EY – WRITTEN EVIDENCE (CDC0038)
CENTRAL BANK DIGITAL CURRENCIES
► Wholesale CBDC – usage generally restricted to financial institutions as a settlement asset for large transactions (e.g. interbank payments and securities settlements)
► Retail CBDC – universally accessible and available to the general public and business - substitutes for, or complements, bank notes in circulation
What are the main issues driving central banks to explore CBDCs?
► Enhancing the efficiency, reducing the costs of, and/or increasing the resilience of domestic payment systems
► Supporting an increasingly digital society and/or facilitating a larger virtual assets ecosystem
► The falling use of cash and declining central bank influence on the payments system
► Digitising an economy reliant on cash
► Gaining full visibility of the financial system and enabling better supervisory control in the face of competition from dominant overseas and local payment providers
► Enhancing financial inclusion and banking the unbanked
What are the main benefits and risks of a CBDC?
► Enhancing the efficiencies of payment systems - digital currencies, such as a CBDC, enhance efficiencies of payment systems by reducing transfer and settlement times (it can take up to three days for merchants to receive funds from ‘near instantaneous’ card payments). Efficiencies could also filter through to commercial banks. This is common reason cited for exploring CBDCs outside the G20.
► Reducing the costs of cash - from a public sector perspective, a cash-based system, that relies heavily on paper currency and coins is a burden for governments given the relatively high issuance, operating and maintenance costs. From a private sector perspective, cash is costly to store, count (reconcile) and move around. Digital transactions would cut these costs while simultaneously providing commercial banks and payment processors with greater insights into how customers spend and save. Efficiencies could also filter through to commercial banks.
► Financial Inclusion – in economies where mobile phone penetration is high but access to payment systems is low, a retail CBDC can have a high impact on financial inclusion. In particular, digital technology is able to reduce the cost of serving lower margin or unbanked customers, particularly in rural areas, leading financial institutions to discover that their small but ‘sticky’ deposits, when considered collectively, can be high value. However, there are complexities around how a CBDC could be used offline.
► Increased transparency - digitization is, by nature, highly transparent, thereby reducing opportunities for financial crime, including money laundering, terrorist financing and tax evasion, and encouraging moves to digital identification.
► Maintaining access to state-guaranteed money - some advanced economies are witnessing a decline in physical cash, as it is replaced by electronic payments via debit and credits cards that are supplied by a few private and very often foreign companies. For example, the Sveriges Riksbank found that in 2018 only 13% of residents paid for their most-recent purchase in cash and it has been predicted that Swedish retailers could stop accepting cash by 2023. Wary of over-dependence on private sector e-payment providers, some governments are considering CBDCs to maintain access to state-guaranteed money and retain the public’s faith in their payment systems.
► Disintermediation – a successful CBDC would be expected to lead to some level of disintermediation for commercial banks, particularly without a limit on CBDC holdings. This could result in commercial banks having smaller balance sheets as households and businesses substitute monies from banking deposits with CBDC holdings. This loss of deposit funding could reduce the levels of credit that commercial banks are able to provide to the wider economy. There could also be other effects on bank balance sheets such as loss of seigniorage.
► Anti-money laundering (AML) and Counter Financing of Terrorism (CTF) – the risk a CBDC could be used for illegal activity is one of the main concerns. This was considered in an Financial Action Taskforce report which found that while a CBDC could present a greater risk than cash, the “design of CBDCs will determine their risks” , which could therefore be lower. If there was any lapse in financial crime controls, or the CBDC was used for illicit purposes, this would have a negative impact on the reputation of the central bank which could affect public confidence in the further use of the CBDC.
► Cybersecurity - security is a large component of a CBDC model for governments issuing CBDCs and there are risks for the wider society and financial institutions, should the government infrastructure be compromised.
► Privacy – there are concerns that storing large amounts of personal data on a centralised system and features such as traceability and transparency make CBDCs risky from a privacy perspective. However, in the Sveriges Riksbank ‘e-krona’ project, intermediaries remain responsible for due diligence and KYC processes for CBDC users and the Riksbank receives no information on account holders, only on the transactions and account balances.
Could the proposed benefits of a CBDC be achieved through improvements to existing payment systems?
How should the Bank of England and HM Treasury address concerns over privacy and traceability of payments when exploring CBDC design?
What effects might a CBDC have on the financial sector?
► The impacts of disintermediation - as noted above, one of the risks of a CBDC is disintermediation. To stem the outflows of customer funds, commercial banks might feel compelled to raise interest on deposits to encourage customers to only use a CBDC for transactions. However, if commercial banks were to find themselves competing with a central bank for deposits, this could lead to an increasingly unstable funding base – without which banks might be forced to deleverage by scaling down loan portfolios, thereby threatening net interest margins. Alternatively, or in addition, commercial banks may need to access more expensive (and volatile) wholesale funding. Such moves would raise their cost of funding, while lowering the volume of loans and increasing credit cost for businesses and individuals. A CBDCs could, however, be designed to ensure its demand vis-à-vis that for bank deposits remains manageable. Such risks could be mitigated in part by a CBDC that does not bear interest, or by limits on holdings to avoid non-transactional cash being stored in the CBDC.
► Payments sector disruptions - a CBDC that is fast, efficient, widely available, and free to use could undermine business models for existing payments providers which charge network fees for facilitating payments. The business models of credit and debit card providers could also be impacted by the changes, such as large segments of unbanked populations in emerging economies transitioning from cash to smartphone payments and retailers providing online sources of buy-now-pay later consumer credit.
► Smart contracts – related developments could include smart contracts which allow for end-to-end settlement without intervention, reducing both the need for reconciliations, financial market infrastructure and credit/settlement risk, though they may come with their own cyber risk implications.
What effect might a CBDC have on competition and innovation in the payments and fintech sectors?
How might a CBDC affect monetary policy?
► Reducing the risks of cryptoassets – a CBDC could, by satisfying a need for better payment technology, reduce the risks to an economy created by a widespread and rapid adaption of cryptoassets, which impact the ability of central banks to effectively implement monetary policy. A retail CBDC providing digital cash could also counteract dollarization from private sector stablecoin offerings.
► Transmission of interest rates – a CBDC, particularly if holdings are unlimited, could be used to enable to transmit positive and negative interest rates on retail monetary assets. However, for a negative interest rate to be effective, cash would need to be withdrawn from circulation to avoid any incentive to hoard large denomination notes to avoid the charge.
► Possible consumer flight to the central bank’s balance sheet - if a CBDC could be used a store of value, there is a risk that customers would jump from commercial banks onto the security of a central bank’s balance sheet in times of stress, significantly weakening the balance sheets of commercial banks. This might, however, be mitigated by providing commercial bank with greater access to the Bank’s balance in times of stress or by limiting CBDC holdings.
How might a CBDC change the Bank of England’s role and responsibilities?
How should HM Treasury and the Bank of England engage with the public on the research and development of a CBDC?
How might CBDCs affect the economic foreign policies or geopolitical influence of different countries and economic areas? Are there implications for the effectiveness of economic sanctions?
26 October 2021
 Crypto Boom Poses New Challenges to Financial Stability’ - https://blogs.imf.org/2021/10/01/crypto-boom-poses-new-challenges-to-financial-stability/
 Seizing the opportunities from digital finance https://www.bankofengland.co.uk/-/media/boe/files/speech/2020/seizing-the-opportunities-from-digital-finance-speech-by-andy-haldane.pdf?la=en&hash=508F4972D17DE5A6DE3E0A1439A284BE904AC1C5