CBDC – The era of sovereign digital money – Part 2

The promise of a better world

Meta’s Diem initiative was abandoned in January 2022, but it will forever be regarded as the first, serious, organizational attempt to challenge the status quo of monetary sovereignty and policy. As governments geared up to look for an alternative, the rolling ball started gaining momentum and as of the end of February 2023, CBDC Tracker ( points out that Jamaica and Bahamas have already launched their CBDC, about a dozen countries are actively testing their CBDC pilots, and more than a 100 others are either in the POC phase or are actively researching for a CBDC of their own.

This is probably a good time to get the definitions out of the way. A CBDC can be thought of a third kind of official/sovereign legal tender, in addition to physical cash and central bank reserves. The latter of the two is what enables intermediaries such as banks to operate and should not be confused with our banking deposits. The money that we keep in banks is not Central Bank money, rather those are merely accounting entries that provide the leverage for fractional banking. In simple terms, cash is public money whereas commercial bank deposits are private money.

CBDC is an official and legal tender, which means that once you own some of it, it is mostly equivalent to physical cash in the normal sense. When we think of CBDC, there are broadly three interested parties – the government/central bank issuing the currency, the general public using the currency and the financial intermediaries such as the commercial banks, facilitating the use of the currency. Let’s understand the impact on each of these stakeholders.

  1. The Central Bank or the issuer has a lot to gain from a well-designed CBDC. It is highly impractical that cash will be totally replaced anytime soon, but a well-functioning CBDC provides an effective alternative and can reduce the need for physical cash in the system. And that would mean a lot of operational optimization resulting for the central bank as this will mean less of printing and handling of cash, and less of surveillance to combat counterfeiting.

Reduction in cash transactions also helps to combat the black economy and tax evasion. Cash offers the possibilities of both counterparty anonymity as well as third party anonymity. With CBDC, third-party anonymity is no longer feasible and that can help fight corruption, black marketing, drugs, crime and the overall shadow economy. With time, the days of storing black money under mattresses could be well and truly over.

CBDC brings in prompt visibility and traceability of the transactional data. Today policymakers trying to understand the economic data need extensive data collection, cleansing and aggregation of the data; and even after all of this, the resultant analysis/insight is approximate and mostly outdated. With CBDC, information collection can be immediate and quality of the data can be far more comprehensive and accurate, thus providing live visibility to policymakers on economic activities. Now that’s something!

Finally, CBDC is programmable money, i.e. it is possible to run smart contracts running on blockchain technology. The possibilities are immense. Shortly after the pandemic decided to be a party pooper and disrupt our lives, governments and central banks around the world had to step in and introduce some massive stimulus measures to help people survive and to get the economy back on track. So far, so good. But the issue was how to ensure that the money reaches the right people and gets spent the right way. With CBDC, the money could have been programmed to be spent on select sectors, in select regions and within a stipulated time failing which that money could have been made to expire. That’s like Michael Jackson on steroids!

  1. For the general public at large, cross-border payments, whether in the form of remittances or B2B payments or securities transactions, are where CBDC can make the most impact. Today we can send an email or an image halfway across the world for free but sending money across borders cost us an average of 7%. Add to that the time taken for this transfer, the possibility of the transactions getting stuck at any point, and the absolute non-transparency of the process while in progress, and we have a problem crying out to be solved. Crypto in general and stablecoins in particular hold the possibility of a faster and cheaper alternative, but a rightly designed multi-CBDC solution can really cater to the mainstream.

CBDC can be the preferred stored value in times to come. CBDC is sovereign money, and hence can be a safe‑haven public option for savings, with lower risk of default than storing savings with commercial banks. Of course, somebody who despises the sovereignty will still go for decentralized crypto as the alternative, but for most others, they have the option of keeping their money in CBDC for safe-keeping, and thus may well emerge as a viable alternative to commercial bank deposits. It will provide the convenience to transact in the digital economy, and thus move away from a fragmented payment ecosystem.

There is one critical innovation which a CBDC design may provide that is hitherto unavailable in regular digital payments. And that is conducting and settling of a transaction when no internet connection is available. This is the world of Offline payments where cash has currently no alternative. CBDC can potentially offer two use cases here. One is an intermittent offline currency that allows offline transfer of money but requires connectivity for settlement; in other words, money gets transferred but is locked for re-spending. The other one is an extended offline CBDC where funds being local to the device can support instant settlement so that ownership is transferred at the time of the transaction. In this case, settlement will happen purely offline and will not require synchronization with an online system.

On the flip side, CBDC can be looked at as a breach of individual data privacy, as every transaction can now be scrutinized and investigated. It’s a ‘Big Brother’ scenario, and it isn’t pretty.

  1. The third piece of the puzzle are financial intermediaries which sit between the Central Bank on one hand and the retail and corporate customers on the other. The most powerful entities here are the banks who seek our deposits and provide credit to the ecosystem through a mechanism called fractional banking. In other words, they can lend more than what they have on their balance sheet, thereby creating money out of thin air. Thus, bank deposits are never, truly, risk free; which is why you earn an interest on your bank deposits.

CBDC has the potential to challenge commercial banks’ market power over retail deposits, pressuring banks to increase interest rates, provide deposit insurance and offer better financial services to depositors. Essentially, they must now compete for our money a lot more. In the best case, a drop in deposits and rising costs of banks may raise the cost of credit in the ecosystem; and debt financing may well be expensive. At the worst, we can be looking at a ‘disintermediation’ of the banking sector.

Now, if you think about this, a very interesting dichotomy can emerge.

On one hand, these banks would now have to be more efficient and conservative, because the first sign of trouble may have depositors move their money from accounts to CBDC. On the other hand, competing for the customers’ money would put pressure on the bank’s margins which pushes their hand into taking on more risk to increase earnings.

Long story short, the central banks need to think long and hard about how to keep the financial system from falling apart. They can look at recalibrating (downwards) the quantum of reserves that banks keep with the central bank and maybe put limits on withdrawal to CBDC. They can also look at putting negative interest rates on CBDC holdings, but that can end up incentivizing physical money and thus defeating the objective. Now these are outside the purview of this article, and so I will stop here, but the takeaway is that the central banks need to think long and hard about the design and implementation of this digital currency.

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