Sovereign Digital Currencies: Risks and Challenges of the Future of Money
Technological advancements have revolutionized the payment system infrastructure. The introduction of bitcoin paved the way for the development of alternative currencies and has altered the preferred means of payment—use of cash has declined and cryptocurrencies are now recognized as a medium of exchange.
The supposed trend towards a “cashless society” prompted central banks to consider issuing currency in digital form—otherwise known as “sovereign digital currencies” or “central bank digital currencies” (“CBDC”). Sovereign digital currency is usually defined as “digital payment token which is issued and fully backed by a central bank and is legal tender.”
Money and its Various Forms
To understand the rationale for its adoption, CBDC should be differentiated from cryptocurrencies, like Bitcoin, and other types of digital money, such as electronic money (“E-Money”). Cryptocurrencies are unregulated digital money which are valued subjectively and not issued or guaranteed by a central bank. E-money, on the other hand, is understood to refer to digital representation of fiat currency which is backed by cash and issued by private institutions. Unlike e-money (which is issued against cash) and virtual currencies (which have no intrinsic value), CBDCs are legal tender, albeit in digital form, that are issued by the central monetary authority and constitute a central bank liability.
The adoption of CBDC is seen as a policy response to counteract the effects of the rise in use of cryptocurrencies, which threatens the central bank’s monopoly over the money supply and hinders its ability to effectively implement its monetary policy. It is also believed to have the potential of improving existing financial systems, including interbank and cross-border payment and settlement systems. Further, since CBDC is in digital form and can be designed to allow for digital records, it is seen as a means to reduce informal economic activities, such as money laundering, and provide data on the market economy.
CBDC Models and Proposals
There are various models for the adoption of CBDC. Proposals seek to differentiate CBDC on either who has access to CBDC or the form of the CBDC.
CBDC may either be a retail CBDC—issued for use and held by the public, or wholesale CBDC—issued to predefined group of users, such as financial institutions. CBDC may also be token based or account based. An account based CBDC involves users holding funds electronically stored though CBDC accounts maintained at the central bank or in designated accounts of supervised depository institutions. In contrast, token based CBDC involves the issuance of tokens or units of account to the users.
Aside from these major frameworks, there are also other variations in the design features of the CBDC, such as: availability (i.e. whether access to CBDC is allowed 24/7 or limited to central bank operating hours), degree of anonymity of the user, transfer mechanisms (i.e. whether transactions will be operated within a centralized structure whereby the central bank shall act directly as an intermediary or a decentralized structure where transfer is conducted on a peer-to-peer basis), caps on the holdings of CBDC, substitutability (i.e. whether the CBDC is intended to substitute or complement cash and allows for at-par convertibility) , and interest accrual (i.e. whether CBDC is interest bearing or not).
Central banks in various jurisdictions are already conducting their research on the feasibility and benefits of issuing their own CBDC. A recent study shows that seventy percent of the central banks surveyed are engaged in the CBDC study and exploration. Some studies have progressed from conceptual work into actual experimentation and implementation.
The Republic of the Marshal Islands is one of the first countries which passed legislation for the issuance and adoption of its own CBDC. In 2018, it passed a law declaring the Sovereign, a digital decentralized currency based on blockchain technology, as legal tender which shall be used for payment of all debts, public charges, and taxes. China has also recently launched its digital yuan to the public, as part of its pilot program.
While projects studying the feasibility of CBDC abound, a survey conducted found that only a few central banks have firm intentions to issue their own CBDC because of the challenges of launching a CBDC.
Policy Considerations: Risks and Challenges
The issuance of CBDC presents several risks and challenges. One major concern is its impact on the functions of a central bank. Maintaining a CBDC imposes additional responsibilities on central banks, such as data privacy and consumer protection, which are not traditionally within the mandate of the central monetary authority.
The introduction of CBDC may also impact financial and economic stability. CBDC allows banks to make available to the public a risk-free account that “could be used as a means of payment, unit of account, and a store of value.” It may cause “bank runs” to CBDC since accounts opened directly with central banks represent a risk-free option, making credit available readily and with less friction than withdrawing cash from deposits held with private banks, specifically, in times of financial stress.
The shift from deposits with the commercial banks to risk-free accounts directly with the central bank could potentially disintermediate the commercial banking sector. The expanded access to central bank accounts may lead to a decrease in the use of financial intermediaries engaged in the provision of payment services.
It also raises data privacy concerns. Unlike cash, CBDC is programmable to record data of users and transactions in such a way to erode privacy and anonymity of users and grant additional surveillance power to the government.
Finally, it poses operational risks, such as cyber security threats, and presents significant operational costs. Broadening the list of persons with direct access to central bank money would require a massive amount of customer facing infrastructure that central banks may not have the capacity to provide.
In view of the inherent risks, the adoption of a new form of money should be a cautious and gradual process. The issuance of the CBDC is not a one-size-fits-all approach. While CBDC presents compelling benefits, it is not without significant costs and challenges that may outweigh the perceived benefits.
Ma. Carla Mapalo serves as a Graduate Editor of the NYU Journal of Law & Business. She is a Corporations LLM candidate at NYU where she focuses on mergers and acquisitions, finance, and securities law. Prior to attending NYU, she worked as a senior associate of the corporate and commercial department of a top tier law firm in the Philippines.