The Empires Strike Back?

TRM InsightsInsights

May 4, 2021

Are CBDCs the Answer for Regulators and Central Banks Across the Galaxy?

A long time ago in a galaxy far far away . . . . (cue the music) a small band of rebels began building a new decentralized financial system based on cryptocurrencies such as Bitcoin. This new financial system runs on distributed-ledger technology, meaning that multiple devices, from Tatooine to Hoth, Coruscant to Jakku, are constantly verifying the accuracy of transactions rather than one central hub. But, regulators and central banks - even nation states themselves - are potentially threatened by this new financial system that bypasses intermediaries with its cross border value transfer at hyperdrive speed.

Well, looks like the empires may be striking back with CBDCs. A CBDC, or Central Bank Digital Currency, is the digital form of a country’s fiat currency that is also a claim on the central bank. Instead of printing money, the central bank issues electronic coins or account backed by the full faith and credit of the government.

Why are central banks in full Jedi training mode on CBDCs? Lots of reasons, depending on the economic situation within a country. The cost of managing and transferring cash is high and the technology can reduce those costs; financial inclusion means those who are unbanked can get easier and safer access to money on smart phones; and, monetary policy can flow - like the force - more quickly and seamlessly through CBDCs.

The designs of CBDCs vary, especially regarding privacy, access, and the basic structure of the systems, but most central banks have chosen to build their CBDCs on a blockchain, with the aim to significantly increase transaction efficiency and lower trading charges. But, perhaps most of all, CBDCs are the answer for central banks that understand the "new hope" of cryptocurrencies to seamlessly transfer value, while addressing what they see as the Death Starish existential threats that come from a fully decentralized system.

As mainstream adoption of cryptocurrencies has spread like the Clone Wars, governments around the world have just started to take notice. When Facebook and a consortium of financial institutions launched Libra in 2019, since rebranded Diem, governments were confronted for the first time with a cryptocurrency launched by an organization with galactic reach. Since that time financial institutions such as Goldman Sachs, BNY Mellon, JP Morgan, Paypal, Visa and myriad others have embraced cryptocurrencies. Crypto adoption has recently been faster than the Millennium Falcon's Kessel Run time (less than twelve parsecs) only accelerating the urgency of central banks to role out a CBDC alternative.

So, grab your Speeder, X-Wing or TIE Fighter and let's take a spin across the CBDC galaxy.

China

China’s digital yuan is likely, based on size and scale, the most advanced of the several CBDC initiatives that are being developed around the globe.

Given China's position as the world's second largest economy and its Jabba-the-Hutt sized manufacturing prowess, the People's Bank of China's (PBOC) CBDC is positioning itself to be a massive player in the digital asset game.

The digital yuan, which does not employ blockchain technology, resides in cyberspace, available on the owner’s mobile phone—or on a card for the less tech-savvy—and spending it doesn’t strictly require an online connection. It appears on a screen with a silhouette of Mao Zedong, looking just like the paper money.  Conceived in 2014, the digital yuan has gone through a series of regional pilot programs. During the rollout, China’s central bank gave out online wallets to lucky consumers in various cities throughout the country.  In tests in recent months, more than 100,000 people have downloaded a mobile-phone app from the central bank enabling them to spend small government handouts of digital cash with merchants, including Chinese outlets of Starbucks and McDonald’s. In addition, China's central bank recently allowed select Hong Kong residents to use the digital yuan to make cross border payments to the neighboring city of Shenzhen. This trial highlighted the PBOC's interest in expanding its reach beyond its borders.

Like everything involving China, the digital yuan rollout has been met with levels of concern from the West usually reserved for Sarlaccs and Wampas. While the programmable digital yuan could speed relief to disaster victims or flag criminal activity, it can also track movement in real time and place expiration dates to encourage faster spending when the economy is in need. In other words, the digital yuan provides China's government a new tool to track its citizens.

Bahamas

In October 2020, the Central Bank of the Bahamas (CBoB) launched its CBDC Sand Dollar.  Not only is the Sand Dollar the best in the CBDC galaxy, it was also the first to market.  The centrally issued digital currency became available for use by all Bahamian citizens upon release, while integration with the commercial banking system will likely launch later this year. Nine institutions have been cleared to operate as CBDC issuers, consisting of four money transmission businesses, three payment services institutions, one credit union and one commercial bank. Interoperability between these entities would allow for the Sand Dollar to be distributed and used more efficiently across a range of different applications. [In addition, Mastercard, in collaboration with the CBoB, and the app Island Pay, provides the option to instantly convert Sand Dollars to traditional Bahamian dollars and pay for goods and services anywhere](https://www.mastercard.com/news/press/2021/february/mastercard-and-island-pay-launch-world-s-first-central-bank-digital-currency-linked-card/#:~:text=The digital Sand Dollar is,build a more inclusive economy.). Each Sand Dollar is pegged to the value of the Bahamian dollar, which in turn is pegged to the value of the U.S. dollar.

The CBoB also released new draft regulations aimed specifically at the way payment services providers interact with the Sand Dollar, with a focus on consumer protection. The regulation is expected to be finalized this month. With the beginnings of a regulatory regime and a fully launched CBDC, the Jawa-sized island nation is leading the CBDC pod race.

The United States

The U.S. has been moving at Bantha-like speed toward a digital dollar. The Federal Reserve CBDC project, a collaboration between the U.S. Federal Reserve Bank of Boston and the Massachusetts Institute of Technology (MIT) dubbed the "Hamilton Project," however, seems to be picking up speed.

In fact, just yesterday, the Digital Dollar Project announced that it will launch five pilot programs over the next 12 months to test the potential uses of a U.S. CBDC.  The pilot programs, three of which will launch in the next two months, will complement the Fed’s MIT project by generating data on the functional, sociological, business uses, benefits and other facets, of a digital dollar.

Generally, the Digital Dollar Project is exploring the use of existing and new technologies to build and test a hypothetical digital currency platform.  According to the participants, "In later phases, researchers will assess technology trade-offs by coding and testing various architectures, to see how they impact the CBDC’s design goals. The research results will be published jointly with MIT, and the code would be licensed as open-source software, so anyone can use or continue experimenting with it."  However, recent statements from U.S. Federal Reserve Chairman Jerome Powell and Treasury Secretary Janet Yellen might signal a readiness to move forward consistent with yesterday's announcement of the pilot programs.

“I gather that people at the Federal Reserve Bank of Boston are working with researchers at MIT to study the properties of it. We do have a problem with financial inclusion," said Yellen. "Too many Americans really don’t have access to easy payment systems and bank accounts. This is something that a digital dollar, a central bank digital currency, could help with. I think it could result in faster, safer and cheaper payments.”

In congressional testimony, Fed Chair Jerome Powell agreed, calling the digital dollar “a high priority project for us.” He added, “We are committed to solving the technology problems, and consulting very broadly with the public and very transparently with all interested constituencies whether we should do this.”

Russia

In 2017, Russian President Vladimir Putin announced the creation of the **crypto**-ruble and Russia’s central bank is planning to showcase a prototype for its ruble-backed digital currency later this year. The project was unveiled in October, when the Bank of Russia published an analytical report outlining the possible design of a ruble-backed CBDC. The report suggested several scenarios for the digital ruble’s operations and requested public feedback. Listed benefits of the project include the ability to track government spending more effectively and to provide digital payment options in areas where internet connections are scarce. The Bank of Russia expects a digital prototype of the Digital Ruble to be finalized by the end of 2021 and will go into pilot trials in 2022. A previous study conducted by Otkritie in January found that 47% of Russian residents are already willing to use the digital ruble.

Europe

Europe is also still very much in the planning stages for a digital Euro. Just this week, the European Central Bank (ECB) issued a comprehensive analysis of its public consultation on a digital euro. The consultation, launched in October 2020, asked the public and professionals to way in on priorities around a potential CBDC. Responses, coming primarily from Germany, Italy and France, indicated that Europeans were most concerned about privacy and security issues but were supportive of the ability of a digital currency to make cross-border payments faster and easier. Next steps are expected in the next few months.

Canada

Canada has been studying a CBDC since at least January 2020, when the Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank, together with the Bank for International Settlements (BIS), created a group to share experiences as they assess the potential cases for central bank digital currency (CBDC) in their home jurisdictions. That group issued a report in October 2020, setting out common foundational principles and core features. Participants agreed that a CBDC would not compromise monetary or financial stability and that digital fiat could coexist with, and complement, existing forms of money, promoting innovation and efficiency.

With the global pandemic pushing more and more people online, however, we have seen more of an urgency in Ottawa to address a CBDC. “For several years, the Bank of Canada has been analyzing which circumstances might lead Canada to decide to issue a digital currency. The pandemic may bring us to a decision point sooner than we had anticipated,” said Bank of Canada deputy governor Tim Lane.  Canadians movement away from cash and the government's deep skepticism of cryptocurrencies like Bitcoin, make a CBDC an attractive alternative in the Hoth-like North, but it is still an open question.

Switzerland

The Swiss are definitely original trilogy when it comes to digital assets. Since December 2020 the Swiss National Bank (SNB) has been working with financial infrastructure operator SIX on Project Helvetia, the landmark study on the feasibility of CBDC in Switzerland. The project has completed two proofs of concept so far, successfully using a CBDC for wholesale transactions between financial institutions and linking a distributed ledger technology (DLT) platform to existing payment systems in a near-live setup. The next stage in the trial is currently underway and is due to be completed by Q3 2021, with cross-border payments also being examined.

The SNB is also focused on the retail side of the CBDC game, releasing, in March 2021, a paper that lays out what a retail CBDC could look like. In the paper, titled How to issue a central bank digital currency, the central bank outlines the key features and characteristics a retail CBDC should have, proposing a scheme for a token-based system that doesn’t run on a DLT platform, and which combines transaction privacy with know-your-customer (KYC) and anti-money laundering and combating the financing of terrorism (AML/CFT) compliance. According to the SNB, a retail CBDC should be more efficient and cost-effective than fund transfer systems currently operated by central banks. It should also not compete with commercial bank deposits but rather replicate physical cash. Like cash, a retail CBDC should preserve transaction privacy and protect the user from government scrutiny, surveillance abuses, as well as the other party in the transaction.

United Kingdom

Watch out Sand Dollar here comes coolest name candidate Britcoin - the U.K.'s effort to go digital. While the Brits have still not decided whether or not to issue a digital pound, British Finance Minister Rishi Sunak recently asked the Bank of England to stand up a CBDC task force to look at the case for Britcoin.  A digital pound, like the dollar, remains early stage and decisions will likely not be made until completion of a lengthy study period. However, Britcoin could lead an effort to reassert London’s status as a global trade center in the wake of Brexit.

India

The Indian government recently announced that it is currently considering a bill that would facilitate development of a CBDC and ban “private cryptocurrencies” such as Bitcoin and Ethereum. The coming legislation will also provide the Reserve Bank of India (RBI) with the legal authority to develop a CBDC.  The Reserve Bank of India has been grappling with a digital rupee viewing it as a way to promote financial inclusion but worried about threatening the role of commercial banks.  In a recent report, the central bank said a “CBDC can be designed to promote non-anonymity at the individual level, monitor transactions, promote financial inclusion by direct benefit fiscal transfer, pumping central bank [money into the economy during times of stress] and even direct public consumption to a select basket of goods and services to increase aggregate demand and social welfare.”

Beyond keeping up with other economic powers such at the U.S. and China, an Indian CBDC could be a bridge to the financial system for many Indians who possess a cell phone but remain skeptical of the traditional banking system and hasten a move toward a more efficient cashless society.

As governments across the galaxy discuss, debate, and implement various CBDC models, there are certainly common themes.

Central banks have embraced the power and promise of crypto to transfer value efficiently and in hyperdrive. However, governments remain skeptical of a decentralized system untethered from central banks and traditional monetary policy. This is where CBDCs storm in.  They offer the speed and efficiency of Bitcoin yet are controlled by central authorities.

How will this all play out? Are CBDCs really an alternative to a decentralized permissionless system built on an immutable open ledger? Will the digital yuan challenge the hegemony of the U.S. dollar? Is Emperor Palpatine really dead this time? Yoda was right, "Always more questions, than answers there are." As things move and evolve at force speed across the cryptoverse, "Patient you must be, my young Padawan."

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