How to make central bank digital currencies work for offline payments

Governments worldwide are exploring state-backed digital cash but face key challenges, including ensuring CBDCs are private, secure, and usable offline… 

Is a central bank digital currency (CBDC) just theoretical? 400,000 Bahamians disagree. In October 2020, the Bahamas launched the Sand Dollar, the world’s first CBDC. Since then, interest has surged. China’s 2021 digital yuan white paper spurred many nations to explore state-backed digital money.

As of September 2024, 134 countries, representing 98% of the global economy, are exploring CBDCs. Let’s recap what a CBDC is and why central banks are looking into it.

What is a CBDC?

CBDCs are digital versions of central bank money designed to address the decline in cash usage and competition from private digital currencies like cryptocurrencies and stable coins. Unlike private money, CBDCs are backed by the central bank, ensuring trust and stability.

Central banks see CBDCs as tools to:

• Enhance financial stability: They bridge the gap left by declining cash usage, maintaining the convertibility of private to public money.
• Boost control and disaster recovery: Digital currencies like the Bahamas' Sand Dollar aid economic recovery and provide programmable financial tools.
• Cut costs: They promise faster, cheaper cross-border payments, potentially saving billions annually.
• Fight fraud: CBDCs allow tracking of transactions, reducing tax evasion, money laundering, and other financial crimes.
• Improve financial inclusion: By removing the need for bank accounts, they help unbanked populations participate in the economy.

This final factor of financial inclusion is extremely important to governments and central banks. But is raises two crucial questions. Firstly, how can they make it easy for the unbanked to keep and use their digital cash? Secondly, how can they ensure that people can use CBDC without access to electricity or internet connectivity?

CBDC on a phone, card or smart bank note

 In a research paper, the UK Bank of England proposed that transactions could be done offline from a phone-based wallet via QR codes, NFC or Bluetooth – all of which can be processed locally without the involvement of an intermediary. There is even the potential to make a payment via SMS from a feature phone. While the latter would not be purely offline, no internet connectivity would be needed. 

In fact, it might even be possible to make CBDC payments from smart bank notes. Thus futuristic concept was unveiled in 2021 by Orell Füssli, Security Printing and AUGENTIC. Smart bank notes can be exchanged like traditional cash. But because they feature encrypted 2D barcodes, holders can convert them into digital cash at any given time.

A secure enclave to keep offline CBDC payments safe?

To shield offline CBDC transactions from attackers, the BoE report noted the potential of tamper-proof secure enclaves. These cryptographically secured areas are widely used in smartphones to isolate wallet applications from other phone functions. However, they can also be placed in smart cards and wearables too. They deploy strong cryptography and robust key management to protect the sensitive data being processed. 

The combination of secure enclave and encryption keys ensures that the user can make CDBC payments offline but cannot spend the same money twice. Of course, there is one major drawback of offline transactions: funds cannot be recovered if devices are lost, broken or stolen. However, since this is already the case with notes and coins, it may not be a strong argument against pursuing an offline option. 

Balancing Privacy and Crime Prevention

Physical cash offers complete anonymity, unlike digital currencies, which inherently leave transaction records. While an offline CBDC cannot match cash's privacy, governments can design some privacy safeguards to protect users’ habits and preferences. This must be balanced with the need for traceability to combat money laundering, terrorism financing, and tax evasion. Central banks are exploring anonymized transaction designs—recording activities without linking them to individuals.

A paper by the European Parliament on the digital euro said: “While the identity of the parties is protected, the transaction itself can be observed and recorded. That difference may be essential in designing a CBDC. Anonymity may go a long way in meeting citizens' concerns while preserving other objectives of public policy.”

Seven arguments for CBDC

In its discussion paper the UK Bank of England summarised seven benefits of CBDCs as follows:

• Supporting a resilient and inclusive payments landscape
• Avoiding the risks of new forms of private money creation
• Supporting competition, efficiency and innovation in payments
• Meeting future payment needs in a digital economy
• Improving the availability and usability of central bank money
• Addressing the consequences of a decline in cash
• As a building block for better cross-border payments.

How to make CBDCs work for everyone

 In a research paper, the Federal Reserve Bank of Kansas City listed six key criteria for a genuinely inclusive form of digital cash. 

1. A CBDC designed for the unbanked should have no minimum balance requirement.
2. Consumers should be able to access CBDC and transact with it anytime, anywhere, and for little or no cost.
3. A CBDC should have to balance transaction privacy for consumers while still complying with anti-money laundering regulation.
4. Users should be able to access their CBDC via more channels than a digital wallet via a smartphone app. Options should include physical locations, stored-value cards and portable hardware devices.
5. Users should be able to turn cash into CBDC at little to no cost.
6. Multiple entities should offer CBDC. Many unbanked households are not interested in opening a bank account, or do not trust banks.