Spare a thought for the trilemma of central bank digital currencies

By on November 13, 2022 0

Clearly, central banks are scrambling to board the CBDC train before it leaves the station. But what is driving this mad rush?

One argument is that by providing digital access to anyone with a cell phone or smart card, a CBDC will extend modern payment technology to the masses. But the experience of countries like India suggests that there are simpler ways to achieve this goal.

India was able to solve its “unbanked” problem by forcing commercial banks to offer no-frills savings accounts with no minimum balance requirement. The “Prime Minister’s People’s Wealth Scheme” also mandates state-owned banks to offer low-cost, zero-balance accounts to underbanked rural residents. Since last year, some 400 million “person accounts” have been opened.

India has also created an efficient and inexpensive electronic payment infrastructure, the United Payments interface. UPI is a real-time payment system operated by National Payments Corp, a government-sponsored non-profit organization. Banks, e-money companies, and technology companies have introduced UPI-enabled mobile payment apps that allow users to send money between bank accounts.

But, while some 300 banks participate in the system, the government remains keen on rolling out a CBDC. Perhaps this is driven by the belief of policy makers that a CBDC will benefit the infotech sector. From a financial inclusion and ease of payment perspective, however, the unit will be redundant.

Cross-border payments are not that cheap or that simple. Moreover, governments are increasingly uncomfortable with their reliance on the US dollar as the dominant vehicle for such transactions, given the United States’ reliance on financial sanctions. The hope is that CBDCs could provide a digital alternative.

Strictly speaking, there are no barriers to exchanging CBDCs from different countries and using them for international payments. Multiple CBDCs can run on a single blockchain. With the help of the Bank for International Settlements, central banks have experimented with platforms, called mBridges, on which CBDCs can be traded.

But, although we have the technical know-how, there are formidable political obstacles to the widespread adoption of these arrangements. Can you imagine China and the US agreeing on how to govern a platform where their CBDCs are traded? Can you imagine an agreement of 120 central banks?

Another motivation for the CBDC rush is the inconsistent belief that financial and even geopolitical primacy will depend on which central banks are quickest to issue one. This view is encouraged by economic and political tensions between the United States and China, and China’s rapid move towards issuing CBDCs, which is seen as a threat to dollar dominance.

But this argument assumes that CBDCs will be used across borders and will supplant the international interbank market as the vehicle for international transactions. But, given the political hurdles preventing a common trading platform for different CBDCs, this is unlikely to be the case.

Ultimately, central banks face a “trilemma” when considering the issuance of CBDCs.

Central banks can only have two out of three things: a digital currency, transaction privacy, and financial stability.

European central banks, when issuing a CBDC, will have to comply with the EU’s General Data Protection Regulation (GDPR), the strictest data privacy law in the world. If they issue digital currencies through licensed intermediaries, their users will enjoy privacy. But authorities will then have a limited ability to track transactions using their CBDCs.

People using currencies in transactions already benefit from anonymity, of course, but one can imagine other transactions involving bank transfers being executed using CBDC instead. Central bankers and others worry that commercial banks will be disintermediated. That transactions typically made by wire transfer will be transferred to the CBDCs. Together with the secrecy of transactions, this could allow financial risks and imbalances to build up out of the sight of regulators. This is why the European Central Bank is only slowly moving wisely in the direction of issuing CBDCs.

The People’s Bank of China is not required to offer confidentiality. When downloading a digital wallet capable of unlimited transactions, it requires detailed information from the user. When downloading a limited wallet capable of small retail transactions, it only requires the user’s mobile number and promises, for what it’s worth, not to track their transactions.

We will see. These measures should prevent individuals from using e-CNY to evade Chinese capital controls, move large sums of money out of the country, and otherwise act in a way that threatens financial stability. As to whether people will trust the Chinese CBDC, given these conditions, only time will tell.

International finance, as trade economists know, faces trilemmas. Instead of avoiding them, CBDCs create just another one. ©2022/Syndicate Project

Barry Eichengreen is professor of economics at the University of California at Berkeley and author of “In Defense of Public Debt”.

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