Central Bank Digital Currency (CBDC) — How DLT-systems can boost economic growth

Central banks around the world have been actively exploring the possibility of introducing sovereign digital currencies. Central bank digital currency (CBDC) is the digital alternative to cash that many policymakers are proposing to engage with the ongoing digitalization of payment means.

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We have collided most of the publicly available information in this timeline highlighting the efforts taken by Central Banks worldwide acknowledging the great opportunities that DLT offers to improve inefficient processes and the value it brings considering salient risks and limitations.

Due to the rapid and escalating digitization process, institutional players are starting to explore and adopt innovative digital means of payment. The debates on CBDC cover broad issues, such as their possible impacts on banks’ fund intermediation, liquidity crises and the transmission mechanism of monetary policy.

In the core of these developments, the emergence of Distributed Ledger Technologies (DLT) has driven discussions around the future of financial markets infrastructure and the possibilities of this technology to solve the aforementioned issues.

Given DLT’s potential to address long-standing challenges such as financial inclusion, payment efficiency, payment system operations, traceability, and cyber resilience, many central banks have spurred CBDC as the application of blockchain technology to the issuance of digital currency.

According to a recent report of the World Economic Forum (2019), there are currently at least 40 central banks around the world that are actively assessing this potential. The current focus is mostly researching pain points and evaluating different approaches of how to develop the (technical) infrastructure necessary for CBDC.

Over the past few years, there has been a lot of attention arising towards DLT from institutional players, especially around the CBDCs topic. Therefore, we would like to join the discussion, adding our experience within the field, working alongside big institutions that are willing to unfold the full potential of their production system using new technologies.

What is exactly a CBDC?

Nowadays central banks issue two types of money, cash and reserve deposits. Both of these types are entered as liabilities on the central bank‘s balance sheet. Hence, the existent money is a scriptural representation created by lending from deposits in banks (Bank of Finland, 2018).

Now, as a result of technological developments, there is a new possibility of creating digital central bank money. One form that can be universally accessible, excluding the privilege that is currently reserved to some institutions, so it can be used, among others, as a means of payment.

Central bank digital currency is any electronic fiat liability of a central bank that can be used to settle payments, or as a store of value. This concept is not new, it has existed for decades, most ubiquitously as the balances (commonly referred to as ‘reserves’) that are held by commercial banks and other selected financial institutions at the central bank to facilitate electronic settlement in Real Time Gross Settlement (RTGS) systems. However, the current understanding of CBDC states as one of its core principles the differentiation between it and reserves, making them not convertible into each other.

This differentiation not only safeguards the financial stability needed every time depositors seek to switch into CBDC in large amounts, but also enables central banks to have a different instrument to conduct monetary policy. To start, CBDC offers different traits given that it has the potential of being broadly accessible, compared to reserves and it can offer more functionalities for retail-transactions than the ones regular cash (paper-based banknotes) does (Bank of England, 2018).

Other than that, there is a wide range of sub-characteristics that can be used to define and differentiate CBDC. Many of these are key traits that the institutional researchers highlight when choosing DLT to support the digital currencies system. Using DLT for the operation of CBDC ensures the resilience needed for a system that would be of critical importance to the financial stability of the economy.

As previously mentioned, one of the most important characteristics is the accessibility of this type of digital currency. When comparing to reserves, it seems obvious that CBDC is universally accessible, which means that it can be held by anyone for any purpose. Thanks to the transparency and security provided by DLT, universal accessibility does not represent additional transaction costs, but rather improves the regular paper-based representative transactions (deposits) in a more efficient manner.

Moreover, CBDC can have a separate operational structure to other forms of central bank money. This opens the door to different purposes, like “settlement account” money or “deposited currency account money” depending on the scale of access, as it is a liability of the central bank (Bech and Garratt, 2017).

All in all, CBDC ticks all the boxes to fill the existing void that is separating central bank money from the cashless system that is becoming predominant.

Why CBDC is relevant?

One of the most important reasons why CDBC has gathered much attention recently is because its proven capacity to boost economic growth solving the welfare trade-off. For this, the optimal outcome of a CBDC shall be interest bearing, under realistic assumptions paying a rate that would be different to the rate on reserves (Bank of England, 2018).

According to multiple analyses conducted, CBDC trades off bank intermediation against the social value of maintaining diverse payment instruments. This relies not only on the potential of CBDC but on the digital currency system being supported on DLT. With this approach, monetary and fiscal policies can be more efficient, increasing the resiliency of the system, for both reserves and CBDC.

CBDC based on DLT has the potential to provide back-up service in case the Real-time Gross Settlement (RTGS) system fails. In these cases, when network effects matter, like having access to the ATMs network or not or having available point-of-sale terminals, CBDC built on DLT fills the void. Like so, if cashless transactions become more common (as they are currently) an interest-bearing CBDC alleviates the central bank’s tradeoff.

Other studies replicating specific economic circumstances have further demonstrated the great potential of CBDC to boost economic growth. In a Dynamic Stochastic General Equilibrium model (DSGE) calibrated to match the pre-crisis in the United States, the academia found that CBDC issuance of 30% of the GDP against government bonds has the potential of permanently raise GDP by as much as 3%, due to reductions in real interest rates, distortionary taxes, and monetary transaction costs (Bank of England, 2016).

CBDC would combine the digital nature of deposits with the use of the peer-to-peer transaction of cash. This results in the reduction of many transaction costs, like the incurred expenses of owning a bank account. Due to the rapidly growing use of mobile (and overall digital) payment and the generalization of cashless payment instruments such as credit cards, having CBDC implies risk-free and digitalized payment systems, that can compete with the current and future status-quo of payments and transactions.

Hence, the improvement is remarkable: currently, when ordinary people want to use central bank money for their transactions, the only available option with no credit risks are paper-based banknotes. Therefore, they bear the costs of storing and conveying banknotes as well as various costs for keeping them safe (i.e. having a bank account). With CBDC, payments would be more efficient and save while reducing the overall costs of economic transactions, because all participants involved will be approved thanks to the DLT-system (International Monetary Fund, 2019).

Moreover, many studies conclude that CBDC could act as a highly effective form of money and promote true price stability, as the real value of CBDC could be easily held stable over time (Bordo, M. D., & Levin, A. T, 2017). With price stability over time, the monetary policy can be conducted in a more systematic and transparent manner, raising financial stability.

CBDC using DLT seem to be the answer that solves problems and inefficiencies present in the current system. Its potential is evident and it is obviously facing the growing recognition of a revolutionary, yet empowering technological tool. This innovation shall become a standard, and will open a system that can shake the base of the economic cycles.

Nevertheless, it is yet to determine whether the institutional players will lead this race or it will have to be guided by private efforts (as any technological development emerging in the last 10 years). Institutions are aware of the potential of this technology, so the question remains whether they want to be follow or keep being the followers and late-comers to innovation.

A fairly recent study even concludes that “most central banks appear to have clarified the challenges of launching a CBDC but they are not yet convinced that the benefits will outweigh the costs” (Bank of International Settlements, 2019). However, digitalization is not slowing down and the cashless systems are taking over. There are several use cases where CBDC based on DLT can enhance the resilience of central banks to keep the pace and make front to these developments that are being mostly made thanks to private initiatives.

For instance, some of the results from the joint research project named “Stella”, conducted by the European Central Bank (ECB) and the Bank of Japan, highlight that DLT-based solutions can offer a trade-off when processing volumes of payment requests thanks to a faster average speed of transaction (from between ca. 10 and 70 requests per second (RPS) to less than one second for all that volume) (ECB, 2017). Additionally, they found that regarding security, on-ledger escrows ensure that all participants in transactions are not exposed to the risk of incurring a loss on the principal amount being transferred (ECB, 2019). With this, DLT improves payment systems not only from the institutional perspective but also for the private end-users, offering a shielded synchronized payment system that can be implemented even for cross-border transactions.

DLT offers a payment system that synchronizes institutional payments (on-ledger) and locks funds along the payment chain, improving the efficiency gains for all parties involved in the transactions (institutional or private). With this, it is more than clear that DLT has matured and claiming that it remains unknown whether its potential can be really beneficial is neglecting many growth opportunities.

Overall, after enumerating all these benefits, it is obvious that this technology can also enable new capabilities for central bank processes that maybe not yet identified. The contemporary scenario is just the base for an analysis that should project on the future outcomes of global digitalization. CBDC will innovate the traditional systems and build new processes and functionalities that will open the economic systems in a novel manner.

If you are interested in knowing more about this game-changing technology, contact us and request a demo of our DLT-based White Label Solutions, thought to increase the efficiency of financial systems and offer great growth potential for all types of business.

About micobo GmbH

micobo GmbH is a leading European software company for Security Token Offerings and Blockchain Software Development (DLT). micobo provides fully compliant software solutions for Security Token Offerings and advises on structuring DLT- and Blockchain-based Securities.

Author

Luisa Fernanda Agudelo, Communications Manager at micobo GmbH (lb@micobo.com).

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