CBDC – The Emperor’s New Clothes?

The Voice of Experience

There has been a lot of buzz around central bank digital currencies in recent years, and central banks continue to explore the potential of these coins, but are they paying lip service to the concept, or is there a real desire to effect change? Our latest Voice of Experience, from a new contributor with over 35 years experience in the FX industry, suggests that all is not what it seems…

Evangelists argue that cryptocurrencies will change the face of the world’s financial system, despite the considerable volatility and high-profile snafus they have experienced. Major financial institutions and central banks seem to be drawn into the idea that digitization is the way forward, and are embracing the concept to varying degrees. These institutions are also exploring a sub-theme of the crypto/digital revolution, stablecoins, which could potentially be even more disruptive because they are asset-backed.

At the very least, the growth in stablecoins has prompted the Bank for International Settlements (BIS), and several national central banks, to investigate — and in some cases launch — central bank digital currencies (CBDCs). However, how far can this work go, and more pertinently, how serious are the major economies’ central banks about actually creating and launching digital currencies?

COVID certainly has a lot to answer for and that seems to be one of the main reasons why the BIS started looking at CBDCs. It is very difficult to argue with central banks – even more so with the central banks of central banks, the BIS. We do know that the BIS and national central banks have the best of intentions, are largely independent and work really hard to keep financial markets efficient through the work of various committees, including public/private bodies such as the Global Foreign Exchange Committee.

But… is the BIS (and central banks more generally) investigating a solution to a problem of their own creation?

First, what is a CBDC? It is a Central Bank digital currency, which is essentially a cryptocurrency pegged to a fiat currency – that is, with a fixed value. The idea is to provide total visibility, using blockchain technology, so that payments can be made in a safe and secure manner. Both retail and wholesale CDBCs are being considered in various jurisdictions.

In many ways, CBDCs mirror stablecoins, of which several already exist, the first of which was launched in the US in 2014. A stablecoin is essentially a “stable” cryptocurrency as it has a value tied to a definite asset, basket of currencies or similar (whereas there is no such security with cryptocurrencies). So, a stablecoin can be pegged to a fiat currency, or perhaps a basket of currencies, but can be issued by any private or public institution. A key difference between a CBDC and a stablecoin is that the latter lacks the security that a CBDC would provide.

Are the BIS and some national central banks worried about stablecoins stealing a march on their own plans? More to the point, are a number of central banks content to have stablecoins developed, possibly to be rolled out instead of CBDCs (all while of course making the right noises about ‘investigating’ CBDCs)?

Several central banks are “looking” to regulate stablecoins, but currently do not, except in the US where they are now covered under the Stablecoin Transparency of Reserves and Uniform Safe Transactions Act of 2022. That said, a lack of regulation has not not stopped the CFTC fined Tether and Bitfitnex more than $42 million in 2021, related to allegations that their stablecoins were not fully backed as claimed.

So far, much of the BIS’s and individual central banks’ work has involved investigating CDBCs. There are a number of studies and workshops looking at the payment chain and the different solutions provided around the world, such as the CPMI (Committee for Payments and Markets Infrastructure) investigation into PvP (payment versus payment) and the cross-border payment program initiative . Admittedly, this is an area where more coherence is required, and the authorities are keen to see more efficiency in this area – one example being the FX Global Code revisions in 2021 where settlement risk mitigation has been made a priority.

Despite the progress being made in some quarters, there are some fundamental questions about CDBCs and their development that currently do not have clear answers

To an outsider, there appears to be a focus on many different solutions, with no definitive stand-out product. Is this the BIS hedging its bets – if they look at and recommend many different solutions, then they must be right when something emerges as the “winner”?

Despite the progress being made in some quarters, there are some fundamental questions about CDBCs and their development that do not currently have clear answers. First, it is not necessarily clear who will have the responsibility for the maintenance and payment delivery for the CBDC. The central bank will maintain the accounts and handle payments – but is this the job of the central bank? Aren’t they supervising the market/commercial banks rather than controlling them as such?

It could be argued that this would impact on the integrity of the central banks or even skew their focus in relation to markets (and their domestic economies on the adoption of a retail CDBC). A central bank running a CBDC can use the information to influence their policies and provide the government with what is essentially privileged information. This could easily impact credibility – a core requirement of any central bank.

The maintenance of the launched CDBCs is outsourced to financial institutions and payment service providers – controversially in Nigeria to a company domiciled outside the country. This outsourcing can be seen as providing a commercial service rather than a gold star central banking service. Nor is it clear that it works, because concerns about the privacy of information can use and inhibit trust.

All the central banks are watching what is happening in this space, but few are talking hard action – who will be the little kid who actually votes for the emperor to be naked?

We also need to consider whether CDBCs are really considered a natural progression from crypto to stablecoin to CDBC, each one being more secure than the last. Could it be that central banks are actually more concerned about losing some of their authority over part of the monetary system?

As of March 2024, three countries had a functioning CBDC: the Bahamas, Jamaica and Nigeria. The Eastern Caribbean Currency Union discontinued its CBDC for technical reasons and started a new pilot program. Interestingly, it is small economies where the retail impact can be particularly useful in eliminating domestic financial fraud.

Apart from that, 134 countries, representing 98% of the world’s GDP, are currently “investigating CBDCs” and many have already said they will look further into it in the coming years. Some are in trial and it is likely that more will be issued this year, but few, if any, major economies are anywhere close to issuing a working or trial CBDC. It appears that these economies have largely paid lip service to the BIS – no one ignores the BIS – by essentially doing everything required of them by participating in the working groups and conducting their own studies.

It is sometimes difficult to understand exactly what central banks are thinking. Reading through some of the reports and press releases, they are careful not to discount a CBDC, but they aren’t committing to one either. Phrases like “we are looking closely at the idea of ​​a CBDC” (UK) and “have not made any decisions about whether to pursue or implement a CBDC” (US) are quite typical.

In addition, the Banque de France and others began a series of experiments with the European Central Bank in 2020 and appear to be actively looking at delivering a CBDC. However, in a speech on April 25, the Banque de France’s first deputy governor, Denis Beau, laid out a good case for CBDC, but also pointed out that “these trends could challenge the role of central bank money in maintaining the stability of our payment system and financial market system”, which is not an insignificant concern. Beau emphasized “that the decision to issue a digital euro has not yet been made” and his conclusion focused on the determination of central banks to support innovation.

And this is probably the crux of the matter; support only goes to a certain point and most central banks seem reluctant to fully commit. This might lead an outsider to believe that it looks like a case of the Emperor’s New Clothes. All the central banks are watching what is happening in this space, but few are talking hard action – who will be the little kid who actually votes for the emperor to be naked?