Code is law: Why design matters in the introduction of CBDCs

Proponents of Bitcoin and other digital currencies often tout their independence from conventional monetary policy as a source of strength. The amount of Bitcoin in circulation, for instance, is controlled not by a central bank or monetary authority but by an algorithm written when the cryptocurrency was first created. While policymakers can change the rules governing a conventional central bank currency on a whim, the framework underlying a cryptocurrency is hard-wired. Code is law. 

The merits of that argument are debatable, but the concept is relevant to any discussion of central bank digital currencies (CBDCs). How a CBDC is coded at the outset will determine how it is used, and these design choices will in turn affect the financial system in various ways. Digital technology allows for a wide range of features that differentiates them from the fiat currencies that drive today’s global monetary system. But once individual features are baked in, they cannot easily be changed. 

“When you hold a USD10 bill in your hand, you don’t worry about being unable to spend it when the central bank app is offline, whether someone is tracking your purchases, or whether the underlying technology is compatible with other currency systems,” said Olivier Fines, Head of Advocacy and Capital Markets Policy Research for EMEA at CFA Institute. “All of these points are really important.”

What, then, will CBDCs be designed to do? In considering the implications of their introduction, we must first understand the design features that are available. 

It is important to understand that all CBDCs are not created equal.

Most CBDCs under discussion today rely on some variation of blockchain or distributed ledger technology, but there are exceptions. China’s digital yuan, or e-CNY, for example, is issued by the central bank and held in digital wallets, but there is no blockchain or distributed ledger to verify transactions.

Blockchain-based CBDCs, meanwhile, rely on the same technology as cryptocurrencies such as Bitcoin to maintain a record of transactions and protect the integrity of the network. Unlike private cryptocurrencies, however, control of the underlying digital ledger for a CBDC remains with the central bank. This allows monetary authorities to perform actions, such as minting tokens, under monetary policy. Other actions, such as validating or viewing transactions, may be performed by commercial banks or other payment-service providers but their access to the ledger is exclusively permissioned by the central bank.

The rails that CBDCs run on could have an impact on their global transferability. If central banks pursue their own versions of CBDCs in isolation, they could unintentionally introduce a new layer of complexity for banks and institutions that trade across borders.

There are initiatives to avoid this interoperability problem: the mBridge CBDC project, for example, backed by the Bank of International Settlement (BIS) and the central banks of China, Hong Kong, Thailand and the United Arab Emirates, was created with Consensys on Hyperledger Besu, a permissioned enterprise Ethereum blockchain application.

In the CFA Institute’s CBDC survey, conducted in February 2023, 69% of respondents said compatibility with other international networks and payments platforms should be a priority for a CBDC.

On top of the blockchain or database, smart contracts may also be used to automate certain transactions or operations, such as predefined rules or conditions for settlements or money supply adjustments. Again, blockchain programming languages are the common platform.

Smart contracts round out CBDC functionality and run on a separate layer from the actual token (similar to how a spreadsheet program runs on top of a computer’s operating system). They add extensive conditionality and programmability to a monetary system. In some CBDC designs, all transactions on the network execute through smart contracts, which write the final record to the blockchain or account system.

This makes CBDCs an attractive foundation for tokenization, where fractional ownership of assets is represented as tradable digital tokens.

It is essential to recognize that the layers of software make CBDCs exceptionally customizable. Their design features will be limited by the imagination – or restraint – of their creators.

Inherent to the original vision for Bitcoin and blockchain was the creation of an electronic form of money that could be used for everyday transactions, potentially offering benefits such as reduced transaction costs, greater cybersecurity and increased financial inclusion. 

CBDCs could do the same but with the added objectives of improving efficiency in bank clearing and settlement activities and reducing counterparty risk. Beyond that, the programmability of CBDC layers offers significant opportunity for a central bank to transmit and reinforce monetary policy or even government social policy in the form of immediate subsidy for specific forms of spending or investment. 

COVID-19 stimulus packages, which governments around the world issued during the pandemic, would be one example. CBDCs could reduce waste and fraud while speeding market impact. An analysis from the Associated Press estimates that more than USD400 billion of US stimulus went to waste or misappropriation; more than half was attributed to fraud. Sent out largely by paper check, these funds, when delivered appropriately, take time to deploy and some economists argue the stimulus is still working through the US economy in 2023 as the Federal Reserve seeks to fight inflation. 

A CBDC, by contrast, would allow funds to be distributed electronically to individual digital wallets, where they would be available for use immediately. This could speed up monetary responses in an emergency, and allow authorities to consider more targeted subsidies based on genuine needs. 

Designing a CBDC to enable such benefits requires a baseline of accessibility, scalability, compatibility and cybersecurity. These are primarily matters of software and system engineering. But assuming this high level of usability can be met, digital technology opens the door to a wide range of creative possibilities. (See table below.)

Perhaps the most significant design feature for CBDCs could be a matter of interest. Digital technology could allow central banks to pay interest directly to CBDC holders, right down to tiny fractions of a digital coin – something that is impossible with physical cash. That could transmit monetary policy decisions much more rapidly to the economy, potentially improving financial and economic stability through much more targeted action.

An interest-bearing CBDC could serve as a potentially more accessible savings option for individuals who may not have access to traditional banking services, such as in isolated and rural geographies, which could boost financial inclusion and shrink the gap between unbanked populations and formal economies.

While that may be attractive to policymakers, the implications of doing so could be profound. A secure, guaranteed CBDC that pays interest directly to digital wallets could persuade individuals and businesses to hold more of their deposits in CBDCs rather than in commercial bank accounts. Ultimately, the proposition could risk draining deposits from banks, reducing their ability to lend to the real economy, and forcing central banks to step in as an alternate source of funding.

It is more likely that central banks would instead entrust commercial banks with the task of maintaining individual CBDC accounts. But even then, there would be competition between CBDC holdings and regular bank accounts.

Our CBDC survey reveals strong support for some of these design features. More than half of all respondents believe a CBDC should pay interest. However, only 26% say a central bank should use CBDC technology to enter the business of providing credit to individuals and businesses.

“Right now we are only skimming the surface of the potential ramifications,” said Fines. “It will take a lot of education, reassurance and comforting for the concept of CBDCs to gain widespread acceptance with the population.”

Choosing which new capabilities to include – and which to exclude – will determine the role that CBDCs will play in the future monetary system. 

Table 1
The limits of imagination: Potential CBDC design features

View more Data & Technology stories