Central bank digital currencies are all the rage, but making them work is far easier said than done, according to a new report. While there are many potential benefits from a central bank digital currency (CBDC), they also bring serious financial risks, according to IBM Blockchain and the Official Monetary and Financial Institutions Forum (OMFIF).
These aren’t the only problems CBDCs have to overcome, according to “Retail CBDCs: The Next Payments Frontier,” released on October 29. Aside from scalability, they must be usable offline, secure against counterfeiting, and have some trade-off between anonymity and trackability.
Based on interviews with nearly two dozen central banks from advanced and emerging economies, the report focuses on consumer CBDCs. It predicts that one will go live within the next five years.
The report’s authors believe a small economy will launch one first, even though China has spent the last few months aggressively hinting that a renminbi-based CBDC is coming soon.
“Central banks are responding to the reality that digital currencies, either privately- or publicly- issued, will be an unavoidable part of the global monetary system,” the report finds. “It is in central banks’ best interest that they are neither left behind nor displaced.”
Just like cash
The report’s authors found that the financial risks that a CBDC bring are largely based on the need for it to work just like physical cash without completely replacing it.
That means the CBDC should be usable offline. That’s particularly important if power goes out. And, it must be usable for anything—be “legal tender for all debts public and private,” like the U.S. dollar says.
Nor will it be interest-bearing. While technologically feasible, a CBDC that offers interest would cause many problems. These range from how the interest is paid to the reality that it would mean the CBDC tokens could not be anonymous. After all, the tax man would want his cut.
The report’s authors add that a non-interest-bearing CBDC brings other, broader problems, particularly during severe economic downturns and crises.
The biggest, according to 82% of the banker interviewed, is that a digital currency could make bank runs faster, more severe, and harder to stop. The panicky and contagious withdrawing of funds by huge numbers of customers can—and has—made banks fail. But, traditional currency gives banks tools to fight runs, notably limiting or even stopping cash withdrawals.
“During crisis periods, a CBDC provides a risk-free alternative into which money can move,” the report said. “A CBDC would be perceived as a safer store of value compared to deposits offered by even relatively robust banks.”
That means a larger and faster bank run could more easily turn a single bank’s problems into a systemic crisis, the authors fear.
Then there’s the problem of negative interest rates. While this is a very new and hitherto theoretical tool in central bankers’ toolbox, it is one they don’t want to lose.
The way this works is that central banks hold short-term deposits for commercial banks, paying them interest. The lower the interest, the more likely banks are to loan out their money rather than hoard it. In financial downturns, central banks use this tool to push more money into the economy. That causes more buying, selling, and job creation.
At zero percent, banks are making nothing on the money stored in central banks. But with nominal negative rates—something part of industrialized economies only since the past few years—banks would actually be paying the central bank to store their money. This would push them much harder to use their money instead of losing it.
The problem is that a non-interest bearing CBDC is a completely safe currency that costs nothing to store, unlike physical money. If banks kept their money rather than parking it at a central bank, the lowest possible interest rate would effectively be zero.
The same dynamic would apply—again theoretically—to another major tool central banks have to fight economic downturns. This is quantitative easing (QE), which is essentially injecting money into the economy by buying government and corporate bonds.
When it comes to blockchain and distributed ledger technologies as the building blocks of a CBDC, the report frankly punts, discussing the technology and possible concerns without actually suggesting anything.
It points to the scalability problems of Bitcoin (BTC) and other decentralized cryptocurrencies, as well as the need to ensure the digital currency can’t be forged. The double spending potential of 51% attacks is mentioned, as it would be a much larger risk for a national currency.
But, the report’s authors note that a CBDC would not necessarily be on a blockchain. “[C]entral banks by and large are technology agnostic,” they said.
The need for currency anonymity is largely recognized by the central bankers. But, full anonymity would stymie the “anti-money laundering” (AML), “countering the financing of terrorism” (CFT), and tax evasion laws. Practically, that means a government-issued digital currency would likely “require a trade-off” between anonymity and trackability, the report concludes.
While the authors doubt that trackability would keep people from using a digital currency, “that this technology may enable governments to monitor citizens’ transactions is disquieting,” they said. And, they note, both law enforcement agencies and private companies (like Chainalysis and CipherTrace) are becoming more adept at tracking supposedly anonymous Bitcoin.
This thing of ours
The central bankers interviewed do not see much likelihood that a privately issued cryptocurrency like Facebook’s increasingly troubled Libra stablecoin will succeed.
“The determination of national governments to protect the monopoly enjoyed by fiat currency, and the commitment of regulators to financial stability, will in our view raise insuperable hurdles,” the report said.
And the authors don’t see any threat to CBDCs from “[p]ure, unbacked cryptocurrencies such as [B]itcoin.”
These, they predicted, “will remain the minority pursuit of speculators and denizens of the dark web.”
Updated link to IBM Blockchain/OMFIF report at 3:19 pm on November 12, 2019.