Central Bank Digital Currency — what is it and why you should care

Central Bank Digital Currency is poised to irrevocably change the familiar nature of cash and banking as our world becomes ever more digital. Putting aside the hype, is this right for our societies?

Physical money is something we are all familiar with. It is tangible enough that we can hold it in our hand in the form of banknotes and coins. We get phrases such as ‘a penny for your thoughts’, or ‘that idea is a dime a dozen’ from money.

Most of us also get our income paid into our bank accounts digitally in the form of bank deposits, and similarly our rent/mortgage is automatically taken from our account. You have the right to walk into a bank branch (if you still have one!) and ask the teller for the money in your account as physical bank notes. You may likewise use an ATM to withdraw money. In the former case, you will be asked a lot of questions about why you need more than £300, but you have the legal right to that cash if you ask in advance. This is the same money you draw down on when you pay with your debit card or phone for a bus fare or a coffee without using hard cash. Finally, your bank will need to transfer money to other commercial banks to meet their daily obligations, which means they hold reserves in the central bank to transact with each other, known as central bank reserves.

So, briefly, there are three types of money today:

1. Physical currency: e.g. £5, £10, £20, £50 banknotes

2. Bank deposits: what is in your current or savings account

3. Central bank reserves: what your bank uses for commercial purposes

This seems to cover everything we could wish to do with money. If I want to transact directly with a friend or colleague, I can hand over a banknote and pay that individual for a good or service. I have no means of doing this fully electronically — you may think that sending a wire transfer does that, but it is in fact a form of bank deposit supported by plumbing from the likes of the Faster Payment network in the UK — it is not truly peer-to-peer.

Introducing Central Bank Digital Currency (CDBC)

What is being talked about with Central Bank Digital Currency (CBDC) is a fully electronic equivalent to physical money that is modelled on the very popular electronic money known as cryptocurrency, which seems to have both fans and detractors in equal measure. The Bank of England describes their proposed CBDC as a complement to physical banknotes, but nevertheless, this is an entirely different type of money that only exists in cyberspace, with no counterpart in the three types of money I described above. With it effectively being represented by ones and zeros and stored on computerised ledger, I would not expect to be taking £10 of digital sterling and drawing it out from the nearest ATM in the physical world. This is literally the stuff of science fiction, that people such as Neal Stephenson wrote about in his novel “Cryptonomicon”, at the beginning of 2000s.

Fiat or Ferrari?

Fiat money is simply willed into existence and relies on the creditworthiness of the issuing government to back it up.

Fiat money is ultimately what we are discussing here. This is a government-issued currency via the central bank that is not backed by a commodity such as gold, as it was before the First World War. Fiat money is simply willed into existence and relies on the creditworthiness of the issuing government to back it up. So, a £5 note relies on the UK government not defaulting on its currency or liabilities (bonds they have issued) to ensure that people can trust that money. Without trust we hold worthless banknotes. When it comes to CBDC, nothing really changes, except that the transfer of money can happen very quickly as we would expect from a well-designed and fully automated digital service.

The Bank of England published its CBDC discussion paper on 12 March 2020 and took feedback from a number of stakeholders to publish a response paper on 7 June 2021, so this is still a very fresh topic. In spite of the feedback and research, what you end up with is still fiat money; just in a fully electronic manner.

The huge difference is that CDBC relies on a technology platform from the central bank, so it really does centralise financial transactions in a way that has never been done before. Unlike its cryptocurrency inspiration — you may have heard of Bitcoin, Ethereum, Doge, etc. — which have a distributed, and thus de-centralised ledger of financial transactions between parties, central banks want to put that ledger in a single place. That means they can view, approve and manage all digital financial transactions as they occur and see a full history. How it ends up operating as a large-scale software system is up for grabs, and the subject for a later posting on this topic. It is noteworthy that El Salvador’s government, who had voted to enact a Bitcoin Law in June 2021, became the first nation to use Bitcoin as legal tender on 7 September 2021. We will see how their use of a non-centralised digital currency plays out and whether other nations will follow them. No doubt there will be lessons for centralised digital currencies.

The technologist response

As a technologist who has spent most of my career running large-scale systems that transact foreign exchange electronically around the world, you would think I’d be tremendously excited about CBDC. Surely society is going cashless, so what’s the problem? In its favour, CBDC as a new technology could speed up cross-border transfers, so that instead of taking up to two days for transfers to complete — which is the case for settling foreign currency transaction at the spot rate (i.e. current market price) — it would happen instantly with CBDC. This would also be the case with instant domestic payments too, so I am certainly not quibbling over the manifold benefits here.

I am still applying my technology perspective when I seek to ask questions about CBDC. I only happened to be in my local library with my daughter recently when the librarian was writing down our returns and borrowed books on a sheet of paper due to the library system being down. Imagine if a centralised system for all money transactions went down? It’s not inconceivable. Again, being a technologist, I’ve encountered total system failures that could not have been planned for and left clients and traders dangling in the wind. Scale that up for an entire economy — considerably more complex than one firm and its clients — and we all dangle in the wind. The technology risk is highly concentrated, due in no small part to central banks not being technology giants who have expertise supporting tens of millions of members of the public that are transacting billions of times per day. Even technology behemoths Facebook and Google have been known to fall over in spite of well-designed systems failure prevention!

For now, CBDC is being talked of, as mentioned, as ‘a complement to physical banknotes.’ It seems inevitable that in the near future there will be pressure to remove physical cash simply due to it being awkward to print and distribute. Shops find it inconvenient to bank their cash takings securely, which is certainly a fair point. It would also be possible that a central bank would conclude it is flying blind when it is unable to monitor physical cash transactions as they would be able to do with CDBC token transfer from entity/person A to B in real-time.

My overriding concern here is ethical, in that we need to understand the purpose of a central bank. In the UK, the Bank of England has a mandate ‘to promote the good of the people of the United Kingdom by maintaining monetary and financial stability.’ That is a pretty clear mission. I view the ability to control and monitor every single electronic transaction as potentially open to mission creep as well as a loss of personal liberty, if we believe in the notion of being private citizens in a democracy. Let’s consider some scenarios that show how powerful and far-reaching a centralised digital currency could become:

1. A person writes something on social media that is deemed offensive and they prevented from transacting within the CBDC network. Regardless of the merits of what they have said or done, or your position on free speech laws, people still need to eat, so this could deny that ability with a digital-only currency; the nadir of cancel culture, so to speak
2. A business publishes content that is considered inappropriate by payment providers, forcing a business into changing their revenue model or risk being blocked
3. A citizen of a country is accused of a crime by their government and has their digital assets frozen. This upends the principle of ‘innocent until proven guilty’ and is moving a central bank into interfering with individuals rather than supporting the good of the people as a whole

There are other examples that could be cited, but these are broad brush strokes to indicate what could ensue for people and businesses if CBDC became associated with political influence or interference.

Stepping up a gear to the national level, what if macroeconomic decisions were taken hastily, due to the quicker feedback from monitoring larger data sets in real-time and people haven’t designed in ‘brakes’ that prevented misleading analytical outcomes?

We’re talking about big data here and likely the deployment of machine learning and artificial intelligence to make sense of it for fiscal (tax) and monetary (interest rate) policy decisions. Those of us who have worked with big data know that it takes a long time to train algos to avoid confirmation biases and false positives. It is also not possible for algos to be truly objective either, given they are still programmed by humans. This is quite apart from the regulatory frameworks needed to run this kind of technology and other stabilisers, which need to be agreed upon.

Whilst this is still billed as a discussion from the Bank of England, most of the world’s advanced economies are conducting the same exercise to explore a CBDC. China is the furthest ahead with this process (see this tracker). In the face of growing use of de-centralised cryptos, central banks clearly want to get in on the act, but this should not be considered lightly. Cash would inevitably be removed and the concerns I have about this from a moral perspective will be discussed in a follow-up piece.

About the author:

Mark McKee is a technologist and digital transformation specialist with 20+ years’ experience on enterprise-scale systems. He is also reading an MA Philosophy at Birkbeck, University of London.

References:

Bank of England CBDC research site: https://www.bankofengland.co.uk/research/digital-currencies

Now is not the time for central bank digital currencies: Stephen Cecchetti and Kim Schoenholtz in the FT, 28 July 2021 (https://www.ft.com/content/288c4de4-2bf0-4995-9157-14e56b325236)

CBDC Tracker: https://cbdctracker.org/