Unlocking the Potential of Central Bank Digital Currency (CBDC)

The Bank of England’s proposed retail Central Bank Digital Currency (CBDC) could be a catalyst in payment innovation within the UK’s financial system. However, there are foreseen potential issues that need to be addressed to convince the financial services ecosystem and the wider public to adopt this new payment method. This blog considers the technological solutions that could address these challenges.

The main aim of CBDCs is to provide privacy, convenience, accessibility, and financial security to businesses and consumers. As well as providing stability to centrally administered currencies, CBDCs could also decrease the cost of maintenance that a complex financial system requires, reduce cross-border transaction costs, and provide those who currently use alternative money-transfer methods with lower-cost options.

The past decade has seen significant advances in the UK payments landscape, including the introduction of Faster Payments, contactless card and smartphone transactions, and Open Banking.

A BIS paper published in July 2023 presented the results of a survey of 86 central banks conducted in late 2022 about their involvement in CBDC work, as well as their motivations and intentions of potentially issuing a CBDC. Although no new retail CBDCs were launched in 2022, 18% of central banks indicated that they are likely to issue a retail CBDC in the near term. A CBDC, as both a new type of money and a new payment system, presents an opportunity to reshape the financial system.

The benefits and opportunities of a 'digiTal pound'

  • Efficiency and cost savings: Digital pound transactions could be settled quickly, allowing for near-instantaneous transfers and potentially reducing the need for intermediaries in certain transactions.
  • Cross-border payments: Cross-border payments may be made faster, cheaper, and more efficient, therefore reducing the complexity of foreign exchange transactions.
  • Financial inclusion: A digital pound could provide a secure and accessible means of payment to individuals who may not have access to traditional banking services. It could enable more people to participate in the digital economy without a bank account.
  • Increased security: A digital pound would likely incorporate robust security features, making it more difficult to counterfeit or manipulate. Digital transactions can also provide enhanced traceability and transparency, potentially reducing fraud and illicit activities. Digital currencies allow central banks to implement policy and provide security, especially when it comes to the use of cryptocurrencies.
  • Implementation of monetary policies: A CBDC would also provide a country's central bank with the means to implement monetary policies to ensure stability, control growth, and influence inflation.

The European Central Bank states, "A CBDC would preserve the coexistence of sovereign and private money in a digital world. This is not an abstract benefit – it is the basis for financial and monetary stability, ensuring competition and efficiency in payment markets."

However, there are highly publicised privacy, cyber security, and regulatory compliance concerns regarding the adoption of CBDCs. A digital pound could potentially revolutionise our financial system, but first the Bank of England and the wider UK financial services ecosystem will need to convince the public and financial services industry that they have solutions to any potential problems.

There is large-scale scepticism within the financial services industry about its utility and value. The House of Lords committee stated that there were “significant risks” including a privacy risk from giving the central bank the power to monitor its citizens’ spending.

The committee also warned of the risk of destablisation of the financial services industry, through people transferring money out of their bank accounts into digital wallets, resulting in vulnerability during periods of economic stress. There were also concerns that a successful digital currency could also be targeted by cybercriminals.

Challenge 1 - Privacy

One of the main objections to CBDCs in general is the threat to the privacy of the citizen, with the UK House of Lords Committee describing a potential sterling CDBC as an, ‘instrument of state surveillance'.

A study conducted by the Bank of International Settlements found consumers were concerned about privacy risks posed by CBDCs. Clarity needs to be provided around the digital pound to address the public’s concerns that their transactions would not be monitored in real-time by the state.

Technological measures that could be used to address privacy concerns

Privacy protection: Offering privacy controls can build trust and enhance user adoption of digital payment systems. Users are more likely to embrace and engage with systems that respect their privacy preferences and provide granular control over their personal data.

Data minimisation: Limiting access to personal data, anonymising transaction data, and utilising aggregated system-wide data, the digital pound can operate without compromising individual privacy rights.

Knowing that personal data is protected and used only in anonymised and aggregated forms can instill confidence in the system and encourage broader adoption of the digital currency.

Challenge 2 - Cyberattacks and Security

Vulnerabilities in a CBDC could be exploited to gain sensitive payment and user data on a massive scale. While these risks are present in the UK’s existing financial system and institutions, with a CBDC they could be amplified.

Addressing cyberattacks and security concerns

However, the security risks around data collection could be addressed by embedding security measures in CBDC design:

  • Validation architecture: Concerns can be addressed by choosing a validation architecture in which each component sees only the amount of information needed for functionality. In addition, cryptographic tools can be used such as zero-knowledge proofs, which authenticate private information without revealing it, or cryptographic hashing techniques.
  • Risk mitigation: Not holding end users' funds directly on their balance sheets can help mitigate certain risks for private sector digital wallet providers. By avoiding direct custody of funds, they may reduce the risk of potential financial losses due to security breaches, fraud, or other operational challenges.
  • Enhanced security: If private sector digital wallet providers do not hold end users' funds, it could encourage the implementation of more secure and robust payment infrastructure. Users' funds may be held in separate, secure accounts or custodial services, minimising the potential impact of security breaches on customer funds.

Challenge 3 - Regulatory Compliance vs Financial Inclusion

The introduction of a digital pound has the potential to significantly improve financial inclusion by offering a secure and easily accessible payment method for those without access to traditional banking services. This could empower more individuals to engage in the digital economy, enabling transactions even for those without bank accounts.

However, the financial inclusion potential of a digital pound must balance with the regulatory and compliance challenges. Implementing a digital currency would require establishing robust regulatory frameworks to address concerns related to money laundering, terrorist financing, consumer protection, and other financial crimes.

Striking the right balance between regulation and innovation is crucial to mitigate risks without stifling technological advancements. A digital pound could allow for advanced accessibility and inclusion, by providing usage to excluded citizens who may lack the credit history to satisfy regular risk assessment requirements.

Regulatory compliance vs financial inclusion - Is tiered access the solution?

  • Tiered access: One solution to reconcile these concerns is the implementation of tiered access. Regulatory concerns can be mitigated while allowing potentially unbanked or financially excluded people greater financial participation.
  • Enhanced security: Linking tiered access to user identity information can help enhance the security of the digital pound. By implementing different access levels based on user verification, it becomes more challenging for malicious actors to gain unauthorised access to sensitive features or perform fraudulent activities.
  • Regulatory compliance: A tiered access system linked to user identity information can help facilitate compliance with relevant regulations and laws.
  • Tailored services: Tiered access can enable the provision of tailored services based on users' needs and risk profiles, allowing for customised offerings that align with user preferences.
  • Accessibility and inclusion: Implementing tiered access should ensure that it does not hinder accessibility or exclude individuals who may face challenges in meeting specific identity verification requirements. Measures should be in place to address the needs of underprivileged or marginalised populations, ensuring fair and equitable access to the digital pound.

Digital Currency Adoption with BJSS

The potential of a Bank of England-backed digital currency is significant, but it comes with its share of challenges. Privacy, cyber security, and regulatory concerns must be carefully considered, and weighed against the potential business benefits. BJSS, with its expertise in innovative technology for financial institutions, offers technical solutions that can help organisations overcome the hurdles associated with digital currency adoption, as well as providing access to a wide range of stakeholder views within its existing client base. To learn more, visit our Financial Services industry page or contact us for tailored assistance in navigating the complexities of digital currency implementation.