We live in uncertain times, characterized by at least three overlapping crises – the climate crisis, the COVID-19 crisis, the conflict in Ukraine, with profound implications, both economically and socially. An interesting and at the same time challenging result of these crises is that we have witnessed an acceleration of the evolution of new technologies, and the digital transformation has penetrated and marked the development of various fields, from the medical sector to the green one. The digital transformation is not only a requirement of our times, but also a natural evolution in the development of the knowledge society and, obviously, under these conditions, the digital transformation also impacts the payment system.
By Leonardo Badea, Deputy Governor of the National Bank of Romania
The pandemic has taught us several lessons. On the one hand, it was about the natural dynamism and wide acceptance of new technologies, while on the other hand, we have to admit, it was about the associated restrictions as well as the concern (especially in the early stages of the pandemic) about the transmission of the virus through money. The restrictions imposed and the fear felt more or less acutely led to an increase of digital payments, in favor of cash payments. Some central banks have even introduced procedures to quarantine or sterilize money precisely to assure the population that the money is safe to use. Other central banks have encouraged and urged the population to resort to digital payments and reduce cash payments as much as possible. Of course, in this situation we also have to consider the fact that often digital payments do not completely eliminate the risk of contamination, but still imply that in some cases, the payer comes into contact with the terminal of the seller to validate the payment. Also, we cannot ignore consumers who do not have a bank account and therefore can only make cash payments, the promotion of digital payments at the expense of those involving cash thus raising a problem of inclusion. Beyond the different approaches and points of view, the conclusion we can state today, two years into the pandemic, is that the pandemic played an active role in accelerating the transition to digital payments on a large scale.
It is very true that the discussion must be nuanced, that the digital transformation does not imply an effective and immediate abandonment of money in its classical form and that it is possible to even witness a resistance to change, an opposition to the widespread adoption of digital payments by some categories of population. What is worth noting, however, is the fact that there is more and more discussion in this context about digital currencies issued by central banks (central bank digital currency – CBDC). Thus, we are discussing a digital currency, which without having a physical, tangible existence is issued by a central bank, is guaranteed and backed by the trust of the central bank. It is in fact the digital alter ego of a fiat currency and carries the properties and advantages of the fiat currency, while adding the privileges that accompany the digital format, such as the decrease in transaction costs, the increase in transaction speed, but also the much- sought advantage of the efficiency of international transfers. Carefully designed, digital currencies issued by central banks can provide greater security to payment systems and lower operating costs. Electronic currency is nothing more than a „prepaid” currency, the unit of value created and stored electronically being exactly the amount of fiat currency made available by the beneficiary to the issuer of electronic money. Virtual currencies and electronic currencies should therefore not be confused. The latter are means of payment issued only by authorized entities, being generally accepted for the purchase of goods or services. Conversely, virtual currencies can only represent a medium of exchange if they are accepted as such by the other contracting party (a merchant or a natural person).
In summary, the main characteristics of CBDCs include: they are issued by central banks and are backed and guaranteed by them, they are easily transferable peer-to-peer, they are designed with a stable exchange rate against fiat currency, they provide increased efficiency and security to payment systems, and they can facilitate and reduce the costs of cross-border payments. It is obvious, however, that at the moment there are no unitary solutions, but flexible solutions must be constructed to answer a series of questions related to the timing and ways of introducing such a currency and to find that fragile balance between ensuring its broad acceptability and not turn it predominantly into a store of value, which would entail other risks (e.g. bank runs).
There will certainly be voices speaking in defense of classical currency and cash payments; as will be voices supporting digital payments and the need to introduce digital currencies issued by central banks. What is undeniable, however, is that we are witnessing a profound change in consumer behavior.
Thus, the debate on the future of the monetary system and the role that digital currencies issued by central banks could play reveals controversies and discloses a whole panoply of approaches and arguments, distributing opinions along an axis that ranges from optimism to pessimism, being rather difficult to take a strong stance. Of course, the optimists have on their side the arguments that claim the indisputable advantages, while the pessimists concentrate the essence of the vulnerabilities. Moreover, there are opinions stating that since we already have digital money in the form of deposits, cards, and mobile applications, we do not need a digital currency issued by the central bank. One of the counterarguments could be the advantages of Distributed Ledger Technology (DLT), which could be successfully applied to CBDC. This technology, although not necessarily new, is credited with the potential to radically change the way various systems work, not just the financial one, essentially proposing a decentralized alternative to classic, centralized mechanisms, virtually eliminating the need for a central authority and allowing the storage of a large volume of information, under conditions of efficiency and security. The indisputable advantage of this technology is the high level of security and the system’s ability to update itself, recording transactions quickly and cost-effectively, while increasing accessibility and ensuring financial inclusion. The technology practically allows the creation of a permanent database, which is continuously updated and whose history cannot be deleted, the records remaining permanently stored.
The question that various international institutions and bodies are currently trying to answer is how the obvious advantages of this technology can be capitalized on by central banks, given their main tasks, namely to maintain price stability and ensure financial stability.
Some countries have already issued such a currency or are running pilot projects in this regard, others are analyzing the implications of such an undertaking. I mention only a few examples in this regard. Bahamas, Nigeria, Eastern Caribbean have launched digital currencies. China and Sweden are running pilot projects to test the acceptability and effectiveness of digital currency. Canada, France, Switzerland, the UK, and the US are exploring the possibilities of issuing digital currencies.
The topicality of the debates regarding the inclusion of digital technologies in the transformation of the monetary system is evident by following the recent concerns of various institutions and many economists, as well as the plethora of studies, reports, projects focused on this topic. The Bank for International Settlements (BIS) published in September 2021 the report entitled Central bank digital currencies: system design and interoperability in which it addresses the structure of a system that incorporates CBDC, as well as the issue of the allocation of roles and responsibilities between the central bank, the public, and the private environment. The central banks that contributed to the report spoke in favor of a system based on collaboration and the sharing of roles between the public and private environments, given the responsibilities of central banks in the field of public policies and the concerns of private entities related to the market and the interest of shareholders. Of course, a variety of scenarios regarding the allocation of functions in a future CBDC system are possible, in relation to the specific peculiarities of different jurisdictions, essentially responding to the requirements related to access to money and from the perspective of social inclusion, to the technical validity of the system and resilience to cyber-attacks, the diversity of payment systems, the efficiency of cross-border payments and, last but not least, ensuring confidentiality while complying with the requirements related to combating money laundering and terrorist financing. Another key aspect mentioned relates to the interoperability of the CBDC system, an essential requirement to ensure its integration into the general payment system, both from a technical and legal perspective.
The Bank for International Settlements (BIS) also published in its annual report from June 2022 a perspective on the future monetary system, in which it addresses the possibility of transforming the monetary system by including a digital currency issued by the monetary authority. The BIS metaphorically places central banks in the role of the trunk that supports the functioning of the financial system, underlining once again the role of central banks, which of course will continue to represent the element of robustness, confer credibility and constitute the guarantee of financial stability. The report reiterates the idea of cooperation between central banks and stakeholders to capitalize on the advantages of innovation in the sense of promoting fast and secure transactions, while also responding to the wishes of financial inclusion and privacy. It is obvious that the future of the monetary system is primarily based on the advantages offered by the digital transformation, which can bring the necessary flexibility and adaptability, in accordance with the real needs of the population and the business environment today.
BIS has also coordinated various projects with CBDC as central themes. I mention in this regard the Jura project, which focuses on cross-border transfers, the Dunbar project that used a platform for international settlements using digital currencies issued by several central banks, or the Helvetia project that sought to test DLT technology for settlements, involving in experiment alongside the central bank and commercial banks.
BIS concerns embodied in numerous CBDC studies, reports, and projects lead to a number of general conclusions, including that the approach will need to be tailored to the particular needs of each jurisdiction, taking into account public policy objectives and specific market conditions, while the needs of the users must be placed at the center of the system design concerns, viewed both in terms of current determinants, but also of future evolution. It is necessary that this construction be done with caution and maintaining a permanent focus on flexibility.
Also the US Federal Reserve published a report in January 2022 entitled Money and Payments: The US Dollar in the age of Digital Transformation, in which it presents the functions and advantages of CBDCs, as well as the controversies surrounding it. The main advantages that the introduction of the CBDC could bring include the efficiency of cross-border payments, the promotion of financial inclusion, but also the strengthening of the international role of the dollar. Challenges that should be taken into account include changes in the structure of the US financial system, the risk of bank runs, given that CBDC would be viewed as a very attractive option especially by risk-averse users in crisis situations, the impact on monetary policy and interest rate control, through changes to reserves in the banking system, operational and cyber security risks, but also achieving the balance between the need to ensure confidentiality and the implementation of measures to combat money laundering and terrorist financing.
Indeed, the implications of the introduction of CBDC are multiple and a realistic and lucid analysis is required, especially through the lens of financial stability and price stability objectives. The literature (Fernández-Villaverde and Sanches, 2019; Schilling, Fernández-Villaverde, Uhlig, 2020) records the so-called CBDC trilemma, which states that at a given moment, the central bank can achieve at most two of the three main objectives regarding CBDC (efficiency, financial stability, and price stability). Efficiency and actions to discourage massive capital withdrawals impact inflation; on the other hand, the possibility of significant capital withdrawals in extreme situations, such as massive liquidation of real assets or affecting price stability, cannot be completely excluded and is always difficult to manage.
Considering the advantages and risks identifiable at this point, a number of scenarios regarding the implementation of CBDC can be explored (Ole, 2017):
– The money user scenario, where CBDC is equivalent to an electronic form of cash;
– The money manager scenario, where CBDC is seen as a universal reserve medium, emphasizing the store of value function that money performs.
– The money maker scenario, where CBDC is the official currency of account.
There are several risks involved in the introduction of a CBDC, therefore this process is not an easy one and requires a thorough analysis in order to mitigate the associated risks. Although the launch of digital currency by central banks will probably become a necessity to adapt to the requirements of simplifying the process of using money in a digital economy, where the speed of operations is constantly increasing, the risks associated with this process should not be overlooked. From the analyzes carried out so far, four main categories of risks have been identified:
1. Economic risks. They are given precisely from the way in which the issue of CBDC takes place. If a digital currency is issued by a central bank freely, uncorrelated with the dynamics of the economy and the exchange of goods and services, monetary policy would be affected, being weakened and subject to the exacerbation of inflationary risk.
2. Financial risks. Financial risks include exchange rate risk and other risks, such as operational risks. A CBDC should be just another form of central bank money. But beyond the access to a safe asset, the digital currency issued by the central banks could be held in large volumes and without significant costs, accelerating digital money runs, something that should be analyzed very carefully.
3. Cyber risks. There is also the risk that a centralized CBDC system could suffer disruptions due to cyber-attacks. Even a brief outage could adversely affect the credibility of the financial system, as well as a significant category of users, by disrupting everyone’s financial transactions.
4. Risks regarding the violation of personal rights. If designed inappropriately, CBDCs have the potential to be used as surveillance and control tools. In a world of programmable money, digital identity is recommended to be protected. It is true that digital identity is necessary to fight tax fraud and money laundering, as well as terrorist financing. But for now, there is no monetary reason to combine CBDC with digital identity.
A layered architecture of the new payment system is necessary to avoid the risks of implementing a CBDC. To some extent, prevention of CBDC risks rests with society as a whole. Essential to risk mitigation is designing a CBDC from the outset to prevent the possibility of these risks. In this sense, a layered architecture is required.
– At the basic level there is a digital currency issued and guaranteed by a central bank.
– In some views, the next layer is made up of digital money issued by commercial banks (which they can create when they make loans, as they currently do in their usual lending business). There are also analyzes that point out that CBDCs must be remunerated with interest when held as a deposit or through a bonus system, this can be a tool that catalyzes the transmission mechanism of monetary policy decisions in the economy.
– Finally, on the last layer are the business applications – wallets, apps, gateways, devices, and so on, where payments are embedded.
A two- or three-layer CBDC architecture has the potential to drive innovation, proliferating the next generation of payment applications and digital business models that can be used to benefit society as a whole. Perhaps a prudent first step would be for the CBDC to initially fulfill the current role of physical notes and coins, with other functions that are currently specific to scriptural currency being added later.
It is obvious that this technology is positioning itself against the classic, traditional approach to the monetary system as a viable, albeit admittedly imperfect, digital alternative, at least for now. Throughout time, there have been technologies that can be classified in the area of disruptive innovations and which, at the time of their appearance, seemed uncertain, unsafe, even problematic, but today we could no longer imagine our existence without their contribution.
I also think it is rational and realistic to accept at this point that the digital transformation cannot bypass the monetary system. Its future is obviously conditioned by flexibility and the ability to adapt to the digital rigors of the moment. I will not say that the current system is obsolete, but only that it is both necessary and inspired to let the new digital technologies prove their usefulness in capitalizing on the advantages in this transition to a new, greener, and more sustainable era.
Much further from the process of digital transformation, but very close to the subtle understanding of human nature, the poet Publius Ovidius Naso said that „times change and we change with them”, this being the essence of an evolutionary process of the habits and customs of human society, which continues to lead us today towards change and responsibility.