By Manuel Klein, Jonas Gross, Philipp Sandner
Central bank digital currencies (CBDCs) are coming. A recent study by the Bank for International Settlements (BIS) shows that 10% of worldwide central banks intend to issue a retail CBDC in the short term and 20% in the medium term. However, introducing a CBDC imposes potential threats to data privacy and financial stability.
Opponents argue that providing generally accessible central bank money can lead to financial instabilities and disintermediation of commercial banks. Moreover, many fear that such a digital CBDC would lead to new surveillance possibilities by the central bank and could undermine data privacy. In this article, we discuss possible ways to address these threats, which have been proposed by the European Central Bank (ECB) in two recent publications. We further discuss the use of distributed ledger technology (DLT) for the issuance of a CBDC.
CBDC – a hot topic
Central bank digital currencies (CBDC) are currently a hot topic. A report recently issued by the Bank for International Settlements (BIS) shows that central banks of around one-fifth of the global population are likely to issue a CBDC in the next three years. CBDCs represent a digital form of central bank money and can feature various design principles e.g., related to the payment of interests, the access to CBDC, the operational setup and the choice of the technology. The advent of crypto assets coming along with tremendous advantages, such as programmable transactions, cost efficiency, high transaction speed and further efficiency gains, have led many central banks to analyze how fiat currencies could entail these advantages in order to facilitate the adoption by regular businesses and citizens.
In the general debate, two major designs of CBDC are discussed: a) a wholesale CBDC in which central bank reserves — that can only be accessed and used by a small number of certain financial institutions — become programmable and are put on a blockchain and b) a retail CBDC in which “non-banks” get direct access to digital central bank money. Proponents of wholesale CBDC argue that the current two-tiered money system, in which central bank reserves constitute liquidity for the commercial banking sector and bank deposits are used as liquidity for the “non-banking” sector, can be enhanced by a more efficient interbank payment system. Apart from facilitating payment efficiency and financial inclusion, proponents of retail CBDC mainly argue that the strong decline in the use of cash — the only form of money issued by central banks that can be held by non-banks — is a major reason in many countries to introduce a retail CBDC (see Figure 1). Such a CBDC ensures that citizens can still hold risk-free money issued by the central bank and that governments maintain their role as the provider of legal tender.
Figure 1: Motivations for issuing a retail CBDC
Even though some central banks, such as China and Sweden, have already officially confirmed that they are working on a retail CBDC, there is still a lot of critique from economists and central bankers against such universal accessible digital central bank money. They argue that the introduction of a CBDC could lead to financial instabilities and disintermediation of commercial banks. Among others, Jens Weidmann, president of the German Bundesbank, recently argued in an interview in the Handelsblatt that introducing a CBDC could lead to bank runs, in which sizeable liquidity from the aggregate banking sector is moved to the central bank. This could result in a lack of financing for the commercial banking sector. In phases in which bank customers fear that commercial banks cannot fulfil their promise to pay out the full amount of money they owe their customers, retail CBDCs are feared to be accelerants. Frightened depositors could trigger a liquidity crisis in the banking system by removing their money to a safe account at the central bank.
Another critique that is put forth frequently is that a retail CBDC could lead to an Orwellian dystopia in which central banks (and the government) can track any transaction and citizens become completely transparent. Many fear that by introducing a retail CBDC, the way is paved to abolish physical cash and, with it, the possibility to pay anonymously.
The European Central Bank (ECB) is very actively researching CBDC and Christine Lagarde announced in her first press conference as ECB President in November 2019 that the ECB will intensify efforts and will set up an own CBDC task force in order to be “ahead of the curve” on digital currencies. These ambitious words followed deeds: In two recent publications, the ECB proposes concepts to address the main threats of retail CBDCs, namely a) how to maintain anonymous payments in a world with CBDC and b) how to maintain financial stability in a world with CBDC. In December 2019, the ECB published a paper about a prototype of a (partially) anonymous retail CBDC based on a distributed ledger technology (DLT) and announced plans to test this prototype. In January 2020, another paper was released, proposing a concrete retail CBDC system that does not disintermediate banks and prevents the threat of bank runs. The ECB therefore directly addresses two major critique points of CBDCs and provides valuable research regarding the debate about CBDCs.
ECB addresses anonymity concerns
The authors present a concrete retail and cash-like CBDC prototype that (partially) guarantees anonymous payments while accounting for anti money laundering (AML) regulations implemented on a DLT system. It discusses a potential solution for AML compliance where a user’s identity and transaction history is not revealed to the central bank and an AML authority. With this paper, the ECB addresses an important trade-off between anonymous payments and the use of money for illicit activities. Of course, it is desirable for society to detect illicit activities, such as terror financing and money laundering. But it is also desirable from a citizen’s perspective to be able to — at least to a certain extent — conduct anonymous payments, which is currently possible for all cash transactions.
This (part-)anonymity is technically implemented by not revealing the identity of the user to the central bank and the AML authority with so-called anonymity vouchers. These vouchers enable anonymous money transfers for a limited amount of CBDC over a defined period. Every citizen is endowed with a certain amount of anonymity vouchers with which anonymous transactions can be made. As soon as all the vouchers have been redeemed, the transactions are no longer processed anonymously. However, note that the transaction data is accessible for banks and therefore not anonymous for them. This is a clear disadvantage of the prototype and should be addressed in future ECB prototypes. Further, all transactions are still processed via commercial banks — transactions, therefore, do not take place on a peer-to-peer basis but still rely on commercial banks as intermediaries. Nevertheless, this research is a very good starting point to further analyze anonymity in retail CBDCs in connection with DLT.
ECB addresses financial stability concerns
The second recently published paper also focuses on a retail CBDC system. It addresses the problem that commercial banks could become disintermediated and bank runs could emerge. The underlying threat is that a retail CBDC would constitute risk-free digital Money, whereas bank deposits bear credit risk, liquidity risk, and market risk. Moreover, bank deposits are only secured up to 100,000 Euro through deposit insurance schemes. Citizens could, therefore, decide to opt-out on bank deposits and transfer their liquidity into a risk-free account at the central bank to hold their money in CBDC.
The author of the paper, Ulrich Bindseil, Director General of Market Infrastructure at the ECB, addresses these pinpoints with a tiered CBDC system with two different interest rates on the CBDC held by the non-banking sector. If a certain threshold of CBDC held at the central bank account is exceeded, the excess amount of CBDC is remunerated with zero or even negative interest rates. This idea is not new: Currently, commercial banks are exempt to pay interest on the six-fold amount of reserves they have to hold with the central bank in order to fulfil the minimum requirements of liquidity (in the Euro area 1% of the bank deposits commercial banks hold on the liability side of their balance sheet). The excess reserves they hold at the central bank are remunerated negatively at currently -0.5 %.
In “normal times” with interest rates > 0%, the amount of CBDC below the threshold would be remunerated. The interest paid on this “Tier 1 CBDC” should follow the movements of all other market interest rates but should be set e.g. 1% below the interest rate paid on reserve deposits of commercial banks held at the central bank to make CBDC less attractive than bank deposits. When the deposit facility rate falls below 1%, the interest rate paid on CBDC consequently would fall below 0. However, the interest paid on Tier 1 CBDC would stay at 0 and never fall below zero in order to guarantee clients a non-negative interest rate (see Figure 2).
Figure 2: Interest rate design of the proposed CBDC system
The “excess” CBDC held at the central bank account (Tier 2 CBDC) would never be remunerated positively. In “normal times”, 0% interest should be paid to avoid “investing” in CBDC. When the deposit facility rate of the ECB drops below 1%, the Tier 2 interest rate would become negative. In times of crises, the spread between the deposit facility rate and the Tier 2 rate could even be raised to avoid bank runs. Such a Tier 2 system would imply that clients would not use CBDC as a store of value and would not shift their major savings from commercial banks to the central bank since Tier 2 CBDC would never be remunerated positively and always yield less than commercial banks receive on their holdings at the central bank.
By making CBDC less attractive to hold through lower or even zero remuneration, the paper contributes to the research on the problem of potential disintermediation of banks and to the acceleration of liquidity crises ín a world with a retail CBDC.
Should a CBDC be blockchain-based?
We showed that the ECB is actively engaged in analyzing the benefits and risks of a CBDC and described possible design principles and features of a retail CBDC. Since central banks aim for stabilizing the current money and financial system, the question of which technology should be used for the introduction of a CBDC is not necessarily the main focus of their research. Issuing a CBDC does not necessarily imply using DLT, such as blockchain technology, even if this technological choice is often assumed in the public debate. Hence, it is imaginable for a CBDC to be issued either via a centralized database system (probably the case in Sweden) or via a distributed ledger technology (as in China). The retail CBDC prototype of the ECB guaranteeing partly anonymous payments will be set up on the Corda DLT. Using DLT to issue a CBDC can be beneficial in various dimensions:
- Data privacy: By design, using blockchain technology can be beneficial in reaching a high degree of data privacy. The underlying cryptography can easily be implemented in a way to feature anonymity. The CBDC could become similar to cash, which is an anonymous means of payment.
- Security: Due to the underlying cryptography, DLT systems are typically very secure and hard to hack. This mechanism makes transactions very secure and operationally resilient.
- Speed: Today, in the classical payment systems, transactions, especially in form of cross-border payments, are typically not efficient. According to data from the World Bank, transaction fees on average amount to 7% of the transaction value and take several days to process. These limitations can be addressed by using a CBDC operating on a DLT system featuring cryptography and energy-efficient consensus mechanisms, such as proof of stake or proof of authority.
- Smart contracts: A blockchain-based CBDC would make the Euro programmable. Euro-denominated smart contracts would make it possible that IoT devices, such as machines, cars and sensors, can offer services directly on a pay-per-use basis including leasing and factoring. The implications of such a digital fiat currency are especially promising in the context of the machine economy. It is estimated that more than 20 billion devices will be connected to the Internet in 2025 — three times as many devices as there are people currently living on earth. Some of these devices will also be integrated into payment networks. These networks will soon cover hundreds of millions of devices, such as cars, sensors and machines. Blockchain technology is best suited for equipping millions of devices with a computer chip and, with it, with their own wallet. Consequently, a device will be able to receive payments and transfer money — and produce SAP-based accounting records and invoices in Euro denomination. For these millions of devices, blockchain technology can easily provide the opportunity to participate in a payment network and integrate these devices into automated business processes (e.g. through smart contracts).
Of course, using DLT for a CBDC also has various drawbacks. Currently, the technology is not 100% mature and has a track record of just over one decade. Further, energy-consuming consensus mechanisms such as proof of work can even decrease transaction efficiency and increase transaction speed. However, both risk factors can be managed if an energy-efficient consensus mechanism is used and if the DLT system is thoroughly tested before its implementation. Of course, determining whether using DLT is beneficial depends on the specific design principles, goals of the CBDC and technological factors. We strongly welcome that the ECB and other central banks all over the world study the technological advantages of DLT and design CBDC prototypes on DLT systems.
Conclusion
The latest survey by the BIS shows that we can expect the first central banks to issue a retail CBDC in the next few years. However, introducing such a retail CBDC poses risks for data privacy of clients and for financial stability. However, if designed properly, these risk factors can be mitigated as proposed in the two ECB publications: Anonymity in digital payments can be reached by using DLT in combination with anonymity vouchers while the proposed Tier 2 CBDC system is well-suited to maintain financial stability. We highly welcome that the ECB is heavily researching CBDC and addresses these important aspects also by experimenting with DLT. Using DLT for the implementation of CBDC can have tremendous benefits for transaction privacy, speed, security and automation.
Remarks
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Manuel Klein is a consultant at a leading provider of financial data and analytic applications for investment management and investment banking professionals. Services are used by the top 10 global investment banks and 95 of the top 100 asset managers. Moreover, since 2015, he has been actively engaged at the NGO Monetative for which he has been giving speeches at several banks, conferences and universities both nationally and internationally. The NGO provides education about the structure and problems of the current monetary system and advocates a “100% CBDC”, “sovereign money” or “Vollgeld” system. You can contact him via mail (manuel.klein@monetative.de) or via LinkedIn (https://www.linkedin.com/in/manuel-klein/).
Jonas Gross is a project manager and research assistant at the Frankfurt School Blockchain Center (FSBC). His fields of interest are primarily cryptocurrencies. Besides, in the context of his Ph.D., he analyzes the impact of blockchain technology on the monetary policy of worldwide central banks. He mainly studies innovations as central bank digital currencies (CBDC) and other cryptocurrency projects as “Libra”. You can contact him via mail (jonas.gross@fs-blockchain.de), LinkedIn (https://www.linkedin.com/in/jonasgross94/), Xing (https://www.xing.com/profile/Jonas_Gross4) or follow him on (Twitter Jonas__Gross).
Prof. Dr. Philipp Sandner is head of the Frankfurt School Blockchain Center (FSBC) at the Frankfurt School of Finance & Management. In 2018, he was ranked as one of the “Top 30” economists by the Frankfurter Allgemeine Zeitung (FAZ), a major newspaper in Germany. Further, he belongs to the “Top 40 under 40” — a ranking by the German business magazine Capital. The expertise of Prof. Sandner, in particular, includes blockchain technology, crypto assets, distributed ledger technology (DLT), Euro-on-Ledger, initial coin offerings (ICOs), security tokens (STOs), digital transformation and entrepreneurship. You can contact him via mail (email@philipp-sandner.de) via LinkedIn (https://www.linkedin.com/in/philippsandner/) or follow him on Twitter (@philippsandner).
Photo by Charlotte Venema on Unsplash – View of the ECB and the Frankfurt skyline from the Osthafen Bridge at sunset.
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