A Digital Future

By James Wall

As a consultancy focused on DIgital Assets and Transformation in financial services, we are closely monitoring the latest developments in central bank digital currencies (CBDCs). Currently, CBDCs are being tested and explored by central banks worldwide, with recent pilots launched in India, Brazil, Hong Kong, and Australia. This increased activity has led to inquiries from clients about the potential impact of CBDCs on the financial system and their businesses. To help address these questions, we analyze the nature of CBDCs, their potential form, and their likely position in the broader spectrum of money supply.

Central bank digital currencies (CBDCs) are a new form of fiat currency that central banks can issue in digital or electronic form. CBDCs are intended to offer the same legal tender status and user protections as physical cash, while also providing the added benefits of digital payments, such as speed, convenience, and security. The Atlantic Council has reported that 120 central banks worldwide are examining CBDCs, with a range of activities spanning from launch and pilot to development, research, inactive, and canceled. Geoeconomics Center CBDC Tracker

Alternative Models for CBDC

As a starting point it is important to understand the various models for Central Bank Digital Currencies (CBDCs) that are currently under consideration by central banks. These models include the Direct CBDC, the Indirect CBDC, and the Two Tier CBDC.

The Direct CBDC (Retail or Account Based) model involves the central bank issuing CBDCs directly to individuals and businesses, allowing them to hold CBDCs in digital wallets and use them for payments without the need for a third party intermediary.

In the Indirect CBDC (Wholesale or Token Based), the central bank issues CBDCs exclusively to banks and payments companies for use in wholesale settlements and payments systems. This model does not extend CBDC access to non-wholesale market participants.

The Two Tier CBDC (Hybrid) is a combination of the direct and indirect models, with the central bank issuing CBDCs directly to financial institutions, such as banks that hold clearing accounts to the Central Bank. The Financial Institutions would then offer these tokens to Individuals and businesses who could hold the CBDCs in either digital wallets or bank accounts.

In addition to the direct issuance of CBDCs by central banks, there is also Synthetic CBDC in development, with Fnality serving as an example. Synthetic CBDCs are digital representations of funds held at a Central Bank, issued by a third party using the Central Bank deposit as the collateral for the settlement token.

The selection of a model for a Central Bank Digital Currency (CBDC) is contingent upon the objectives that Central Banks prioritize, including but not limited to increased efficiency, strengthened oversight (AML/KYC), greater liquidity, or financial inclusion. Additionally, it is imperative for Central Banks to determine the role that a CBDC will play in the money supply of the economy, whether it will replace cash or work in conjunction with cash to offer more effective digital services, will it be a store of value. Based on current Central Bank discussions, the option of working alongside cash appears to be the favored approach.

Money Supply and CBDC

Central Banks play a critical role in moderating inflation and stimulating economic growth through their influence on the supply of money. The introduction of CBDC has the potential to impact this economic lever significantly. As such, it is essential that Central Banks conduct a thorough evaluation of the potential impact of CBDC and determine how it will fit within the traditional money supply categories, ranging from M0 to M4.

M0 refers to the Monetary Base of the economy, which includes cash, coins, and equivalents held by the public and banks in the form of savings and deposits. M1, on the other hand, is Narrow Money, which includes M0 and other highly liquid deposits in the bank. This is significant as commercial banks are mandated to hold a fixed percentage of deposits as reserves in case of emergencies, and this makes up a significant proportion of the money supply. By lending excess reserves to consumers, banks increase money circulation.

M2 is the most common definition of money supply and consists of M1 plus marketable securities and less liquid deposits held by banks. This includes cash, deposits, and available-for-sale assets such as CDs. M3, or Broad Money, is M2 plus short-dated term deposits up to 3 months and marketable securities and money market funds up to 2 years maturity. Finally, M4 includes M3 plus other illiquid assets held within and outside banks, such as Mutual/Pension Funds.

It is important to understand these categories and their implications on the economy.  Each Central Bank utilises a unique combination of these measures to monitor and influence the supply of money, with the ultimate goal of sustaining economic stability and fostering growth.

Summary of key benefits and risks

The potential benefits and risks associated with CBDCs need to be well understood as the level of interest in CBDC is increasing due to the potential to improve efficiency, financial inclusion, and monetary policy. However, it is important to consider the potential risks associated with CBDCs, including security, cybersecurity, financial stability, and privacy.

Benefits of CBDCs

Efficiency: CBDCs have the potential to revolutionize the payment system by making transactions faster, cheaper, and more efficient. The elimination of physical cash and checks allows for instant payments, particularly beneficial for cross-border transactions.

Financial inclusion: CBDCs have the potential to increase financial inclusion by providing access to digital financial services, particularly in developing countries where traditional banking services are not easily accessible. CBDCs can provide a safe and secure way for people to store and transfer money, ultimately reducing poverty and promoting economic growth.

Monetary policy: CBDCs give central banks greater control over monetary policy by allowing direct control over the supply of money in the economy. This can be particularly useful during a recession when central banks can inject money into the economy to stimulate growth.

Risks of CBDCs

Security: CBDCs can be more secure than traditional forms of money due to encryption and digital wallets. However, there is a risk of theft or counterfeiting if the system is not robust enough.

Cybersecurity: CBDCs are vulnerable to cyberattacks, which can lead to financial instability and loss of money. It is essential to implement robust security measures and encryption to prevent such attacks.

Financial stability: CBDCs have the potential to decrease the use of traditional banking services, which can lead to a decrease in the amount of money banks have to lend out, ultimately impacting economic growth.

Privacy: CBDCs can pose a risk to privacy as they can be tracked by governments and other entities. It is important to take steps to protect the privacy of CBDCs, such as using anonymous wallets and strong encryption.

In markets where financial inclusion is a top priority, central banks may lean towards the direct CBDC model. However, in markets where there is already a significant level of financial inclusion and funds mobility, central banks may prefer the indirect model due to the circuit breaker mechanism on funds flowing back to the central bank that the model offers.

Market based examples

According to the Atlantic Council CBDC Tracker, there are currently 11 countries that have successfully launched a digital currency. China's pilot program has already reached 260 million individuals and is anticipated to expand to cover the majority of the country by 2023. Additionally, Jamaica recently launched its own CBDC, known as the JAM-DEX.

As Central Banks continue to experiment with CBDCs, it is important to note that a preferred model has not yet emerged. Currently, all three variations - Direct, Indirect, and Hybrid - are actively being used by Central Banks. 

Implications

Looking at CBDC within the context of Financial Services, it is evident that the potential benefits are substantial, and as adoption grows, our clients' operating models are likely to be impacted. The tokenization of currency represents an incremental step in the digital transformation of the economy. CBDCs will play a transformational role in facilitating the cash leg of payments and settlements. Once digital assets and liabilities achieve scale of adoption, the ability to originate, trade, transfer, and settle in real-time will result in a significant compression of the current market operating model. This will require most companies to fully digitize their workflows, settlement, and liquidity management processes.