Central bank digital currency (CBDC)—fiat currency issued by central banks in digital form—has progressed in the past few years from a bold speculative concept to a seeming inevitability.
More than 80 percent of central bank respondents to a Bank for International Settlements survey in 2019 reported engagement in CBDC projects. One in 10 central banks, representing approximately one-fifth of the world’s population, expected to offer CBDCs within the next three years. The People’s Bank of China has begun to pilot a digital yuan, while the United States and European Central Bank are exploring CBDC development. At the same time, a Facebook-initiated fiat-backed cryptocurrency called Libra has raised the prospect of an industry alternative.
Various forms of CBDC have in a sense existed for years, but as wholesale facilities available exclusively to financial institutions. What is striking and potentially transformative about many recent CBDC initiatives is their retail focus. They aim to democratize central banking by making accounts or liabilities directly available to individual consumers, households, and/or businesses.
While the goals of cryptocurrencies such as Bitcoin differ dramatically from that of CBDC, they offer evidence of feasibility and technical ideas for retail deployment of digital currency. Their technical foundations underpin Libra, have somewhat influenced CBDC design plans, and strongly inform the findings and recommendations of our paper.
Benefits and risks
The main potential benefits spurring central bank exploration of CBDCs are:
- Efficiency: CBDCs can reduce friction in existing payment systems, potentially lowering the cost and increasing the speed of transactions while ensuring finality.
- Broader tax base: CBDCs can potentially bring more economic activity into the effective tax base, limiting tax evasion, boosting tax revenues, and inhibiting the use of CBDC for illicit purposes.
- Flexible monetary policy: CBDCs could facilitate novel flexibility in monetary policy, theoretically allowing central banks to institute negative nominal interest rates and implement non-distortionary helicopter drops or withdrawals of central bank money.
- Payment backstop: CBDCs could act as a backstop to privately managed payment systems, avoiding the risk that payment systems will break down in times of crisis.
- Financial inclusion: CBDCs could serve as a gateway for unbanked and under-banked individuals to have access to electronic payment systems and, potentially, to other financial products and services as well.
Novel financial technologies could yield additional benefits, particularly for financial regulators, as we discuss in “Opportunities for innovation” below.
The many potential benefits of CBDCs should be weighed against potential risks, both financial and technical, including:
- Disintermediation of the banking system: Many CBDC plans involve a two-layer architecture; the CBDC itself serves as a basic functional layer, while existing non-governmental financial institutions manage a second layer that interfaces with users. Nonetheless, by reducing transaction frictions and possibly even providing interest-bearing accounts, CBDCs could disintermediate significant swaths of the banking system, with potentially destabilizing systemic effects.
- Miscalibration of government involvement: The balance between ensuring adequate central-bank oversight and leaving room for innovation may be challenging to strike, with risks to overemphasizing either side.
- Financial risks due to lack of regulatory expertise and capacity: Regulators may struggle to develop the tools and expertise to address the dramatic structural changes and financial innovations brought about by CBDCs.
- Loss of privacy: Given the limitations of current privacy-enhancing technologies, it seems likely that a true retail CBDC will expose new forms of sensitive information to CBDC operators. CBDC designers should consider legal and technical mitigations from the outset.
- Technological vulnerabilities or entrenched design mistakes: Even with conservative design, CBDCs will represent a technical experiment with significant risk of information-security failures. Design mistakes may be especially difficult to fix.
Important design choices for CBDC
As they contemplate issuing CBDCs, central banks should give special consideration to certain elements of policy and technical design.
Ledger infrastructure: A range of architectural options for the digital ledger could underpin a CBDC. Central banks will wish to retain tight control over currency issuance and transaction processing, including the ability to alter or reverse transactions. The two-layer approach embraced by many CBDC efforts continues existing customer-service models and is the easiest to integrate with existing laws, such as anti-money-laundering and countering the funding of terrorism regulations (AML/CFT). Other designs will have a harder time supporting important legal use cases, such as secured credit and consumer protection against fraud. Notably, however, a two-layer system would not remedy the privacy concerns associated with representation of individuals’ accounts (or banknotes) in the CBDC and may introduce complications around authority and legitimacy of customer tools as compared to complete management by the central bank.
Wallets and funds / key custody: Users will need a secure way to hold their funds and send provably legitimate transactions. For cryptocurrency users, management of the secret keys needed for authentication has been unduly burdensome, resulting in heavy reliance on financial intermediaries. Unless central banks innovate a user-friendly secret-key-management system, CBDC users are likely to pursue the same route, potentially impeding the very financial inclusion that is a major goal of CBDC creation. Workable approaches to custody of funds and/or secret keys will be of pivotal importance in a CBDC.
Privacy: A CBDC can potentially reveal significantly more information about individuals’ transactions to central banks than existing systems do. Should a CBDC maintain the account balances of individuals on the ledger, which would seem to be a prerequisite for a retail CBDC, privacy will become an issue of major importance. This observation strongly motivates considering technical and legal confidentiality protections for ledger contents.
Monetary policy considerations: Notwithstanding the potential benefits, there are many unanswered questions about how the new financial technologies could affect the structure of financial institutions and markets. Questions also abound about whether retail CBDC will in any significant way affect monetary policy implementation and transmission. These uncertainties suggest a cautious approach to embracing the concept of CBDC.
The issuance of CBDC will not mask underlying weaknesses in central-bank credibility or other issues such as fiscal dominance that affect the value of cash. In a shift to digital forms of retail central bank money, the transitional risks could be higher in the absence of stable macroeconomic and structural policies, including sound regulatory frameworks that are agile enough to be able to recognize and deal with financial risks created by new types of financial intermediaries.
Opportunities for innovation: We believe there are rich opportunities for innovation in a CBDC. Some derive from the unprecedented transparency a CBDC would afford regulators, including a panoramic yet fine-grained view of global spending in an economy. These opportunities would also include new monetary policy levers, such as the ability of central banks to institute negative nominal interest rates, create currency with time limits or other spending conditions (e.g., required spending on durable goods) in order to create highly targeted monetary interventions in a national economy. Innovation would be best captured by CBDC support for smart contracts, programs that can extend a CBDC’s functionality.
In summary, the benefits and risks of CBDC are complex, encompassing financial, legal, and technical considerations and the interplay among them. Each country will have to take into account its specific circumstances and initial conditions before deciding whether the potential benefits of introducing a CBDC outweigh the possible costs.
Our full paper, “Design Choices for Central Bank Digital Currency: A Position Paper” by Sarah Allen, Srdjan Capkun, Ittay Eyal, Giulia Fanti,, Bryan Ford, James Grimmelmann, Ari Juels,, Kari Kostiainen, Sarah Meiklejohn, Andrew Miller, Eswar Prasad, Karl Wüst, and Fan Zhang is available here.