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Authorities explore how to design central bank digital currencies

Central bank digital currencies are on the radar of central banks. Xenia Kalogirou of Elias Neocleous & Co discusses the issues they raise and how these are being addressed

The widespread digitisation of economies and rapid changes in the retail payment landscape resulting from the burgeoning interest in digital forms of payments, such as cryptocurrencies and ’stablecoins’, have prompted financial authorities and central banks to explore the possibility of issuing central bank digital currencies (CBDC). 

Meanwhile, the group of central banks and the Bank for International Settlements (BIS) have stressed that the significant adoption of money not denominated in the sovereign currency could limit the impact of monetary policy or the ability to support financial stability.

Consequently, by offering an efficient and convenient CBDC itself, a central bank may reduce the risk of alternative units of account dominating and, as a result, protect its monetary sovereignty and preserve a level playing field in payments.

The CBDC concept

Based on the possible features of the CBDC and its legal and financial implications, various monetary authorities and financial institutions have expressed their views on the definition of the CBDC. Some of the most noteworthy approaches are:

  • Committee on Payments and Market Infrastructure (CPMI): “CBDC is not a well-defined term. It is used to refer to a number of concepts. However, it is envisioned by most to be a new form of central bank money. That is, a central bank liability, denominated in an existing unit of account, which serves both as a medium of exchange and a store of value.”
  • Bank for International Settlements: “CBDC is different from cash, as it comes in a digital form unlike physical coins and banknotes. CBDC is also different from existing forms of cashless payment instruments for consumers such as credit transfers, direct debits, card payments and e-money, as it represents a direct claim on a central bank, rather than a liability of a private financial institution. This type of riskless claim also makes CBDC different from cryptocurrencies (such as Bitcoin) or other private digital tokens (e.g. so-called stablecoins such as Tether).”
  • Eurosystem: “A central bank liability offered in digital form for use by citizens and businesses for their retail payments. It would complement the current offering of cash and wholesale central bank deposits […]. The digital euro would be a risk-free form of central bank money (i.e., a digital representation of cash), which means that it is issued by the central bank and remains its liability at all times [...]. Commercial bank money and electronic money are by contrast liabilities of supervised private entities. Private money issuance needs to comply with the regulations and the issuing private institution is subject to supervision or oversight by public authorities.”
  • G7: “CBDCs are not ‘cryptoassets’. Cryptoassets are not issued by a central bank, can be highly volatile, and are not currently widely used for payments. CBDCs are fundamentally different from privately issued digital currencies such as stablecoins, which are a liability of private entities that seek to maintain stability in their price (typically in relation to stable assets such as fiat currency).”

CBDC design options

The various design choices, technical and organisational approaches, operating models and architecture of CBDCs are being researched by many stakeholders.

The design options for the technical implementations of a CBDC vary significantly. The main ones are:

i. Regarding the underlying back-end infrastructure for the provision of CBDC, there is discussion (see ECB (2020): ‘Report on a digital euro’; Bank for International Settlements 2020: ‘Central bank digital currencies: foundational principles and core features. Report no 1 in a series of collaborations from a group of central banks’) about the ledger’s structure. This structure could be centralised, with all transactions recorded in the central bank’s ledger, or decentralised (e.g. through the use of distributed ledger technology) where either end users, or supervised intermediaries acting on their behalf, would verify any payment. It could also be a combination (e.g. a centralised ledger could record only the total CBDC issued, with individual balances being stored locally on a smartphone or card).

ii. In respect of the form of access, researchers have identified two main options (see Committee on Payments and Market Infrastructures (2018): ‘Central bank digital currencies’; Deloitte (2021): Central Bank Digital Currencies (CBDC): ‘Regulatory and policy considerations in the US’): (a) account-based CBDCs (similar to balances in reserve accounts and most forms of commercial bank money) which could be implemented by opening accounts directly with the central bank or through supervised intermediaries via an identification scheme; and (b) token-based or value-based CBDCs (similar to cash and many digital currencies) which would probably require the involvement of supervised intermediaries and would be accessed via password-like digital signatures using private-public key cryptography, without requiring personal identification. 

iii. The taxonomy distinguishes between two forms of CBDC (see Bank for International Settlements (2021): Annual Economic Report, III. CBDCs: an opportunity for the monetary system): wholesale and retail (general purpose). The wholesale variant would serve the same purposes as the reserves held at the central bank and, as a result, would be restricted to a predetermined group of users. The retail or general purpose one would be similar to cash as a direct claim against the central bank and, hence, geared to the general public.

iv. As regards architecture and the distribution, the following models have been identified (see GFMA Considerations for Developing Central Bank Digital Currencies and ‘On the Road to a U.S. Central Bank Digital Currency – Challenges and Opportunities’): 

  • Direct model: a system operated by the central bank which handles all payments in real time and keeps records of all transactions. Based on this model, which represents the largest change to current market structures, the role of the present intermediaries, such as banks undertaking the onboarding and know your customer (KYC) procedures for customers, will be reduced, while the role assumed by the central bank will be significantly increased.
  • Indirect or intermediated model: a system where CBDC is distributed indirectly through intermediaries. The central bank, based on the decentralised nature of record-keeping, does not record retail transactions, but only the wholesale transactions/balances of individual payment service providers (PSPs). The complete records of retail transactions are maintained by the PSP. In the indirect model, the financial system nearly resembles the existing two-tier financial system where many of the roles and responsibilities of market participants remain the same; however increased safeguards and prudential standards would be necessary, as PSPs would need to be supervised to ensure at all times that the wholesale holdings notified to the central bank correctly reflect the customers’ retail holdings.
  • Hybrid model: a system that combines aspects from both the direct and indirect models. Real-time payments are handled by intermediaries, while the central bank periodically keeps a register of the transactions by updating and retaining a copy of all retail CBDC holdings. A hybrid model differs from an indirect model as it allows the central bank to substitute for the intermediary and restore balances in the event of an intermediary’s failure by reducing, in this case, the counterparty risk mainly associated with non-simultaneous transactions.

CBDC: legal considerations

The introduction and issuance of CBDCs raises fundamental legal questions (see Bossu, W; Itatani, M; Margulis, C; Rossi, A; Weenink, H and Yoshinaga, A (2020): ‘Legal Aspects of Central Bank Digital Currency: Central Bank and Monetary Law Considerations’. International Monetary Fund) in fields including tax law, private law, property law, contract law, payment systems and settlement finality law, insolvency law, privacy and data protection law, private international law and regulations regarding the prevention of money laundering and the financing of terrorism. 

As regards the legal basis for the issuance of CBDC by the central banks, the IMF observes that not all central banks have the authority and power to issue digital currencies and expand account access. Thus, it is imperative that each jurisdiction reviews the powers assigned to central banks and ensures that there is a strong legal foundation underlying the CBDC which describes inter alia the legal nature of CBDC and the roles and responsibilities of the central banks, the relevant competent government entities and the private sector in the design, issuance, distribution, access and continuous support of CBDC.

In a European context, according to the ECB Report on a digital euro, the primary Union law (i.e. Article 127(2) of the Treaty on the Functioning of the European Union (TFEU) in conjunction with Articles 17, 20 or 22 of the Statute of the ESCB, Article 128(1) of the TFEU in conjunction with Article 16 of the Statute of the ESCB and Article 133 of the TFEU) governing the issuance of the CBDC will be determined by the design features of the digital euro which are briefly plotted as (a) an instrument of monetary policy similar to central bank reserves and only accessible to central bank counterparties; (b) an account-based CBDC available to the general public; (c) a settlement medium for specific types of payment, processed by a dedicated payment infrastructure accessible to eligible participants; or (d) an instrument equivalent to a banknote. 

In respect of the possible legal tender status of the CBDC (i.e. granting by law its use as a means of payment with the power to validly and definitively discharge monetary obligations), based on the ECB Report on a digital euro, EU primary law does not exclude digital euro from the definition of a banknote. Hence the possibility for the Eurosystem to issue digital euro with the status of legal tender, which would consequently require payees/creditors to accept it for payments.

As observed by the IMF though it is fair that the state attributes legal tender status to a means of payment when that instrument is easily receivable by the vast majority of the population; otherwise fundamental questions might be raised, including from a fairness perspective.

Depending on the form of digital currency chosen for issue, whether account-based, token-based or both, law reforms would be necessary to include these instruments in the system and to ensure that appropriate data, privacy and consumer protections and transaction risk allocation are in place and that anti-money laundering/combating the financing of terrorism concerns and requirements have also been taken into account.

Digital euro

In July 2021, the ECB decided to launch a two-year investigation into a digital euro project, starting on October 1 2021. The investigation will include an analysis of the design, scope and distribution of the digital euro to retailers and the public, its impact on the retail payments market and the changes needed to the relevant European legislation. 

When the investigation is finalised, its results will determine the possibility of the development of a digital euro.

The ECB Occasional Paper No. 2021/286 on ‘Central Bank Digital Currency: Functional Scope, Pricing and Controls’ identifies three conditions for success of a CBDC under the condition that the risks of crowding out the private payment solutions are avoided or minimised to the extent possible: (1) legal tender status, to support effective merchant adoption; (2) motivations for supervised intermediaries taking into account their cost and revenue structure; and (3) demand from consumers to pay with CBDC in accordance with the nature of their transactions.

Based on the view of the Governor of Central Bank of Cyprus,  Constantinos Herodou (see ‘Central Bank Digital Currencies are coming,’ Adonis Adoni, October 2021, Gold Magazine), further experiments during the investigation phase of the digital euro project would provide guidance for decisions, assessments and future work on digital euro and finalisation of its desired design features.  This should help to avoid or mitigate any potential undesirable consequences for the accomplishment of the ECB’s mandate for the implementation of monetary policy, monetary transmission and financial stability.

Xenia Kalogirou
Senior associate, Elias Neocleous & Co

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