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Should Central Banks Offer the Public Token-Based Digital Currencies?
By Nikhil Sridhar and Patrick Horan
After the cryptocurrency boom of 2017, many enthusiasts of central bank digital currency (CBDC) quickly began exploring ways to harness the power of blockchain and distributed ledger technology for policy ends. In general, there are two categories of CBDCs. The first category, which we have discussed elsewhere, refers to central bank accounts. That CBDC is not a circulating currency like paper bank notes or digital coins. Rather, it includes transferable account balances held at the central bank, similar to the balances one would hold in an online checking account.
The second category of CBDCs, which is token-based and encompasses digitally issued coins, is the subject of this essay. Last month, China unveiled a token-based CBDC, the digital yuan. There has also been talk about “Fedcoin” in the United States. But as with CBDC accounts, token-based CBDCs have both advantages and disadvantages. Policymakers should proceed cautiously in evaluating and adopting this technology.
Understanding Token-Based CBDCs
A token-based CBDC is a digital version of physical cash. It is a liability issued by the central bank that exists in a “digital token” form. A token is a representation of a digital asset on a blockchain; both the asset and the blockchain are established by the central bank. Much like account-based CBDCs, token-based CBDCs could be used for retail payments. Unlike account-based CBDCs, however, the liabilities are not stored at accounts—per the traditional definition—at a central bank. Rather, they are stored through “wallets,” similar to the wallet technology employed by users of cryptocurrencies such as Bitcoin or Ethereum.
Despite their name, wallets are not actually where the tokens are stored. Instead, each wallet has a private key that corresponds to an address on the blockchain, which, in turn, corresponds to the number of tokens held by the owner of the wallet. These wallets could take the form of a website, a mobile app or even a hardware wallet.
In most cases, when tokens are transferred between wallets, the sender is directed to the public address of the receiver’s wallet, and the transaction is confirmed by other members of the blockchain, commonly called “miners.” Miners solve complex math problems to verify the transaction and then receive a reward, usually units of the cryptocurrency, incentivizing them to keep the network going. The difficulty of these math problems and their rewards are adjusted depending on the number of transactions on the blockchain.
This “proof of work” concept, in which miners receive financial rewards for dedicating their hardware to verify transactions, is the most popular model for a token-based CBDC. For many cryptocurrencies—Bitcoin being the most well-known example—anybody with the computing power to engage in mining is free to do so. However, given the policy objectives of central banks, it is unlikely that just anyone would be able to engage in this activity for CBDC token transactions. Instead, miners would likely be “permissioned” to ensure that mining occurs in ways and quantities consistent with the central bank’s broader goals.
There are also alternative approaches, such as the “proof of stake” model, in which individuals put digital coins into particular wallets that then stake the network, and individuals are rewarded for staking. Finally, there is the centrally distributed model, in which a single entity controls the digital ledger and determines who can change it and verify transactions on it. Central banks could emulate this model to prevent unwanted actors from interfering with the central bank’s monetary policy goals.
Potential Advantages: Accessibility and Privacy
Under a token-based CBDC regime, users would be able to withdraw digital tokens from banks in the same way they can withdraw physical cash. They would maintain their digital tokens in a wallet and could spend them online or in person or transfer them via an app. Cell phone apps are probably the most convenient form of wallets today. Presumably, the central bank would ensure that tokens can be exchanged at a 1-to-1 rate with physical currency.
Token-based CBDCs share several potentially desirable characteristics with account-based CBDCs. Perhaps the clearest example is the ability to facilitate easy cross-border transactions. So long as both parties have wallets, tokens can be exchanged regardless of the geographic location of either party. Additionally, token-based CBDCs can be used to accomplish financial inclusion goals: Anyone with an internet connection can obtain a wallet, while most traditional bank accounts require minimum balances or fees. Depending on how the CBDC is designed, government agencies also could better crack down on illicit transactions and collect better macroeconomic data.
Furthermore, it is possible to engineer a token-based CBDC that preserves a higher degree of anonymity than an account-based CBDC. Although a central bank would know the exact quantity of CBDC assets it issued, it would not necessarily know who holds those assets—just as central banks issue physical currency but do not know who holds it.
Additionally, blockchain technology allows for relatively high security for settling transactions, especially between countries. This is because token-based CBDCs utilize encryption techniques—similar to those of traditional cryptocurrencies—to verify transactions. The storage and delivery of tokens from private wallets to public ledgers and back to private wallets requires recording all transactions on the blockchain, which are difficult, or often impossible, to change. For those who are concerned about CBDCs and their potential to threaten people’s privacy, token-based CBDCs may be an attractive alternative to account-based CBDCs.
Token-based CBDCs can also be used to implement monetary policy. First, a central bank could impose negative interest rates on wallets to encourage users to spend money balances. Second, token distribution could be based on an algorithm that implements monetary rules. For example, some cryptocurrencies, frequently referred to as “stablecoins,” use algorithms to peg their value to external assets such as the U.S. dollar or other cryptocurrencies. The cryptocurrency Basis, for instance, was described in 2018 as an “algorithmic central bank.”
One could imagine real central banks using similar technology to attain a goal such as an exchange rate pegged to the U.S. dollar. This could provide a substantial degree of institutional credibility, particularly in developing nations with weaker financial institutions.
Potential Disadvantages: Cost, Speed, Lack of Novelty
Despite the benefits of token-based CBDCs, policymakers have had little reason to exploit them simply because the private sector is already doing this. Anonymous cryptocurrency tokens based on decentralized technology have existed for several years. Stablecoins and existing payments services already offer a high degree of security for international settlements. In fact, the introduction of CBDCs could crowd out potential investment and innovation in private-sector cryptocurrencies.
Just as token-based CBDCs share many of the advantages of account-based CBDCs, they also share many of the demerits. Although token-based CBDC proposals are not intended to provide universal banking services and therefore would be less difficult to implement than account-based CBDCs, in both cases, central banks would have to go outside their area of expertise, so CBDCs could potentially be very costly in terms of human and monetary resources.
Further, token-based CBDCs offer several distinct disadvantages compared with their account-based counterparts. This is particularly true in the realm of transaction speeds. The proof-of-work system (or any other arrangement that works on the blockchain, for that matter) will necessarily be slower than the instantaneous transmission of currency enabled through accounts systems. Cryptocurrencies themselves are unable to keep up with many private payment providers in terms of speed. This is a significant issue because one of the primary motivations of adopting a CBDC is to create a better medium of exchange that could enable instantaneous settlement. The blockchain necessarily prevents this.
A proof-of-work model could also be costly to implement. Bitcoin mining takes up approximately 121.36 terawatt-hours a year, which is roughly equivalent to the annual power consumption of the entire nation of Argentina. A CBDC with more widespread use could require even more power to keep the network from crashing. Alternative models, like the proof-of-stake model, could alter the demand for money in ways that are inconsistent with broader monetary policy goals as well. Consider also the possibility of hacks to the network—particularly if the network is decentralized—or general attacks on the power grid that could lead to the collapse of the network or the halt of all transactions.
Additionally, the nature of tokens makes them somewhat like bonds, particularly if the central bank attempts to pay interest—positive or negative—on the tokens, or even to alter the fees associated with using the tokens in attempting to influence monetary policy. Such actions could affect the value of the token itself, analogous to the impact of Federal Reserve policies on Treasury securities prices. This risk could prevent the central bank from engaging in appropriate monetary policy, especially if it is attempting to prevent a flight to cash.
In our view, token-based CBDCs appeal more than account-based CBDCs because the former can better respect users’ privacy. They also require less central bank bureaucracy than account-based proposals, which is desirable. However, it is not clear that they serve a purpose that isn’t already being handled pretty well by the private sector. Policymakers should consider these factors as they develop a framework for evaluating future CBDC proposals.
This article is the second part of a two-part series describing the advantages and disadvantages of central bank digital currencies. Part one focuses on central bank accounts.