There is no universal design or recipe to implement central bank digital currency (CBDC), the International Monetary Fund (IMF) asserted in its report on the challenges and implications of CBDCs in six different countries. It further recommended that countries should share information and insights from their projects, and extend cooperation on policy and design issues of CBDCs.
Key takeaways from the report:
- The IMF does not think that countries will have to choose between centralised and distributed technology, and central banks could adopt CBDCs that utilise different technologies for different ends.
- It pointed out that all CBDCs currently in circulation have design characteristics that limit competition with bank deposits.
- Countries are looking to balance key aspects of the traditional monetary and financial system while reinventing the role of central banks in the digital era.
- They will find it difficult to make choices in a field which is rapidly-evolving, and deal with costs associated with the development process.
- Countries should not shy away from pushing the boundaries of innovation to explore features such as off-line capacity.
The report offers insight that may help nearly 90 countries, including the US, China, Russia, and many in the EU, currently exploring CBDCs. India is looking to introduce its CBDC in early 2023 as deliberations on its design and security are currently underway at the Reserve Bank of India.
What are the operating models identified by the IMF?
The report examined six advanced CBDC projects in The Bahamas, China, Canada, Organisation of Eastern Caribbean States, Sweden, and Uruguay. Many countries continue to explore how CBDC will be issued and circulated, and what the role of the central bank and the private sector will be in the system.
- First model: The report calls it “unilateral CBDC” where the central bank carries out all functions in the payments system, from issuing the CBDC to distributing it, and interacting with end-users.
- Second model: “The second model entails issuance by the central bank, but includes a role for private sector firms to interact with the end-user. The intermediary role can be filled by financial firms, but also other types of companies such as payment service providers and mobile phone operators,” the report explained. It cautioned that the model would require the central bank to regulate other actors, which adds an extra layer of legal and operational complexity.
- Third model: In this model, digital currency is issued by private firms that back the issuance by holding central bank liabilities. It makes it a stablecoin, or a special type of e-money, as it is not issued by a central bank and may be referred to as synthetic CBDC or sCBDC.
What are the features proposed by the IMF?
The report said that CBDCs need to be designed keeping in mind certain features which can support countries’ policy goals and mitigate risks.
Restrictions to ensure financial stability: The report said that central banks with CBDC projects should commit to not jeopardising financial stability and avoid any sudden shifts to the structure of the financial system. Some of the risks arising out of CBDCs include crowding out banks and facilitating bank runs.
- Restricting remuneration of CBDC: Three central banks, The Bahamas, China, and ECCU, do not pay interest on CBDC holdings in order to limit CBDC competition with bank deposits. “There is a potential policy trade-off between limiting competition with bank deposits and ensuring an effective transmission mechanism of monetary policy,” the IMF wrote in the report. A possible solution is a CBDC with an interest rate that is consistently lower than the policy rate, the report suggested.
- Quantitative Restrictions: “Small CBDC holdings are allowed without the need for identification or other KYC procedures to lower the threshold to onboard new users in aforementioned projects,” the report said. It highlighted features like limits on sending money to a wallet that has reached its specified limit, coupled with an error message. It also noted that CBDC holdings can be connected to a bank account to which excess holdings of CBDC may automatically be transferred.
Dealing with anonymity: “Anonymity is one of the key traits of cash, and the rise of digital payments threatens the lawful or legitimate preference for anonymity by certain segments of the public or for certain purposes—such as buying a present for one’s spouse,” the report observed. However, anonymity can also be used for illicit purposes and can undermine AML/CFT measures.
“Anonymity, therefore, poses a policy trade-off—the more anonymity, the larger the risk for illicit use.” — IMF report.
- Use tiered wallets: Referring to CBDC projects of China and the Bahamas, it was suggested that a tiered selection of wallets with different levels of thresholds can be provided wherein those with lower thresholds allow for greater anonymity. “The use of tiered CBDC wallets gives rise to ‘policy synergies’ between anonymity, risk-reduction (of bank runs), and financial inclusion,” the IMF wrote in the paper.
Coming up with offline capacity: “The ability to pay when not connected to main telecommunication systems is important to increase resilience in crisis situations, such as during natural disasters and armed conflicts,” the IMF advised. It is especially crucial in areas with patchy telecom access.
- The IMF said that the feature has posed technical complications. There is also confusion over what constitutes going offline.
- It becomes difficult to resolve this issue in events such as prolonged black-outs or electromagnetic disturbances. The report said that China has tested different solutions, and claims that it has safe and efficient offline payments in place.
- “These include hardware-based e-CNY wallets placed inside mobile phones, or held as cards that can make payments to another mobile phone wallet in physical proximity without internet access,” the report said.
- It went on to add: “To reduce the effects of illicit tampering with the devices, which could lead to double spending and counter-feiting, each user can only perform a limited number of off-line payments before needing to go back online to access the main ledger.”
Enabling cross-border payments: Many central banks and international organisations are evaluating the use of CBDCs to enhance the efficiency of cross-border payments, which are generally costly and inefficient. The IMF wrote that discussions are ongoing to leverage CBDCs for cross-border payments. Some of the problems on this front are-
- Technical interoperability: “The lack of coordination on technology and messaging standards in initial stages of development could imply that retrofitting CBDC for cross-border use will be costly and complex,” the report warned. It said that decentralised forms of compatibility between different DLT systems may be promising.
- Legal and regulatory harmonisation: The countries facilitating payments may require harmonisation regarding the treatment of data and privacy, tax and payments laws, and capital flow management measures to explore cross-border transactions.
Developing legal backing for CBDCs
CBDC requires a legal framework that clarifies whether the central bank has the mandate to issue CBDC and what status it would have legally. The report flagged the following legal challenges:
Law follows technology: The report asked central banks to initiate legal reflections very early in the process which should be complemented with sufficient internal legal capacity in central banks’ legal departments. It recommended the measure because the operating and legal design of CBDC was initially driven by technological developments, under the advice of consulting firms.
Understanding the legal nature of CBDC: The report said that central banks should consider combining internal capacity building with a needs assessment for external counsel while initiating dialogue with financial intermediaries to gain insights on how CBDC impacts their business models.
Flexibility during pilot stages: The IMF said that several central banks saw fit to not reform the law in the pilot phase, but recognised that it would be necessary for the final phase. “Maintaining this type of flexibility during the pilot phase may be useful for other central banks, in particular at a stage where CBDC is not yet issued as an actual liability of the central bank, and central banks may alter fundamental design features subsequent to the pilot,” the report explained.
Specific vs. general law reform: The fastest route, according to the IMF, will be to modify the central bank law and other laws to strengthen the legal basis for CBDC issuance. However, it also pointed out that a few central banks (The Bahamas) chose to opt for a broad reform of the central bank’s charter to address several legal issues. It recommended that countries should assess whether CBDC-related law reform could be an opportunity to introduce other legal amendments.
Legal tender status: The IMF advocated granting legal tender status to CBDC. “This approach could be possible under a fairly “relaxed” legal conception of legal tender status, with ample space for contractual derogations,” read the paper.
What were the policy goals identified in the report?
Some of the crucial goals identified were:
Promote financial inclusion: It is one of the common goals of several projects. It entails access to appropriate and affordable financial services and is associated with poverty reduction worldwide. “CBDC could potentially facilitate financial inclusion by increasing access to digital payments and thus serving as a gateway to wider access to financial services,” the report said.
Access to Payments: The following aspect is associated with financial inclusion but differs from financial inclusion as many countries with high rates of inclusion suffer issues with payments. “Some central banks are concerned that private payment service providers might not find extending services to all parts of the population sufficiently profitable, and that a declining use of cash will exacerbate the problem,” the report remarked.
- Bringing efficiency into payments: Many countries face high operational costs, even for existing digital payments. CBDC is a potential policy tool to offer digital forms of payments that are cheaper to operate, IMF commented. “The non-profit nature of central banks means that they could potentially offer low-cost payments as a public good,” the organisation said.
- Ensuring resilience of payments: Countries are looking to secure the ability to pay and extend government transfers to individuals under severe circumstances especially in disaster-prone situations. Some of the concerns include destruction of physical, financial infrastructure and impediments to shipping cash.
Reducing illicit use of money: Cash offers anonymity and ensures the lack of an audit trail, making it conducive for illicit transactions (for example, tax evasion, money laundering, and terrorist financing). CBDC can address this problem as per the report.
Monetary sovereignty: The IMF acknowledged that new forms of digital currency may have a competitive advantage to older forms of currencies leading to currency substitution. “If a sufficiently large portion of a country’s population adopts a foreign digital currency or a global stablecoin, the ability of the country to carry out several crucial central bank functions might be impaired, such as monetary policy and lender of last resort,” the paper wrote.
Develop competition: CBDC is likely to increase competition in a country’s payments sector. It could compete with existing forms of payments. It would also ensure low barriers of entry for new firms seeking to offer new payment services if CBDC is designed as a platform open to private payment service providers.
- Nandan Nilekani suggests India’s CBDC should have anonymity to avoid concerns of surveillance: Report
- PM Modi announces digital rupee will be interchangeable with physical cash, offering glimpse into India’s plan for CBDCs
- RBI will issue digital rupee cryptocurrency in 2022-23, says Finance Minister Nirmala Sitharaman
- RBI says it needs to assess cybersecurity risks before rolling out CBDCs
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