Countries are diving into digital currencies. Here are 5 choices they need to make.

July 20, 2021 | By Jesse McWaters

Cryptocurrencies are exploding in popularity at the same time the COVID-19 pandemic has forced an acceleration to digitization. Against that backdrop, it’s no surprise that central banks are weighing whether they should jump into issuing their own digital currencies, which are essentially virtual versions of their paper money.

The Bahamas has already launched the Sand Dollar digital currency, while Sweden, China and the U.S. are all in different stages of exploring their own digital money.

These projects, dubbed central bank digital currencies, or CBDCs, could transform the role of central banks while also changing the way we pay and get paid. For instance, they have the potential to lower the cost of cross-border payments, speed up money transfers and provide basic financial tools to more people. At the same time, developing a CBDC has important implications for the broader financial system that must be carefully considered.

We believe there is a common set of principles that should become the foundation of any CBDC. If a central bank decides to develop a CBDC, it should serve the needs of consumers and work seamlessly with existing financial infrastructure, such as banks and payment networks.

Of course, within these principles there are many important design choices central banks will need to make to ensure that a CBDC is a good fit for their economy — such as whether a CBDC should pay interest like a bank account, or if it should be able to function in an offline environment, such as remote islands or rural areas.

Over the past few years Mastercard has been meeting with central banks around the world, sharing our payment expertise as they explore these very questions — such as how different models of issuance, distribution, interoperability and security could impact their economies, and whether a CBDC is even the right tool to solve the challenges they face. This work helped us identify a number of design choices that need be weighed to best balance the key risks and emerging opportunities of CBDCs. Here are five of the most important choices policymakers should consider when exploring and piloting CBDCs.

Single tier vs. two tier

In theory, a central bank could launch a CBDC by simply competing with banks to offer accounts directly to consumers. But while central banks are well versed in ensuring financial resilience and managing monetary policy, are they prepared to deliver cutting-edge financial experiences or run a customer help line?

Instead, most central banks are exploring two-tier models in which they “mint” the CBDCs and leave it to the private sector to distribute this money and innovate atop this new foundation. Our perspective is that two tier is a better approach, since it draws on the strengths of both central banks and existing private companies while using competition to create new products for customers.

Directly issued vs. synthetic

Central banks with more advanced payment infrastructures are likely to create their own platforms to distribute CBDCs and settle transactions. However, there is an alternative approach that the International Monetary Fund has floated. This method allows a government to partner with private companies that make stablecoins, a form of cryptocurrency that maintains a consistent value. These companies can then deposit their reserves at the central bank, meaning their payment tokens would be indirectly backed by the central bank, creating what the International Monetary Fund has dubbed a “synthetic CBDC.”

A synthetic CBDC is an option that may appeal to central banks whose resources and technical capabilities are limited, as it would rely on the private sector to underwrite the development of the new infrastructure. At the same time, they would lose some of the fine-grain control over the design and operation of these digital currencies.

Account vs. token

Even after a central bank has decided who will issue and operate a CBDC, it still needs to decide the form that the CBDC will take. One option is for a CBDC account, or digital wallet, to look and feel a lot like an online bank account. This approach would provide a familiar payment experience and could allow the central bank to “piggyback” on existing infrastructure, simplifying the development of a CBDC. However, this version isn’t especially novel when compared with existing bank accounts that can be accessed via mobile app.

A more technically challenging but potentially more innovative approach would be to develop a “token-based” CBDC, which would behave a lot more like physical cash. A token-based CBDC could enable new features, such as offline payments, and the details of those transactions might be known only to the people exchanging the money, as with cash. However, this form of CBDC might also require people to learn new ways to use this kind of money. It might also increase the risk of theft and fraud, since it would be less secure than an account-based CBDC.

So should a CBDC act more like a checking account, which is more protected, or a $20 bill, which is more flexible? There’s no right answer for every situation.

Privacy vs. compliance

Once a CBDC is ready to be issued, privacy is likely to be a big question on prospective users’ minds. After all, one of a central bank’s other products — cash — is unique in that it provides near total anonymity. In comparison, CBDC transactions would likely need to capture personal data to some degree. It’s unlikely that central banks would allow CBDCs to bypass existing anti-money-laundering and counterterrorism financing requirements, but they will have to navigate privacy tradeoffs carefully. Ultimately, it’s a political and social question, not a technical one, beyond ensuring user privacy and security of user data.

Most CBDCs will likely follow the same strict privacy restrictions that already exist for wire transfers and electronic payments. Mastercard’s view in this area is very clear: We believe that CBDCs should be held to that high standard, and we will support only CBDC projects that protect consumer data in accordance with local laws.

Domestic vs. cross-border

Ideally, money should move swiftly and smoothly across the globe, but cross-border payments remain complex and expensive. Some experts have speculated that connecting CBDCs of multiple countries could reduce the time, risk and costs associated with cross-border payments. A handful of central banks around the world are currently exploring this promising idea, but unfortunately, addressing the challenges of cross-border payments requires much more than just building a CBDC. Linking CBDCs requires so much cooperation and trust between just two countries, not to mention on a global basis, that we shouldn’t expect to see many cross-border CBDCs operating in the near term. That said, they are certainly worth exploring, and central banks should think carefully about how best to implement a CBDC design that is flexible enough to ensure that they work with future cross-border payment initiatives.

Building the digital future

While research into CBDCs is widespread, the path forward is far from certain. The unique role of central bank money in the economy means the task of deploying a CBDC faces unique challenges and shouldn’t be attempted without thorough evaluation.

Properly implemented, a CBDC could serve as a foundation for these players to drive new innovations, but poor design choices could just as easily crowd out private sector investment and discourage innovation. The trick will be finding a design that is just the right fit to the unique contours of a given economy.

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Jesse McWaters, Vice President, Public Policy