This is an extract from Finextra's 'The Future of Regulation 2022' report.
CBDCs: A love-hate saga
While monetary authorities in many countries around the world are conducting studies on the feasibility and utility of adopting CBDCs, there are only a few nations to date that have actually rolled out their own CBDCs, states Arvin Abraham, partner and UK
fintech lead, McDermott, Will & Emery.
“The most prominent of these is China where the digital yuan is already in pilot phase and the Chinese government has been quite public about its aims to make it a mainstream currency, so it’s probably going too far to say there is a general sentiment towards
adoption of CBDCs.”
In July 2021, the European Central Bank announced that it would begin investigating the creation of a digital euro and the Bank of England established a CBDC taskforce to explore the creation of a digital version of sterling in April 2021.
“It’s worth noting, however, that the investigatory efforts by major monetary authorities do not necessarily mean that the adoption of CBDCs is being looked upon favourably. Rather, it is a recognition that CBDCs represent a potentially useful application
of modern technologies (which could involve blockchain but doesn’t have to) to revolutionise existing monetary systems.”
However, Abraham notes that there is a recognition by certain monetary authorities that despite the current focus on CBDCs (the BoE’s Discussion Paper on CBDCs for instance), their real-world utility is mixed and they may not convey more benefits than the
current monetary system which is already largely electronic.
While the
US Federal Reserve released its highly anticipated report exploring potential opportunities offered by a digital dollar in January 2022, ‘Money and Payments: The U.S. Dollar in the Age of Digital Transformation’, there remains a lack of ubiquitous sentiment
toward adoption of CBDCs.
When it comes to the divergence of approaches across various systems, Franklin Noll, expert in the history of money and president of Noll Historical Consulting LLC explains that most central banks seem to agree that CBDCs need to be studied in order to meet
the challenges of a changing monetary world.
“Central banks that fail to stay up to date risk losing their monetary sovereignty to private cryptocurrency issuers, especially stablecoin issuers. Losing monetary sovereignty or the monetary monopoly would result in the loss of control over a state’s monetary
affairs. This is unacceptable to any sovereign nation.”
Central banks differ in their views of the importance or necessity of a CBDC. Some central banks or governments, especially those of smaller countries, see CBDCs as a way to lower costs (cash distribution and maintenance can be expensive) and to extend financial
inclusion. The Bahamas and its Sand Dollar CBDC is an example.
Other countries see a CBDC as a way to extend control and influence, not only within its own borders but also beyond them. They seek to build ways to improve international transactions or to create currency spheres where their CBDC could become the primary
currency. China is a prime example of this attitude.
Noll argues that most central banks in major economies have a more detached attitude toward CBDCs. “With advanced public and private payment systems already in place, they do not see a pressing need for a central bank digital currency that does not add a
lot of utility at the price of a lot of unknowns. This is the position of the United States.”
Abraham elaborates on the point, explaining that, generally speaking, the fundamental differences in approaches to CBDCs can be seen between countries that have become early adopters and are pushing forward with CBDC technology (notably China) versus countries
that are taking a more cautious approach and doing in-depth study (e.g., the UK).
“Early adopters may also be vying to establish the relevance and primacy of their currencies in a world where crypto-currencies are becoming more readily accepted as a real means of payment.”
Notably, some countries where CBDC projects have pushed forward with the greatest force are also those that have taken the hardest line towards rival cryptocurrencies – e.g., China’s bank on trading in cryptocurrencies and the reputed similar bank to be
enacted in India ahead of the launch of a formal CBDC project there.
“Countries that are moving rapidly ahead with CBDC projects may also be trying to establish their currencies as competitors to the dollar, which is clearly the case with China. Countries that are taking a more measured approach appear to be less interested
in utilising CBDCs as a means of economic competition and rather truly trying to weigh the benefits and costs.”
Risks and concerns
Naturally, this type of technological development presents the opportunity for a seismic shift in the function of a nation’s economy, and there are several concerns being raised about the risks CBDCs present.
According to Abraham, the primary concern is whether CBDCs would be worth the cost of establishing a new monetary structure when the world already operates on largely electronic means. “Against this backdrop the demand and utility of a CBDC is unclear and
the monetary authorities undertaking detailed evaluation of this are well-served by taking a measured approach before diving into a costly project.”
Noll sees three primary areas of concern in CBDC development right now: privacy, consumer accounts, and offline use. Privacy in individual transactions using a CBDC is a major concern, particularly in Western Europe where cash is highly valued for its anonymity
in transactions.
“A lot of work is being done to figure out ways to allow CBDC users to preserve their privacy in transactions while not opening the door to money laundering and other illegal uses of a digital currency. Ideas being explored to ensure privacy include advanced
cryptography (like zero knowledge proofs) and spend limits (where transactions under a certain amount remain unrecorded).”
Regarding consumer accounts, where every CBDC user should have an account with the central bank, Noll believes this would allow for financial inclusion and lower the cost of transactions (and many banking functions) to the public at large.
“Working against this idea of a ‘retail CBDC is the resistance of central banks to taking on a new retail function. Also, such an idea would take business away from the banking industry. This disintermediation is a major concern in the deployment of a CBDC.”
Finally, Noll posits that allowing for the use of a CBDC offline, away from an electronic network, is increasingly being seen as a major concern as the use of offline CBDC ensures a degree of anonymity in transactions, behaving much like traditional cash.
“There are many people around the world that do not have regular, or any, access to the internet. They may lack a smartphone or computer, live in an internet desert, or may not even have dependable electricity. To these people, a CBDC would be useless. Thus,
ideas of e-purses (rechargeable cards) or cryptobanknotes (cash with augmented capabilities) are being developed to allow for offline deployment of CBDCs.”
Given the adoption of CBDCs by certain nations and the extensive interest being shown across digital currency across the board, it’s difficult to imagine a future where CBDCs, in one form or another, don’t exist. Noll believes that central banks will need
to be in the crypto game in some way so as to deal with the threats to their monetary sovereignty.
“A central bank cannot allow a firm or firms to usurp its control of the money supply and, by extension, monetary policy and influence on the financial markets.” Yet, he notes that a fully-fledged central bank digital currency as defined and discussed in
the literature may not work for every country.
“Instead, a central bank may opt for a stablecoin, which it will issue and control. Or, a central bank may work with a private firm to issue a legal tender cryptocurrency of its own design. In sum, there is no one way for a central bank to issue its own
digital currency.”
Abraham believes that, in short, the adoption of CBDCs is not an inevitability. That said, “discussions around CBDCs, and for that matter most things relating to crypto or blockchain, are du jour in the current economic environment, it is not yet clear whether
CBDCs will replace fiat money as we know it. What is clear is that they are a concept that is worth looking into further, which we are seeing many monetary authorities do.”
Can institutional investors resist crypto temptation?
With seemingly insatiable retail interest in crypto trading, alongside heightened engagement with the opportunities or threat that decentralised finance offers by governments and central banks, institutional interest in the sector is gaining pace.
Addressing the question of whether incumbent financial institutions should be focused on building infrastructure to support digital currency, Alan Higgins, UK chief investment officer, Coutts, says it remains to be seen if they should if their business model
is successful in traditional assets.
“However, given the increasing interest and adoption of cryptocurrencies and the fact that it is moving more to the mainstream, many financial institutions are keeping a watchful eye on developments.”
Central banks including the Bank of England are looking at developing their own digital currencies, notes Higgins, so it is likely that as blockchain technology grows and more solutions are developed, financial institutions will start to consider if it is
worth building or investing in the infrastructure to support digital currency.
Abraham suggests that a focus on building infrastructure is dependent on whether non-state sponsored digital currencies are here to stay or whether they will be regulated in such a manner as to make them unviable (for instance, the approach taken by China).
“Assuming the regulatory environment does not shift in a way as to make it impossible to hold and trade them in most countries around the world, then all signs point to digital currencies becoming a mainstream part of financial services and if a great number
of consumers are using them, the driver of capturing profit is a huge motivator to building infrastructure to support digital currency use,” adds Abraham.
While he doesn’t think investment in cryptocurrency is a key priority for institutional investors, Higgins believes that it presents somewhat of a research priority, as many institutions are still questioning the overall philosophy of crypto investing and
the volatility of individual currencies.
Jeffrey Neuburger, co-head of Proskauer’s Technology, Media and Telecommunications Group, and head of the firm’s Blockchain Group, explains that cryptocurrency is now being regarded by many institutional investors as an asset class that should be considered
as part of an overall strategy. “Depending on the profile of the investor, some portion of their portfolio might be tied to cryptocurrency-related opportunities. Some investors are more aggressive in this respect, while others are taking a more measured approach.”
This position is echoed by Abraham, who stated that while cryptocurrencies have become incredibly popular and accepted in the past year, for some traditional institutional investors, concerns linger about cryptocurrencies’ volatility, susceptibility to abuse
by criminal actors and the gradual creep of regulatory restrictions around holding and trading them - which may make them unpalatable as an asset class for certain institutional investors.
The classifications and persisting conflicts around the definition of cryptoassets continue to present a concern for institutional investors. Abraham continues that fundamentally, this comes down to now knowing how they will be regulated and what new restrictions
you may face if you make a significant investment in or trade cryptocurrencies.
“In the case of XRP, the SEC had charged that its issuer, Ripple Labs, had engaged in an unregistered securities offering. This is despite mixed guidance over the past several years and a prior general consensus that cryptocurrencies are viewed as commodities
and not securities in the eyes of US regulators. Given the increasing adoption of cryptocurrencies, the desire for regulatory oversight is increasing and creating uncertainty that lax rules of the past may give way to more stringent rules in the future.”
Higgins agrees, adding that many institutional investors have concerns and have heard from somewhat sceptical industry leaders like Jamie Dimon and Warren Buffet. “The main concerns reflect a zero income crypto belief system as opposed to earning a risk
premium such as corporate credit or equity.”
Neuburger argues that the question of “how cryptocurrency fits within our regulatory framework is a significant question which needs to be clarified to allow institutional investors and regulators to understand how to analyse particular situations in a consistent
manner.”