Central Bank Digital Currency: functional scope, pricing and controls

	Occasional Paper Series
Ulrich Bindseil, Fabio Panetta, Ignacio Terol	Central Bank Digital Currency:
	functional scope, pricing and
	controls

No 286 / December 2021

Disclaimer: This paper should not be reported as representing the views of the European Central Bank (ECB). The views expressed are those of the authors and do not necessarily reflect those of the ECB.

Contents

Abstract		2
Non-technical summary	3
1	Introduction - why CBDC?	5
2	CBDC and the risk of bank balance sheet disintermediation	7
3	Preventing excessive holdings of CBDC	11
4	CBDC as a means of payment: factors affecting use	14
	4.1	Why do people pay with banknotes?	14
	4.2	Types of payment for which CBDC could be used	15
	4.3	A possible objective for CBDC use: width vs. depth	17
	4.4	First condition for success: widespread merchant acceptance	18
	4.5	Second condition for success: efficient distribution of CBDC	20
	4.6	Third condition for success: demand from consumers to pay with
		CBDC	23
5	The international dimension	25
6	Conclusions	30
References		32

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Abstract

Even before their deployment in major economies, one of the concerns that has been voiced about central bank digital currency (CBDC) is that it might be too successful and lead to bank disintermediation, which could intensify further in the case of a banking crisis. Some also argue that CBDC might crowd out private payment solutions beyond what would be desirable from the perspective of the comparative advantages of private and public sector money. This paper discusses success factors for CBDC and how to avoid the risk of crowding out. After examining ways to prevent excessive use as a store of value, the study emphasises the importance of the functional scope of CBDC for the payment functions of money. The paper also recalls the risks that use could be too low if functional scope, convenience or reachability are unattractive for users. Finding an adequate functional scope - neither too broad to crowd out private sector solutions, nor too narrow to be of limited use - is challenging in an industry with network effects, like payments. The role of the incentives offered to private sector service providers involved in distributing, using and processing CBDC (banks, wallet providers, merchants, payment processors, acquirers, etc.) is discussed, including fees and compensation.

Keywords: central bank digital currency, store of value, means of payment, payment solution, cross-border payments, financial stability

JEL Classifications: E3, E5, G1

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Non-technical summary

Central bank digital currencies (CBDCs) have been discussed with growing intensity since 2016. In October 2020 the ECB published its first report1 on a possible Eurosystem-issued CBDC called the digital euro, "for use in retail transactions available to the general public - that is, including citizens and non-bank firms - rather than only being available to traditional participants (typically banks) in the large-value payment system managed by the central bank". In July 2021 the ECB decided to launch a two-year investigation phase into a digital euro project, starting on 1 October 2021. The expectation that CBDCs will eventually be issued reflects the benefits of maintaining central bank money in a world where more and more people and merchants prefer the convenience of electronic payment. Central bank money is the most basic, liquid and resilient form of money, and should continue to play its role. This paper examines concerns that the introduction of a CBDC, if not properly designed, could lead to undesirable bank disintermediation and crowd out private payments solutions. If CBDCs are to be successful, central banks need to establish digital currency as a means of exchange which is sufficiently widely used to achieve the necessary network effects but does not become a significant means of investment.

Because of their unique nature as risk-free institutions, central banks have a comparative advantage in the store of value function. In physical cash payments they hold a monopoly position as sole issuers of banknotes. Yet they have no experience in providing digital means of exchange directly to the public. Paradoxically, central banks must avoid being too successful in the area where it is easier for them to be so, while at the same time trying to succeed where they have fewer comparative advantages. The paradox is only apparent, however. Unlike private players, who seek to maximise profits by leveraging their competitive advantage, central banks operate in the interest of society, setting goals in the public rather than private interest. When it comes to retail payments, central banks' primary aim is to promote a competitive and efficient market for payment services that meet the needs of users.

Given that their objective is not to reach a dominant market share, central banks can instead aim at ensuring broad access to central bank money within their currency area, without displacing payments intermediated by regulated institutions at the aggregate level or in any specific segment. They might prefer a situation where a large portion of the population uses CBDC on a regular basis for a small fraction of their payments, rather than one where a minority of the population relies on it for the overwhelming bulk of their day-to-day payments.

Three key success factors of a CBDC will be: (i) merchant acceptance; (ii) the willingness of intermediaries to distribute it and interact as needed with users; (iii) an attractive value proposition for individuals and firms to use it for payments. This also raises the question of a business model for a CBDC, e.g. the incentives for front-end service providers.

1 European Central Bank (2020a)

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Another important dimension in designing a CBDC to be successful without crowding out the private sector is scope. A list of functions covering all the proposals that have been made from different perspectives would be extensive. For example, it has been suggested that CBDC should: (i) be offered in the form of all major payment instruments, including cards, mobile payments and desktop access, and be as convenient as existing private solutions; (ii) allow anonymous payments, as banknotes do, to protect privacy; (iii) allow offline payments; (iv) allow instant credit transfers to any commercial bank account and direct debits; (v) be programmable and allow "smart contracts" for advanced uses in industry and commerce; (vi) promote financial inclusion (i.e. be accessible to those without bank accounts, mobile phones or internet access); (vii) be available for international uses, to strengthen the international role of the currency. Supporters of a broad functional scope for CBDC argue that a central bank is in a unique position in terms of credibility and economies of scale, such that even very significant investment in a comprehensive CBDC based on new technology can easily be justified, at least in large currency areas. It has also been suggested that excessively narrow scope could make a CBDC insufficiently attractive and lead to low demand, so the potential benefits would remain unachieved. Narrower functional scope could minimise the dangers of crowding out the private sector; a broad-scope CBDC might prove hard to manage from a project perspective and suffer delays in introduction. The payments industry offers plenty of examples of promising approaches and technologies which ultimately did not take off for reasons that could not easily have been foreseen. The paper devotes particular attention to functionality for cross-border and foreign exchange (FX) payments and how this may affect adoption. Comprehensive international payment functionality would obviously increase the attractiveness of a CBDC and its financial system footprint.

The paper concludes that while there can be little doubt about the merits of CBDC and the need for central banks to follow changes in retail payments habits and technology to continue serving individuals and firms, many questions about the design of a CBDC still need to be addressed. These include the functional scope, business model and controls required to meet demands and ensure robust use. Any CBDC project has also to be kept realistic, manageable and focused.

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