Last week, the US government indicated that it would investigate the issuance of digital forms of its currency. Many central banks have considered this possibility, including in the UK, but this is the most tangible evidence of their intentions to date. Central bank currencies offer many advantages that cryptocurrencies do not. But recent government actions that cast doubt on their reliability are jeopardizing the trust essential to the adoption of central bank currencies.
The idea of a central bank digital currency is the virtual opposite of Bitcoin and other blockchain-based cryptocurrencies. Bitcoin’s value proposition is to completely remove a trusted central issuer and create trust among end users, replacing trust with sophisticated cryptography. A central bank digital currency would be just another form of its existing currency, based on the full faith, credit and trust of the central bank from which it is issued. Its selling point, trust in a central authority, would be exactly the dependency that blockchain-based currencies are designed to avoid.
Building a centrally managed currency would be much simpler, more efficient, and potentially more secure than blockchain-based ones. The presence of a central ledger, as opposed to a distributed ledger, means that both parties of a particular transaction would be visible to the central counterparty and the processing of the transaction would not depend on any other user of the system. Additionally, there would be no need for crypto mining, which can impose an unacceptable environmental burden on blockchain usage.
Depending on the protocol used, a centrally managed currency doesn’t even need to rely on public-key cryptography, which is likely essential to any distributed ledger system. Public-key cryptography is the use of an algorithm based on different, but mathematically related, encryption and decryption keys, or more specifically for blockchain, signing, and key verification. Eliminating the public key and other aspects of blockchain protocols could speed up processing and reduce the long-term existential risk that quantum computing poses to virtually all public-key systems, including the one used in Bitcoin.
The likely use of central bank currencies would also be the opposite of Bitcoin. The use of bitcoin as a means of transaction still faces significant challenges. Most holders do this to profit from capital gains or to facilitate large illicit transactions, not to make day-to-day payments. Central bank currencies would tend to be used where cash is useful; essentially anonymous small transactions. Lack of interest or prospect of capital gains would likely discourage large balances. The potential efficiency benefits would make it suitable for small transactions.
Presumably, with digital currency, central banks would issue a wallet in which to keep it. This would mean holders would have an app they could use to make payments and transfers. Like cash, these transactions could be completed without the exchange of personal information. Anonymity between participants in a transaction could be maintained. Of course, there would be no anonymity vis-à-vis the central authority, which could monitor all transactions. More on that later.
Since a central bank currency would be just another form of its existing currency, it would share all the stability and exchange characteristics that its underlying currency has. Modern central banks focus on maintaining price stability subject to low inflation and the digital form would inherit the same characteristics. This would remove the primary reason most people hold cryptocurrencies: the prospect of long-term price appreciation. A central bank currency would actually lose value every year, regardless of the inflation target achieved.
The introduction of a digital central bank currency would have systemic implications for the banking system. Currently, the physical form of Canadian currency stands at approximately $112 billion. These physical notes have been issued for many decades and the funds used to pay for the notes are invested in securities held by the Bank of Canada. Interest on these funds generates seigniorage revenue for the Bank, last year amounting to more than $4 billion, most of which goes into government coffers. For holders, this interest represents the income they give up in exchange for liquid, usable funds. Issuing a digital currency would undoubtedly increase the amount of currency in circulation, perhaps many times over, as many could use their central bank in the same way they currently use their bank and Interac balances. The benefits of higher central bank income would come at the expense of commercial bank balances and fees and reduce, perhaps substantially, their deposit bases.
But lately, the trucker protests in Ottawa and the war in Ukraine have called into question trust in governments and central banks. This has important implications for the marketing of digital currencies. The common feature of these two seemingly disparate situations is the confiscation of the assets of supporters of the trucker protests by the government and the seizure of Russian central bank deposits by central banks around the world. The obvious question surrounding central bank currencies, and which will now be asked more seriously, is whether central bank currencies pose unacceptable risks to government holders based on their security, policy, or even political concerns. Whether the purchases will then be visible to governments can become a serious issue, as governments with easy access to spending information could use it in how the Chinese government implements its social credit system.
If central banks cannot put in place a governance and legal framework to ensure that the funds held will be above political interference, their deployment will be much more difficult. The central value proposition of central bank currencies is trust. If citizens cannot be assured of trust, they will hesitate to use them. The spectacle of Canada’s Minister of Justice warning that Trump supporters could face bank account freezes couldn’t be more toxic to building that kind of trust and plays into the perceived benefits of cryptocurrencies. The seizure of Russian central bank deposits, for whatever reason, is a significant break with the trust in central banks that was considered absolute in the past. Many people see no material separation between governments and central banks, and actions that put deposits at risk without due process will erect significant barriers to trust.