, in stable countries, we barely ponder the difference. Reality only comes back to hit us in the case of a bankruptcy, with the infamous bank run scenarios. A good analogy, although slightly provocative, is the casino one. Depositing your money at a commercial bank is like entering a casino and exchanging your money against chips.6 These chips are a form of “I owe you,” legal tenders for any transaction inside the casino and ones that bind the casino to exchange them back to you for currency.
However, if you go outside and try to pay for your groceries with your chips, you will likely raise an eyebrow. The illusion of one money is broken. In the case of the banking system, interconnection between banks helps maintain the illusion further, allowing us to use our “private chips” almost anywhere. These interconnections are made possible by clearing house systems, on which a digital form of public money is automatically and periodically compensated, balancing out overall private bank accounts through required reserves.
Now is the time to introduce the distinction between wholesale and retail CBDC. The former is an evolution of the process described above. The central bank issues a digital currency, which private banks hold and can use to settle with one another in real time. As such, interbank transfers could become much faster than they are today. A wholesale CBDC would also facilitate cross-border transactions. Today, the public form of money that banks exchange is already remarkably close to what a wholesale CBDC would be, minus the technology allowing for instantaneous settlements. Retail CBDC on another hand is a much more significant project to grant access to digital public money to the general public and is what we have been describing in this article so far. Note that hybrid projects exist, which would work to implement both in one package.
The “Benevolent” Intermediary
To better understand the fragile balance between public and private forms of money, one must be aware of the money creation process. Today’s banking system is organized as “fractional reserve banking.” This means that commercial banks, as credit institutions, have near free reign to create money out of thin air by crediting your accounts. This is a loan, or debt instrument, and is how the money supply is expanded. Of course, loans should eventually be repaid, and banks want to make a profit through interests. This means that lending money to individuals or businesses involves credit analysis and due diligence over the borrower’s solvency. Furthermore, banks do not have completely free reign over lending, as they are required to hold reserves at the central bank. This consists of a fraction of their deposits, hence fractional reserve banking. The role of central banks is to control the money supply through different instruments, required reserves ratios being one. This has an impact on the dynamics of the economy – supply expansion, or heightened lending activities, will stimulate investments and GDP growth, while supply contraction might harm the economy but will exercise downward pressure on inflation rates.
Private banks thus play the role of the intermediary in the system, managing deposits and granting loans, on a scale that the central bank would not be able to sustain. Of course, they do not do this out of benevolence, but profit seeking (or return objectives in the case of credit unions). This system promotes competition between banks, which in theory is beneficial to customers through lower interest rates and better financial services. Financial innovation is also fostered, leading to more efficient payment and transaction settlement schemes. The convenience of using these payment schemes has pushed back the use of cash. In recent years, new entrants have progressively challenged the traditional banking landscape, mostly coming from the tech industry with both large companies – think Google and Apple – and smaller “fintech” startups – think neo banks, international transfer, decentralized finance. This is further eroding cash use, and leads central banks to worry as, compared to banks, they do not yet have a large regulatory apparatus for tech companies. In a sense, today the balance already weighs heavily in favor of private forms of money.
The Elusive Equilibrium
By issuing CBDCs, central banks would attempt to rebalance the scale and have public money play a renewed and strengthened role in the economy. The right equilibrium is however hard to pinpoint. A significant risk which made most central banks frisky about CBDCs for years was that CBDCs would lead to the uncontrolled disintermediation of the system. Because of the potential attractiveness of central deposits to the public due to factors like safety, liquidity and solvability, the launch of CBDCs could turn people away from commercial banks, deteriorating their balance sheet and causing the risk of bank runs. Such a disintermediation would also be catastrophic for the economy, as the activity is fueled by investments made possible by loans. This might sound overly apocalyptic, as there is reason to believe an introduction of CBDC would not substitute commercial bank’s deposits overnight. After all, many less financially literate people would have trouble seeing the difference and the benefits of switching. Nevertheless, central banks considered this a serious enough issue to pull the brakes on CBDCs and launch in-depth review programs and impact studies. The critical point is that even if a large-scale bank run is avoided, even a slow but steady disintermediation of the financial system could be detrimental.
Reaching the right equilibrium will be a crucial element in the choice of CBDC deployed. Wholesale CBDCs present no risk, being a simple evolution of the current interbank system. Retail CBDCs present a higher risk and warrant more caution. In recent years, central banks task forces have examined hybrid infrastructure which promises to solve this problem if well calibrated. Restrictions on deposits and CBDC programmability could be used to keep the private banking sector attractive and mitigate the disintermediation risk. To conclude, the main approach should be caution, something that central banks understand well. In a report by the Bank for International Settlements co-authored by seven major central banks published in 2020, they outlined a Hippocratic Oath for CBDC: “First, do no harm”.7
Now that we have explored the motivations and explained the challenges, we have the required ingredients to answer our original question: “will CBDC be useful?”
Usefulness, a matter of perspectives
Usefulness, like beauty, is in the eye of the beholder.
For individuals, valid concerns
While individuals should be excited at the prospect of increased efficiency, better stability, and new financial services, many argue the cons outweigh the pros. Retail CBDCs are seen as yet another intrusion of the state into people’s lives. Indeed, the aim of every CBDC project is a centralized currency, even those that will use distributed ledger technology for efficiency, meaning the central bank will always have full control over the network. This gives a large amount of power to the state via the central bank to add or remove money from accounts. More concerning and realistic for non-corrupt states, the risk of cyberattacks with hackers taking control of the central authority and using it to modify accounts should not be thrown aside too quickly.
Privacy concerns are obviously also a significant issue for many individuals. If the CBDC implementation gives full visibility over financial transactions and records to the state, which people argue is likely even if central banks include privacy walls into the system, everyone is at risk of seeing their financial data used beyond their consent. In a more extreme case, a full-fledged surveillance state could develop, monitoring its citizens’ transactions and enforcing limitations on certain activities via the programmability of the CBDC e.g., prohibiting purchase of alcohol on weekdays or donations to politically opposed NGOs. These are valid concerns and would resonate well with the quote “technological progress has merely provided us with more efficient means for going backwards” from Aldous Huxley,8 writer of the famous Brave New World dystopian novel. We let it up to the reader to assess the likelihood of this risk. Central banks will certainly need to balance the safeguarding of privacy rights and the transparency necessary to deter criminal activity. In any case, it seems the usefulness of CBDCs to the public will depend on the specific implementation chosen. It is our view that central banks should strive to provide all reassurance required by being transparent and including tight checks and balances to foster trust in the population.
For countries, different paths
Let us conclude this article by stating that there will not be one version of CBDC, there will be as many versions as there are countries implementing them. Each will have its own specific characteristics, trying to address the specific needs of the country but also rooted in that country’s sociopolitical ideology. China, for instance, already released to the public a pilot version of its CBDC, the digital yuan, back in August 2020. The currency has been progressively expanded to more regions, reaching 261 million of users for USD 13.8 billion worth of transactions at the end of 20219 – a moderate result, likely explained by the country’s pre-existing advance in digital payment services. The PBoC states that the objectives are to enhance efficiency and help the state fight against illegal activities. It also defends itself regarding privacy concerns and surveillance accusations, adding that they have included limitations on tracking as part of “anonymity control.”
On another hand, for major economies like the US or the EU, the implementation of CBDC will be much slower, as project calibrations are carried over the coming years and central bank laws will need to be ratified. The Fed has been involved since 2022 in extensive research projects in partnership with the Massachusetts Institute of Technology to assess potential implementations of CBDC as well as their impact. The US will most likely favor a hybrid system, with great incentives given to users to keep using the private banking sector in order to protect this leading industry. They will certainly incorporate into the project the ability for the central bank to directly transfer funds to deposit accounts, as an additional tool of monetary policy. The EU, champion of data protection regulations, will no doubt spend a considerable amount of time to reassure its citizens over the full transparency and limited tracking ability of the central bank. The ECB Governing Council will review the outcome of its first large-scale investigation phase, as part of the “Report on a digital euro” during Autumn 2023 and decide whether to carry forward with a realization phase.11
Because individual and national interests may not align neatly, there is no doubt citizens of different countries will have diverging perspectives on the usefulness of CBDCs based on their nation’s chosen path.
Throughout this article, our aim was to give the reader a better understanding of Central Bank Digital Currencies. By exploring the numerous motivations behind them, by delving into the issue of the public-private money balance and assessing the usefulness of such projects for all the involved parties. Our view is that central banks should move with caution and high transparency if these projects are to have a controlled impact on the existing financial system and be widely accepted by the population. However, the risk of taking too much time to develop CBDCs in the context of a global economic arms race could prove dangerous to national interests. As such, central banks and the governments backing them should ensure to chart an efficient and resilient path towards CBDC.
We hope that this article will empower the reader to think about this technological progress in a nuanced and complete manner. By self-appropriating the issue and developing a critical perspective, one can participate in the broader debate and hold governments responsible for an appropriate and beneficial development of Central Bank Digital Currencies.
 James Tobin, Essays in Economics (MIT Press), 1987
 Aldous Huxley, Ends and Mean, 1937