Advantages and Challenges

CBDCs are responses by Central Banks to two broad sets of challenges: internal factors, including the need enhance efficiency and reduce cost, to promote financial inclusion, and to be more scalable in a cost-effective manner; and external factors, such as the innovations in cryptocurrencies that make many financial operations flexible, easy and programmable.  Just as fiat currencies constitute a sovereign function of the State, CBDCs also are sovereign in nature, in contrast with cryptocurrencies, which are do not possess regulatory compliance.

Further, CBDCs are a direct claim on the Central Bank, in contradistinction to commercial bank deposits (which are not necessarily fully guaranteed). There is thus an incentive to hold funds as CBDCs which can theoretically lead to a run on banks. To avoid this, Central Banks have at their disposal a number of policy instruments such as wallet caps; monthly transaction caps; zero or negative interest rates; and even the automatic expiry of CBDCs after a pre-set date. Together, these ensure that CBDCs are used more as a medium of exchange rather than storage of value for longer-term (aka hoarding).

CBDCs also bring in a number of advantages to the end-user: these include its role as easy-to-use legal tender in place of cash in merchant establishments; zero transaction fees; the ability to transact from user wallets even without Internet (for short periods and with caps in place); and easy maintenance of expense accounting. From a longer-term perspective, CBDCs provide “programmable money” services that can form the foundation of a large number of services automated using the equivalent of “Smart Contracts” such as Digital Asset Management and Tokenization that are popular on crypto platforms such as Ethereum.

Depending on implementation–particularly AML/KYC norms–there could be privacy implications for CBDCs. There are also several challenges in the technology stack used for implementation of CBDCs.

Challenges

CBDCs also come with a number of challenges when compared to the way cryptocurrencies function. These include:

Governance Aspects

1. The need for centralized control: Given that all fiat currency—whether paper or digital—are sovereign in nature, Central Banks may need to exert control over all aspects of CBDCs including the issue, movement, money supply, interest rates (or their absence), as well as factors such as performance, scalability, user experience and device/platform agnostic nature. This centralization runs contrary to the spirit of cryptocurrencies. It therefore follows that most decentralized technology implementations typical of cryptocurrencies cannot be moved easily to CBDCs as their Governance as well as implementations of will be vested with external groups or communities.
2. The need to go beyond “Code is Law”: For most cryptocurrencies, the only artefact available to community members is the code, which embeds all rules of governance as well—they have often no other physical documents such as bylaws. In the case of CBDCs, the situation is dramatically different, and there will have to be several documents that explain the concepts, governance, operations and security practices to the citizen/end-user as well as to other arms of the Government.
3. Privacy vs AML/KYC: Cryptocurrencies vary in the strength of the anonymity of their counterparties, but there is at least a weak form of pseudo-anonymization that provides some protection to parties. CBDCs would be subject to AML/KYC norms which, depending on the implementation, may expose personal financial information to the Government or Payment Services Providers (PSPs). One of the ways to reduce/prevent such exposure is to maintain multiple “Data Islands”, where the one data island is with the a separate Government Identity Service organization to which each user is registered on a one-time basis (with KYC information as well as the public key), while the other data islands are with each PSPs which use the cryptographic keys (and no other personally identifiable information) for transaction information.

Operational Aspects

1. Transaction fees: Unlike cryptocurrencies for whom transaction fee forms an important revenue stream, CBDCs are digital cash, and there are usually no transaction fees associated with them.
2. Account Tiers, Wallets caps and Expiration: The primary use of CBDCs is to provide a cheap, convenient way to make payments, and any tendency to hoard funds in them must be resisted in order to ensure that banks continue to have access to deposits. Different policy instruments are employed for such control, including different account tiers (user accounts, merchant accounts), caps (holding cap, monthly spending cap), and expiration (digital “coins” automatically expire after a period).
3. Language and User Experience: The wallet and other interfaces used for managing CBDCs may need to support all languages of the jurisdiction as well as be simple enough for the average user in order to be used by all citizens. If this is not done, it results in new forms of the Digital Divide and will considerably erode claims of enhancing digital inclusion
4. Ability to work offline: As a national digital currency, the ability to work offline (ie., when there is a network disruption, as after a natural disaster or other outage) is a strong advantage, and some CBDCs have implemented such capabilities (subject to caps).
5. No requirement of bank accounts: In order to promote financial inclusion, CBDCs could waive the requirement of bank accounts.

For a more complete analysis of CBDCs in the Indian context, please see Central bank digital currencies: policy and operational perspectives for India (July 2021).