Central bank digital currencies

The USA, UK, China and India are considering launching Central Bank Digital Currencies (CBDCs). In this week’s deep-dive, I’m going to lay out why CBDCs aren’t what they sound like. It’s really just an umbrella term for payment infrastructure and payment apps.


What is a CBDC?

CBDCs are digital currencies issued by a central bank. By default, the currencies are legal tender. Like other money supply, the central bank regulates the supply of the CBDC.

To understand the benefits of a CBDC, let’s start by looking at the objectives of money.

Objectives of money

Money has 3 objectives:

  • Store of value: it holds value over time, though this value depreciates over time due to inflation.
  • Unit of account: serves as a common measure of value for goods and services. In other words, everything being denominated in USD or whatever currency you use, makes life easier.
  • Medium of exchange: facilitates transaction between parties.

CBDCs seek to improve money as “medium of exchange”. They have no impact on money as a store of value, or a unit of account. This is because any country or government that issues a CBDC is going to issue it as their existing currency.

Theoretically, it’s possible to have an impact on the “store of value” and “unit of account” objectives. This would require the CBDC to be different to the existing currency. This is confusing and impractical; every citizen will need to choose between 2 currencies within their country and worry about exchange rates between the two.

Digitising money

The aim of CBDC’s is to offer a better medium of exchange by digitising money.

In any economy, money supply flows from the central bank to private banks to end users. Central banks control the amount of money in an economy. Private banks distribute this money to people.

Most money today is already digital. Here are two graphs to illustrate this point. The graphs below are from the Federal reserve (as of December 2020):

  1. M1 money supply: value of money that is not paper notes, i.e. bank deposits. This amounts to ~19.2 trillion
  2. Paper money: the amount of paper money in circulation. This amounts to $2 trillion.

M1 money supply: “digital” money
M1 money supply: “digital” money
Paper money
Paper money

When the US Fed prints money, they aren’t sending paper money to banks. They’re keeping track of how much they’ve lent to private banks using a journal. The key takeaway:

90% of money in circulation is digital.

Private banks distribute money to citizens as paper cash and in digital forms (e.g. bank cards). Most of the financial technology firms we know today (Venmo in the US, PayTM in India, AliPay in China) are solving problems for consumers. Once the central bank has distributed money to private banks, they help end consumers transact more easily using technology.

A direct relationship with end users

CBDCs empower central banks with a direct relationship to their end users.

If a digital USD did exist in the future, a central bank doesn’t have to go through a private bank to reach its citizens. The proclaimed benefits are:

  • Efficiency of capital: without private banks, a central bank could allow users to lend and borrow at superior rates. Incidentally, this is one of the proposed benefits of decentralised finance (we’ll come back to why I think this is superior later).
  • Complete transparency: if money were digital, it’d be much easier for a central bank to track its money supply.
  • Better levers: a direct relationship with citizens gives a central bank more levers on the economy. For example, if the economy needed stimulation, a central bank could drop $1,000 in every account. Alternatively, it could charge a 1% fee for money that was not spent and incentivise citizens to consume more.

The scary stuff

Here’s the scary part about a central bank controlling the distribution of money:

  • Censorship: money that is digital can be prevented for certain use cases. For example, an economy could decide that its CBDC cannot be used for a particular good (a textbook that opposes the views of the government in power).
  • Concentration: CBDCs concentrate the power of distribution in a single entity. This feels a lot like nationalisation. What happens when you are unhappy with your service? Who do you go to if your only option is the central bank? This is more acute when you consider the extent to which businesses depend on the private banking system.

CBDCs with traditional money

Every central bank that talks about CBDCs will be quick to tell you that it plans to run CBDCs in parallel to traditional money.

If the intent is purely to make it easier to pay for goods and services, why not use a system like India’s Unified Payment Interface (UPI)? It is one of the most successful products of our generation and has scaled to billions of users.

UPI adoption in India
UPI adoption in India

Most of the material I’ve read on CBDC’s actually talks about infrastructure like UPI. CBDCs are not comparable to blockchains at all.

Given a central entity controls them (central bank), it makes no sense to use a permissionless database. A database that stores data in one location, will always be faster than a database that stores data in multiple locations. If a central authority controls your data, you have no incentive to use a blockchain because it’s inferior.

Anonymity or pseudonymity will never be features of a CBDC. It removes one of the key benefits of CBDCs — the ability for governments to have a full overview of money supply.

In reality, CBDCs are two things:

  • Infrastructure to facilitate to movement of digital money between parties.
  • Consumer applications that enable customers to transact digitally.

Countries like India have taken an approach where (1) is built by the government and (2) is built by private players. In China, the government is trying to do both (partly because it’s trying to reduce the power of players like Alibaba).

A better model

In my view, decentralised finance using the blockchain with the traditional banking system offers a much better alternative.

There’s more competition. If there’s room for an alternative, it will be built. Ethereum was built because people saw the use case for a blockchain beyond just value transfer (which Bitcoin provided).

It removes intermediaries, but offers multiple alternatives. Decentralised Finance allows you to borrow and lend without banks, but you can choose from a variety of protocols (UniSwap, SushiSwap).

If you don’t believe in blockchain technology or crypto, I’d still advocate for payment infrastructure like UPI over a CBDC that is entirely controlled by the government.