Central Bank Digital Currency: A Review of Bank of Canada Papers

This year the Bank of Canada has published 9 staff analytical notes and staff working papers discussing Central Bank Digital Currencies (CBDCs).

As the most recent paper says, as a contingency the Bank of Canada is looking to build its capability to issue a cash-like retail denominated CBDC. It will be denominated in Canadian Dollars, not earn interest and be geared towards the public and small businesses. The Bank has been working in this area for a number of years, and these papers reflect the intensive and detailed work being done by the Bank to be able to issue a contingency CBDC. There is significant interest in CBDCs in central banks around the world and these papers provide a route to what the Bank of Canada’s has learnt.

Although, “the views expressed in this note are solely those of the authors”, they reflect the focus and work of the Bank on CBDCs. It is perhaps no surprise, therefore, that the Bank for International Settlements has put one of their innovation hubs in Canada.

The papers we report on here fall into two groups, those dealing with the concept of introducing CBDCs and those looking at how to do it. We focus on two policy papers, “Is central bank currency fundamental to the monetary system?” and “CBDC adoption and usage: some insights from field and laboratory experiments” and one practical paper, “Technology approach for a CBDC”. A list of all papers, their authors and links to them is given at the end of this article.

Is central bank currency fundamental to the monetary system?

This answer to this question addresses what a central bank should do if cash usage falls to the point where it ceases to circulate. CBDCs are much discussed but are they actually necessary?

The author’s literature search concluded that, “central bank money that is available to all is needed if bank money is not trustworthy and therefore not accepted.” However, it could be that rather than issuing central bank money, the central bank just needs to safeguard bank money.

One of the risks around bank money is that they over-issue it since they make money from what they issue. The existence of central bank money, assuming it is well managed, creates a stable competitor and the choice that gives the population ensures private money is issued appropriately. On the other hand, it is credit demand that restricts bank money creation. Banks can’t extend more credit than the central bank’s rate of interest allows people to afford to borrow. So long as the central bank manages interest rates appropriately, over-issue is not a risk. Banks can still extend too much credit relative to their capital requirements will support but, again, that is determined by how the central bank regulates the banking sector. Over-issue is not, therefore, a reason to have central bank money, whether cash or a CBDC.

The measures to safeguard commercial bank money are sound macroeconomic policies, a strong legal framework and practices that support contract enforcement and a well planned and executed regulatory framework. This needs to cover both rules such as the minimum capital levels mentioned above, accounting and disclosure standards and actions if a bank becomes insolvent. Society needs to know that the central bank can, and will, intervene to safeguard bank accounts and the payment system. For example, the processes around the central bank being the lender of last resort and deposit insurance guarantees need to be understood and credible. In economies where these are in place, cash/CBDCs are not required.

Perhaps cash/CBDCs are necessary for other reasons? One is the requirement to have what is known as “uniformity of money”, that funds can be exchanged at par between banks. If central bank money exists, then bank money requires uniformity. On the other hand, central bank reserves are used by banks and electronic payments schemes for settlement which negates the need for central bank money.

The authors focused on how people regard risk. Research shows that if people have control over an outcome of an event or activity, they are more likely to take risks. Equally, if they have a choice about whether to participate in an event or activity, they avoid risk. In this case it appears that people anticipate regret and so want to avoid this. Cash/CBDCs give people a sense of control. People are willing to hold bank money knowing that they can always withdraw it and exchange it for central bank cash. Equally, in many highly banked economies, they have no choice but to use bank money to pay for items, for example utility bills or high priced items such as a car.

In a crisis the option to access central bank money matters. Because people have the option to turn to cash, they can continue to use bank money and so not precipitate a run on the banks. Would a CBDC work as well as cash in that scenario, or would the ease of exchange from bank to central bank money mean that people exchanged their money “just in case”. In practical terms, of course, CBDCs could allow high volumes to be moved quickly. Knowing this might delay the point at which people decided to move.

The report’s conclusion on uniformity of money is that cash/CBDCs are not needed if the institutions are strong, the government has the ability and will to quickly address systemic problems and if payment alternatives are instantaneously and fully understood to be so. If those aren’t in place, then cash/CBDCs may help. People’s sense of control though, appears to be an important element in assessing whether central banks need to maintain their own money.

CBDC adoption and usage: some insights from field and laboratory experiments

The Canadian payment landscape is well developed offering businesses and consumers a wide range of choices. Innovation is continuing. For example, Payments Canada has recently introduced Real-Time Rail, a new platform to process low value transactions. This paper considers how a CBDC might succeed in a crowded field.

It is possible to create a CBDC that builds on attributes of cash that are valued and alternative payment methods are weaker on. It is possible to create a CBDC that works off line and that offers high levels of privacy.

A CBDC could offer universal accessibility. The Bank of Canada could provide a free device to consumers to house the CBDC which would allow payments without the need for an internet connection, ownership of a mobile phone or even a bank account. The resilience this offers in the event of power outages, provider failures or unexpected crisis is valuable.

Whether on or off line, there would be no need for intermediation fees or charges for either merchants or consumers. In many countries banks charge customers for transactions.

Privacy can be designed in to the CBDC both using encryption of payment data as well as operational arrangements, for example distributing decryption key fragments across multiple agents who do not have an incentive to collude. Off line privacy similar to cash is possible, but on line cash cannot be replicated exactly although a much higher level of privacy can be attained. There are also legal and regulatory barriers to this.

A challenge is that many digital payment options offer reward points and this is a growing element of the payment landscape which a CBDC could not replicate. This paper is clear that a CBDC should not be planned to replace or to compete with digital payments but to co-exist with them filling a niche that they don’t operate in effectively.

The history of new payment launches suggest that unless the new product is better than what it replaces or the alternatives, it will fail. The paper cites examples of solutions that started off as person to person solutions, Swish in Sweden, Interac e-transfer in Canada and WeChat in China, and rapidly expanded into person to business solutions. Sometimes governments can nudge acceptance by stipulating that government services or taxes are paid using the solution. The paper sees this as the route for a future CBDC in Canada.

Technology Approach for a CBDC

This paper lays out the Bank’s thinking about how it could create a CBDC ready for issue as a contingency measure. It succinctly summarises the thinking and decision points considered to date.

The design of the CBDC will be determined by policy choices (privacy, resilience), the business model (partners, end-user channels, cost model) and the qualities required (the user experience, security levels). The Bank is clear that its CBDC will need cash-like properties not typical in other payment methods, in particular privacy, universal access and resilience against infrastructure outages. It also needs to deliver financial and digital inclusion for example by allowing CBDCs to be purchased from online merchants.

Broad Approach

Today’s available technology allows a retail CBDC. Privacy and controlled disclosure are challenging but advanced cryptography and operational arrangements may allow solutions. Universal access is possible through compact dedicated devices, known as “Universal Access Devices” (UADs), or stored value cards, or a combination of both. This means a cash-like experience, including person to person (P2P) payments are possible. Finally, the Bank has explored both centralised and decentralised (blockchain) systems. Decentralised systems provide most value where there is no commonly trusted partner, which is not the case where a central bank is a key entity in the payment process. Blockchain does offer benefits, namely immutable data, smart contracts and support functions like conditional payments.

Payment Performance

When considering what its contingency CBDC must deliver, the Bank believes transaction rates of 1,000 transactions per second, the equivalent of 25 million people making two payments in a 12 hour period. This is scalable to do more although that might require trade-offs such as less openness to third party extensions. The system will need to store a claim in dollars against the Bank, make P2P, POS and online payments and for people to be able to buy or sell CBDCs with bank money or cash. To achieve this, the CBDC must integrate with Canada’s Interac and Real-Time Rail systems. For POS/online payments, it will either have to integrate with the existing systems, in which case the existing interchange fees and charges will apply, or there will need to be a new network for it built from scratch. If people have no bank accounts, then there will need to be access points that allow cash to CBDC purchases and redemptions, similar to the successful MPesa system.

Technical Approach

There are often discussions about whether CBDCs will be account or token based. For the end-user, at the functional level, the distinction is not clear and there is no universally accepted definition of a token. At this stage, therefore, the Bank is taking a technology neutral approach to this question. When considering the architecture and core technology needed, the options are the Bank provides all, the Bank only issues and redeems CBDCs leaving third parties to provide the end-user experience, or a mix of these. Currently the Bank is looking at design a core system with clearly defined interfaces between system components to the front end-user experience since this should future proof the system against technology developments and give it options.

Attributes

Defining the attributes requires some decisions to be made. For example, for people with no bank accounts, the CBDC must work with a stored value/UAD device; the Bank is only looking at non-interest bearing approach because the existing of UADs adds significant complexity to this; in addition to the usual resilience protections for digital payments, the UAD gives the CBDC a level of resilience not available for other payment types; the POS/online transactions will operate through the national clearing and settlement system, but for other transactions the Bank prefers the CBDC to have cash-like immediate settlement because transaction revocation would complicate the engineering and add the need for operation support; the Bank may allow financial institutions to act as the distribution channel for the CBDC.