Coins & Code: Unravelling the Mystery of Central Bank Digital Currency
- Ronit Khopkar
- Feb 3, 2024
- 13 min read
The Origin
The idea of central bank-issued digital currencies can be traced back to the 1970s, with discussions on potential electronic cash systems. In 1993, the Bank of Finland launched the Avant smart card, considered an early experiment with CBDC features. It was eventually discontinued.
However, the push to implement a CBDC came with the creation of the Bitcoin Network and Fiat-backed stablecoins. The success of Bitcoin and Stablecoins issued by private organisations threatened the monetary control of Governments on its economy.
In 2014, the People's Bank of China began researching digital currency, laying the groundwork for their e-CNY project.
Central Bank Digital Currency: Deep Dive
A Central Bank Digital Currency (CBDC) is a central bank-issued, digital-only fiat currency that resides in a central bank-operated distributed ledger and is directly accessible to authorised end users and financial institutions for peer-to-peer or intermediated transactions.
Defining the key elements further here:
Central bank-issued: Created and controlled by the central bank
Digital-only: Exists solely in electronic form, no physical equivalent
Fiat currency: Backed by the central bank's guarantee, not linked to any physical asset
Distributed ledger: Stored and updated on a shared, secure database accessible to authorized entities.
Peer-to-peer: Potential for direct transfers between individuals, bypassing intermediaries
Intermediated: Can also involve commercial banks or other financial institutions for certain transactions.
A simplified version
Picture your pocket, but instead of bills and coins, you have a secure digital wallet on your phone. Inside the wallet, rests a special type of electronic cash – a Central Bank Digital Currency. Issued directly by your country's central bank, it's the digital twin of your familiar dollar, rupee, euro, or any other fiat currency. Just like physical notes and coins, it's legal tender, backed by the central bank's guarantee.
This sounds very familiar to the digital currency in all our bank accounts today. So what’s the difference?
CBDC vs Digital Money
Metric | CBDC (popular as e-money) | Digital Money (Current form of money) |
Issuer | Central Bank of the country | Commercial Bank (An intermediary between us and the Central Bank) |
Guarantee | Backed by the credibility of the Central Bank | Backed by the credibility of the commercial Bank; Insured by the government up to a certain amount. If the bank fails, one could lose their money beyond that limit. |
Transaction Type | Peer-to-peer transactions without needing a bank as an intermediary | Requires using bank's infrastructure for transactions, adding an extra layer of processing and potential fees |
Availability | Accessible through a government-issued digital wallet | Requires a bank account and specific bank apps for accessing and managing your funds |
Monetary Policy | Central banks could implement targeted monetary policy measures directly through CBDCs, like programmable expiry dates or programmable stimulus | Monetary policy changes by the central bank indirectly affect bank lending rates and ultimately your interest rates, but there's no direct manipulation of your individual account |
Privacy | Raises concerns about privacy as transaction data could be accessible to the central bank | While banks also record transaction data, there are regulations and privacy policies in place to protect your information |
Weighing Pros and Cons
CBDCs offer intriguing possibilities, but also raise concerns. Fans say they'll speed up and cheapen payments, even reaching folks without bank accounts. Governments could save money by ditching physical cash, and enjoy easier tracking for better security.
But privacy watchdogs worry governments might peek too closely at our purchases. Setting up a CBDC needs advanced tech and everyone online, leaving offline folks out. Hackers pose a big threat, too. Plus, CBDCs might shake up the banking world, leaving banks with fewer customers and fewer services to offer. Before we jump into the CBDC pool, we need to weigh the good and the bad carefully.
Here’s Augustin Cartens, the General manager of Bank of International Settlement’s (BIS) take, on it:
CBDC will always be a national issue and it will be the liability of the nation's central bank and will only respond to them. China, US, Mexico are in different stages of implementation and are building it specific to their needs of the economy. CBDC has equivalence with Cash. But there is a huge difference. Today we don't know who is using a $100 bill or a 1000 pesos bill. But with CBDC the central Bank will have absolute control over rules that will determine the use of CBDC. Also, we will have the technology to enforce that. So we can build CBDC in such a way that it will not be available for fragmentation and won’t cause financial instability. It is not a threat to the International Monetary System. For anyone to use it cross border, it requires consent of the Central Bank
In short, CBDC gives the Central Bank a power to surveil and control its usage. While CBDC provides strong benefits such as cross border payments, it opens up significant privacy and control issues for the public.
Let us study some use cases of CBDC in detail.
CBDC: Use Cases
Use Case 1: Easing International Trade
Implementation of CBDCs could potentially ease international trade. It can do this by offering Faster and Cheaper transactions, Reducing counterparty risk and improving transparency of operations, and finally by enhancing financial inclusion of SMEs to participate in cross border trade.
Project mBridge, a collaborative initiative for multi-CBDC cross-border payments, was conducted to prove the above hypothesis.
Project mBridge
Project mBridge is a collaboration between the BIS Innovation Hub Hong Kong Centre, the Hong Kong Monetary Authority, the Bank of Thailand, the Digital Currency Institute of the People's Bank of China and the Central Bank of the United Arab Emirates.
Over the course of six weeks in 2022, the mBridge platform was put to the test through a pilot involving real-value transactions among 20 commercial banks from 4 different jurisdictions. Over US$12 million was issued on the platform, facilitating over 160 payment and FX PvP transactions totalling more than US$22 million in value.
Use Case 2: Negative Interest Rate Mandate
In the standard world of interest rates, lenders earn money for loaning their capital, while borrowers pay interest for using it. However, negative interest rates flip this script. It's a monetary policy tool employed by central banks where the official interest rate falls below zero percent.
This means:
Instead of earning interest on deposits, savers pay a fee to keep their money with banks. This discourages hoarding cash and encourages spending or investment.
Banks are charged a penalty for keeping reserves at the central bank. This incentivizes them to lend out money to businesses and individuals, boosting economic activity.
Before we deep-dive into the effects of a Negative interest rates, let’s take a short detour and understand a little bit about how the Central Bank plays a main role in all of this.
Role of a Central Bank
Central banks have three main responsibilities
Keeping inflation low and stable
Managing the money supply
Ensuring the smooth functioning of the financial system.
They do this by setting interest rates, printing money, and regulating banks. By balancing these tasks, they aim to promote economic growth and stability.
Central banks use a variety of methods to manage inflation. But largely the strategy boils down to Controlling the money supply and Influencing borrowing costs.
Controlling Money Supply:
Open Market Operations: Buying/selling government securities directly impacts the amount of money in circulation.
Reserve Requirements: Adjusting this requirement indirectly controls the amount of money banks can lend, affecting the overall money supply.
Quantitative Easing (QE): Large-scale asset purchases directly inject money into the system, increasing the money supply.
Influencing Borrowing Costs:
Interest Rate Adjustments: Directly affect the cost of borrowing for businesses and individuals, impacting economic activity and demand for goods and services.
Communication and Forward Guidance: Public pronouncements about future interest rate changes influence expectations and borrowing decisions, indirectly impacting borrowing costs.
Inflation targeting: While not directly influencing borrowing costs, achieving the inflation target indirectly stabilizes borrowing costs over the long term, fostering economic stability.
In the event of a financial crisis especially recession, the Central Bank to boost spending, lowers the Interest Rates. But sometimes the gap to zero is so low that there is not enough room to project significant change in the interest rates. In such scenarios, the Central Bank takes the decision to impose Negative Interest Rates.
Imposing Negative Interest Rates:
Discourages saving: As cash loses value over time due to the negative fee, saving becomes less attractive. People are more likely to invest or spend, which injects money into the economy.
Stimulates borrowing: With cheaper loans, businesses and individuals have increased incentive to borrow, leading to more spending and investment.
Weakens currency: Negative rates can attract foreign investment by lowering the currency's value. This makes exports more competitive and potentially boosts economic growth.
Examples of NIRP
There are many examples of countries implementing Negative Interest Rate Policy (NIRP). I have cited a few below:
Early Implementations:
Switzerland (1972-1978): During a period of currency appreciation, the Swiss National Bank briefly experimented with negative rates to discourage capital inflows and stabilize the franc.
Denmark (1979-1982): Denmark implemented negative rates to prevent currency speculation during a period of high inflation
Although initially successful, it raised concerns about financial stability and was not repeated for several decades.
Modern Era:
Sweden (2009-2010): In response to the 2008 financial crisis, Sweden became the first major economy to adopt negative interest rates in 2009. Initially implemented as a temporary measure, it remained in place for several years to boost lending and inflation.
European Central Bank (2014-present): Facing persistently low inflation and weak economic growth, the ECB lowered its deposit rate below zero in 2014. This policy, although controversial, remains in place to stimulate borrowing and investment in the Eurozone.
Japan (2016-present): Following suit, the Bank of Japan implemented negative rates in 2016 to combat deflation and bolster growth. However, its effectiveness has been debated due to limited impact on lending and concerns about potential financial instability.
However, the biggest impediment for a Central Bank in implementing an NIRP is the USE OF CASH.
Cash: An impediment to NIRP. But is it really?
In a cashless world, there would be no lower bound on interest rates. A central bank could reduce the policy rate from, say, 2 percent to minus 4 percent to counter a severe recession. The interest rate cut would transmit to bank deposits, loans, and bonds. Without cash, depositors would have to pay the negative interest rate to keep their money with the bank, making consumption and investment more attractive. This would jolt lending, boost demand, and stimulate the economy.
When cash is available, however, cutting rates significantly into negative territory becomes impossible. Cash has the same purchasing power as bank deposits, but at zero nominal interest. Moreover, it can be obtained in unlimited quantities in exchange for bank money. Therefore, instead of paying negative interest, one can simply hold cash at zero interest. Cash is a free option on zero interest, and acts as an interest rate floor.
Cash is an important part of our Economy. Sharing a few statics below to steelman the point
Emerging & Developing countries have a HIGH Currency In Circulation to GDP ratio. Almost greater than 10%
Rank | Country | CIC/GDP Ratio |
1 | Japan | 21.00% |
2 | Hong Kong SAR | 18.20% |
3 | India | 14.40% |
4 | Argentina | 13.80% |
5 | Taiwan | 13.70% |
6 | Brazil | 13.00% |
7 | South Korea | 12.80% |
8 | Colombia | 12.70% |
9 | Indonesia | 12.00% |
10 | Turkey | 11.80% |
11 | Thailand | 11.70% |
12 | Mexico | 11.60% |
13 | Malaysia | 11.30% |
14 | Vietnam | 11.20% |
15 | Pakistan | 11.10% |
16 | Philippines | 10.90% |
17 | China | 10.80% |
18 | Peru | 10.70% |
19 | Nigeria | 10.60% |
20 | Egypt | 10.50% |
21 | Bangladesh | 10.40% |
22 | Iran | 10.30% |
23 | Venezuela | 10.20% |
24 | South Africa | 10.10% |
25 | Russia | 9.90% |
26 | Algeria | 9.80% |
27 | Saudi Arabia | 9.70% |
28 | Morocco | 9.60% |
29 | Ukraine | 9.50% |
30 | Poland | 9.40% |
Currently Cash is a MULTI-TRILLION Dollar economy
Rank | Country | Currency in Circulation (Trillion USD) |
1 | United States | 20 |
2 | Eurozone | 12.8 |
3 | Japan | 10.8 |
4 | China | 9.2 |
5 | Switzerland | 6.2 |
6 | United Kingdom | 5.2 |
7 | Canada | 2.2 |
8 | India | 1.5 |
9 | Brazil | 1.4 |
10 | South Korea | 1.3 |
11 | Mexico | 1.1 |
12 | Australia | 1 |
13 | Indonesia | 1 |
14 | Taiwan | 0.9 |
15 | Turkey | 0.8 |
16 | France | 0.8 |
17 | Germany | 0.7 |
18 | Thailand | 0.7 |
19 | Poland | 0.6 |
20 | Netherlands | 0.6 |
21 | Spain | 0.6 |
22 | Italy | 0.5 |
23 | Argentina | 0.5 |
24 | Hong Kong SAR | 0.4 |
25 | Malaysia | 0.4 |
26 | Colombia | 0.4 |
27 | Saudi Arabia | 0.3 |
28 | Philippines | 0.3 |
29 | Russia | 0.3 |
30 | Vietnam | 0.3 |
The data from above tables says that Cash is an essential part of the economy. Eliminating cash will not simply raise privacy concerns or cybersecurity risks, it will create Financial Exclusion of unbanked or underbanked populations, including low-income individuals, elderly people, and rural communities. They will not have a way to participate in the economy.
CBDC: A Solution in search of a Problem
A CBDC can counter this limitation posed by the use of Cash.
E-money would be issued only electronically and would pay the policy rate of interest, and cash would have an exchange rate—the conversion rate—against e-money. This conversion rate is key to the idea working properly. When setting a negative interest rate on e-money, the central bank would let the conversion rate of cash in terms of e-money depreciate at the same rate as the negative interest rate on e-money. The value of cash would thereby fall in terms of e-money.
To illustrate, suppose your bank announced a negative 3% interest rate on your bank deposit of 100 dollars today. Suppose also that the central bank announced that cash-dollars would now become a separate currency that would depreciate against e-dollars by 3% per year. The conversion rate of cash-dollars into e-dollars would hence change from 1 to 0.97 over the year. After a year, there would be 97 e-dollars left in your bank account. If you instead took out 100 cash-dollars today and kept it safe at home for a year, exchanging it into e-money after that year would also yield 97 e-dollars.
At the same time, shops would start advertising prices in e-money and cash separately, just as shops in some small open economies already advertise prices both in domestic and in bordering foreign currencies. Cash would thereby be losing value both in terms of goods and in terms of e-money, and there would be no benefit to holding cash relative to bank deposits.
This dual local currency system would allow the central bank to implement as negative an interest rate as necessary for countering a recession, without triggering any large-scale substitutions into cash.
Downsides
Imposing negative interest rates can also have multiple down-sides:
For a shocker, enforcing NIRP does not always have its intended outcome, which is a boost in lending and economic activity. Based on a research paper by Gauti Eggertsson: Negative Nominal Interest Rates and the Bank Lending Channel, we observe that banks do not fully pass on negative rates to retail depositors to avoid losing customers. When central banks set negative rates, banks face costs for holding reserves but often don't pass these costs to retail depositors to avoid losing customers. This squeezes banks' net interest margins, leading to a reduction in their profitability. Lower profits can make banks more risk-averse, leading them to lend less. This reduced lending can counteract the intended stimulative effect of negative rates, making them contractionary by decreasing loan availability and economic activity, instead of stimulating them as intended.
But let’s say that we move beyond this and the NIRP was successfully implemented, then we face the following bad outcomes:
For Individuals:
Erosion of savings: Imagine your hard-earned savings actually shrinking in value due to negative interest rates. This could discourage saving altogether, especially for retirees and those aiming for long-term financial security.
Debt trap for vulnerable groups: Borrowers with pre-existing debt could find themselves in a worse situation, as their interest payments remain the same while the value of their assets shrinks. This could lead to a debt spiral for vulnerable groups.
Reduced bank stability: Banks might struggle to maintain profitability under NIRP as their own income from interest-bearing activities declines. This could lead to instability in the financial system, posing risks to individual bank deposits and broader economic stability.
For Society:
Ineffective stimulus: The effectiveness of NIRP in stimulating economic growth is still debated. It might not translate into real-world spending and investment if there are deeper structural issues in the economy.
Asset bubble inflation: Low interest rates can inflate asset prices like stocks and real estate, creating bubbles that could burst with potentially disastrous consequences.
Social and political unrest: Discontentment with declining savings and economic uncertainty could lead to social and political unrest, especially if the benefits of NIRP are not widely felt.
Use Case 3: Enforcing Law Strictly
If physical cash were to be invented today, it would be made illegal. It is only viewed as normal today because it has been in use for thousands of years now. But as you know, the Govt. Agencies and central banks don’t really like it. Govt bodies have spent years crafting stricter ways to freeze bank accounts, and physical cash represents the largest workaround to this.
Hence, many authoritarian governments love the idea of CBDC. CBDCs can be surveilled and controlled by the issuer with much granularity. I have cited two examples below to explain this.
Example 1: China
1000 years ago when money meant coins, China invented Paper money. And now when money means paper money, China is reinventing it with e-Money/CBDC.
They're transforming the bedrock of money, turning their legal tender into digital code with their very own central bank digital currency, or CBDC. This isn't just about convenience; it's about control. China wants to see every transaction, understand every penny, and in doing so, monitor both its economy and its people. No anonymity here, folks. Think Big Brother, but with a yuan in its pocket.
But it's not just about internal surveillance. This digital yuan also aims to conquer the world of international trade, bypassing sanctions and SWIFT. One can use it offline, like cash for the digital age. With new Pilot programs popping up, slowly weaving the e-yuan into the very fabric of China's economy. China is playing the long game, aiming for total digital domination.
Remember all those cameras watching for jaywalkers and spitting sunflower seed offenders? Imagine the power they'll have with a digital leash on everyone's finances. Debit that jaywalking fine straight from your e-wallet, no questions asked. China can limit how much you can hold, shaping your spending habits.
China was aware that cryptocurrencies can threaten their grip on the economy. That's why they started researching their own digital solution back in 2014.
China is driving this narrative of CBDC through creative marketing. Think patriotic TV ads and heartwarming jokes about e-yuan grandma. They're weaving a narrative of national pride and convenience, making digital money seem as inevitable as sunrise.
So, buckle up, world. The digital yuan is coming, and China's not just playing – they're rewriting the rules of the game.
Example 2: Nigeria
In December 2022, Nigeria imposed limits on cash withdrawals. The reason was the Govt and Central Bank wanted consumers to use its own Central Bank Digital Currency (CBDC), the eNaira.
The limits were as follows: (All were in local currency Naira)
$225 for individuals per week
$1,123 for businesses per week
$45 from ATMs per day; $0.45 notes and smaller denominations available
To take out larger sums in some instances pay processing fees of between 5% and 10%
The move was justified as being in line with “the Cashless policy of the CBN.”
The adoption of eNaira showed a slow start.
The eNaira was launched in October last year, but less than 0.5% of Nigerians are thought to be using it. On the other hand roughly 35% of them use Cryptocurrencies
The CBN offered various incentives to kickstart the CBDC’s popularity, including a discount scheme for motorized rickshaw taxis for users. In August, the scheme was opened up to people without bank accounts.
However, the success of e-naira is yet to be clearly evaluated
Bonus: A prank on the President of European Central Bank
Two Ukranian Reporters conducted a Prank on the President of ECB, Lagarde by posting as the Ukraine President Zelensky. They recorded the interview interaction and posted it on the internet.
In the video the pranksters asked her about the plans for CBDC implementation and what her response will be to the idea that people dont like to be controlled. Her response:
“Now in Europe we have this threshold: above 1000 Euro you cannot pay cash. If you do you are in the gray market. The risk is yours. You get caught: you are fined or you go in jail. The digital Euro will have control, but it will have limited control. We can have 300-400 Euro for zero control. But that could be dangerous. For example, terrorist attack on France back 10 years ago was highly financed by anonymous credit card, that you can recharge in total anonymity.”
You can observe here that, despite France having one of the lowest limits for Cash payments, it is considered not low enough by the ECB president. In the past 50 years less than 0.001% of the population has been killed in terrorist attacks. And yet it is her reason to go for a Top-Down Centralized surveillance and control of transactions in the country.
All of this makes us wonder, What does the Future of CBDC look like?
CBDC: A possible Future
The future of CBDC is still being written, with many possibilities and uncertainties looming on the horizon. I believe varied approaches by different countries will put them forward into different paths of Progress and Challenges over the span of next decade or maybe even the century
Broadly we will witness the following paths:
Coexistence: CBDCs could coexist with existing private currencies like Cash, Digital Money and cryptocurrencies, with each playing a different role in the financial ecosystem.
Domination: CBDCs could become the primary form of money in some countries, potentially displacing physical cash and private currencies.
Limited adoption: Some countries may opt not to issue CBDCs at all, or only adopt them for specific purposes.
It's important to note that the future of CBDCs will depend on a variety of factors, including political decisions, technological advancements, and societal acceptance. Regardless of how they ultimately evolve, CBDCs are likely to have a significant impact on the future of money and finance.
THE END
Notes & Source of Information:
Augustin Carstens - Cross Border Payments - A vision for the Future: https://www.youtube.com/watch?v=mVmKN4DSu3g
Bank for International Settlements - Project mBridge, connecting economies through CBDC: https://www.bis.org/publ/othp59.htm
Full Report: https://www.bis.org/publ/othp59.pdf
Gauti Eggertsson: Negative Nominal Interest Rates and the Bank Lending Channel https://www.nber.org/system/files/working_papers/w25416/w25416.pdf
Book Review: https://www.imf.org/external/pubs/ft/fandd/2016/09/book1.htm
China Creates Its Own Digital Currency, a First for Major Economy https://www.wsj.com/articles/china-creates-its-own-digital-currency-a-first-for-major-economy-11617634118
Alys Keys, Nigeria Limits cash withdrawals to $45 per day in CBDC, Digital Banking Push, Yahoo Finance https://finance.yahoo.com/news/nigeria-limits-cash-withdrawals-45-100611213.html
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