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Governments in every continent are researching how to launch state-backed digital cash. They have major challenges to solve first – not least how to make CBDCs private, safe and useable offline…
Is the central bank digital currency (CBDC) just an interesting theoretical idea? 400,000 Bahamians don’t think so. In October 2020, the government of the Bahamas launched the Sand Dollar. It was the world’s first CBDC. Since then, interest has soared. Most significantly, the People’s Bank of China issued a white paper in July 2021 outlining its objectives for a digital yuan.
China’s active interest in CBDC appears to have encouraged other nations to – at the very least – research the concept of state-backed digital money. According to the CBDC Tracker website, there were 143 CBDC projects at the research/proof of concept/pilot/launch stage as of September 2023.
This adds up to a lot of activity – especially for an idea that no one was seriously discussing until very recently.
So let’s briefly re-cap what a CBDC is and why central banks are looking into it.
CBDC: What is it? And why now?
Today, central bank money takes two forms: physical banknotes and reserves held by financial institutions. This money is hugely important because it underpins financial stability. In most cases people can exchange their bank balances for notes and coins. This gives citizens a degree of trust in their country’s money. We can see this when there is a ‘run on the bank’ and customers rush to turn their ‘risky’ bank deposits into ‘safe’ cash.
In a 2021 speech, Tom Mutton, director, central bank digital currency unit at the UK Bank of England, summed up the thinking as follows: “Confidence in money and payments is fundamental to financial stability. The ability to convert, on demand, ‘private’ money – such as a bank deposit – into ‘public’ money, issued by the central bank, in the form of cash, is a foundation of that confidence.”
But now the way people pay for things is changing. The biggest shift is that consumers are reducing their use of cash. This undermines that ‘last resort’ option of a citizen turning his or her bank reserves into notes and coins. When cash disappears, the link between central bank money and the commercial economy is broken. This risks instability. It reduces the government’s ability to nudge and shape the economy.
Competition from ‘private money’
Meanwhile new forms of money are emerging. There’s bitcoin and all the other cryptocurrencies, of course. But there are also stable coins – digital currency which is created by private companies, but which is pegged to official fiat money to make it stable.
The most high profile example a stable coin is Diem, the digital currency project led by Facebook’s parent company Meta. It was eventually cancelled. But for a while it illustrated the potential for a ‘private’ form of money to spread across the world beyond the control of any single nation state.
So what’s the answer to the problem of cash decline and private competition?
Well, one possibility is to create ‘virtual’ bank notes. In this scenario the central bank issues cash in the form of unique and immutable digital tokens, which can be held in a digital wallet. This is CDBC, And every unit of CBDC is a claim on the central bank, just as banknotes are now.
The momentum behind this idea is growing. Increasingly economists believe that the CBDC concept has many benefits.
Let’s list them:
• Control over the economy
Creating a CBDC – in theory – gives central banks some control of the financial infrastructure of a country even when cash is dying out. In the case of the Sand dollar, for example, Bahamian leaders see digital banknotes as a tool to aid disaster recovery. In a country vulnerable to extreme weather, they believe a CBDC can help them get the economy moving again.
Physical notes and coins are ‘dumb’. By contrast, digital banknotes can be programmed. In other words, central banks can build rules and constraints into them. They could, for example, put in an expiry date or mandate its use only for specified products. This is useful as it can give governments more control over stimulus programs or direct welfare payments to targeted recipients.
• Cost savings
The digitisation of money has reduced costs and improved speeds in many areas. But not all. For example, cross border payments remain slow and rife with hidden fees. Some experts think CBDCs could change this. A research report by Oliver Wyman and JPMorgan said a network of CBDCs could save global corporates up to $100 billion in transaction costs every year.
• Reduce fraud, money laundering and illegal labor
CBDCs can significantly reduce the risk of criminal financial activity. Since digital currencies can keep a history of all past transactions, central banks can track the flow of money and monitor risks such as tax evasion, money laundering and the employment of illegal immigrants. The IMF has warned against these threats. And reports say China has already uncovered one money laundering scam thanks to its digital yuan project.
• Improve financial inclusion
A system based on a CBDC should make digital payments more inclusive too since citizens would not need to open bank accounts to hold and use CBDC. By making cash digital it will (in theory) be easier for the unbanked to store and save money – and then access loans or other financial products. This is the stated aim of the proposed Jamaican CBDC for example. “The majority of Jamaicans are financially excluded,” said Natalie Haynes, deputy governor with Bank of Jamaica (BOJ). “To get those persons into the formal financial system, we decided that the central bank digital currency would be a good opportunity.”
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 with the need to fight crime
The privacy issue is another extremely facet of the CBDC conversation. Physical cash is private by nature. It is entirely anonymous and leaves no trace. By contrast all transactions of digital currency are ultimately recorded by a third party.
For this reason, even an offline CBDC can never ensure the same level of privacy as notes and coins. However, there are still ways for governments to design a degree of privacy into digital cash. This matters. After all, a person’s payment history reveals their habits and preferences.
However, the pursuit of privacy should be balanced against other objectives. Regulators have good reason to demand some form of traceability into a CBDC system. They need to be able to combat money laundering, financing of terrorism and tax evasion.
This is why central banks are currently investigating how best to build anonymity into their CBDC designs. Anonymity is attractive since it ensures that there is a record of all transactions, but they are not directly linked to specific 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.”
Off and running – Australia’s offline CBDC pilot
Never mind the theory, what’s it like to use an offline CBDC in the real world? Australia’s central bank decided to find out. Here, we asked Alain Martin, head of consulting and CBDC lead at pilot partner Thales, to share what was learned…
How will consumers interact with offline CBDC payments? What’s the best form factor for storing the currency? How can users load or convert funds? Payment industry stakeholders and central bankers need to investigate these (and other) questions before launching any offline currency platform.
Earlier this year, Australian payment insiders launched a pilot to find answers. The process began in September 2022 when the Reserve Bank of Australia and the Digital Finance Cooperative Research Centre (DFCRC) published a white paper and invited proposals for CBDC use case tests. They chose 14, one of which focused on the offline challenge.
This pilot was run by ANZ Bank and Thales and took place at two sites: RMIT University and Southern Cross University. In each case, students were given smart cards to make payments with campus merchants.
So what happened? We asked Alain Martin, head of consulting and CBDC lead at Thales, for insights.
What was the process for loading, storing and spending funds in the pilot?
We gave university administrators mobile phones containing a CBDC app, which allowed them to store digital Australian Dollars. They loaded the currency up online. But then we made it possible for the admins to distribute the digital cash to students offline. They did this by transferring funds to the students’ smart cards with a tap – using the phones’ NFC interface.
The students could then pay offline for goods by tapping their cards on to a merchant’s phone. From time to time, the merchants would connect their phone online to turn their digital cash into conventional currency.
How were the CBDC dollars created and distributed?
RBA minted digital Australian dollars onto a central ledger and distributed them to participating banks. As a participating bank, ANZ created wallets on the ledger for universities and merchants to use. These university wallets became the source of funds for loading digital cash on to the admins’ mobile phones.
What did users think about the smartcard form factor?
There was a mixed response. Most users found the cards easy to use. However, some struggled with where to tap their cards on the merchants’ phones. For example, they could tap on the front of an iPhone, but only on the back of an Android device. Also, some students commented that they would have preferred to have a visual display on their cards.
What were the challenges with not having a display?
Users didn’t know their account balances until their made a payment and saw it on the merchant screen. Some liked this. Others felt their privacy was infringed. There was also some concern about losing the card. Obviously, when you store your funds locally, you lose them forever if you lose your card. Though you can say the same about cash of course.
What’s a solution for this?
Well, you can improve the security of the card itself so it cannot be used if stolen. At Thales we have launched cards with screens, keyboards and fingerprint readers. So it is possible to restrict access to the cards. However, these features come at a cost. I expect most governments would want to keep the unit price of an offline CBDC device down to a dollar or two. Advanced biometric cards cost more than this. That said, I think banks will also look into the possibility of creating bespoke offline payment devices with some kind of battery, NFC and screen.
What else is Thales doing in the CBDC space?
We are involved in several pilots and evaluations. For example, we worked with Bank of England on an evaluation of our proof of concept. For this project we connected to their core CBDC ledger using APIs jointly defined with the Bank for International Settlements. It was all done as part of Project Rosalind, a scheme to develop prototypes for APIs that can help private sector service providers connect to central bank ledgers so they can provision retail payments securely.
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 new 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.