hile 86% of the world’s central banks weigh the potential risks and rewards of issuing a central bank digital currency (CBDC), much of the analysis remains abstract to experimental. This is a good thing, since there are numerous potentially destabilizing risks and other considerations central bankers must weigh as they contemplate entering the digital currency space race. Indeed, a space race is afoot for the future of money and payments, but the real choice is not whether central banks should become retail-level technology companies, an implied change of launching a CBDC. Rather, the real debate is how to let a growing and increasingly competitive private sector thrive in adding much needed competition and optionality when it comes to the future of payments and money.
Here are 10 key risks and considerations that are often missed in the CBDC debate, and should be carefully weighed as central banks look at the tradeoffs of digitizing their national currencies.
1. Technology risks and obsolescence - Launching a CBDC would transfer substantial technology risks to the public sector and ultimately taxpayers, who would bear the brunt of fast moving and often experimental technologies. Blockchains are now in their third generation and the technologies of public, open-source financial infrastructure are evolving rapidly. Consumers, markets and public authorities will all benefit in equal measure if this evolution in the movement of value on the Internet, like all others before it, remains a free market activity with public sector oversight.
2. Cyber threats and single points of failure - Invariably, a CBDC would necessitate centralization, which would amplify already rife cyber vulnerabilities and increase the surface area and vectors of attack to now include central banks, in addition to the economy overall (recall Equifax, Solar Winds and the Colonial gas pipeline as 3 examples). To truly leverage the inherent cyber resilience of distributed systems, public blockchains alongside a competitive free market for the movement of value on the internet is a better long range posture. Just as the failure of any one bank erodes confidence in banking, a CBDC could potentially transition this risk to central banks negating the benefits of strategic risk-sharing structures and operational “air gaps” between participants in the financial system.
3. Privacy and consumer protection - A CBDC, particularly if issued at the retail level or by a less than benign government (noting the thin line between democracy and anarchy), would represent a potentially troubling encroachment on consumer privacy and protections. What would stop the weaponization of a CBDC against citizens or the potential blockage of lawful transactions by groups that fall into disfavor? To the right of lawful, the use of money (a public good to which equal access is a human right) and how it is saved, sent, spent and secured, should be as free as possible while maximizing the penalty on bad actors.
4. Systemic risk and destabilization - A CBDC creates a potential domestic “flight to quality” problem, which would destabilize the very two-tiered banking system central banks are designed to protect. The potential systemic effects of a CBDC, the prospect of spillover effects by virtue of increased velocity of money, among other perils, could pose serious detrimental effects to the banking system and economy writ large. The model represented by privately-issued digital currencies with a veritable “air gap” between reference assets (such as cash, cash equivalents and high quality assets inside the banking system) and tokenized assets on public blockchains results in no new money creation and protects and preserves the two-tiered banking system. Critically, the transmission of monetary policy is also preserved.
5. Vendor risk and technology capture - For a CBDC to exist, someone is selling some newfangled technology to central banks. This introduces the often overlooked operating vulnerability of supply chain and vendor risk, let alone the potentially insidious prospect of buyers remorse or technological obsolescence. Protecting the public provenance of money and monetary oversight does not require central banks to become retail banks or, worse yet, technology service providers with massive stores of data recreating the very “honeypot” databases that attract swarms of cyber ne'er-do-wells.
6. The limitations of digital twins - Conceptually, CBDCs come in many shapes and sizes, with the most likely outcome being a wholesale variant, which could potentially make interbank relationships more efficient, but would leave retail and market-level improvements up to trickle down effects. The real financial inclusion and innovation gains, as with the current state of play of digital currencies, e-money and mobile money innovations, hinges on robust free market competition and innovation with exponential technologies. Many of these can be considered digital public goods, which benefit from open source standards that promote competition and rapid prototyping and gain from thousands of developers and cybersecurity experts (leveraging bug bounties) who collectively improve resiliency.
7. Decentralization is the point - If a CBDC is to work at all, at least as currently conceived, it must ride on blockchain rails. Herein lies the conundrum from a technological, operational and governance point of view, which is that with blockchains decentralization and distribution are the key. Therefore, a CBDC issued and managed by a central authority would likely involve closed loop systems or pseudo blockchains, which in turn would replicate the very cyber and other potential manipulation vulnerabilities distributed systems were designed to combat.
8. Regulate the activity not the technology - Most competitive regulators and banks for that matter, acknowledge the need to regulate the financial activity and not the technology. Notwithstanding the void of an industrial policy in the U.S. and other countries on how to harness exponential technologies such as blockchain, artificial intelligence and quantum computing, among others, there is a tendency among
regulators to want to bar crypto-assets and blockchain-based payment systems. Ironically, these very technologies may represent the most material upgrade to financial inclusion, innovation and integrity in 50 years - the sum of this translates into potential exponential gains in financial crime compliance and security as well, through the collective witness of public financial ledgers on the internet.
9. Disruption of free markets - A vibrant and competitive economy produces growth through the creative destructive process. Over the maiden decade of cryptocurrencies, digital assets and public blockchains (now in their third generation), entrepreneurs have built a $2 trillion dollar sector. This journey has been rife with risks, failures, lessons learned, and, critically, growing regulatory understanding and clarity on how to responsibly harness these foundational innovations. The free market is where these risks (and those outlined in this article) should remain. Indeed, the key is to espouse and practice activity-based, technology neutral regulations and, vitally, to regulate the economic behavior of digital assets and not take a catch all approach - in short not all crypto is created equal. If it behaves like a security, it probably is. If it behaves like a currency or payment system, it should be afforded the benefits of “digital legal tender” or conformity with well-laid money transmission, e-money, financial markets infrastructure and prudential rules.
10. Complex systems fail in complex ways - While there is no question the public sector must continue to innovate and evolve their digital transformation agenda. Keeping up with the central bank Jones’ and jumping onto the CBDC bandwagon transitions more risks to the public sector, which already labors under challenges with core infrastructure upgrades, than the potential rewards a CBDC warrants. As the risk management adage goes, complex systems fail in complex ways. Transitioning a rapidly evolving blockchain-based business model to the public sector for something as fundamentally critical as money and monetary oversight negates the fact that most value-added money in circulation today (M2) benefits from a robust banking, payments and technology landscape - all operating under the purview and global coordination of central banks, who are the guardians of the macroprudential framework.
Against this backdrop, there is a sobering choice ahead on whether it is prudent for central banks to digitize their fiat currencies. As with every other evolution in the movement of money since humanity shifted from trucking and bartering their goods, to more formalized units of account and mediums of exchange, how money moves invariably has evolved into a public-private phenomenon.
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The Risks Of Central Bank Digital Currencies
Image by AdobeStock.
June 16, 2021
Central banks around the world are considering whether to issue a central bank digital currency (CBDC). While the potential gains are enormous, there remain numerous and as yet imperfectly understood challenges which must first be met.
W
hile 86% of the world’s central banks weigh the potential risks and rewards of issuing a central bank digital currency (CBDC), much of the analysis remains abstract to experimental. This is a good thing, since there are numerous potentially destabilizing risks and other considerations central bankers must weigh as they contemplate entering the digital currency space race. Indeed, a space race is afoot for the future of money and payments, but the real choice is not whether central banks should become retail-level technology companies, an implied change of launching a CBDC. Rather, the real debate is how to let a growing and increasingly competitive private sector thrive in adding much needed competition and optionality when it comes to the future of payments and money.
Here are 10 key risks and considerations that are often missed in the CBDC debate, and should be carefully weighed as central banks look at the tradeoffs of digitizing their national currencies.
1. Technology risks and obsolescence - Launching a CBDC would transfer substantial technology risks to the public sector and ultimately taxpayers, who would bear the brunt of fast moving and often experimental technologies. Blockchains are now in their third generation and the technologies of public, open-source financial infrastructure are evolving rapidly. Consumers, markets and public authorities will all benefit in equal measure if this evolution in the movement of value on the Internet, like all others before it, remains a free market activity with public sector oversight.
2. Cyber threats and single points of failure - Invariably, a CBDC would necessitate centralization, which would amplify already rife cyber vulnerabilities and increase the surface area and vectors of attack to now include central banks, in addition to the economy overall (recall Equifax, Solar Winds and the Colonial gas pipeline as 3 examples). To truly leverage the inherent cyber resilience of distributed systems, public blockchains alongside a competitive free market for the movement of value on the internet is a better long range posture. Just as the failure of any one bank erodes confidence in banking, a CBDC could potentially transition this risk to central banks negating the benefits of strategic risk-sharing structures and operational “air gaps” between participants in the financial system.
3. Privacy and consumer protection - A CBDC, particularly if issued at the retail level or by a less than benign government (noting the thin line between democracy and anarchy), would represent a potentially troubling encroachment on consumer privacy and protections. What would stop the weaponization of a CBDC against citizens or the potential blockage of lawful transactions by groups that fall into disfavor? To the right of lawful, the use of money (a public good to which equal access is a human right) and how it is saved, sent, spent and secured, should be as free as possible while maximizing the penalty on bad actors.
4. Systemic risk and destabilization - A CBDC creates a potential domestic “flight to quality” problem, which would destabilize the very two-tiered banking system central banks are designed to protect. The potential systemic effects of a CBDC, the prospect of spillover effects by virtue of increased velocity of money, among other perils, could pose serious detrimental effects to the banking system and economy writ large. The model represented by privately-issued digital currencies with a veritable “air gap” between reference assets (such as cash, cash equivalents and high quality assets inside the banking system) and tokenized assets on public blockchains results in no new money creation and protects and preserves the two-tiered banking system. Critically, the transmission of monetary policy is also preserved.
5. Vendor risk and technology capture - For a CBDC to exist, someone is selling some newfangled technology to central banks. This introduces the often overlooked operating vulnerability of supply chain and vendor risk, let alone the potentially insidious prospect of buyers remorse or technological obsolescence. Protecting the public provenance of money and monetary oversight does not require central banks to become retail banks or, worse yet, technology service providers with massive stores of data recreating the very “honeypot” databases that attract swarms of cyber ne'er-do-wells.
6. The limitations of digital twins - Conceptually, CBDCs come in many shapes and sizes, with the most likely outcome being a wholesale variant, which could potentially make interbank relationships more efficient, but would leave retail and market-level improvements up to trickle down effects. The real financial inclusion and innovation gains, as with the current state of play of digital currencies, e-money and mobile money innovations, hinges on robust free market competition and innovation with exponential technologies. Many of these can be considered digital public goods, which benefit from open source standards that promote competition and rapid prototyping and gain from thousands of developers and cybersecurity experts (leveraging bug bounties) who collectively improve resiliency.
7. Decentralization is the point - If a CBDC is to work at all, at least as currently conceived, it must ride on blockchain rails. Herein lies the conundrum from a technological, operational and governance point of view, which is that with blockchains decentralization and distribution are the key. Therefore, a CBDC issued and managed by a central authority would likely involve closed loop systems or pseudo blockchains, which in turn would replicate the very cyber and other potential manipulation vulnerabilities distributed systems were designed to combat.
8. Regulate the activity not the technology - Most competitive regulators and banks for that matter, acknowledge the need to regulate the financial activity and not the technology. Notwithstanding the void of an industrial policy in the U.S. and other countries on how to harness exponential technologies such as blockchain, artificial intelligence and quantum computing, among others, there is a tendency among
regulators to want to bar crypto-assets and blockchain-based payment systems. Ironically, these very technologies may represent the most material upgrade to financial inclusion, innovation and integrity in 50 years - the sum of this translates into potential exponential gains in financial crime compliance and security as well, through the collective witness of public financial ledgers on the internet.
9. Disruption of free markets - A vibrant and competitive economy produces growth through the creative destructive process. Over the maiden decade of cryptocurrencies, digital assets and public blockchains (now in their third generation), entrepreneurs have built a $2 trillion dollar sector. This journey has been rife with risks, failures, lessons learned, and, critically, growing regulatory understanding and clarity on how to responsibly harness these foundational innovations. The free market is where these risks (and those outlined in this article) should remain. Indeed, the key is to espouse and practice activity-based, technology neutral regulations and, vitally, to regulate the economic behavior of digital assets and not take a catch all approach - in short not all crypto is created equal. If it behaves like a security, it probably is. If it behaves like a currency or payment system, it should be afforded the benefits of “digital legal tender” or conformity with well-laid money transmission, e-money, financial markets infrastructure and prudential rules.
10. Complex systems fail in complex ways - While there is no question the public sector must continue to innovate and evolve their digital transformation agenda. Keeping up with the central bank Jones’ and jumping onto the CBDC bandwagon transitions more risks to the public sector, which already labors under challenges with core infrastructure upgrades, than the potential rewards a CBDC warrants. As the risk management adage goes, complex systems fail in complex ways. Transitioning a rapidly evolving blockchain-based business model to the public sector for something as fundamentally critical as money and monetary oversight negates the fact that most value-added money in circulation today (M2) benefits from a robust banking, payments and technology landscape - all operating under the purview and global coordination of central banks, who are the guardians of the macroprudential framework.
Against this backdrop, there is a sobering choice ahead on whether it is prudent for central banks to digitize their fiat currencies. As with every other evolution in the movement of money since humanity shifted from trucking and bartering their goods, to more formalized units of account and mediums of exchange, how money moves invariably has evolved into a public-private phenomenon.
