At this time, numerous initiatives are attempting to provide citizens with a digital form of central bank money, referred to as Central Bank Digital Currency (CBDC). CBDC promises many benefits for citizens, such as providing a risk-free means of payment, preserving monetary sovereignty in light of the growing usage of private cryptocurrencies, and strengthening the transmission of monetary policy. The central banks of Sweden and China recently started the pilot phase of their CBDC prototypes and are expected to issue CBDC to the broad public in the near future. Furthermore, there are countries where some kind of CBDC is already issued with the help of e-money providers. In El Salvador, for example, providers have been issuing e-money to the broad public since 2015, which is fully backed by central bank money. A similar case can be found in China where e-money providers like Alibaba (Alipay) and Tencent (WeChat Pay) have been required to back their e-money with central bank money since spring 2019. In Lithuania, backing e-money with central bank money is voluntary but is still used in practice.
Banks are also engaged in the CBDC business. In Norway, the Safe Deposit Bank of Norway (SDBN) is offering deposits that are fully backed with central bank money. The Puerto Rico-based off-shore bank, Euro Pacific Bank, offers a similar safe deposit, globally. The Connecticut-based The Narrow Bank (TNB) also wants to invest all its customers’ funds in central bank money and offer safe accounts (The Federal Reserve Bank of New York refused to provide TNB a central bank account, resulting in litigation.)
CBDC has also gained traction in national parliaments. In the Netherlands, the parliament voted unanimously for the implementation of a “safe deposit bank”, where citizens can safely keep their money – implementation has stalled for legal reasons.
All these CBDC designs have different regulatory requirements which have recent scant attention in the academic literature. In my recent paper, I show how the issuance of CBDC and the provision of access can be regulated. For this purpose, I develop a conceptual framework that encompasses two components: first, the legal form of CBDC, and, second, the levels of obligation which indicate how binding the issuance of CBDC and the provision of access are for the central bank and third parties. Additionally, I show how the issuance of CBDC and the provision of access should be regulated.
Existing Legal Forms of Money
Most countries distinguish among six legal forms of money: central bank deposits, cash, bank deposits, e-money, money market mutual fund shares (MMMF-shares), and virtual currencies. The central bank issues central bank money in the legal form of deposits and cash. Both constitute a liability of the central bank (and a claim of the owner). While deposits are only accessible by banks, cash can be used by everyone. Commercial banks issue money in the legal form of bank deposits, which are liabilities of the bank that are usually partially backed by central bank money. E-money is a liability of a non-bank electronic money provider (EMP) that is usually backed by bank deposits or government bonds. Some jurisdictions, however, also permit banks and even the central bank to issue e-money. MMMF-shares are liabilities of money market mutual funds, more specifically, they are equity which has money-like properties. They maintain a net asset value of one Dollar/Euro per share and are redeemable at any time from the issuer. Lastly, virtual currencies are used for payments but do not belong to any of the above-mentioned forms. Examples of virtual currencies include cryptocurrencies without a central issuer and digital vouchers, which are only accepted for payments by the issuer.
The Legal Form of CBDC
By definition, CBDC is “any electronic, fiat liability of a central bank that can be used to settle payments, or as a store of value”. Thus, it can be a central bank deposit, central bank-issued e-money, and even cash, if stored electronically. However, depending on the access option, CBDC can be a combination of central bank money and other types of money.
There are various access options which differ in the type of legal relationship that the user has to access CBDC and the entities involved. With direct access, the user has a legal relationship with the central bank. With indirect access, the user would only have a legal relationship with a third party. Indirect access may be provided by intermediaries or custodians. Furthermore, there is hybrid access, where the user has a legal relationship with both the central bank and a third party. Hybrid access may be provided by Payment Service Providers (PSPs) or Technical Service Providers (TSPs). Overall, there are five possible access options.
Direct access
The user has a claim at the central bank and access is provided by the central bank or third parties on behalf of the central bank. The user would have a contractual relationship with the central bank (e.g. an account contract), or the central bank is obligated to issue CBDC and provide the user with access to CBDC by law. The legal form of CBDC would be a central bank deposit, cash, or central bank-issued e-money.
Hybrid access through payment service providers
The user also has a claim at the central bank, but access is provided by PSPs on their own accounts. The PSPs would offer payment initiation services and account information services, which is in line with the Payment Service Directive 2 (PSD2) in the EU. Therefore, the user would have a legal relationship with the central bank and the PSP. The central bank would need to provide the PSPs access to its Application Programming Interface (API) so that the PSPs can perform their services. The legal form of CBDC in this access would not be different from direct access CBDC. Therefore, CBDC would be also a deposit, cash, or e-money.
Hybrid access through technical service providers
In this access, the user again has a claim at the central bank, but access to CBDC is provided through TSPs on their own accounts. The TSP offers services on the storage and transfer of CBDC, which constitutes a contractual relationship between the user and the TSP. Additionally, the user still has a legal relationship with the central bank. This access option is especially relevant for Distributed Ledger Technology (DLT), since multiple TSPs may run a shared database with the same state, which enables competition among them. A central database can only be run by a single TSP, which creates no competition.
Indirect access through intermediaries
An intermediary provides the user with an asset that is fully backed by central bank money (i.e., indirect CBDC, also called iCBDC). The user would have a contract with the intermediary and the intermediary has a contract with the central bank. In this access, the legal form of CBDC would be a fully backed deposit, fully backed e-money, or fully backed MMMF-share, depending on the type of liability and the applicable regulation of issuance.
Indirect access through custodians
The user has a claim at the central bank, but this claim is held in custody by a custodian. Thus, the user has an agreement with the custodian and the custodian has an account contract with the central bank. The legal form of CBDC would be similar to the CBDC in direct access and hybrid access, with the difference being the central bank deposit, central bank-issued e-money, or cash held in custody.
Figure 1 gives an overview of the legal classification of the different access options.
Figure 1 – Legal classification of CBDC
Levels of Obligation
The legal forms of money alone are not sufficient to regulate CBDC. Regulatory rules will also depend on whether the central bank, and potentially involved third parties, are obligated to provide CBDC or provide it solely at their discretion. I identify the following three levels of obligation in my research:
Discretionary for the central bank and potentially involved third party
The central bank and involved third parties are permitted to issue CBDC and provide access at their discretion. Thus, the central bank and third parties are each free to enter into a contract with citizens. Additionally, intermediaries would have permission to invest in central bank money.
The first level of obligation with central bank deposits can be found in Germany, the EU, Japan, and Sweden. In Germany, central bank deposits can only be issued on the sufferance (non-objection) of the European Central Bank (ECB), while in the EU (ECB), Japan, and Sweden, these can only be issued in pursuance of monetary policy. In the EU, the national central banks (NCBs) are permitted to issue e-money with the permission of the ECB. In Uruguay, the central bank is permitted to issue CBDC in the legal form of digital cash. Other countries allow banks (Norway and the U.S.) and e-money provider (Colombia) to offer fully backed deposits. In Lithuania, Brazil, England, Switzerland, and Germany, e-money providers are permitted to invest in central bank money and offer fully backed e-money at the discretion of the central bank.
Discretionary for the third party
This level of obligation relates to hybrid and indirect access options only. In this category, the third party has full discretion, where they are free to provide access to CBDC or issue iCBDC (intermediaries) and the central bank must provide all conditions for the third party to offer their services. For hybrid access, this level of obligation means that the central bank is obligated to issue CBDC for the citizens and give PSPs access to its API. For indirect access, this level of obligation implies that the central bank is obligated to issue CBDC for the intermediary or custodian. Additionally, intermediaries have the right or requirement to invest in central bank money.
An example of the second level of obligation is China. Chinese e-money providers are required to back their e-money with central bank money. Thus, the central bank is obligated to provide them with a central bank account. Additionally, in the U.S., if The Narrow Bank wins its lawsuit against the Federal Reserve Bank of New York, it would also be at this second level of obligation. Switzerland held a referendum on the introduction of Vollgeld (Sovereign Money), which included the implementation of a custodian central bank deposit. Although this proposal was rejected by the majority of the people, it serves as an example of the second level of obligation.
Mandatory for the central bank and potentially involved third party
The central bank and third parties are obligated to issue CBDC and provide access to citizens. Therefore, citizens have the right to CBDC. For direct access, this level of obligation implies that the central bank is obligated to issue CBDC and provide access for every requesting citizen. With access through PSPs, the user additionally has the right to a service contract with the PSP and the central bank is obligated to give the PSP access to its API. TSPs are obligated to enter into a contract with every citizen who wants to store and transfer CBDC. Applied to intermediaries, this level means that intermediaries are obligated to issue iCBDC and custodians to enter into a custodian agreement with all requesting citizens. This would also include an obligation for the central bank to issue CBDC for intermediaries and custodians. Furthermore, intermediaries have the right or the requirement to invest in central bank money.
Examples of the third level of obligation can be found in Ecuador and El Salvador. In Ecuador, citizens had the right to participate in the e-money system of the central bank, which was active between 2014 and 2018. In El Salvador, e-money providers are required to offer fully backed e-money accounts to every requesting citizen.
Only with both of these components — the legal form and levels of obligation — can CBDC be regulated. Figure 2 gives an overview of how these regulatory options are implemented in various countries.
Figure 2 – Levels of obligation with examples
Notes: a Only applies to indirect and hybrid access options b Only applies if CBDC is issued independently of monetary policy c Only on the sufferance of the ECB d Only in pursuance of monetary policy e Discontinued or rejected f Depends on the result of the TNB lawsuit
Assessment of Different Regulatory Options
After identifying the various ways that CBDC can be regulated, my paper assesses how it should be regulated, in terms of the optimal level of obligation and the optimal access option. I do not assess the optimal legal form since this decision depends on the chosen access option and further design decisions, such as whether CBDC is interest-bearing or whether it is issued for monetary policy.
Optimal level of obligation
First, looking at the different levels of obligation from the consumer’s perspective, a right to CBDC, the third level of obligation, is the least discriminatory way of providing CBDC to citizens and therefore is the most favorable. This is the only option where CBDC is cash-like. In contrast, access to CBDC at the discretion of the central bank and third parties gives the authority to discriminate against citizens and should therefore not be considered.
Optimal access option
Second, the different access options are evaluated. Figure 3 summarizes the most important advantages and disadvantages for each access option.
Figure 3 – Pros and Cons of different Access Options
With Direct I access, i.e. the central bank performs all CBDC related tasks, the central bank is completely independent of third parties. However, there are downsides due to the increased volume of operational duties imposed on the central bank and the lack of competition. Direct II access, i.e. third parties perform CBDC related tasks on behalf of the central bank,reduces operational duties. Nevertheless, the central bank becomes strongly dependent on third parties. Moreover, there is still a lack of competition and the outsourcing binds central bank resources.
Hybrid access (through PSPs and TSPs) is favorable because it provides competition and minimizes operational duties for the central bank while not being as complex as intermediaries or custodians. Hybrid and indirect options have the risk that there are not enough third parties available. Apart from this, intermediaries have additional disadvantages. CBDC offered by intermediaries might bear a remaining default risk due to operational risk of the intermediary. If a bank or MMMF cannot cover its expenses and goes bankrupt, its user’s funds would be included in the bankruptcy estate. Moreover, intermediaries require monitoring of their backing, which binds central bank resources.
Within hybrid access, whether PSPs or TSPs should be chosen ultimately depends on the chosen technology. While PSPs are more suitable for CBDC stored on a central ledger, TSPs are for CBDC stored on a distributed ledger.
Conclusion and Implications
Central Bank Digital Currency is the next milestone in the evolution of money. Its legal implementation, however, needs thoughtful consideration of all possible regulatory options. My research shows that the regulation of CBDC encompasses two major components: the legal form of CBDC, and the levels of obligation, which indicate how binding the issuance of CBDC and the provision of access are for the central bank and potentially involved third parties. My research identifies certain regulatory options as more favorable than others. Only a right to CBDC for everyone is non-discriminatory, and therefore favorable from the consumers’ perspective. Furthermore, hybrid access may be a favorable trade-off between the pros and cons of all access options.
This research has implications for theory, practice, and policy. My framework provides a theoretical foundation for the legal assessment of CBDC. The levels of obligation can be considered as a design option for CBDC. The framework also helps central banks assess their legal authority for issuing CBDC. Finally, the framework helps policymakers consider the various objectives and tradeoffs involved in introducing and regulating CBDC.
Simon Hess is a Research Associate and PhD candidate at the University of Salzburg.
This post is adapted from his paper, “Regulating Central Bank Digital Currencies: Towards a Conceptual Framework,” available on SSRN.
