CBDC: Innovator's Dilemma for Central Banks?

Dec 2023

The announcement by Facebook (now Meta) of the ‘Libra’ project in June 2019, to issue a digital currency governed by a consortium of global companies, may have struck fear and loathing in the hearts of central bankers everywhere. Since then, over 100 central banks are today racing to work out if, when and how they should counter the crypto barbarians at the gates with their own ‘Central Bank Digital Currency’ or CBDC.

Too keep it simple, a Central Bank serves two primary market segments to facilitate payments: the public uses cash and regulated financial institutions use central bank money delivered via ‘Exchange Settlement Accounts’ on the central bank's ledger.

The ability of cryptographically powered digital tokens to represent value in the form of ‘bearer’ instruments has sparked keen interest. A tokenised form of central bank money, potentially with cash-like qualities but with digital super-powers, is now the focus of significant research.

Most central bankers would prefer that markets are run with private but regulated money, reserving the use of public money only to mitigate systemic risks or to fill gaps in market needs. As one European central banker has put it, CBDCs should be successful, but not too successful!

So, what is a central banker to do?

‘Sustaining’ innovation (to use Prof. Clayton’s terminology) for a central bank would be to offer a faster horse – a superior Exchange Settlement Account. A ‘wholesale’ CBDC issued only to regulated financial institutions could target large but inefficient domestic markets via tokenisation, and make private money tokens (like stablecoins) interoperable.

This approach substantially maintains the existing ecosystem and regulatory hierarchy, mitigating systemic risks with a managed upside.

‘Disruptive’ innovation by a central bank would be to offer tokenised central bank money as a ‘general purpose’ CBDC for domestic use. This could be used by the public as a complementary product to cash, for more efficient delivery of government benefits or for 'financial inclusion' of segments underserved by banks. Offering CBDC as a ‘cheap’ product - primarily by removing or substantially reducing regulatory burdens and enabling wider ‘retail’ access - could spur innovative business models. E.g. new tokenised asset markets could be established quickly and cheaply for peer-to-peer trading. The use of CBDC for settlement, especially in non-custodial models (where customers are always in control of their CBDC) could substantially de-risk these markets. Reducing transaction and liquidity costs could enable broader access to asset classes like fractionalised property and private equity. Broad access risks some misuse, to be addressed via smarts built into the CBDC, plus light regulation.

Extending CBDC use to regulated foreign entities, for designated cross-border trade and remittance services, offers further potential, though the need for collaboration on global regulatory settings makes this a longer-term opportunity.

With either approach - sustaining or disruptive innovation - a commercial tokenised ecosystem would be a prerequisite for a CBDC (or a private token) to be a new driver of economic growth and productivity. This might include platforms for the tokenisation of assets with integrity, mechanisms for the provision of liquidity, use of digital credentials with privacy, enhanced or new payment rails to suit (DLT or traditional), interoperability of tokens and intuitive user interfaces – all wrapped up in a cohesive regulatory architecture. Building entirely new ecosystems is hard!

This is where the lessons from start-up innovation might offer ideas:

1. Launch a product that a few people love, rather than one that many people like.

2. The first version of product will always be imperfect - iterate quickly to improve market fit.

3. The timing of market entry is the leading factor for success; the team, idea, business model and funding are secondary.

Different countries are tailoring their CBDC efforts and focus to suit their own strategic goals. Whether such payments innovation is better achieved via regulated private money or central bank money remains a policy question for governments.

The ECB might be first to market with a Digital Euro for both retail and wholesale use, followed closely by the Bank of England. China’s CBDC seeks to wrest back control of payment systems from their own Big Tech cohort but may ultimately target greater use of their currency in cross-border trade. India is trialling CBDC to reduce the use of cash and achieve financial inclusion of the last 20% of their population that remains unbanked. In countries like Cambodia, CBDC brings with it new payments infrastructure to enable efficient payments and commerce.

In Australia the RBA has concluded a successful industry engagement to pilot a 'live' CBDC, with 16 use cases demonstrated. The RBA has signalled there might be a role for a ‘wholesale’ CBDC in operating more efficient and lower risk markets as more assets, financial and real, are tokenised. More work is planned to test the case for an Australian CBDC.

In most countries, the introduction of a CBDC would require broad public and political support, leading to the legislative empowerment of the central bank to issue a new form of public money. A regulatory framework to enable the innovative use of CBDC as well as private money tokens, and the tokenisation and trading of assets would be essential. Finally, the opportunities for commercial returns will be the ultimate drivers for private sector participation and investment. A true public-private partnership between industry, government, the central bank and regulators will be critical to success.

[Image courtesy: National Museum of Australia]