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Compliance Implications of Central Bank Digital Currencies

by InnReg on July 22, 2022

A CBDC is a new type of money that uses blockchain technology to create a unique digital identity and is issued and guaranteed by a central bank. Its value is linked to the national fiat currency, and as a digital innovation has the potential to be used by both households and companies to store value and make payments.

The rising digitization of economies, the desire for real-time payments and settlement, and the need for more efficient domestic and cross-border monetary transactions are the key forces driving the demand for CBDCs. According to the International Monetary Fund, centralized financial technologies like CBDCs can lower costs, enhance financial inclusion, and enable safer access to money through digital channels.

Increasingly, central banks globally are also becoming aware of the growing influence of CBDCs as a form of digital money, and are devoting time and resources to assess the potential consequences for the financial system at large.

Overall, the emergence of CBDCs needs to be recognized as a disruptive force in the financial ecosystem, and one with the potential to improve payment efficiency and provide an operational and technological alternative to the current money paradigm.

CBDC Launch and Regulation Compliance Imperatives and Challenges

How widespread is CBDCs adoption today?

The convergence of Covid-19's socioeconomic dynamics with the advent of blockchain technology has sped up work on CBDCs, and central banks worldwide are exploring the possibility of issuing retail central bank digital currencies. According to the Atlantic Council’s latest research tracker, a total of 105 countries, accounting for 95 percent of global GDP, are engaged in the exploration of a CBDC.


Global activity in CBDCs launch and regulation

China's digital yuan pilot has registered over 70 million transactions totaling $5 billion since it began in the spring of 2020. Elsewhere, Thailand's CBDC project is moving forward with plans to establish a digital baht in three to five years, while Singapore’s Ministry of Finance has launched a project to build the necessary technical infrastructure to enable the issuance of a digital Singapore dollar.

In Europe, the European Central Bank and the European Commission have formed a joint technical group to examine the policy, legal and technical issues of a digital euro, with the goal of fostering innovation and ensuring the security of European payment networks.

Elsewhere, in the United States, given the variety of electronic payment options available today and the planned introduction of FedNow, the Fed's instant payment system due to launch in 2023, policymakers including Federal Reserve Chair Jerome Powell have expressed skepticism about the need for a general-purpose CBDC.

While it is unlikely that a retail CBDC will be operational in the United States in the coming years, the Fed is expected to continue to participate in the international policy debate to maintain influence in setting regulatory standards and best practices.


Key compliance considerations in the CBDCs risk-reward calculation

To understand what the future of money laundering may look like in a CBDC world, one must consider how they may operate. Let’s look at the key implications of a CBDC-based banking model:

  • The end of bank runs: As direct liabilities of the central bank embodying sovereign credit, CBDCs are a safer form of digital money than commercial bank-issued digital money where the risk of “bank runs” is effectively removed.
  • The end of paper money: Given the central bank's role as custodian and clearing of financial transactions, and the CBDC's status as a central bank liability comparable to paper money, it's plausible to assume that paper money will eventually become obsolete.
  • Easier regulation and implementation of policies: Data analytics and artificial intelligence will increasingly monitor transactions to swiftly identify potential bad actors. Furthermore, CBDCs can provide traceability in ways that cash cannot, and regulators may be able to more readily identify the persons involved in a transaction, making it easier to uncover illegal activities and eliminating black markets.
  • Greater inclusivity: CBDCs are viewed as catalysts to foster greater participation in the financial ecosystem, especially in poorer nations where typically a third of the population lacks access to traditional finance but has mobile internet access.

Key challenges for an effective CBDC implementation

While 86% of the world’s central banks consider the dangers and benefits of issuing a CBDC, much of the research is still preliminary. The Bank for Worldwide Settlements and central banks from seven jurisdictions, including the Bank of England, Bank of Japan, European Central Bank, and US Federal Reserve, are leading one of the most significant international attempts to investigate the utility of a CBDC system.

The following important problems that must be carefully weighed in building a balanced and effective CBDC arrangement have already been recognized as part of this effort:

  1. Technology risks: Establishing a CBDC would shift significant technology risks from the private sector to the public sector, and eventually taxpayers, who would bear the burden of rapidly evolving and frequently experimental technologies. If this evolution stays a free market activity with public sector control, consumers, markets, and governments will all profit.
  2. Cyber vulnerabilities and blockchain technology: As based on blockchain technology, CBDCs amplify centralization, thereby expanding the risk of cyber vulnerabilities to central banks. With this in mind, public blockchains, supported by a competitive free market, provide a more secure, long-term foundation for fully benefiting from distributed systems' inherent cyber resilience. Equally, policymakers should focus on ensuring interoperability between a CBDC and other payment systems to allow the flow of funds required to accomplish payment accessibility, resilience, and diversity.
  3. Privacy and consumer protection: As the reach of CBDCs across the economic activity of consumers and citizens expands, privacy implications will become ever more critical. Privacy-first architecture and techniques like zero-knowledge cryptography will be a necessary design consideration to strike a balance between regulatory needs, individual privacy, and data sovereignty.
  4. Design flexibility: A focus on maintaining design flexibility to accommodate evolving user needs over time will increasingly be a priority. This could be achieved, for example, by adding the option to be programmable via specific obligations or conditions.

CBDCs: can they survive the crypto winter?

The move to CBDC-based, low- or no-cash economies is very certainly unavoidable. Its presence will undoubtedly disrupt the banking industry, allowing nimble fintech firms focused on creating value to compete with the industry's big, powerful incumbents.

The new banking model will reach more people with better services and provide credit to businesses on better terms while maintaining liquidity and efficiency in the capital markets. Overall danger will be reduced, and while some privacy will be compromised, the benefits in the form of deterrence to fraud and other crimes will likely outweigh the costs.

In a special chapter of its Annual Economic Report 2022, the Bank for International Settlements offers a compelling roadmap for envisioning a future monetary system based on a digital version of central bank money where innovation would be combined with risk management and governance safeguards. In particular, the BIS posits that CBDCs can avoid the structural limitations of cryptocurrencies by relying on a solid foundation of trust to offer a more efficient, transparent, and cheaper framework.

Pointing to the recent and ongoing market turmoil with crashing prices and widespread illiquidity, the BIS identified key flaws in the crypto sector, including security risks, high fees, issues with scalability, and lack of regulation and an investor protection framework, which collectively point to the sector’s fragmentation and inability to fulfill the key priorities of a stable digital monetary system. As argued in the BIS’ Report, central banks around the globe share the belief that stablecoins backed by a single currency are far more likely to succeed as a method of payment than other types of stablecoins pegged to commodities or other cryptocurrencies.

On the other hand, the CBDC system is grounded on enhanced technical capabilities built on a foundation based on the trust provided by central bank money.

In the age of digital payments, effective and sound implementation of a CBDC architecture could assist policymakers to achieve goals like payment efficiency, financial inclusion, banking and payment competitiveness, and access to safe central bank money.

While issues and open questions with governance, law, economics, and policy remain open, it is essential that any company leveraging blockchain technology be aware of the ever-changing and evolving regulatory landscape.

As an outsourced compliance provider, InnReg can help fintech and blockchain companies stay compliant with the rapidly evolving regulatory landscape of CBDCs.

Topics: Crypto Regulation


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