Central bank digital currencies – the end of money as we know it?

Hogan Lovells

Hogan Lovells

Retail Central Bank Digital Currencies or “CBDCs” are hot right now with estimates that as many as 80% of the world’s central banks are engaged in pilots or other activities.  The Bank of England, the European Central Bank and the U.S. Federal Reserve are all publicly exploring their use cases while China has unveiled its digital yuan ahead of the Beijing Winter Olympics.  But, depending on how they are designed and implemented, retail CBDCs could fundamentally change how we think about money and interact as consumers with the financial system.  There are a number of legal issues that CBDCs could cause for today’s banking ecosystem so should banks and payment services providers be worried?

Why have a CBDC?

Financial services are changing at an unprecedented rate with the use of new technologies speeding up payments and giving consumers greater access to a wider range of services through their phone. But despite this, little has changed in terms of the basic rails that underpin the banking and payments landscape. 

The emergence of cryptocurrencies and distributed ledger technology opened up new possibilities to fundamentally alter that landscape but progress has been hampered by issues including price volatility, privacy and interoperability. The emergence of stablecoins has seen a potential leap forward in addressing particularly the first of those challenges, but still relies heavily on an exchange of value with fiat currencies. 

The possibility of private stablecoins becoming a significant means of payment seems to have spurred central banks into acting. Whether they are being driven by the potential monetary policy benefits to them, or also as a defensive action against concerns they have with the emergence of truly global private stablecoins, almost every major market is now exploring the possibilities of launching a CBDC. Some examples include:

  • The UK has announced a planned consultation in 2022, which could result in the launch of a “Britcoin” in the second half of the decade.
  • In Europe, the ECB has launched a 2 year investigation phase, with possible launch from 2026 – see our Engage article ‘The digital Euro – taking shape in 2022’ for further details.
  • In the U.S., the Federal Reserve published a discussion paper in January 2022 on the pros and cons of a U.S. CBDC.

In addition, a number of central banks have gone further and started issuing a CBDC. These include the Bahamian “Sand Dollar”, Sweden’s experimenting with the e-Krona and China’s digital Yuan, the adoption of which has expanded significantly ahead of the Beijing Winter Olympics, with a pilot mobile app being released in January 2022.

Central banks see CBDCs as providing a number of potential benefits.  These include:

  • Providing a new foundation to underpin the payments systems, potentially bringing further efficiencies to payments, particularly on a cross-border basis.
  • Maintaining the safety and security of the money in the digital economy by having it backed by a central bank.  Until now, digital money has traditionally been a form of commercial money issued by banks, which can fail but are subject to capital and liquidity requirements designed to mitigate against that. But the emergence of private crypto-currencies and stablecoins threatens that security as issuers are not (yet) generally subject to prudential requirements similar to those imposed on banks. 
  • For financial inclusion, there is an argument that a retail CBDC would be more accessible to all and allow more people to have direct access to digital financial services products. 

“A solution in search of a problem?”

Not everyone shares these views on the potential benefits of a CBDC. A recent report from the House of Lords’ Economic Affairs Committee posed the above question and expressed clear concern that there has not yet been “a convincing case for why the UK needs a retail CBDC”. The report concluded that “while a CBDC may provide some advantages, it could present significant challenges for financial stability and the protection of privacy.”

It is clear that the use of cash is declining and that decline has gained greater impetus during the pandemic with many more customers turning to card and digital payments. As cash is currently the only form of central bank-backed currency that is available to retail customers, it is natural that central bankers would want to consider alternatives. 

But do customers want it?  It is perhaps too early to say but one challenge for a CBDC is to consider why customers would want to use it. The increased demand for digital forms of banking and payments has been met by a plethora of apps and cards issued by traditional banks and newer Fintech challengers. Those products are popular and widely used and given the protections already built into the regulatory framework, the vast majority of customers would see little benefit in having a CBDC instead, although those holding amounts above depositor protection thresholds would see a benefit in holding their funds in a CBDC.

While stablecoins have increased in market capitalisation and use, they are not yet being used for payments in a way that would threaten commercial money issued by banks. 

So, at least for the moment, it is unclear whether consumers would really want to switch in high volumes to a retail CBDC. That could change as retail CBDCs are developed. For example, one functional option would be for a CBDC to be issued as “programmable” money, which can only be used for a specific purpose, and it may be that innovations such as that create use cases for retail CBDCs that make them very different from conventional cash or commercial money. But at the moment, this all remains theoretical. 

Issues that CBDCs could create

Assuming the demand for CBDCs changes over time and retail CBDCs become widely used, they could significantly change the banking and payments landscape, raising a number of legal issues.  These include:

  • Changes in how banks operate: Bank deposits remain a significant source of funding for their lending and other activities. There is no certainty that CBDCs would need to be held by a bank, in which case banks could find themselves with significantly lower levels of deposits and would need to fund their activities through other funding methods. This would likely alter the pricing models of a whole range of products and may lead banks to exit certain products as they adapt to a very different business model. 
  • The risk of bank runs: If consumers continue to maintain bank deposits, those deposits could be at greater risk of flight in an unstable market. If depositors have any concerns about the solvency of financial institutions, they would be likely to move their funds into central bank-backed CBDCs, making a run on a particular bank, or the sector as a whole, much more likely.
  • Operational resilience: Banks and payment firms are subject to operational resilience requirements to ensure the stability of the infrastructure. What requirements will need to apply to CBDC wallet providers?  How would the system cope in a world without offline transactions in the form of cash, which could be used in extreme situations?
  • Cybersecurity: A linked threat comes from cybersecurity. Threats to the centralised ledger would be the preserve of the relevant central bank but the wallet providers could also be vulnerable.  What requirements would they be subject to?
  • Privacy: One of the key issues for a retail CBDC is how to address the anonymity that comes with cash and the corresponding issues if that anonymity no longer exists in a CBDC world. 
  • Financial crime: A linked concern is then, if there is anonymity for some aspects of the retail CBDC, how will that fit with the financial crime obligations of the participants in the payments system? 
  • Identity of wallet providers: The above issues will place a great deal of responsibility on the wallet providers and, unless wallets are required to be held with banks, a regulatory regime will be needed for those wallet providers. As the CBDC is backed by the central bank, the prudential requirements should not need to be at the same level that banks are currently subject to but what is the appropriate level for the regulatory burden?  Where will liability sit in the payment chain if there is a particular issue with the retail CBDC? 

Next steps

These concerns and others are currently being considered and debated by central banks and regulators around the world. Many can potentially be mitigated by CBDC design choices. A non-interest-bearing CBDC, for example, would be less attractive as a substitute for commercial bank money or there could be limits placed on how much retail CBDC an individual could hold. But others will require a careful balancing of competing benefits and risks.

While much remains uncertain, one thing is clear – there is a growing focus on retail CBDCs and a good chance that they will become more widespread over the coming years. When they do, they could change the banking and payments ecosystem as we know it, with potentially far-reaching knock-on consequences. The industry should ensure it engages in the debate to make its voice heard and to help central banks and regulators understand the practical challenges that retail CBDCs could bring.

[View source.]

DISCLAIMER: Because of the generality of this update, the information provided herein may not be applicable in all situations and should not be acted upon without specific legal advice based on particular situations.

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