Making sense of the new kid on the Digital Payments block - Central Bank Digital Currencies (CBDC)

Keeping up with the world of fintech and especially digital payments, feels like standing on a treadmill running at 20 kph; standing at the same point seems like a lot of effort. It also, sometimes, feels like you are drowning in an alphabet soup.

While we were all trying to make sense of all the digital payments innovations across the world over the last few years - Apple Pay, Google Pay, AliPay, and what not; now we have the PBOC running a limited scale experiment in the area of CBDC (Central Bank Digital Currency) or DCEP (Digital Currency Electronic Payment).

China's central bank has issued 10 million yuan ($1.5m; ￡1.1m) worth of digital currency to 50,000 people in the Shenzhen area via a lottery. - BBC

This has generated a lot of interest in the minds of people, as to what exactly is CBDC and in this specific case DC/EP ( Digital Currency/Electronic Payment).

So, as we try to unpack this, let us try to get answers to the following 3 questions:

• Why are Central Banks focusing their time and attention on Central Bank Digital Currencies?
• How CBDCs are/will be different from various other Digital Payment Options
• Will there be any impact, if at all, on Commercial Banks

So, what really made the PBOC think in the direction of issuing CBDC or Digital Yuan for simplicity?

Well, essentially 3 things:

1. Move from Physical to Digital - globally, the demand for cash is slowly moving to digital modes of payments what with the proliferation of smartphones, improvement in digital connectivity, etc.
2. Threat to Central Bank monopoly on issuing currencies - With rise of independent alternatives like Bitcoin and private innovation like Libra, central banks the world over perceive a threat to their traditional role on issuing currencies, regulating money supply, etc.
3. Dominance by few Private Players of the Digital Payments Space - This may be not as big a reason as the above two, but central banks must have been watching how private players like WeChat & Alipay have cornered the entire digital payments landscape and the risks emerging out of this concentration.

Let us talk in detail about threats to Central bank monopoly on issuing currencies?

There have been developments over the years that have emerged as potential threats to the Central Bank monopoly on currency, bitcoin has been the most talked about one. The sheer lure of the bitcoin to its users (as a medium of exchange) is anonymity in a transaction is what makes it appear dangerous to regulators.

And, of course facebook entering the field with what can only be described as the most ambitious endeavor ever undertaken by a private company (Sorry SpaceX). It decided to make its project (appear) less confrontational to regulators the world over by saying that its currency (Libra) will not have an inherent value but would instead derive its value from a basket of currencies (simplistic explanation 1 Libra = 0.1 $ + 0.1 Euro + 0.1 Yen). Now this is going to be a private blockchain, run by a global giant, deriving its value from a basket of fiat currencies.

This probably accelerated the regulators' thinking and effort around their own development of digital currencies. The regulators did not want to let go of their traditional monopoly on issuing currency, controlling money supply and having (almost) complete visibility to the movement of money within their respective economy. This was obviously moving in this direction owing to the significant developments happening around digital payments like those of Alipay and WeChat in China, and elsewhere.

All money is created equal, but some money is more equal than other

So, after all that background we come to what is CBDC. Well, almost; when I first heard about central bank digital currency, the thought that came to my mind was how this is any different from the money that I have parked in my bank/wallet and use those n number of apps to transact. you may or may not have that same question, but if you did/do, welcome to the club.

This brings us to the fundamental difference between cash and amount parked in a bank/wallet and how the obligation/safety of those change.

A banknote is the obligation of the central bank in the country - put simply, if you have a Rs. 100 note with you, it is the obligation of the Reserve Bank of India. Ok, what about the 100 Rs, lying in your bank account with any commercial bank. As some of the recent developments in the banking space have suggested, that deposit in bank is not an obligation of the central bank but are only covered to the extent of deposit insurance.

Cash is claim on the central bank; money lying in a commercial bank is only guaranteed upto the value of deposit insurance

I can imagine that is too much to process and digest, and shocking more so, as all these years, there have been a concerted and sustainable push towards moving people from cash to digital payment methods but suddenly you realize that the safety aspect on both of them is entirely different - ofcourse I am not considering here the multiple benefits of digital payments.

Anyway, coming back to the point - now you understand what is the difference between cash and money lying in bank account. now time for a thought experiment - what is the best way to arrive at a best of both worlds - you guessed it right, a digital currency issued by central bank. and that everyone, is CBDC.

What does this mean for Commercial Banks?

If you are thinking, what would CBDCs do to commercial banks, you are on the right track. Commercial Banks so far have worked on the business model wherein they are middlemen between Central Banks and general public and businesses. To keep their money safe and participate in the banking network, folks have to open an account with a commercial bank and then use that money to lend .

Now there are obvious problems that you can figure out with CBDC; cash is easy, the central bank prints it and sends them out in the market via commercial banks; it only has to do account keeping between commercial banks and not with the general public; that job is delegated to commercial banks. But if people start getting digital currency issued by Central Bank and maybe have direct accounts with the central bank, where would that leave commercial banks. Of course, it is not my point that commercial banks will vanish tomorrow, but yeah, the going will be significant different, if not difficult.

So, if the central bank starts issuing digital currencies, it gives rise to many questions, mainly:

1. What would be the role of commercial banks? Will they be disintermediated by the Central Banks?
2. What would be the role of Central Banks? Will the Central Bank maintain retail ledger and take over that role from commercial banks?
3. Is there only one single model of making CBDCs work or are there alternative models which need to be deliberated upon and chosen by Central banks?

What could be the possible models for CBDCs?

Single Tier CBDC Model

Two tier CBDC Model

The Single Tier model is pretty self explanatory wherein the Central Bank manages both user ops and retail payment ops.

The easier analogy to understand the 2 Tier model will be to compare it with UPI; wherein you may hold your money with any commercial bank but PSP entities in the middle (Google Pay, PhonePe, etc.) help you access/move that money. In this case also, PSP intermediaries help central bank manage user ops and payment ops and the central bank may chose to record a copy of retail ledger at regular periodic intervals or may only concern itself with wholesale ledgers.

I guess this has been a long enough post and I sincerely hope that through this post, I have been able to do the three things that we started out to achieve.

I am sure you have more questions on CBDC, especially on how would they work, I would love to discuss those, do feel free to leave your questions below or DM me.