Disclaimer: this blog post was put together for informational purposes only based on my review and analysis. This should not be construed as a solicitation, offer, or recommendation to acquire or dispose of any investment, engage in any transaction.
By Nassim Olive, CFA — Partner at Eterna Capital
As we learn to navigate in a world where we have to co-exist with COVID-19 for the foreseeable future, we have witnessed an increase in the use of technology in our day-to-day lives. We anticipate that the changes in our behaviour will accelerate the rate of development and adoption of innovation in the coming years.
While the jury is still out on its utility and fundamental value, it is undeniable that Bitcoin has been a phenomenal technological innovation that has driven a lot of interest. Having said that, even if some merchants accept it, Bitcoin has limitations and remains an inefficient payment tool. Goods and services are not denominated in Bitcoin meaning that its exposure to a combination of FX conversion risk and volatility risk make it burdensome to use as a payment method.
Over the past few years, we have witnessed an exponential growth of digital payment systems and we expect the number of e-money related tools to continue growing rapidly. You have probably heard of WeChat Pay and AliPay in China, Venmo and CashApp in the US, M-Pesa in Kenya, or USDC in the digital asset’s world. The level of adoption is impressive — 90% of Kenyans above the age of 14 are using M-Pesa , Chinese platforms account for more than all transactions handled worldwide by MasterCard and Visa combined. However, with innovation comes various challenges: customer data and ownership protection, safety of payment systems and financial stability.
The developments around the topic of central bank digital currencies (CBDCs) and the idea of money becoming fully digital and programmable have caught a lot of attention over the past few months. The use of blockchain or distributed ledger technology (DLT) provides the right balance between privacy and security — two essential features for the infrastructure of money. A poll from the Bank for International Settlements (BIS) issued earlier this year outlines that 80% of the surveyed countries are in some stage of CBDC research or development .
We don’t think that the pandemic crisis alone is a good enough reason for central banks to suddenly adopt digital currencies. However, it could accelerate the process to modernise the existing transactional infrastructure that is becoming increasingly outdated.
Why are CBDCs interesting?
Central banks have constantly evolved through the centuries, and history shows that central banks are willing to adopt new technologies as they readjust to customers’ behavioural change — which is part of their mandate. As the world moves towards a cash-less economy, we wouldn’t be surprised to see central banks rethinking the money supply and transmission mechanisms.
A CBDC as a new medium of payment and financial instrument, combined with a new blockchain or DLT transactional infrastructure network, would provide a new payment rail upon which central bank backed e-money could be sent and received.
CBDCs present a significant number of interesting features with the potential to improve cost and efficiency when it comes to settlement cycles, cross border transactions and the ease of implementing monetary policies. It could also improve financial inclusion and become a development tool for the rest of the economy in several parts of the world where access to bank accounts and cash is limited.
CBDCs also exposes some geopolitical and sovereignty considerations. The U.S. dollar has been the dominating currency when it comes to trade and finance. The status-quo could be challenged by the emergence of a new ‘easy-to-move’ digital currency — both the private and public sectors are positioning themselves accordingly.
After almost 6 years of research, China’s central bank (PBoC) has announced its plan to launch its own CBDC called Digital Currency Electronic Payment (DCEP). The development is far beyond the prototype phase as various retail players, provinces and cities are running real-world pilots. While the government is still working on finalising the overall plan and no clear timeline for full implementation is currently available, we believe that the launch of a digital yuan (or renminbi) might happen sooner rather than later.
Announced in June 2019, the Facebook Libra initiative sounded the alarm as central banks and governments felt a serious threat to their monetary sovereignty. While Libra’s idea hasn’t been built around the creation of a CBDC (but around stablecoins), its ability to reach more than 2 billion users gives the project a considerable network effect that could jeopardise central banks’ hegemony.
Stablecoins and CBDCs are fundamentally different
Referring to Facebook Libra requires outlining the differences between a stablecoin and a CBDC.
While stablecoins and CBDCs have in common the underlying technology — both rely on blockchain technology to work where transactions and information are protected through cryptographic encryption — they are fundamentally different. They differ in terms of control, utility, and their value.
In a nutshell, a stablecoin is a cryptocurrency backed by some sort of quantifiable asset (e.g. USD, EUR, gold, etc.). Let’s consider stablecoin USDC for simplicity. USDC is backed (1-to-1) by U.S. dollars and issued by regulated financial institutions who maintain a reserve of U.S. dollars in FDIC-insured bank accounts to ensure it can cover any potential liquidations and that the currency peg is maintained. It is controlled by a membership-based consortium (Centre) composed of institutions and developers. In simple terms, one USDC equals one U.S. dollar.
On the other hand, a CBDC is not a typical cryptocurrency, it is a digital representation of a fiat currency issued by a central bank. It should have the same legal status as a physical bank note. China’s DCEP (or digital yuan) is a great example. It will be controlled by the PBoC. The DCEP will be backed by 100% depository reserves and bear no interest rate. The circulation of DCEP will be processed via two layers — wholesale and retail — such that the PBoC will issue DCEP to commercial banks and commercial banks will distribute DCEP to the public for retail use. The PBoC will set-up a certification centre whose responsibilities among many things will be to manage AML/KYC checks as well as provide surveillance on the record of ownership and transactions.
CBDCs development will accelerate
Governments have come to realise that CBDCs are potentially highly disruptive and there are implications to the financial stability to consider.
We are likely to see the acceleration of money-related technological developments as we gradually move away from the use of physical cash. We anticipate CBDCs to be part of the development agenda put forward by governments as they work alongside central banks and the private sector to reduce growing pressure on the financial system.
The Digital Dollar Project , an initiative put forward by a not-for-profit organisation and Accenture, has recently released a white paper outlining the potential benefits of a “digital dollar”. The aim is to promote an open dialogue between the public and private sector to explore and propose different potential models for the development and creation of a U.S. dollar CBDC.
A technological advancement can be revolutionary but it becomes obsolete if no wide adoption is reached. When you are faced with an unprecedented economic shock, you have even more reasons to seek innovative solutions and adjust to allow for adoption. When it comes to money, this is no different. Both geopolitical tension and de-globalisation threats may intensify the race as countries seek to regain some sort of sovereignty.
The economic implications
History shows that central banks used to be more engaged in commercial activities and to some extent be direct competitors to commercial banks. Sometimes, central banks’ commercial activities were such that they were considered the dominant player in the lending and borrowing markets. Post-World War II, a new economic shift led to the nationalisation of many central banks. With the disappearance of the gold standard and the economic growth that created operational challenges, governments pushed central banks to abandon all commercial activities and focus on monetary policy control .
There are clear benefits for a central bank and the public to start using a CBDC which explains why central banks around the world have put digital currencies on the drawing board. From the need to re-adapt the bank lending model to ensuring a reserve system that works in tandem with a CBDC, there are multiple ongoing debates and unanswered questions.
One of the most critical points relates to ownership and issuance of a CBDC. Who should be issuing it? Should central banks issue it directly to the public and record it as a liability on their balance sheet? If so, should individuals hold a “bank account” at the central bank or should the central bank send it to our own separate wallet? Who should own the database which records all transactions and ownership? What should be the role of commercial banks and regulated money transmitters? One thing is certain, central banks can’t be handling it all by themselves.
Over the past year, the IMF have been working on the idea of a “synthetic CBDC” resulting from a public-private partnership  where the central bank would regulate and provide trust to the system and the private sector would be responsible for developing the technological advancements required to create, issue and maintain a “synthetic CBDC” fully backed by central bank reserves.
We believe that the creation of such a partnership between the various actors would strike the right balance. It would enable leveraging technological advancements put forward by the private sector to permit e-money innovation to be implemented within a clear regulatory framework without compromising price and financial stability — the core mission of central banks.
The arrival of CBDCs has undeniably revived the debate about the role central banks play in the economy and society. Should we revisit the separation between central banks and the public?
Innovation can be quite challenging to implement
The implementation of a CBDC requires significant work at the infrastructure level and rethinking of the incumbent interaction models — from developing an easy-to-use interface to protecting customers identity and privacy.
Cryptography introduces complexity such as digital keys (private and public). How can we make sure keys are safely stored? How can we make sure that someone can get access to their assets even if they lose the keys? There are several projects and innovative start-ups building products to make the user-experience and user-interface better, simpler and safer (e.g. multi-party computation wallets) — this is the only way to drive wide adoption.
We believe that while it could be a catalyst to reshape the existing model, money related innovation has to fit within the existing financial system and the restrictions that come with it to make an impact — this is no different for a CBDC to achieve the level of efficacy and trust required for a successful monetary system. We think that such technological advancement can only be achieved if both the public and private sectors cooperate to build an interoperable infrastructure that allows the creation of a consensus model between the different players.
The use of cash has been preserving privacy but is restricted up to a certain amount before any questions are raised. Finding the right balance between privacy and transparency has been a long and difficult debate. While blockchain and DLT can offer an efficient way to programme a privacy/transparency check balance, it doesn’t have a clear answer to this debate. This issue is easier to solve for wholesale CBDCs (between commercial banks) as all AML/KYC checks are done at the corporate level and organisations can agree on a shared ledger to complete any transaction. For retail CBDCs the topic is much more complex. Should individuals agree to complete identity checks on every single transaction they do? Do they really need someone to approve their identity to buy a “Diet Coke”? This is a very “2020” fundamental question on individual privacy.
There is a clear shift in trust when it comes to centralised financial institutions and how younger generations want it to evolve. It is the incumbent’s responsibility to adapt to their needs.
The role of governments in close cooperation with the financial sector in combating the risk of de-globalisation and the economic fallout resulting from COVID-19, will guide discussions about CBDC. While this won’t be happening overnight, previous economic crises have demonstrated that the foundations for a post-crisis social and financial framework are laid out during the crisis. We anticipate the discussion to accelerate soon.
China has taken the lead and we are likely to see more progress coming from the PBoC over the short to medium term. We don’t expect one single CBDC model to succeed. Ultimately, governments will develop models that fit with their political agenda. Some will prioritise privacy, others will build a more centralised model, while others will build a model based on community trust.
One thing is certain, for any technological advancement to become a reality, governments will need to collaborate with the private sector to build interoperable systems that sit on top of the overall infrastructure. This will create an efficient way to build applications by leveraging this infrastructure.
As we move to a post pandemic era, geopolitical tension intensifies between China and the US, and pressure on big-tech deepens, we face a fundamental question: who wants to own the Internet of Value of the future?
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 Source: The Rise of Digital Money, July 2019 https://www.imf.org/en/Publications/fintech-notes/Issues/2019/07/12/The-Rise-of-Digital-Money-47097
 Source: Impending arrival — a sequel to the survey on central bank digital currency, January 2020 https://www.bis.org/publ/bppdf/bispap107.pdf
 Source: Federal Deposit Insurance Corporation: the FDIC is an independent agency created by the U.S. Congress to maintain stability and public confidence in the nation’s financial system.
 Source: The Digital Dollar Project — Exploring a US CBDC, May 2020 https://static1.squarespace.com/static/5e16627eb901b656f2c174ca/t/5ecfc542da96fb2d2d5b5f15/1590674759958/Digital-Dollar-Project-Whitepaper_vF.pdf
 Source: Central Bank Digital Currency: Central Banking for All? — Federal Reserve Bank of Philadelphia, June 2020 https://www.philadelphiafed.org/-/media/research-and-data/publications/working-papers/2020/wp20-19.pdf
 Source: Stablecoins, Central Bank Digital Currencies, and Cross-Border Payments: A New Look at the International Monetary System, May 2019 https://www.imf.org/en/News/Articles/2019/05/13/sp051419-stablecoins-central-bank-digital-currencies-and-cross-border-payments