Money vs. Currency
Money is a public good. As such, it should be non-excludable and non-rivalrous. Meaning everyone should have access, and the current use does not deplete future use.
Trusted money has the following features:
A unit of account
Store of value
A medium of exchange for goods and services
Fungible
Durable
Portable
Divisible
Limited supply
The currency, on the other hand, refers to the form of money in circulation- paper, and coins. In many cases, both money and currency are understood to be the same...except for one hidden difference.
Money does not inflate over time; hence the store of value observation above. For example, gold, silver, and other forms of commodity money (wheat, barley, oil, etc.) have kept their value for well over 5000 years. Since the beginning of recorded history, there has been no fiat currency issued that has survived for more than 40-50 years, with the current version of the US dollar being an exception.
This is because all people have governments that inflate away the value of their currency. Currently, all fiat currencies have built-in inflation that occurs annually, and if the target is below, governments adjust the targets until that magical 5% mark is hit. In other terms, you better find a way to increase your cash flow by 5% each year, or your spending power will be totally diminished before retirement.
Modern banking has its roots in 20th-century innovations where a network of payment service providers (PSPs)/ intermediaries coordinate with banks to accommodate transactions. This has made banking expensive. As such, there exists a large population of unbanked and underbanked individuals.
The innovation of blockchain technology and digital assets has sought to serve as an alternative without the need for strenuous KYC, AML, and CDD actions. Additionally, distributed ledger technology (DLT) allows for person-to-person (P2P) transactions undermining the intermediary model used in modern banking.
What is a Central Bank Digital Currency (CBDC)?
A CBDC is a form of central bank money based on DLT. It represents a liability on the books of the central issuer compared to that of a commercial or other kind of bank.
CBDCs based on DLT offer the public a direct way to hold central bank money vs. commercial bank money. There is much caution due to the unproven nature of this tech and the resulting behaviors that will result. Most countries are starting to explore, but few have gathered enough empirical evidence to prove the intrinsic value of using a digital dollar.
CBDCs have to merge aspects of technology and operations based on the monetary policy of a central bank (design and implementation) and how it will impact fiscal policy.
Examples of CBDCs
A CBDC has to be personalized for each region. Here are seven such projects and some observations on each
E-Hryvnia from Ukraine - plausible in the right environment.
e-Krona from Sweden - the public does not see the need for one.
e-Peso - from Uruguay
The digital EU - this was researched but not deployed as the public does not see the need for one.
The Petro - from Venezuela and deemed unsound. This was called out in the cryptocurrency space when the project was a whitepaper.
The Digital Currency Electronic Payment (DC/EP) from China - China is looking for ways around the USD while maintaining full control. It is being deployed for this reason.
The Sand Dollar from The Bahamas - just launched and is the first official CBDC. No government has voiced a problem as yet.
How is it different from a cryptocurrency?
By its very definition, open banking is built into the infrastructure of most cryptos via the open ledger and decentralized coding used. As such, no one entity has absolute power over the entire system. At any point, anyone can fork the currency and have their own personalized version of the digital asset. A CBDC is solely owned and controlled by the state.
CBDCs serve the following uses:
Allow for effective law enforcement
Limited anonymity
Consumer protection (BIS, 2020; Garratt and van Oordt, 2020).
In their current states, stablecoins act similar to CBDCs but are not claims on a central bank. Instead, they are fiat-pegged and anchored in the traditional financial system or, in the case of DAI, are collateralized by other digital assets.
A cryptocurrency is open, meaning its use is defined by the whitepaper. Once issued to the public, it can be manipulated into whatever and by whoever can find a use for it. The creator no longer has absolute control.
Important things to consider
Each digital asset is a tool, and as such, it is neither good nor bad. The effects of usage by each person determine what is good or bad about the asset. But here are a few things to consider when using each:
What does a CBDC that settles in real-time mean for privacy and protecting a local economy from being taken over in the same manner as was the 2016 US election?
Given its digital nature, the system can be hacked.
Behavior can be influenced based on the data generated.
A government can take, freeze or otherwise adjust funds at will and in real-time. Do you trust anyone with that unlimited financial power?
In times of crisis, the central bank uses moral suasion to get commercial banks to cooperate. With a CBDC, the government will have to ask the people directly for help. Can issues be resolved in a timely manner with this extra step?
Interoperability and infrastructure upgrades need to be overlaid onto currently used rails to accommodate real-time payment and settlement of digital assets. Is the investment worth it?
Will the central bank disintermediate PSPs and give access to any legal holder of the CBDC to its ledger? Or, will the central bank take a two-tiered approach where it mints, protects user data information, and then uses PSPs and banks to deploy to the public?
CBDCs must be able to be used without data or internet access.
The central bank can give citizens direct access to the bank's ledger.
What are the real benefits for the central bank to become a deposit holding institution?
How will saving and lending rates be impacted?
The Fed on CBDCs
It should be noted that the Fed is not at all concerned with income distribution. It is only concerned with minting and issuance.
With more Fintech companies being considered and used in the distribution of stimulus checks to US citizens, the question of a USD CBDC has been raised. For example, issuing an e-wallet tied to the tax ID of each citizen from birth, then using these wallets to directly send funds to citizens without intermediaries. But it is through government spending with companies that many economies are kept afloat. A CBDC will impact the economy in ways never seen or thought of before.
If CBDCs are interest-bearing central bank liabilities held directly by the public, commercial banks will change loan terms which may lead to a decrease in lending.
Andolfatto (2018) shows CBDCs will cause banks to match the central bank interest rate, encouraging savings from current depositors. Also, those who choose to be unbanked will be encouraged to pay the nominal fee to gain access to banking. In short, the bank's depositor base increases, and CBDCs will erode bank profits.
Andolfatto's results were also validated by Chin (2020). The central bank must set the best interest rate for CBDCs to make it accepted. If the aim is to evolve the financial system using DLT, having the Fed still setting rates is counterproductive.
In essence, tests are showing that in times of financial stress, CBDCs are considered as "good" money vs. "bad" money in the form of cash and cash deposits. Tests show that users will dump fiat and cash deposits in favor of the CBDC. This observation shows bank runs are likely, but instead of persons pulling money out of the system and into their mattresses, it would be persons bypassing banks and banking directly with the central bank.
The Sand Dollar
A CBDC serves to strengthen the payment and financial systems if it relies on a balanced two-tier structure. This balance refers to cooperation among central banks, payment service providers (PSP), and the public.
For citizens to understand their role and responsibility, as was seen in The Bahamian Sand Dollar project, mass public education campaigns were done to get both private and corporate integration.
It is important to note that globally, bank fees for loans, account holding, etc. represent between 6 and 40% of their net incomes. This means that without being able to charge fees, all banks will shrink as their business model is based on being the only intermediary vs. providing additional value.
The Sand Dollar aims to widen financial inclusion and is targeting the unbanked in The Bahamas. These are individuals who cannot meet the minimum requirements for opening and maintaining a bank account.
The early results have shown that an educational approach about responsible money management is helping garner both public and private support. To date, the Sand Dollar has been given a 1:1 conversion with the Bahamian Dollar. Additionally, it has been issued in a limited manner as less than $50,000 was minted and in circulation.
Pros
Contactless payment to enable more social distancing observations. Not having to touch cash etc.
Cons
A central bank tends to trigger bank runs into the CBDC. They realize Gresham's law where good money would drive out the bad money.
Lessons from E-Hryvnia
During the life of the project, the e-Hryvnia had legal recognition with a 1:1 conversion with cash or cashless funds. It should be noted that it is not money, but rather a means of payment not intended as a store of value. The project used both an e-wallet and mobile app platform and featured both anonymous and user id features.
Issues: no infrastructure is present. Also, there is a need for more public buy-in.
Pros: it is proven to be secure, fast, and safe.
Once CBDCs are backed by central banks, they are a proven alternative to e-money. CBDCs do not need DLT unless they are actually designed to be decentralized. DLT is proven to be more efficient.
Without transaction fees, bank and business participants are not satisfied. The issuer then has to determine the charge if there is any.
CBDC tests in Africa, Asia, and The Middle East
The Khokha was launched by the South Africa Reserve Bank. The main result was that all of South Africa's settlements can be completed in 2 hours, with each transaction having privacy enabled.
The Ubin pilot was run between the Singapore Monetary Authority and the Hong Kong central bank. This is based on the Corda platform, using atomic swaps between the Hong Kong dollar and the Thai Baht to guarantee real-time settlement without the RTGS system and intermediates.
Project Aber was a joint project between Saudi Arabia and the UAE.
For both Ubin and Aber, the issues came with getting the participating banks to agree on a set of behaviors for the system to work, such as interoperability and interest rates.
Due to the subtle differences on the ground, each project showed that the system works, but behavioral agreements are needed to prevent participants from overloading any one provider.
Other considerations
Using an ERC20 token standard allow these tokens to be compatible with current centralized and decentralized exchanges. Simply put these tokens could be sent anywhere and is fully integrated with the entire internet.
Systemic exclusion of SWIFT, the BIS, the US govt, the UN, etc.now gets exposed and addressed.
How does this compete alongside SWIFT?
Both SWIFT and cryptos are communications platforms. The difference is one being open-source and the other being closed source.
Consider the recognition of the digital asset as an acceptance of currency and money. But this form of money was not made in a bank nor approved by a government.
For example, in the case of stablecoins, some derive value from accounts holding the equal amount of fiat in an escrow account. Projects such as DAI get their value from other digital assets being held in escrow.
Will stablecoins be explicitly banned if governments decide to have CBDCs become mainstream?
Within 1 year of exposure to bitcoin and the crypto-ecosystem, ~30% of digital asset owners eventually move to own other forms of assets.
For example, reports done in the UK show this as "reckless" behavior, which is why they enforced the crypto ban.
By legally recognizing wallets as equivalent to bank accounts and providing on- and off-ramp services, an evolution in value will be had. In this way, formalizing the unbanked by using tech that is easy to deploy, scale, and use. This means considering standards that give private citizens more sovereignty as it relates to transactions since, practically speaking, nothing stops the technology from allowing the transactions unless it is programmed to.
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