Much discussion has happened in the past few months regarding Central Bank Digital Currencies (CBDC). Will China's CBDC take over global economies? Should our current central bank database models be switched to a blockchain/distributed ledger technology (DLT) based system? How will different national CBDCs be exchanged? Will there be CBDC interoperability? I argue that these complex decisions will be solved much later, only after a distributed ledger digital ID system has been fully established. The use of digital ID for retail payments will be a precursor for CBDC's, which is a considerably complex undertaking.
The Design Basis of a Transaction
The core questions of design basis for digital or any transaction system for that matter are: do we make the system consumer-centric, currency-centric or a hybrid of the two and why? Consumer-centric systems focus on identity and come with the baggage that the system allows for tracking specific individual activities unless privacy measures are implemented. Currency-centric systems allow for privacy but can lead to exclusion without proper access (banking, smartphones, internet access, et cetera).
Suppose we posit that CBDCs will come into existence. In that case, they will likely have been forced by a private sector design or foreign CDBC becoming widely used as an alternative payment method. These can make domestic monetary policy irrelevant as they could drastically reduce the use of local dollars, pounds, and pesos.
CBDCs have two primary forms: retail CBDCs and wholesale CBDCs, either directly or indirectly managed by central banks. Retail CBDCs are for payment transactions between individuals and businesses similar to today's fiat cash, and wholesale CBDCs functions as a medium for interbank settlements. Wholesale CBDCs are much more useful for financial markets and monetary policy, while the retail CBDCs are far more complex and interesting. A retail system could ensure the public has continued access to a risk‑free form of money provided by the central bank in an era of privately issued currency and declining cash use.
For retail CBDC's, central banks are currently considering (1) an account-based (digital ID required), (2) token-based (cryptographic keys/digital wallets required), or (3) a hybrid system. To some extent, the decision for one over the other is driven by the associated digital ID requirements. Taking on the responsibility of identity verification and management of users in the system is no small feat for central banks.
CBDC skeptics argue money is already digital. The problem is that our money is mostly controlled by corporations such as Visa, Paypal and Alipay, amongst others. While a wholesale CBDC will be implemented by most countries soon, retail CBDC may only be implemented appropriately through a complete overhaul of the financial system. Only then will DLT based systems provide vastly improved functionality and significant cost savings on every transaction. Minor implementations will have little to no benefit, especially if they are only implemented on post-transaction accounting. In retail CBDCs, the most critical aspect is pre-transaction, where digital IDs provide the most significant benefit. One could argue that digital IDs will be primarily responsible for the widely claimed benefits of retail CBDC listed here:
reduction in transaction costs by payment efficiencies
better control of monetary policy, especially cross border
compliance with Know Your Customer (KYC)
compliance with tax payments
eliminate identity theft
reduce money laundering
theoretically easier banking for the unbanked
minimum interest payments for everyone
easier to target stimulus money
no need for cash transaction during pandemics
faster online payments
smart contracts – programmable money
financial stability eliminating bank runs
On the other hand, CBDCs will likely introduce the following challenges – with and without digital IDs:
severely reduce the needs for banks and other intermediaries, unless they revamp their roles as intermediaries
give governments too much control in several ways:
through gaining more information than you are willing to share
allowing politically motivated controls to be placed on individuals or groups
may increase short term volatility
transaction immutability and/or reversibility
further disenfranchisement of poor and/or people that are not technologically savvy
building redundancy for system-wide and local failure of hardware/software issues
Digital IDs on a blockchain can expand the utility of CBDCs
Digital IDs have considerable advantages if they are established on a DLT system (rather than a centralized database) because several agencies and companies would be able to update and create entries in real-time. Additionally, with a DLT system, there is no single point of failure for hackers to steal treasure troves of data.
By establishing digital IDs in this manner, then linking them to person-specific CBDC accounts, governments can administer aid and allow aid or benefits to be transferred directly and instantaneously to citizens or corporations directly through their digital ID. The digital ID would be the link to a digital wallet that can hold retail CBDC money. In this case, the actual CBDC, such as the Canadian dollar, could still use the existing database structure, and only the wallet and ID would use DLT technology. This would reduce social welfare fraud and enhance social development finance.
For those who don't want to be tracked, the digital identity requirement of retail CBDCs will push some users towards cash and cryptocurrencies. For those wishing to maintain privacy and anonymity, using cash is the easiest route. Existing cryptocurrencies also inherently circumvent identification requirements, although platforms exist which can potentially identify some users. So, even if CBDC users' identification is only associated with a certain threshold or type of transaction (as ruled under KYC law), people currently (and for the foreseeable future) have two very real alternatives in exchanging value. That said, the extent to which cash and crypto will be able to compete in a payment space along with CBDCs will be determined by whether or not banks keep cash in circulation (and for how long) and the ability for crypto transaction processing to scale significantly.
Visa presents another source of competition to CBDCs and digital identity. With a CBDC, transactions can complete in a little as 20 seconds and, importantly, can be done for nearly free. Visa is in terror of having its vast array of merchants choose to use this nearly instant digital alternative form of payment and have worked closely with digital currency wallets to issue Visa credentials. They are acting as the verifier and providing the credentials. With a Digital ID system, this would no longer be required. See the table and figure below to understand the magnitude of transactions and dollars involved for Visa:
At the core of Visa's evolution is a new understanding of itself as a "network of networks," some of which Visa owns, like Visa Net, and others it doesn't, such as the Swift interbank payment network, and local ACH networks. The ACH Network is the American national automated clearing house (ACH) for electronic funds transfers. Visa's latest push has been to partner with Circle to implement USDC stablecoin support in its platform (Castillo, 2020). This gives them experience with distributed ledger payment processing, gaining ground in competition with CBDCs.
Progress on digital IDs infrastructure
Progress towards national digital ID infrastructure varies hugely within and between countries. As recently highlighted by Ahmed Alkholifey, Governor of the Saudi Arabian Monetary Authority, national digital identity systems take considerable time and resources to develop. Without sufficient capacity, CBDC progress for some countries will be highly constrained, while for states with digital identity infrastructure already, retail CBDCs are closer to being a reality (IMF, 2020). Digital identities based on the blockchain are well underway in China, North America, Singapore, and the European Union. It will not take long (if it hasn't already been done) to extend the digital ID system to support retail CBDCs. However, for countries with little to no digital ID infrastructure, the economic divide may dramatically widen once some CBDCs launch.
Without knowing how international financial regulatory frameworks will adapt to CBDCs, it isn't easy to understand what it would mean to live in a world where some countries are using cash, others are using a mix of CBDC and cash, while others have fully transitioned to a CBDC.
In the absence of an existing or near existing digital identity infrastructure, the alternative means of addressing KYC/AML/CTF in CBDCs, are few and far between. The European Central Bank has recently proposed anonymity vouchers, but the idea requires more research (ECB, 2019). Indeed, a recent BIS report calls for more research on this topic (BIS, 2020).
In this paper, I explored several concepts around the relationship between digital identities and the development of CBDCs. In reflection, it is interesting to note that we are at a point where central banks are discussed in the same context of digital currencies and blockchain - it wasn't too long ago where central authorities were adamantly dismissive or opposed to such tech. My best guess is that digital identities are going to be essential for the success of retail CBDCs. Because of the intricacies of establishing digital IDs and their interlinkages with CBDC, it will be a very long time yet before we see retail CBDCs rolled out.
Castillo, M., December 2, 2020. Visa Partners with Ethereum Digital-Dollar Startup That Raised $271 Million. Forbes. Available online.
European Central Bank (ECB), December 2019. Exploring anonymity in central bank digital currencies. In Focus. Issue No. 4. Available online.
IMF. October 19, 2020. Cross-Border Payments – A New Beginning. Panel Discussion "Cross-Border Payments – A vision for the Future." Available online.
Bank for International Settlements (BIS). 2020. Central bank digital currencies: foundational principles and core features. Report no 1 in a series of collaborations from a group of central banks. ISBN: 978-92-9259-427-5 (online). Available online.