A central bank digital currency can shape the national payment system

With the dominant use of digital payments, it seems obvious that, as the traditional issuer of paper money, central banks would consider creating a digital version of their own. But given the wide availability of digital payment tools, they hesitate. Ousmène Jacques Mandeng writes that if central banks want to strengthen the payment system and influence the direction of its development, a central bank digital currency is a potent way to achieve it.

Central banks are exploring the idea of issuing a digital banknote or retail central bank digital currency (CBDC). Today, they offer only physical banknotes to the general public.

With increasing digitalisation in payments and already dominant use of digital means, it seems obvious that central banks should follow suit. Yet, many remain hesitant amid the availability of a broad range of alternative, typically bank-based, digital payment tools. Andrew Bailey, Governor of the Bank of England, recently questioned the need for a retail CBDC if banks can offer a good alternative. The question therefore is, is a retail CBDC needed?

The answer depends on how central banks see their role.

Banknotes

Central banks were established mainly to facilitate banks’ orderly issuance of banknotes, typically with a monopoly on the right to do it (though in many cases not immediately granted).

The proliferation of banknotes occurred with the generalised adoption of the gold standard towards the last quarter of the nineteenth century. They served as a proxy of payments in gold, were backed by gold and typically bestowed a right to the bearer to be converted into the precious metal. Banknotes were a convenient way to pay. For the general public, for a long time they remained the only payment instrument at the point of sale and in person-to-person transactions.

Fast forward to today. Payments, including at the point of sale, are initiated mostly by convenient digital means like cards and mobile apps. As end users, the general public typically no longer interacts with paper money. At the point of sale, an end user may be indifferent between using a debit or credit card, Google Pay, PayPal or a CBDC. This makes it harder to offer a differentiated payment experience and drive payments to a CBDC. Here are some considerations:

Privacy

The possibility of central banks issuing digital currencies raises privacy concerns. Banknotes offer unparalleled anonymity that any digital payment means will not be able to match. At the same time, it is not central banks’ remit to safeguard privacy. Given the wide range of payment instruments, citizens can choose which one to use.

Governments today in many instances can already request financial transactions data. Broader privacy concerns would have to be addressed through privacy legislation. Society will also have to weigh the cost of anonymity in payments, such as facilitating money laundering, tax evasion and other illicit transactions, against the benefits of an untraceable transaction.

Bank deposits

Banks have also voiced opposition to the idea of a retail CBDC. It rests in large part on the assumption that the general public, if given the choice, would want to hold central bank money, considered normally safer than bank deposits.

This would trigger a migration out of bank deposits. It is not clear whether those concerns are warranted, as citizens do not seem to allocate liquid balances, those held for transaction purposes, on grounds of safety concerns. Otherwise, bank deposits in public institutions or very large institutions would crowd out other bank deposits which is not the case, including during times of distress.

The decline of the use of banknotes naturally raises a question about the role of central banks in retail payments. Banknotes today are insignificant in terms of value processed. By far most payments are credit transfers, cards and direct debits. Their small share in payments is indicative of the fact that retail payments work well without a central bank instrument.

CBDC is about payment processing

A CBDC has two main components: payment instrument and payment processing. How a payment is triggered (swiping a card or pressing the pay button) and the device that is being used (a card or mobile app) will unlikely differ from existing means and in many cases will be the same. The payment instrument, the CBDC, will serve in payment processing. It is not about how payments are made but how they are processed.

The innovation with retail CBDC is the use of blockchain, with its advanced functionalities and composability as infrastructure for processing payments. Where a public blockchain is used, it is a readily accessible infrastructure and offers significant economies of scale.

The role of central banks

The most important operational role of central banks by far is to ensure the smooth functioning of the payment system. Having their own digital currency offers them a strategic opportunity to shape the evolution of payment processing. The use of blockchain would support diversification, choice and resilience in payment processing and expand access to central bank money across a wider range of financial market infrastructures. It would also signal forcefully that central banks are willing to embrace new payment developments.

Central banks continue to struggle to message the need for a retail CBDC. It is largely because the benefits are unlikely to accrue to the public directly. In a digital payment environment with multiple instruments, the banknote may have no natural successor. Central banks need a vision for their role to drive retail CBDC. If they see greater diversification in payments as a means to strengthen the payment system (and hence to meet key public policy objectives), and if they believe they should influence the direction of development (including giving rise to possible new payment applications), then adoption of a retail CBDC seems the obvious choice.

Sign up for our weekly newsletter here.

• This blog post represents the views of its author(s), not the position of LSE Business Review or the London School of Economics and Political Science.
• Featured image provided by Shutterstock
• When you leave a comment, you’re agreeing to our Comment Policy.