Takeaways from Russia’s CBDC project

It doesn't look like a wholesale CBDC will help Russia to get around sanctions, nor that a retail CBDC will be met with voluntary widespread acceptance...

Russia’s CBDC project is now more a question of when than whether. Earlier this month, the head of the central bank confirmed a concrete estimate of a launch timeline, with the platform going live for mainstream transactions next year.

There are three relevant stories behind this. One is the official focus on a retail CBDC, when you would think a cross-border CBDC would be more urgent given the impact of sanctions on Russian banks’ ability to make and receive trade payments. Another is the success so far of the West in thwarting attempts to use digital currencies to get around sanctions. And a third is the potential substitution of other types of digital assets for fiat in order to circumvent restrictions.

Let’s start at the beginning:

Russia’s CBDC origins

Russia’s central bank first hinted it was studying CBDCs in 2019, and went as far as formally soliciting public feedback in 2020. Among the ideas explored were a digital currency compatible with existing rails and payment types, the utility of smart contracts, use-specific payment tokens, and bank compensation.

In 2021, a paper published by the Bank of Russia outlined what the country’s CBDC could look like, still focusing on retail uses. Rather than centralize issuance and distribution at the central bank, it would use commercial banks as intermediaries, but with balance limits to mitigate any adverse impact. The paper talked about the need to develop an offline wallet, as well as about smart contracts to enable conditional payments and to limit some uses, such as for certain grants. It also suggested drawing up new laws giving the central bank powers to deny digital ruble access to certain companies and individuals.

Initial testing began in 2022, and in early 2023, the Bank of Russia announced the April launch of a retail CBDC pilot, to trial peer-to-peer transfers and the purchase of consumer goods. The necessary legislation authorizing the creation of a digital ruble took longer than expected, so the launch was pushed back several months, eventually kicking off in mid-August with 13 banks, 600 users and 30 companies across 11 cities. The pilot is currently being expanded to include an additional 19 banks, including Russia’s largest financial institution Sberbank. A broader scaling is expected in 2025, with “mass adoption” occurring five to seven years after that, according to the central bank.

Why a retail CBDC?

Here’s where we pause to take a look at the first story: the focus on a retail CBDC. Why, when arguably a cross-border CBDC would be more urgent given the impact on trade of sanctions?

The easy answer is inertia and momentum, which has weight even in autocratic societies. Russia started public work on its CBDC before it invaded Ukraine, back when retail CBDCs were not only a hot topic in central bank boardrooms, but they also offered the biggest social impact.

A slightly deeper answer, also easy, is that financial regulators like the idea of greater transparency into commercial transactions and a tighter control over the use of money. This is especially relevant if regulators expect more social unrest. The central bank has promised that use of the CBDC will be optional. But it’s not hard to see how that could change, step by small step.

The passed digital ruble law makes no mention of privacy, but does specify that transaction data related to “security personnel” will be encrypted (implying that everyone else’s won’t). It also gives the government powers to seize digital ruble balances when appropriate.

There is a geopolitical angle to the retail CBDC: just before passage, the new law was amended to expand the ways foreigners can access the digital ruble, adding authorized foreign banks and the central bank itself as contact points.

Would a wholesale CBDC help get around sanctions?

This segues into the second story: the scramble to launch a wholesale CBDC, with the aim of supporting cross-border trade without needing to touch the dollar-denominated global payments system.

The cross-border use case makes sense, sort of. Almost all Russian banks are on the western sanctions list, which limits their ability to pay for imports. Exports are less of an issue, since Russian businesses are generally happy to receive yuan – before the Ukraine invasion, the Chinese currency accounted for 0.4% of exports and 4.3% of imports. Now it accounts for 34.5% and 36.4% respectively.

Here is where the “sort of” comes in. If Russia’s transactions with China are increasing, why does it need a wholesale CBDC? Its systems are already set up to accept foreign currencies – a CBDC is a profound, expensive and risky re-wiring that does not, as yet, promise a clear benefit to the user, even if the aim is to get around sanctions.

Of course, faster settlement and greater transparency improve financial flows. But, for now, it’s not clear that isolated CBDCs will deliver that. First, there is unlikely to be enough demand, at least at first, to justify the disruption, assuming the CBDC will run as a standalone currency. The weight of the ruble in global reserves today is minimal. If trade partners are not keen to hold the offchain ruble, why would they want to hold the onchain version?

Second, a problem with all CBDC projects currently in development is that there is no network or functionality standard. Even when launched, trade partners would have to do some tech development on their side. Would they be willing to undertake this expense in order to hold a digital currency they probably don’t want?

Then again, we could see Russia apply to join the mBridge project as a CBDC partner, which would facilitate exchange. Currently, the key participants of mBridge are China, Hong Kong, Thailand and the UAE, with participation and oversight from the Bank of International Settlements. You see the problem? Unless sanctions are lifted, Russia couldn’t join a group with any ties at all to the west.

In sum, Russia has a strong incentive to drastically reduce its reliance on the global dollar system. But a digital ruble probably isn’t going to help much with that.

Could tokenized assets work?

This brings us to story number three: tokenized assets. Regular readers will know that I get excited about the role that blockchain-based assets can play in the blurring of boundaries between securities and money.

Russia seems to be thinking along those lines. Last month, its government passed a law authorizing the use of tokenized assets as payments in cross-border trade. Russian businesses have already tokenized precious metals. In 2022, nickel producer Norilsk tokenized palladium on its Atomyze platform, and in January 2023, Sberbank tokenized gold on the Sber blockchain, but neither token was created to be used in payments, as at the time that was prohibited by Russian regulation.

In theory, this new law would abstract the need to use global financial rails to make cross-border payments by substituting dollars for blockchain-based assets. And, presumably, trade partners would be more interested in holding tokenized gold or palladium than a tokenized ruble.

But, less than two weeks after the passage of the new rule, the US added most of Russia’s tokenization platforms to the list of sanctions (those of Sberbank and Norilsk were already on it). This makes it risky for any counterparty to accept the transfer of tokens from an address linked to the named entities.

What about cryptocurrencies? The State Duma is currently considering a bill that would allow the use of cryptocurrencies in cross-border trades.

In June of last year, Rosbank announced the development of a facility that would enable importers to settle transactions in cryptocurrencies. Rosbank is one of Russia’s largest financial institutions, owned by a company controlled by Vladimir Potanin who also has controlling interests in nickel (Norilsk), gold, agriculture, and other conglomerates. Both Rosbank and Potanin are on sanctions lists, so you can see how this facility could be useful.

Russian law prohibits the domestic use of cryptocurrencies for transactions, so the plan was for an offshore entity to handle the transfers. But last month, the US placed this offshore entity on the sanctions list, making it hard if not impossible for it to send crypto to western-facing trade partners.

With the new law, Russian entities could manage the cryptocurrency transfers themselves, leaving the idea less vulnerable to western rules. But the potential scope would still be limited as the US is getting very good at sanctioning businesses that help Russia avoid restrictions.

The takeaways

In sum, it’s not easy for CBDCs, tokenized assets or even decentralized cryptocurrencies to get around external and politically motivated controls. Platforms, developers and counterparties can be targeted and materially inconvenienced, as can the on- and off-ramps necessary for connection to the fiat world.

Apart from the complexity of introducing new payment tokens, we can extract two main takeaways from Russia’s progress.

One is that wholesale CBDCs can introduce certain cross-border transaction efficiencies, but only if there is widespread acceptance and compatibility, neither of which is simple to achieve. In a fragmenting world, with trade coalescing into blocks and bilateral agreements becoming more significant, the advantages are less clear. China’s CBDC is more likely to be used between Russian businesses and non-Chinese trading partners given its probable relative liquidity and infrastructure support, than is the digital ruble.

The other takeaway is that retail CBDCs are likely to only become widely used in authoritarian regimes, as individuals more steeped in democratic tradition tend to distrust what is obviously a deeper degree of surveillance. The Russian retail CBDC will probably get some pick-up, especially if its use is mandated in certain situations. But, when given a choice, it’s not clear why individuals would want to put up with low limits, frequent wallet top-ups, and slow transactions.

Nevertheless, the exploration of these concepts does push the boundaries of how money can work. Beyond the valuable information in failed experiments, even CBDC development has significant secondary effects. Key among these is the new form of thought: the experimentation triggers questions around what money is, who gets to control it, and how much information we are comfortable with sharing. Here, rather than the answers, it’s the questions that are more important in shaping what finance looks like going forward.

(excerpted from the Crypto is Macro Now newsletter)