In an ever-changing payments landscape the interest in central bank digital currencies (CBDC) has grown considerably. According to a survey conducted by the Bank for International Settlements (BIS), CBDC is being considered by nine out of 10 central banks. In fact certain countries such as Jamaica and the Bahamas have already launched a CBDC. But what is a CBDC?

Put simply it is a digital form of fiat money issued by a central bank. It can generally either be a retail CBDC, in which case it is available to the general public for everyday payments (in the same way as banknotes), or a wholesale CBDC in which case it may only be available to financial institutions for the wholesale settlement of high value payments. 

Benefits and risks of a CBDC

Advocates for a CBDC talk about financial inclusion and accessibility (particularly for developing countries), cheaper, faster and more secure payments and better data (which could help combat financial crime). They also point to CBDCs being an anchor for stability for monetary and payment systems. Critics, however, question the use cases of a CBDC and highlight concerns around a perceived loss of privacy given central banks could in principle have visibility on how people spend their money. 

As consumers, we have historically used cash and commercial bank deposits to make payments. With cash declining in the UK, a retail CBDC could invaluably step into that void. CBDC could sit alongside, and be fungible and interoperable with, cash and other forms of payment. As noted by the Bank of England (Bank) in its CBDC Consultation Paper, “a digital pound would help to ensure that central bank money remains available and useful in an ever more digital economy, continuing to bolster UK monetary and financial stability while safeguarding the UK’s monetary sovereignty in a changing global financial system”. 

The potential relationship between CBDC and commercial bank deposits (which according to the Bank represent 95% of the funds which consumers hold to make payments in the UK) is however a bit more complex. The risk of outflows from commercial bank deposits to CBDC is a real issue which central banks are alive to and must manage carefully given the potential financial stability risks. The Bank for example has proposed limits on the holdings of CBDC in the initial phase to, in large part, mitigate this risk. It will however need to strike the right balance between having a limit that isn’t too high so as to disintermediate commercial banks, but not too low to ensure that there is sufficient uptake of CBDC.

Central banks will want to ensure that they do not stifle competition in the payments space, and that any CBDC is interoperable with other forms of payment.

On the wholesale side, financial institutions already have access in a number of jurisdictions to central bank money by way of deposits or reserves in a central bank’s Real Time Gross Settlement System (RTGS). So arguably in these jurisdictions the solution may be to enhance the current RTGS system, which is the work which the Bank is prioritising as part of its multi-year programme to renew its RTGS system. 

A wholesale CBDC could however grant wider access to wholesale central bank money than current RTGS systems do, as well as provide the technologies (such as blockchain or distributed ledger technology) to allow faster and more efficient wholesale settlement (particularly for cross border payments).

How CBDCs fit in the future payments landscape will also depend on the progress made by new forms of digital assets emerging which can be used as a means of payment (such as stablecoins which are essentially tokens backed by an underlying asset). When progressing their work on CBDCs, central banks will want to ensure that they do not stifle competition in the payments space, and that any CBDC is interoperable with other forms of payment.

Legal framework

A country’s decision to launch a CBDC will primarily be a political and economic one, but there are fundamental legal issues which will need to be worked through. A key question will be whether a CBDC will be classified in the same way as cash or deposits, or whether it will be subject to a new type of classification. This will then in turn inform how it is caught by the current regulatory framework, or whether a new bespoke framework needs to be introduced.

Regulators will also need to grapple with questions around for example;

• the authority of the central bank to issue a CDBC;
• the impact on competition which a CBDC could entail;
• privacy and data protection issues;
• how to provide robust protection to users (and where liability sits in the CBDC ecosystem between the central bank and the private sector);
• how CBDC payments settle with finality (particularly with respect to cross border payments); and
• how to tackle the complex issues – such as the increased money laundering risk – raised by offline payments (ie transfers of CBDCs made without a connection to a CBDC platform). 

Whilst the legal framework will be driven by design choices and differ by jurisdiction, it will be fundamental for governments to work with global partners to adopt global standard and rules to enable CBDCs to be interoperable.

CBDC uptake

But will CBDCs be widely adopted even if they are underpinned by a robust legal framework?  This may depend on a number of factors, including:

• Design choices. For example confidence in CBDCs may be enhanced if a CBDC is legal tender. On the other hand, uptake may be limited if (as noted above) low limits are placed on CBDC holdings. Additionally, should CBDCs be unremunerated like cash (as proposed by the Bank) or remunerated like commercial bank deposits? 
• Lack of anonymity for users. In the UK, the Bank is proposing that a CBDC would be as private as other forms of digital money but the government and the Bank would generally not have access to a user’s personal data;
• The technology that underpins the CBDC. Many jurisdictions are currently considering whether a CBDC should be issued on a centralised or decentralised ledger;
• The role of the private sector in the CBDC ecosystem. Design choices which require private sector involvement and create innovation in the market are likely to enhance the uptake of CBDC. In the UK, the Bank sees the private sector as playing a fundamental role in the CBDC ecosystem. The Bank would provide the CBDC infrastructure, but the private sector would act as the overlay and interface directly with consumers; and
• How effective the outreach to users is. There will be a huge educational piece for consumers to ensure that CBDC is well understood.

To conclude, whatever your views of CBDCs it would appear likely that they are here to stay and will form an important part of the future payments landscape. The ECB announced a two year investigation project looking at the digital euro which will conclude in October 2023, with China’s CBDC pilot also set to expand in 2023. 

In the UK the Bank is currently consulting on the introduction of a retail CBDC, and has noted that “the Bank of England and HM Treasury judge that it is likely a digital pound will be needed in the future” and therefore work will now move onto a ‘design phase’ which will look at the technology and policy requirements for a retail CBDC. If the Bank decides to proceed, a retail CBDC would be launched in the second half of the decade.

Chris Glennie is a partner in the Financial Services Regulatory practice at CMS London. Chris has significant payments, fintech and financial regulation expertise. He has a unique background and insight having joined CMS from the Bank of England.