Australia’s central bank digital currency (CBDC) research project formally kicked off this week after its announcement earlier in the month. This represents quite a change of tune from an October 2020 statement, when the RBA pronounced that “no strong public policy case [had] yet emerged for the introduction of a CBDC for general use”. Perhaps this speaks to the sheer velocity of change we’ve seen in the digital asset ecosystem over the past two years.
CBDCs have long been considered controversial. On one side, some believe they offer more innovation and greater efficiencies than the traditional financial system, while on the other side, many argue they erode privacy and financial freedom. It’s not surprising, then, that the RBA’s CBDC research project has sparked a diversity of opinions, ranging from support to outright fear:
A number of key questions arise that will help us determine what all the fuss is about:
- What are CBDCs?
- What are their purported benefits?
- To the extent that there are benefits, do they outweigh the costs?
CBDCs: What is a Central Bank Digital Currency?
A CBDC is best described as a blockchain-based digital form of currency issued and regulated by a central bank (in this case, hypothetically, the RBA).
What is the difference between a CBDC and conventional currency?
Despite being so integral to our lives, most people haven’t given all that much thought as to what money is and how it works. For example, a 2020 estimate suggested that as much as 93% of money is digital and not backed by any paper notes or coins. Less than 10% is physical currency. Given the shift towards touchless payments over the past two years, the physical cash portion may now be even lower.
Within the traditional financial system, money is created by retail banks (such as Westpac) when they loan it out to their customers, who may be individuals or businesses. It’s a simple entry in a ledger. The bank credits your account and creates a liability (debt) on its end — simple. That’s how things currently operate in the fiat currency model, but CBDCs are an entirely different beast.
CBDCs, by contrast, are issued by a central bank such as the RBA or the Federal Reserve in the US. For simplification, the central bank can be considered the bank your bank borrows money from and the central entity who sets interest rates. Retail banks, by comparison, are often used for obtaining mortgages, for example, or are where you keep your savings. The central bank and the retail bank have distinct roles to play in the current system — the central bank lends money to the retail bank, who in turn lends to customers such as businesses and individuals. This is an over-simplification to an extent, but sufficient for current purposes.
What is the technology behind CBDCs?
The primary technology underlying CBDCs is its reliance on distributed ledger blockchain technology. This enables final settlement payments to be made directly from the central bank to the person concerned. There is no single standard as to which blockchain CBDCs should be issued upon. That decision lies solely in the hands of the central bank, although one would assume it would be the more secure and widely used blockchains. One of the key elements of CBDCs to note is smart contracts, which is why it has been described by some as ‘programmable money’.
The traditional financial system, by contrast, is a hodge-podge collection of systems glued together by various layers and delayed settlement times. Furthermore, if the government wanted to send money to specific individuals, it could not do so directly in the current system. It would have to go through a series of intermediaries, making final settlement a slow and tedious process.
Types of CBDCs
CBDCs can be either retail or wholesale.
Wholesale CBDCs are issued by a central bank to large financial institutions such as commercial banks (like Westpac). Let’s talk about what that means. First, it’s important to know that with the system we have today, when one bank wants to send money to another, it can only do so at a snail’s pace (which is exponentially worse for international transfers). This is technology invented in the ’70s. Think of the current system as a cargo ship and wholesale CBDCs as a high-speed modern financial train. There’s no comparison, and the case for wholesale CBDCs is compelling and largely uncontroversial.
Retail CBDCs are different, however. They are issued directly to people and businesses, and could be seen as a useful mechanism to deliver ‘helicopter money’ or universal basic income. Say there is some sort of crisis and the government wants to airdrop $1000 to certain qualifying citizens to alleviate the pain. Retail CBDCs enable that. This sounds good in principle, but a basic knowledge of smart contracts suggests that there may be a dark side that many are not considering.
More than 100 governments are at some stage of experimenting or implementing CBDCs. It therefore pays to have a sense of the various costs and benefits. For clarity, the discussion below is focused on retail CBDCs, which is where the controversy lies. Let’s start with the good stuff.
CBDC proponents cite a number of advantages of retail CBDCs. These include:
- technological efficiency — money transfers and payments can be made in real time, directly from the payer to the payee with no intermediaries
- reduced risk for merchants as settlement is instant
- financial inclusion — in that any legal resident or citizen can be provided with a free or low-cost basic bank account
- preventing illicit activity by tracking each unit of CBDC since all transactions are traceable
- improved tax collection — taxes can simply be deducted at source
- combating crime — the blockchain is transparent, making it easy to track criminal activities
- improved safety — as carrying physical cash constitutes a risk
To illustrate how a retail CBDC could be used, consider the Australian government’s JobSeeker program during the pandemic. To get that money into the hands of those who qualified was difficult, slow and clunky, not to mention the examples of some who abused the system. CBDCs would have solved that problem entirely, and could even have been designed so that the money had to be spent on housing, and not alcohol, for example.
The chief executive of the Bank of International Settlements (a bank for central banks) has himself praised CBDCs for their transparency because, unlike cash, all transactions are fully visible on the blockchain:
Despite any efficiencies, it’s worth taking a serious look at the costs, which in this case are significant.
The first major issue is that you will have no financial privacy since every single transaction will be capable of surveillance. “I don’t care, I don’t have anything to hide,” you’ll hear some folks say. In saying that, however, there is an implicit assumption that you’ll always be on the right side of those in charge. That’s just the beginning.
As noted earlier, CBDCs are defined by having smart contracts built into them. They can be programmed in any way imaginable by centralised authorities who could create a series of ‘carrots’ and ‘sticks’ to drive the sort of behaviour it wants — behavioural finance meets social engineering. The authorities could decide where, when and how you spend your money. Your money can literally be turned on and off like a switch, which as Edward Snowden points out, means you do not own your money:
Retail CBDCs are an authoritarian regime’s proverbial wet dream. If you can control people’s money, you can pretty much get them to do whatever it is you want. It’s no surprise, then, that China is by far the furthest along in its use of CBDCs, with an estimated 123 million citizens currently involved. It forms an integral part of the state’s social credit system.
In summary, retail CBDCs raise significant concerns relating to privacy, financial freedom and personal autonomy. Arguably, legitimate questions could be raised as to whether they are at all compatible with the ideals of modern Western democracies such as Australia and the US.
Australia’s foray into CBDCs
According to the announcement earlier this month, the research project is a collaboration between the RBA and the Digital Finance Cooperative Research Centre (DFCRC) designed to focus on the uses for, and potential economic benefits of, a CBDC.
The process is anticipated to take about a year to complete and will involve the development of a limited-scale pilot that will operate in a ring-fenced environment for a period of time. At the time, RBA deputy governor Michelle Bullock described the project as “an important step” on the path to a potential Australian CBDC, saying on ABC Radio’s The World Today program it was effectively “an experiment”.
In its most recent meeting on August 25, the RBA discussed CBDCs again, saying it was “investigating the potential merits, design and implications of a CBDC”. Interestingly, it highlighted the probability of wholesale use, but that the “desirability and feasibility of a [retail] CBDC” was still undergoing research.
At this early stage, it’s too soon to tell what the prospects of a retail CBDC are in Australia. The probability of a wholesale CBDC, however, appears quite likely, given the benefits seemingly far outweigh any costs. The tricky tightrope that the RBA will have to walk in its design of any potential retail CBDC is balancing efficiency against privacy and freedom — a difficult task that sceptics will say is near impossible. Either way, Australia’s CBDC pivot is a clear demonstration that it doesn’t want to get left behind.