If the dollar goes digital, how will payment systems change?

As the case study above shows the use of Blockchain in CBDC needs to be evaluated carefully. Regardless of the choice of infrastructure, the technical issues of counterfeiting, double spending and traceability need to be addressed.

Exploring how to tackle these issues will be an important part of the studies currently under way at central banks around the world. In a public consolidation, the European Central Bank found out that public (private citizens) and professionals (including banks, payment service providers, merchants and tech companies) would value privacy (43%) and security (18%) the most out of potential CBDC aspects. While these are valid concerns, it’s important to consider that anonymous CBDC would make it possible to abuse the relevant regulations and be used for criminal purposes. This is associated with compliance issues and the risk of reputational damage.

CBDC could be used for two different use cases: retail and wholesale. In both cases, it can be assumed that CBDC is issued by the central bank.

Retail, today, refers to the use of coins and banknotes by end customers for purchases e.g., in shops, restaurants, at the hairdresser's or at gas stations. These are usually held by customers in an account with their preferred bank. The retail case provides for end customers to use CBDC as a digital representation of the existing coins and notes of a currency. They would be used for daily use in shops, restaurants, at the hairdresser's or at the petrol station. For off-chain, cash-like CBDC, customers withdraw these digital units from their bank account and store them in a digital wallet until they are issued again, just like normal banknotes.

Wholesale uses existing reserves at the central bank and is only available for commercial banks. The wholesale case would provide commercial banks with a digital representation of existing reserves at the central bank. These would be used in real-time gross settlement payments system and thus by core banking systems to perform bank settlement and clearing.

Digital currencies can be structured either on an account or token basis. Token-based digital units are exchanged directly and correspond to digital representations of banknotes and coins. The main difficulty lies in verifying the authenticity of the individual tokens. This is mainly used in retail. Account-based balances are held on accounts and are mainly used in wholesale. The difficulty lies mainly in the verification of the account owner.

When we talk about CBDC, we should not confuse it with a simple electronic accounting method. Although the monetary units that we hold in our bank accounts today are not stored one-to-one as coins or banknotes in the vaults of the banks but are also a kind of digital representation of our assets, they are still only accounting deposits. When paying by online banking or credit card, there is only an accounting reduction of our balance and an accounting increase of the balance of the counterparty. Settlement is then done between the banks. The situation is different when we pay with cash. When we withdraw cash from our bank account, the accounting balance is first reduced, and we receive cash in exchange. This then actually changes hands as a physical unit when we pay with it. We can think of it in a similar way in the case of off-chain CBDC. If we withdraw digital central bank money from our bank account, we receive these digital units in a digital wallet and transfer them to the seller when we buy them. Here, the units actually change hands, not just in accounting terms. It’s important to keep in mind that is mainly true for a token-based retail CBDC and might differ in a wholesale account-based solution.

A final consideration in how CBDC could work in practice is how it would be treated from a regulatory perspective. As a digital representation of existing currencies, CBDC must also be compliant with existing regulations such as:

• Know your customer (KYC) – the obligation of a bank to identify its customers before opening an account and to establish that customers are really who they claim to be.
• Anti-money laundering – rules, obligations, and guidance to prevent the financing of criminal activities or terrorism or, in general, to disguise the source of income.

Although the current CBDC projects are still in their infancy, the high level of interest shows the potential impact on the payment landscape and the way we as a society think about money. Fundamental design decisions need to be made and the impact on security and privacy will have major socio-economic implications. These implications will define how CBDC and digital currencies in general will be accepted in society and thus have far-reaching implications for other digital payment methods.

Summary

As central banks around the world turn their attention to central bank digital currencies, we explore the background, feasibility and technical implementation of CBDC solutions. Structured around three key questions, this article explains the main features of CBDC and clears up some common misconceptions about overlap between this new central bank-backed payment system and cryptocurrencies.