Central Bank Digital Currencies: Still a solution in search of a problem?

Despite this, the Bank of England and HM Treasury published their consultation paper for a potential retail central bank digital currency last month.

Does the paper make the case for a ‘digital pound’, and what are the risks and opportunities?

Around 100 countries are already exploring CBDCs at one level or another, be that through research, testing, or even distribution to the public. In the Bahamas, for example, the Sand Dollar CBDC has been in circulation for more than a year, while in China, the digital renminbi has more than a hundred million individual users and has already processed billions of yuan in transactions.

In light of the BOE and HM Treasury’s consultation paper and following the ‘Digital Money Regulation’ event earlier this month with panellists Michael Patchett-Joyce FCIArb, Peter Oakes, Flavia Kenyon and Ainur Akhmetova, and moderator Dr Paresh Kathrani, I recently posted five days of quickfire thoughts on CBDCs on LinkedIn, highlighting what we need to look out for and what still needs debating. This article consolidates those posts.

From private to public money

Historically, private finance has supplied or supported consumer loans, savings accounts, insurance policies and investments, etc., while public finance has focused on tax, public revenue, public expenditure, public debt and fiscal policy. CBDCs represent something of a shift in this paradigm, a change from private to public money, with central banks increasingly involved in conventionally private money transactions and perhaps even holding customers’ funds directly.

One of the stated advantages of CBDCs is that they could enhance financial stability by reducing the reliance on commercial banks for payment services. However, if too many people suddenly convert their bank deposits to CBDCs then that could create a run on commercial banks and destabilise the financial system. The paradigm shift and the potential risks it gives rise to therefore create questions about the role of commercial banks in a CBDC world and what mechanisms central banks need to be building into their designs at the outset to protect the integrity of their financial systems.

If CBDCs are designed to coexist with traditional bank deposits, commercial banks will continue to play a critical role in the financial system. However, if CBDCs are designed to replace traditional bank deposits, commercial banks could see a significant decline in their role (and revenues), with customers no longer needing to rely on commercial banks to provide financial services.

While CBDCs could potentially enhance the effectiveness of monetary policy by giving central banks more direct control over the money supply, much needs to be considered as to how a CBDC should be designed and implemented in any given territory and how it may be affected by (or may affect) the regulatory environment and competitive landscape of the financial system in which it operates.

Monopolisation and market concentration

When it comes to CBDCs, central banks may want to be in control, though in reality much of the technology (be that design, infrastructure or code) will likely come from third parties.

Those third parties will almost certainly include big tech. These companies already hold significant power in the digital economy and their involvement in CBDCs could further concentrate that power, increasing the risk of monopolies and undermining competition. This may be difficult to manage given the challenges of regulating international entities.

Geopolitical risks could also arise from the involvement of other actors—not just in the private sector, but the public sector too. “Note Printing Australia”, a subsidiary of the Reserve Bank of Australia, already prints banknotes for several countries in addition to Australia. If a few countries or companies ultimately dominate and supply CBDC services on a white-label basis to others, control over one country’s currency or economy could end up in the hands of another—and in an environment where many more things could go wrong. You can’t really print a computer virus or a cryptography vulnerability onto a bank note, after all.

Big tech as well as those states that lead the way will certainly have a lot to offer others in terms of expertise, experience and resources, but their involvement creates risks. Parties might be on friendly terms when contracts are awarded, but the future is always less certain. Last year legal notices were issued to 35 UK broadband and mobile operators ordering for Huawei technology to be removed from the UK’s 5G public networks by the end of 2027. It may be difficult to mandate similar requirements in a CBDC environment where digital currencies, wallets and ledgers might reside beyond a state’s borders.

One only needs to look at the current state of the cryptocurrency market to recognise that CBDCs might also be particularly prone to network effects, where the value of a currency is dependent on the number of users adopting it. This may exacerbate monopolisation and market concentration issues by creating a “winner takes all” dynamic that favours larger, established players. This may stifle innovation, reduce choice, reduce quality and/or increase costs and perhaps even topple some CBDC projects post-release. Governments, regulators and central banks will need to think carefully about how they protect against these risks.

Security

Like crypto, CBDCs will become the targets of romance fraud, phishing scams and mis-selling. Cybercriminals will to try to trick CBDC holders into revealing private keys and passwords to gain access to users’ digital money.

As CBDCs rely on digital technology, they may also be vulnerable to cyberattacks where hackers directly attempt to steal funds, disrupt transactions or cause other damage.

Where CBDCs use blockchain technology, if any smart contract code that executes transactions is flawed it could lead to security vulnerabilities and losses. (Aku Dreams’ NFT launch last year locked up $34m of Ethereum forever due to a faulty smart contract!)

The first of these issues might be addressed by increased account security and multi-factor authentication, though these could reduce the accessibility of CBDCs and limit their stated goal of increasing financial inclusion. Intrusion detection, monitoring and patching, etc., will all be part of plans to combat the latter. However, some security concerns go beyond users, nefarious actors and coding errors: the state.

The UK Secretary of State’s powers are extended under the Investigatory Powers Act 2016 to requiring telecom operators to install interception capabilities. The Online Safety Bill also challenges the future of end-to-end encryption through proposals that tech companies must scan messages for potentially illegal material. In 2020, the CJEU declared the EU-US Privacy Shield invalid as it didn’t protect users from US authorities accessing the data. When it comes to encryption, some states seem keen to hold the keys to the door.

CBDCs are likely to involve similar encryption techniques. Third parties that supply CBDC tech may therefore be susceptible to disclosure orders or may have to build backdoors in their systems. These could present security risks by providing access to private information or by making a system vulnerable by deliberately weakening its security.

If CBDCs are to succeed, central banks must ensure robust security measures protect against the risks, and much will need to be done to resolve how issues are dealt with when they arise. The UK has become something of a favoured jurisdiction for litigating cryptofraud matters of late. However, it was roughly 10 years after the first bitcoin was minted that cryptocurrencies were recognised as property in the UK, giving rise to legal remedies such as proprietary injunctions. Much needs to be done from a legal and regulatory perspective to ensure CBDC issues can be dealt with swiftly pre-launch, particularly given CBDCs may become much more mainstream than crypto, putting far greater sums of money at risk.

Privacy

In its consultation, the Bank of England frames privacy as it not knowing who spends the money by its outsourcing of wallet arrangements to third parties who hold users’ data instead.

However, such an arrangement just moves sensitive data from the state to the private sector. It does not fix privacy concerns. The arrangement may even exacerbate issues, as rather than a single state actor being subject to public scrutiny and criticism, many third party providers will store users’ sensitive data. They may prove harder to scrutinise and hold accountable.

Depending on the rules of a CBDC scheme, wallet providers may not even need to operate in the same jurisdiction as a central bank or its users. Users might then have to bring actions overseas to address any issues or rely on foreign privacy regimes.

Privacy concerns may also arise if wallet providers offer linked services or have data sharing agreements with other service providers on which CBDC users rely. Certain health insurers, for example, offer discounted gym memberships and free health monitoring equipment to their customers, provided those customers agree the insurer can access details of their use of these facilities. Many organisations will be interested in CBDC users’ spending data, and could use these to price their services (or level of risk).

Through the digitisation of money, CBDCs will eliminate the anonymity/pseudonymity that cash and some crypto offers if users’ identities are linked to their CBDC wallets and potentially traceable to their transactions, raising monitoring and surveillance concerns. Even if the authorised parties in a CBDC system are trusted, information might still be accessed or hacked by unauthorised third parties.

The absence of anonymity in CBDC transactions may aid AML and CTF efforts, though may also make it difficult to send CBDCs to persons in need who do not have access to conventional banking facilities due to social, economic or political barriers. In Afghanistan, some emergency aid has been sent in crypto, as the Taliban has limited cash withdrawals leaving millions unable to afford food and medicine. If CBDCs reduce privacy, are more easily linked to individuals, or are difficult to obtain without specific IDs, they could further exclude from the financial system those who are already marginalised, or deny vulnerable people the aid and support they need.

CBDCs could significantly impact individuals’ privacy, especially in countries with limited protections. Privacy therefore needs to be front and centre of any CBDC plans, including the BOE’s.

Sovereignty and borders

Many issues need thinking through when considering the role of CBDCs in cross-border transactions. If a CBDC is only accepted within a particular country, cross-border transactions may necessitate that CBDCs are converted to a foreign currency before they are moved across a border. Such procedures bring with them foreign exchange costs and risks, and could limit the use of CBDCs in international trade and commerce.

Equally, if interoperability issues are overcome and CBDCs are freely movable between jurisdictions without conversion, then large amounts of a country’s money could be moved offshore. This could present a threat to the sovereignty of a state, and it could diminish the power of national governments to control their own economies.

To a similar point, if CBDCs are easily transferred across borders without the need for traditional payment systems then national governments may be less able to regulate and monitor cross-border transfers at all. That could undermine their ability to enforce international economic sanctions or other policies.

All these issues become even more pronounced if CBDCs are tied to an underlying currency (e.g. USD), particularly if the child CBDC gets bigger than its parent. Central banks might then struggle to hold sufficiently large reserves of the central currency to back the CBDC, which could weaken the value of and erode confidence in the CBDC.

Central banks have historically been able to intervene in managing the markets and related risks by, for example, banning the use of a foreign currency in a country, restricting currency exchange to government-approved exchanges only and fixing exchange rates. However, if these or other appropriate control mechanisms are not “baked in” to the CBDC system from the outset then they could prove difficult to fit retrospectively, resulting in a loss of control. Baking these measures in though could lead to concerns about the extent of central bank influence over financial markets and the potential for their interference in private sector decision-making, limiting a CBDC’s appeal. Either way, if the value of the CBDC is tied to the value of a central currency, the central bank may not be able to adjust the value of the CBDC independently anyway to respond to changes in the economy.

Conclusion

CBDCs could offer some benefits, although the need for them is not yet clear. Noting that the BOE and HM Treasury state in their consultation that “International developments have the potential to affect the UK domestically and as a global leader in finance”, perhaps the fear is that the UK will be left behind if it doesn’t follow others in the pursuit of a central bank digital currency.

CBDCs raise complex issues which need to be properly understood and balanced by governments, and appropriate regulations will be needed to ensure the safety, stability and integrity of CBDCs, to help prevent money laundering, terrorist financing and other illicit activities, and to ensure CBDCs can contribute positively to the financial system and the economy. Without this, the concept could present a lot of risk for limited reward.

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The original posts from which this article is formed are available online:

• Day 1: From private to public money
• Day 2: Monopolisation and market concentration
• Day 3: Security
• Day 4: Privacy
• Day 5: Sovereignty and borders