Insight & Analysis

Focusing on the fundamentals of CBDCs

Published: May 2023

As many countries around the world pilot central bank digital currencies (CBDCs), one policymaker calls for caution and a back-to-basics approach by focusing on CBDCs’ purpose, mitigating their risks, and implementing a high bar for their technology.

As the saying goes, it’s money that makes the world go round. But, as Carolyn Wilkins, External member of the Financial Policy Committee at the Bank of England, points out, that’s not true. It’s actually trust that makes the world go round.

With so many countries planning and piloting central bank digital currencies (CBDCs), that trust is crucial because of the role this new money will have in terms of financial stability.

Speaking at the OMFIF Digital Monetary Institute symposium last week, Wilkins said the recent run-on Silicon Valley Bank, as well as the collapse of the terraUSD stable coin, is a reminder that runs on deposits in the future could be exacerbated by new technology and new forms of money. “Money is the core of any financial system and relies on broad-based trust. A central bank digital currency is no exception,” Wilkins said.

In her speech Wilkins pressed for the need to focus on the fundamentals and outlined three principles that should inform the design of CBDCs. Firstly, there needs to be a focus on the purpose and objectives and an avoidance of ‘mission creep’. Secondly, the financial stability risks should be identified and effectively mitigated. And lastly, there should be a high bar set for the technology used for CBDCs.

With the first principle of purpose, Wilkins said there needs to be a focus on the problem that is being solved, particularly in markets like the UK where there is already a proliferation of payment forms. One key motivation is the safety the central bank money provides because it is viewed as a safe and trusted asset. Cash serves that purpose – because it is issued by the central bank and backed by the state – but its use is declining. This, Wilkins pointed out, is the reason why many central banks are designing CBDCs, “to ensure that central bank money can remain available and useful in a modern economy in order to support monetary sovereignty and financial stability”.

On the second principle of identifying and mitigating financial stability risks, Wilkins homed in on the issue of financial system stability. There is the question of whether a retail CBDC would challenge the commercial banks and ultimately disintermediate them if the digital currency is more popular and individuals choose to hold more value of it in their accounts over regular bank deposits. This could impact on deposit levels at commercial banks as well as their ability to lend. Also, with more money held in the form of a CBDC, monetary policy could also be impacted. If – unlike cash – a CBDC is remunerated and can earn interest then a central bank may have more direct control over its monetary policy, for example. Base rate changes would be directly passed on through its own money, rather than the central bank relying on commercial banks to pass on the rates. There are particular concerns about how this kind of scenario would play out during a crisis, and whether the CBDC – and its accompanying policies of bank liquidity regulations – would be a stabilising factor when the system is under stress.

And on the third principle of the choice of technology, Wilkins said, “Here the bar must be set high, particularly given the central role a retail CBDC would have in the financial system and the reputational implications for the central bank of any flaws”. Once the initial model has been decided – such as a ‘platform’ or ‘two-tiered’ model – the highest standards need to be implemented for privacy, security, resilience, performance, extensibility and energy use. All of these, pointed out Wilkins, have serious challenges that need to be addressed. As with the first two principles, these issues need to be thought through clearly to ensure that the trust in central bank issued money is maintained. And with trust, perhaps one day it will be CBDCs that make the world go round.

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