Money Developments (5b) Problems for Central Bank Digital Currencies

Developing, implementing and maintaining a digital currency presents central banks with several problems. The following are just some of the issues that need to be considered and remediated.

• Hacking and tampering – If the CBDC increases in popularity, huge amounts of important data will have to be managed and kept secure by the central bank. Hackers and thieves will be tempted to penetrate the system to steal funds or manipulate the accounts of people they dislike. Keeping the system secure will be costly for the central bank.

• Monetary policy transmission mechanism – Modern central banks attempt to control the supply of money available in their economy. Most do this by controlling interest rates. Experts are concerned that the growth of CBDCs will restrict the transmission mechanism for monetary policy.

• Interoperability with existing payment networks, including commercial bank and e-money networks and ATM machines. – Money is important for the operation of an economy. If the CBDC becomes the dominant currency, the central bank will be responsible for ensuring interoperability with all the other computer systems that use money transactions. This interoperability is currently maintained by banks and other private businesses. A central bank might not want to take this responsibility over from them.

• Money laws and regulations, including data protection laws – if a CBDC is introduced, the central bank must ensure that all laws about money and credit will continue to function effectively. This might be a big task.

• Resilience – The design of all aspects of the CBDC system will need to exceed the established resiliency and security standards of financial market infrastructures. It will need to provide instant transaction settlement around the clock all year long and be able to recover quickly from any disruption.

• Scalable – CBDC systems will need to be developed with scalability in mind and be able to handle rapidly increasing volumes of transactions without running into operational difficulties.

• Upgradable – A CBDC system will have to be easily upgradable to take account of developments in the software and hardware used by the various computer systems that need to interact with it. The system would need to be future-proofed to handle all technological developments. It will need to be upgraded continually. Most central banks do not have the skills to do this.

• Two-tier system – Most central banks will adopt a two-tier approach in which they maintain the central system, but leave many other functions to other businesses. This might be a more practical solution, but the central bank will need to maintain relationships with a range of private-sector intermediaries.

• Privacy – When developing a CBDC, the central bank will comply with all the existing standards for protecting privacy and the use of personal data.

• Capital Flow Management – Many governments choose to control capital flows in and out of the country. These measures are mostly operated by the banks that organise international payments and receipts. If the CBDC can be used for international transactions, the central bank will need to build software constraints into the CBDC system to implement the government’s capital flow management measures. This may be quite complicated to achieve.

Credit Creation
If the role of the CBDC accounts at the central bank is extended to paying interest on deposits and making loans to businesses and households (mortgages), the situation changes significantly. Under the existing monetary system, commercial banks create money by giving loans to their customers. They can do this because the money they loan is eventually deposited in an account within the banking system. I describe how this “money creation” process operates in Credit Creation.

If the central bank gets involved in lending and borrowing by paying interest on deposits and lending money to businesses and households, they will get the ability to create credit in the same ways as commercial banks are currently doing it. If the central bank makes a loan to a customer (business or personal) the money will eventually be paid into the recipient's account at the commercial bank. They end up with a loan and a matching deposit, which balance each other.

The only limit on credit creation by the central bank would be supply and demand at the prevailing interest rate. Modern central banks control interest rates, so they would be able to manage interest rates and the volume of loans to achieve their goals.