You can lead a horse to water...
With the considerable interest and speculation that has occurred in recent years relating to blockchain, cryptocurrencies, and non-fungible tokens (NFTs), it’s not surprising that the old guard has wanted to ensure a place at the table, particularly when it comes to the relevancy of something as fundamental as a fiat currency on the world stage. Enter the central bank digital currency, or CBDC.
If CBDCs are going to be able to displace physical money and convince consumers to buy in, then the anonymity component will need to be met. For now, most of these initiatives seem to be valuable proof of concepts, but largely unfeasible from an adoption standpoint. Cash remains ubiquitous, trusted, secure, and anonymous. Its successor will need to meet these requirements and then some if it is going to make the cut.
The introduction of CBDCs may therefore have some significant opportunities for organizations in the identity management ecosystem to find a way to replicate the attributes of paper money, but meeting the requirements for anonymizing the good guys and identifying the bad ones. This will be a particularly challenging conundrum to address.
Fortunately, there is time for this to be worked out -- given the speed of payment system evolution, possibly decades China has made the most significant strides with CBDCs, launching a program for a digital yuan earlier this year. But other countries have considered following suit. Sweden, France, The Philippines, Japan, the United Kingdom, and many other countries have begun researching a CBDC. In total, 86% of central banks have started research into the idea, according to Morgan Stanley. The US, unsurprisingly as the world’s reserve currency, has taken a very contemplative approach to a CBDC of its own. Still, the Federal Reserve has an ongoing research project with researchers at the Massachusetts Institute of Technology to determine the viability of a digital dollar.
According to BIS, three major design choices need to take place to implement a CBDC, architecture, infrastructure, and access:
Two architecture models can be used for CBDCs -- direct and indirect.
In a direct model, the central bank would hold the consumer’s account and provide all payment services around CBDCs. This would require a central bank to take responsibility for account administration, AML/KYC monitoring, transaction monitoring, disputed transactions, and more. A direct model is attractive for simplicity methods, as it eliminates the dependency on intermediaries, and the central bank would be the repository for all the data.
An indirect model would be analogous to the system that consumers and entities are accustomed to today -- consumers would have CBDC accounts with banks or other financial intermediaries, and these institutions would be responsible for retail payments and the consumer’s accounts. Central banks would only be liable for monitoring the CBDC balances of those intermediaries and relieving them from the obligation of providing banking services.
There are two models from an infrastructure standpoint for CBDCs -- a central bank infrastructure, or one using distributed ledger technology.
A central bank infrastructure for CBDCs is similar to the system today and its relationship with intermediaries -- central banks would hold an account and handle retail payments for each business entity or consumer, crediting or debiting each transaction. Alternatively, infrastructure using distributed ledger technology (DLT) would save all transactions on the ledger similar to the blockchain platforms currently in the market, such as those that support cryptocurrencies.
There are two options for access and authentication for central banks deploying CBDCs: token-based or account-based.
A token-based system would rely on public-key cryptography, with the owner holding the private key, and tokens held in digital wallets or accounts. This system would be most equivalent to "digital cash," providing users with privacy and data protection due to the system's anonymity.
An account-based (also known as identity-based) system would be where the CBDC is attached to a particular owner and passed from one owner to another. This system would still rely on the private sector as the CBDC transactions would be provided through the intermediaries currently in the market.
The design choices made in terms of architecture, infrastructure, and access could have a significant impact on consumer adoption. Why? Because CBDCs are likely to be met with intense skepticism by a public that is accustomed to using physical cash for transactions.
Despite its cumbersome, clunky, and potentially unhygienic attributes, consumers are prepared to overlook these for one specific reason -- anonymity.
Getting consumers to use a new system of payment, be it checks, cards, or contactless, can take years, even decades, and requires a significant amount of coercion to develop the necessary muscle memory to make the choice autonomous at the checkout. We may be on the cusp of seeing contactless payments cross the chasm from optional to preferable in the wake of the COVID-19 pandemic, with a real-world use case of minimizing the physical contact between consumer and retailer. Card readers are up there with self-check-in terminals at airports and arcade games at Chuck-e-Cheese as bacteria fests, and the likes of ApplePay suddenly made a lot of sense from a hygiene standpoint in 2020.
CBDCs, however, are an entirely different animal. Contactless payments are an evolutionary step from an already very familiar form factor - the plastic card. CBDCs would be more of a quantum leap, jettisoning a form of payment that has been trusted for hundreds of years and beloved because it carries zero identifying attributes relating to its owner. It is inherently analog, universally understandable, and completely ubiquitous. CBDCs are the antithesis of this -- digital, opaque, and in most countries, commercially unavailable. Also, irrespective of the design choices outlined above, CBDCs will probably not be anonymous.
That CBDCs are not anonymous can be expected in countries like China, where state surveillance is a part of everyday life. In fact, a representative of the People’s Bank of China stated in March 2021 that "a completely anonymous central bank digital currency is not an option." However, consumer pushback in other regions on the issue of CBDC anonymity could be significant. A survey conducted by The European Central Bank in 2020 found that what the public and professionals want the most from a CBDC is privacy (43%), followed by security (18%), the ability to pay across the euro area (11%), no additional costs (9%) and offline usability (8%).
The degree to which consumers want privacy above all other characteristics of a CBDC is going to be problematic for any central bank intending to issue one. Whether or not a CBDC is or isn’t privacy-preserving may be irrelevant -- it’s unlikely that the layperson will understand their architecture, and will presume that the electronic nature of this newly minted digital currency is inherently traceable by its government of manufacture. It may also be beset by a lack of trust given that it doesn’t physically exist -- it’s not as if you can stash a supply of digital Euros or “Britcoins” under your bed.
CBDCs may also further exacerbate the digital divide -- there are an estimated 10% of the US population that are unbanked, and a further 24% that are underbanked. The reliance on cash for this segment of the population could be seriously impacted by the introduction of a CBDC, compounded by the requirement for also having smartphones or other devices that can fulfill the requisite digital wallet capabilities.
There is also the potential that the introduction of CBDCs could actually make some financial crimes worse. While the traceability of CBDCs could be instrumental in reducing crimes such as money laundering and the funding of terrorist entities, fraudsters and criminals will inevitably gravitate to CBDCs as a way of exploiting the naivety of new users, both consumers and retailers. There is solid historical precedent -- according to Shilpa Arora, CAMS, AML Director—Europe, Middle East, and Africa, ACAMS;
“The movement to digital forms of payment through credit cards and PSPs, such as PayPal, about two decades ago must also be taken into account. These innovations introduced the concept of digital identity theft, compromised account and card details, and so on―crimes that were either nonexistent or committed in a very limited capacity previously. The use of CBDCs will no doubt result in the increase of certain criminal typologies and result in the invention of new ones.”
The adage, “you can lead a horse to water, but you can’t make it drink” may be particularly apt when it comes to CBDCs. There are significant advantages to moving away from cash. It’s costly, degradable, dirty, and favored by criminals. Despite its flaws though, it holds a valuable role in today’s payment mix and its ability to be off-record should not be underestimated. I’m reminded of a recent taxi journey where the driver was having connectivity issues with his in-car payment terminal (I saw him yank the connection cable out), which required a detour to an ATM at the end of the trip. It speaks to the continued desire for the economy to have an option for those with a more analog and old school preference for money that they can see, touch, and smell, and most of all, not have to report.