Digital cash is coming, but will it really be built on blockchain?

Over 100 countries are exploring ‘central bank digital currencies’, but it may not be the crypto coup some imagined...

Cash is in a death spiral. Driven partly by the pandemic, payments in cash plunged to a record low in 2020, according to the Bank of England, and with retailers increasingly going card-only, it is predicted that by 2031 banknotes and coins will account for just six percent of UK transactions. A similar pattern is being replicated across much of the world. So where does that leave the millions, often society’s most marginalized, who do not have access to bank accounts and credit cards, and therefore depend on cash for daily life? The answer may well lie in central bank digital currency (CBDC).

Unlike cryptocurrencies, which are built around distributed autonomous communities rather than a centralized authority, CBDCs are digital money in the national unit (e.g. sterling or euros) issued by a central bank directly to consumers and businesses. They differ from credit or debit cards, bank transfers, and apps, because when we pay with those we are essentially using our own money guaranteed by the financial institution that provides our account. Instead, CBDCs are backed by central banks, and carry the same guarantees as the cash in our pockets. Their proponents argue that they will help promote financial inclusion and open up access to digital payments to the unbanked, largely because governments can make CBDCs cheap or free to use, and available to entire populations in a way that private banks and credit card firms cannot.

Today CBDCs are evolving at different speeds around the world. The International Monetary Fund (IMF) says around 100 countries are at varying stages of exploration, ranging from research and testing, to distribution; the Bahamas’ ‘Sand Dollar’, for example, has been in circulation for over a year, while the e-CNY – the digital version of China’s renminbi, or ‘digital yuan’ – reportedly has 261M individual users and 4.5M shops. However, while there is a lack of consensus among the world’s central banks surrounding their design and implementation, there had been widespread conviction that CBDCs would harness crypto’s underpinning blockchain technology, specifically because of its ability to track every transaction on an immutable distributed digital ledger, which could provide a bulwark against fraud.

That conviction is disappearing fast. Despite blockchain being seen by investors as a durable technology with myriad practical applications – VCs plowed $25.2BN into blockchain startups last year – a report from the Bank of International Settlements (BIS) and the World Bank, published in April 2022 and which interviewed nine central banks, found that blockchain or digital ledger technology (DLT) has an inherent weakness: namely, relative lack of speed.

“Each ledger’s change must be synchronized between all entities’ nodes, which takes time,” wrote the BIS paper’s authors. “As a result, transaction throughput in DLTs is lower than in traditional designs”. Of those central banks interviewed that were not considering a DLT-based infrastructure, decreased transaction throughput was the main reason given. Separately, MIT researchers in collaboration with the Boston Fed reached a similar conclusion, when a test of processing technologies found a blockchain-based digital ledger had “pretty significant bottlenecks”, according to Neha Narula, director of MIT’s Digital Currency Initiative at the MIT Media Lab.

So, if not DLT, then which infrastructure will ultimately prevail? The short answer is that it’s unclear. China’s front-running e-CNY, which has been rolled out to users in 23 pilot cities across the nation, does not use DLT, but is instead centrally managed by its issuer, the People’s Bank of China. Critics worry, however, that centralized control could allow the Chinese authorities to snoop on users in real time.

A US initiative, meanwhile, is taking a strikingly different approach. The ECASH Act, introduced earlier this year, would direct the US Treasury to “develop and pilot digital dollar technologies that replicate the privacy-respecting features of physical cash”, which would mean offline transactions using secured hardware devices rather than a smartphone app. Other countries are road-testing yet more approaches. Indeed, with 105 nations, representing 95 percent of global GDP, now exploring a CBDC, central bankers are busily building a veritable Tower of Babel. Consensus is still a long way off.