CBDCs - the potential upsides and the risks to data privacy and commercial banks. Everything you need to know.

Central Bank Digital Currencies (CBDCs) have the potential to materially impact industries – including payments – as well as dramatically increase the risk of bank runs and create serious questions about data privacy and security.  If you’re catching up on CBDCs, this is what you need to know.

What are Central Bank Digital Currencies?
A Central Bank Digital Currency (CBDC) is a virtual currency distributed by a central bank – typically using distributed ledgers and circulating on blockchain. CBDCs could be one of the biggest central bank innovations since bank notes.

Why are CBDCs important?

CBDCs are one of the first central bank innovations since the circulation of bank notes. They have the potential to transform industries, lower payment transaction costs and increase payment speed. They also create scenarios whereby central banks gather and store data on individuals and companies and increase central banks’ needs for digital security. 

Which economics are involved in CBDCs?

There are 114 countries exploring a CBDC – up from 35 in May 2020.  Eleven countries have launched a CBDC, while 18 are piloting digital currency programmes, according to a tracker from the Atlantic Council. Here are some of the most notable:

1.     The Bahamas launched the sand dollar in October 2020.  The sand dollar was the first CBDC to launch but despite the notoriety, it hasn’t brought the financial inclusion that was hoped.

2.     Nigeria launched the e-Naira in October 2021 in pilot; the number of digital currency wallets and transactions continues to rise – a positive for the Central Bank of Nigeria as goals of the eNaira included limiting user’s abilities to circumvent the formal banking system and boosting financial inclusion – but there are complaints that places to use and spend the e-Naira are limited.

3.     China is piloting the digital yuan. While it’s possible that it is doing so to increase its ability to monitor and control users or to evade potential future sanctions, it says its aim is to provide “convenient, safe and inclusive” payments. The digital yuan issued by the People’s Bank of China has the same value as analog yuan and while the user experience may be similar between the digital and analog yuan, digital yuan payments aren’t routed through a commercial bank and can be moved from one digital wallet to another without transaction fees.

4.     The United States, while joining the CBDC exploration more recently, claims to be undecided on how a CBDC could improve on what it calls ‘an already safe and efficient U.S. Domestic payments system’.

5.     The UK continues to investigate the digital pound and last month published a paper on the work to date stating that it is likely that a digital pound will be needed. The digital pound is expected to be similar to a digital bank note and issued by the Bank of England.

6.     The ECB is working with the national central banks in the euro area to investigate the introduction of a digital euro. It would be a central bank digital currency, an electronic equivalent to cash. This month there is an EU pilot to trial the adoption of trading and settlement of tokenised securities before regulation is amended to accommodate them.

Why do CBDCs have potential?

CBDCs are being explored to improve payment speed, lower payment costs and remove the risk relating to international payments. By leveraging CBDCs the funding and settlement for international payments would be instantaneous.  Anyone with experience of international payments knows that this is vastly superior to conventional (legacy) foreign exchange transactions where funding and settlement are not simultaneous or instant and international payments are enabled through a network of correspondent bank relationships. Delays and, unforeseen, costs are common.

What do we and central banks need to consider?

Privacy, data protection and security breaches shouldn’t be overlooked

CBDC users, businesses and retail, will need to understand and trust who controls the data from digital currency transactions and trust that central banks have the appropriate security measures to mitigate the risk of breaches. Users will also need assurances that in the case of a breach it will be handled as per the data protection rules. In a CBDC breach, establishing how to proceed should be up to the data regulator rather than the central bank but that could have implications for monetary policy and/or financial supervision. What’s good for users in the case of a data breach might not be good for financial stability.

Many jurisdictions considering the launch of CBDCs haven’t established data protection standards or regulations. This further introduces the risk that CBDC users might be vulnerable not only to security breaches, but also to having their data mined by the authorities themselves.

Given that there are fewer global standards for data regulation than financial services regulation, the hope that CBDCs will finally make financial systems interoperable on a cross-border basis remains distant at best.

CBDCs could exacerbate the bank runs we’ve seen recently

The recent deposit flight from specialist, regional and community banks such as SVB showed how quickly capital moves from perceived risk to safety – most recently to tier 1 banks, Treasurys, money market funds and even bitcoin. The recent bank runs, however, were driven by corporate deposits as retail deposits tend to be more sticky given that individuals typically have fewer bank relationships than businesses and more limited access to Treasurys and money market funds. With CBDCs, however, retail deposits could easily move from commercial banks into CBDCs in the next crisis. What retail depositer wouldn’t want to hold their savings with a central rather than commercial bank in during periods of financial instability such as 2008 and 2023? Already identifying this very risk, some central banks have published scenarios estimating that 20% of deposits could flee commercial bank accounts to new digital money.

Issuing central banks will need to consider and limit the CBDC value users can hold by setting wallet and transaction limits as well as limiting interest earned on CBDC deposits. If the value users can hold is too high, businesses and individuals could move their funds from commercial banks into CBDCs – just as we saw a flight to safety in the wake of Silvergate, Signature and Silicon Valley Bank.

With this in mind, the ECB suggested that the digital euro would be limited to just EUR3,000 per person. In the Bahamas, there are daily transaction limits. The Bank of English suggested it will set a maximum digital pound value of GBP20,000 and will not pay interest on it.

What next?
We all want payment speed at lower costs. Users and central bank have a lot to look forward to and consider. Central banks have more to do as they find ways to balance the upside of CBDCs with the associated risks.

Innovation continues beyond central banks. The Lightning Network, a payment protocol built on top of bitcoin, is already available and enables instant, cost-effective nano-transactions.