Central bank digital currency (CBDC) is a digital form of fiat currency which is pegged to the sovereign currency of the issuing nation.
Although governments recognize that legal considerations are critical to the development of digital currencies, they’re just starting to come to terms with regulatory design. As such, there is still a gap in any legislation that would govern CBDC.
There are an array of legal issues that would have to be covered from tax, to privacy and data protection, to contract law, payment systems, and international law, to name but a few. Perhaps the biggest issues stem from the fact that digital currencies are international in nature, just like physical money is, but have no corresponding global legal structures in place.
Questions also remain over the extent to which Central Bank Digital Currencies would replace physical notes, or coexist with cash and other digital currency and crypto assets.
Legal and regulatory oversight
Any scheme would have to address who would be responsible for regulatory oversight, and what implications it would have for monetary policy, consumer protection, international remittances, and more broadly, global financial stability.
While Central Bank Digital Currencies could radically change the international financial system, they could also bring regulatory and technological challenges that add to the complexity. With no current agreed upon framework, and countries in the early adoption phase, the specific details remain uncertain.
As 130 countries are now exploring CBDC, the interactions between them could require the setting up of a new global digital money network. So, what shape would it take, and what would be the foremost challenges?
In May 2023, central banks from Canada, Japan, Switzerland, and England came together to discuss ongoing policy objectives for CBDC adoption. This article draws on their findings to explore the key issues for policy makers.
The legal definition of digital money
At present, in the vast majority of counties, CBDC does not have the status of legal tender under existing laws. The legal framework for digital assets and CBDCs is somewhat vague. Digital assets can be both tangible and intangible.
The legal framework for physical money is well established, but digital currency is very different. Money is tangible, it is a state-backed instrument, with the principle that possession equals ownership.
Digital currency has no intrinsic value unless it were converted into real assets backed by a federal reserve. Citizens can’t be prevented from spending cash, but the programmable nature of digital currencies means they could be. The threat that digital money could be canceled raises questions about civil liberties, and the nature of public ownership.
It is not yet clear what extract form CBDC will take. Whether it will be token or account based. Decisions still have to be made about retail use for consumers and businesses, or for wholesale use by governments and financial institutions. All of this begs questions about the function of governments in the regulatory control and oversight of CBDC.
Creating the blockchain infrastructure needed
To support the infrastructure needs of a Central Bank Digital Currency, it must be interoperable with other forms of money and existing payment systems. The extent to which a new digital payments system would coexist with other forms of digital assets like stable coin or cryptocurrencies, is not clear. A hybrid system, or a system involving financial intermediaries, are various models in mind.
Unlike cryptocurrencies which use public distributed ledger technology, CBDCs are based on permissioned blockchains. A central bank would be the single point of control over how the currency is issued.
Cryptocurrencies use decentralized peer-to-peer blockchains to bypass conventional monetary systems. Stable coins are tied to the reserve currency, blockchain enabled, but not backed by a central bank. Regaining control of unregulated crypto and combating its power to destabilize existing financial systems is a central reason why CBDC is being explored.
But, in terms of creating the blockchain infrastructure needed, a reserve bank would need to harness decentralized cryptography to create a distinct CBDC architecture. They would need the support and expertise of the private sector, big tech players, and potentially commercial banks.
A lot would depend on whether digital currencies are used in a hybrid arrangement with cash and existing digital assets. The hybrid model is favored by the European Central Bank at present.
In building a new CBDC ecosystem, a central bank would have to consider:
- The legal nature of public-private partnership.
- Which services to procure?
- The range of digital products and solutions available.
- Cost of developing the blockchain and who pays.
- How it will interface with existing digital payment systems.
Whether central banks define the scope and uses of CBDC technology, or whether the private sector innovation takes the lead, a whole new set of public policy rules and objectives will need to be developed.
It’s clear that legislators and authorities will need a wide range of private and public stakeholders to resolve the legal issues and policy choices. The final design of CBDC will impact how business is conducted across states, which could necessitate changes to business rules, like the Uniform Commercial Code, for example.
Security and digital currencies
Critics argue that by being held in a single system, a centralized digital currency would be vulnerable to hackers. Certainly, if the security protocols were weak or outdated, it may be easily exploited. Similarly, if the network infrastructure is unreliable, it could cause slow transaction processing or outages.
The challenges for the federal reserve relate to:
- Technical infrastructure difficulties with internet connectivity, interoperability with the existing systems, and cyber attacks.
- The stability of the digital currency to protect against potential vulnerabilities and threats.
- Advanced encryption and authentication protocols to prevent unauthorized access to CBDC.
- The overall security of digital wallets.
- If the infrastructure would be available 24/7.
- Human error in forgetting passwords.
The whole CBDC system, and in turn financial stability, could be undermined by security breaches, and this has vast implications for the technical architecture of a CBDC payment system and any potential legislation.
Privacy and transparency
Given the claim that a Central Bank Digital Currency would give the government the potential to monitor and control transactions, how should anti money laundering legislation evolve?
Having transactions recorded on a digital ledger, accessible to the central bank, could help identify and investigate suspicious activity better. However, a less scrupulous government could take advantage of this.
If CBDC adoption is broad, the anonymity of a purely digital currency could make it easier for criminals to launder illicit funds and engage in terrorist financing. Under these conditions the role of the Financial Action Task Force, the global money laundering and terrorist financing watchdog, would have to reexamined.
To ensure privacy, retail CBDC requires a federal reserve privacy protocol but the relationship with AML is complex and will depend on the design features. While a Central Bank Digital Currency would require privacy checks to inspire confidence in the general public, there is a desire to make the retail version anonymous for small transactions.
To be private, retail CBDC requires a central bank privacy protocol, with a connected wallet, user interface, or mobile application. These protocols should provide some anonymity, as the use of cash does, but also comply with KYC and AML regulations. It’s a tricky legislative balancing act.
Money supply and financial stability
The goal of monetary policy is to maintain financial stability, protect currency reserves, and economic growth. As CBDCs are untied, monetary mistakes could threaten the stability of the financial system. Trouble is, the concept of a digital financial asset is not covered in most legislation around the world.
So the policy implications of CBDCs are largely theoretical. They do, however, have real world consequences. A good example of this is in the setting of interest rates for CBDC deposits. Retail CBDCs would be based on short-term deposits, while the wholesale versions are for longer-term deposits, interbank transactions and their settlement by the federal reserve.
With both the retail and wholesale money markets, how would interest rates be applied? How would interest be determined relative to the reserve rate, and what would be the impact on inflation?
CBDCs would be held in digital wallets rather than banks, and there would be various challenges in applying deposit account rates. CBDC will also compete with other forms of digital money, so what will the implications be on the cryptocurrency markets? Cryptocurrencies and stablecoins are far outside the scope of financial regulation.
The policy challenge is not simply a choice between paper money versus digital. A regulatory framework for digital money would have to decide on which other forms of digital assets to endorse. Laws must also address the programmability of digital currencies, to avoid ambiguity between cryptocurrencies and CBDCs.
The issuing of money is central to any economy, and the potential of systemic risk of a CBDC has to be considered. If the system were to fail, it could disrupt the entire financial system. In this respect, policy makers need to understand if CBDCs would facilitate contagion or financial market failure, and consider:
- The systemic risk of technology failure of the central bank server system.
- How cyber-attacks, technical malfunctions, or other technological issues would play out.
- The security measures needed to ensure system resilience.
- A disaster recovery plan.
- Concerns over displacement of bank deposits by CBDC, a bank run.
CBDCs would be global in nature, as they all have broadly similar qualities, and be used for international remittances. But, how would they connect across jurisdictions for wholesale and cross-border transactions?
Existing pilot schemes have experimented with wholesale CBDC for cross-border payments, broadening access to central bank systems to enable collaboration with a wider group of stakeholders.
Bringing those efforts to fruition would entail further alignment of regional, national, and international governance procedures. The current global legal framework for CBDCs is uncertain and will have to be standardized to realize the potential benefits of CBDC.
If they are adopted which seems inevitable, at least in part, CBDCs could have many advantages. In particular, advocates point to improved speed and efficiency of payments, and the potential benefits of financial inclusion for the poor and marginalized. Allowing the authorities better control and monitoring powers is seen as key in the fight against financial crime and money laundering.
CBDCs would also help sovereign currencies compete with unregulated cryptocurrency and other digital assets. All this, it is argued, would promote greater financial stability, better consumer protection, and help avoid macroeconomic volatility.
There are also potential risks, such as privacy and concerns around civil liberties as we move to a cashless future. It’s widely agreed that the technical and infrastructural challenges of CBDCs are considerable, and that central banks should be wary of new cybersecurity risks.
At a time when cash is losing its relevance for many, central banks see an opportunity to reestablish theirs. CBDCs would offer a welcome foothold for central banks to better dictate monetary and fiscal policy in a time of upheaval for traditional financial systems.
CBDC has given central banks a role in promoting financial innovation. They will need to recognise their constraints, and deploy the best solutions possible to create the CBDC ecosystem needed. The federal reserve will also need to be mindful of the objectives of public policy to deliver a digital currency that works for the general public, businesses, and financial institutions.
The risk of not getting it right is the threat to international monetary and financial stability. With coordinated and effective national and cross-border regulation and supervision, the wide-scale adoption of CBDC is possible.
Success will depend on the decisions and agreements reached by governments, financial regulators, and relevant stakeholders. Although governments recognize that law is critical, they are just beginning to get to grips with regulatory design.
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