MASTER OF FINANCE

COURSE: FINANCIAL MARKETS AND INSTITUTIONS (FIN 7302)

TERM PAPER ON CENTRAL BANK DIGITAL CURRENCY

Prepared by:
SYLLA SIDIKI (G1821241)
MARYAM MOHAMMED-ASAFA (G1911324)

To be Submitted to:
DR. ROSLILY BT RAMLEE AND
DR. FARIHANA BINTI SHAHARI

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 HOW COULD CENTRAL BANK DIGITAL CURRENCY
TRANSFORM THE FINANCIAL SYSTEM

TABLE OF CONTENT
Pages
I- ABSTRACT….…………………………………………………… 3
II- INTRODUCTION………………………………………………. 3
▪ Context of CBD…………………………………………………. 3
▪ A brief history of money and digital currency………………... 4
▪ Some key concepts and definitions…………………………….. 5
▪ What is a central bank digital currency and why issuing it?.... 6
▪ The role of International Monetary Funds (IMF)……………. 6

III- PROBLEM STATEMENT…………………………………… 7

IV- LITERATURE REVIEW.…………………………………….. 7
▪ Retail form of CBDC based on DLT………………………….. 9
▪ Wholesale form of CBDC based on DLT……………………... 9

V- DIFFERENT IMPLICATIONS OF CBDC…………………… 10

▪ Monetary policy challenges…………………………………….. 10
▪ Effect on interest rate………………………………………… 10
▪ Reduce the effective lower bound……………………………. 10
▪ Helicopter money……………………………………………… 11
▪ Financial stability…………………………………………………. 11
▪ Disintermediation of banks………………………………………. 11

VI- CONCLUSION…………………………………………………. 11
References………………………………………………………….. 12

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 I- ABSTRACT:
FINTECH is here and possesses within itself the potential of transforming both our life and the
whole financial system. It includes both services and information technology and invest all
sectors of banking and financial intermediation: from credit (Crowdfunding and peer to peer
lending) to payment services (instant payment), from cryptocurrencies (Bitcoin) to consultancy
services (robot-advisor), from decentralized transaction validation technologies (Blockchain or
DLT) to biometric identification (fingerprint, retina or facial recognition) and to support delivery
of services (cloud computing and big data). The digitization that follows rises the debate around
the creation of a CBDC. In addition, the 2008 global financial crisis is a factor generating the
interest towards central bank digital currency (CBDC) as well as the creation of cryptocurrencies
and the rise of digital transactions. The way and pattern of conducting payments are changing
and ipso facto, we realize that the technological changes that are taking place affect the central
banking as there is a decrease in role played by the physical notes and cash observed in some
countries (Sweden, for example where cash is almost vanishing). This context is bringing several
central banks to envision the creation of digital money. A fiat currency in the digital form backed
by a central authority. This paper will focus on a more likely model of CBDC that is supposed to
function as there is concerns about the model to be implemented as well as the question about a
DLT-based CBDC or a non DLT-based.
Keywords: Central Bank Digital Currency, Fintech, Blockchain, IMF, BIS, Cryptocurrencies

II- INTRODUCTION:
▪ The context of CBDC
The world financial landscape has changed after the 2008 financial crisis and with it the trust of
people in their financial system. The new financial ecosystem that resulted is a kind of revolution
as it is changing the way people transact with each other. With Blockchain the rise of
cryptocurrency is offering alternatives methods of storing money and making payments without
relying on the traditional banking system and government controls. Needless to mention the
number of improved solutions coming to market from the constant flow of new cryptocurrencies
since the creation of the first cryptocurrency (BITCOIN) in 2009 by Satoshi Nakamoto. There
were 2,520 cryptocurrencies available as of 4 February 2019 with a global market capitalization
of $113billions (Ward et al 2019).
But there are so much to be said about cryptocurrencies as they have, both advantages and
disadvantages. Their low adoption costs and online availability are playing significant roles in
increasing global economic participation. Also, their underlying technology which is Blockchain
is quite famous as it is changing our future not only on the field of finance and payment system
but also in many other domains. The concern is about cryptocurrencies and how riskier they can

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be when it comes about dealing with the whole international financial system. Hence, from that
perspective they do not fulfil all the requirements of money being a combination of (1) legal
framework and (2) technical framework. They simply have no legal status and therefore are
considered by some economists and regulators as Assets that people trade with each other. In
addition to that, despite all their features they represent some kind of threats because they are
issued by private sectors and have the following problems:
➢ High volatility and this lack of stability might cause investors to experience loss of
capital;
➢ Used for money laundering & financial crime.
➢ Used in the black market.
➢ More attractive to hackers, mainly the digital currency exchanges.

➢ Complicated and difficult to gain proper understanding of Blockchain Technology

used in cryptocurrency

➢ Prices are mainly set by market sentiment.

➢ Digital currency scheme is not (yet) regulated and not yet closely supervised or
overseen by any public authority, and this reduces investors’ confidence

➢ Intrinsic value extremely hard to assess

➢ Anonymity of the economic agent involved increase counterparty risk and create a
market that can be used for illegal activities

➢ They lack transparency, clarity of legal status and uncertainty of continuity

Therefore, as they cannot play the role of central bank currency in order to avoid jeopardizing our
fragile financial system, many countries authorities and regulators as well as practitioners are
gathering to analyse and understand the potential effects of issuing a Central Bank Digital
Currency (CBDC). It should be a sovereign digital currency that is supposed to serve as legal
tender and usable by any citizen.

▪ A brief history of money and digital currency:

Money as we know it today is the fruit of many years of evolution, sometimes imposed by the
reality of the period. Despite the problem it may cause, we invented it because it was the only
mean able to relieve us from the difficulties of doing business related to the barter system.

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Hence, even the most primitive societies tried to use some form of money, whether in the form
of feather, beads or cowry shell etc. From their original form of receipt for grain stores in ancient
Egypt, they evolved to represent value with different metals. And the metals were able to store
value because they represent a standardize weight when they were stamped into coins. This
standardization paved the way for banking whereby coins could be valued by the weight of the
metal and stored in a secured location for credit. Then the increase of trade obliged the
merchants to seek for a medium of exchange much more efficient than metal. Hence, the paper
money was created and while this latter was at its initial stage in the Chinese Tang dynasty, by
the 1900s, most industrialized countries were using paper notes and coins to represent a gold
standard.
A digital currency defined as any medium of exchange recorded electronically has a much more
recent history even though a similar concept was around since 1983 when DAVID CHAUM
(considered as pioneer of digital money) introduced the idea of digital cash. Although it had the
characteristics of traditional currency, this digital cash had the ability to instantaneously
exchange values between parties across borders. Moreover, in 1990, the dot-com bubble pushed
the digital currencies to take a step back as many services were shut down for money laundering.
But in 1997, they made a jump forward when Coca cola introduced the first mobile payment
vending machines. The year that follows announced the beginning of a new era as the first
PayPal online services was founded. Then in 2008, the first cryptocurrency was introduced, and
digital currencies were enabled to be sent directly from one party to another without going
through financial institutions.
▪ Some key concepts and definitions:
- Fiat currency: currency issued by a national central bank, typically in the form of
currency banknotes and coins. Can also be issued by private institutions under the
authority of the government.

- Legal tender: form of payment that a creditor is legally obliged to accept from a debtor
in order to extinguish a debt. Fiat currencies are typically legal tender.

- Digital currency: general term encompassing any form of currency that is not tangible.

- Central Bank Digital Currency (CBDC): Fiat currencies issued by the central banks in
place of, or as a complement to physical currency (banknotes and coins).

- Cryptocurrency: a digital currency in which encryption techniques are used to regulate

the generation of units of currency and verify the transfer of funds, operating
independently of a central bank.

- Fintech: refers to the financial innovation made possible by technological innovation,

which can take the form of new business models, processes or products, producing a
decisive effect on the financial markets, on institutions, or on the offer of services.

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 ▪ What is a central bank digital currency and why issuing it?

A central bank digital currency (CBDC) is a digital extension of a central bank’s medium of
exchange which is able to permanently settle transactions between parties. The central bank has
the ability to remove credit risk and ensure stability by guaranteeing the value of the CBDC,
exactly like paper money. And any person(s) tied to any central bank on the network can
instantaneously transfer value between any other person tied to any other central bank on the
network.

In effect, Central bank digital currency is a potential innovation in central banking. It is supposed
to fulfil all the 3 functions of money (medium of exchange, store of value and unit of account) as
well as improving the way central banking is conducted. According to the October 2018 Official
Monetary and Financial Institutions Forum (OMFIF) report titled Central Bank Digital
Currencies, “The main motivations for pursuing a CBDC, according to survey respondents, lie in
the potential to improve speed and cost efficiency. It may also help to overcome the limitations
of existing systems, especially in system security and resilience. A CBDC can reduce operational
risks and running costs due to productivity gains as more financial assets become tokenized and
recorded on distributed ledgers.

Therefore, the idea and incentive of creating a CBDC is related to factors surrounding the safety
and the improvement of the way the financial system functions. Interest in such currency has
risen since regulators and policymakers have noticed some episode of instability in the life of
cryptocurrencies. The CBDC will serve the same function as physical currency.

▪ The role of International Monetary Funds (IMF):

The International Monetary Fund (IMF) is an organization of 189 countries, working to ensure
global monetary cooperation, secure financial stability, facilitate international trade, promote
high employment and sustainable economic growth, and reduce poverty around the world. Its
primary purpose is to ensure the stability of the international monetary system (the system of
exchange rates and international payments that enables countries (and their citizens) to transact
with each other).

With regards to its aforementioned purpose, the IMF can help realise the CBDC in three basic
ways:
1- by informing the policy debate;
2- by convening relevant parties to discuss policy options and
3- by helping countries develop policies.
Furthermore, it has mostly been active in the first two areas, but it is gradually moving into the
third area as member countries consider CBDC options and seek advice.
Firstly, the IMF can help inform the policy debate. This body is well-placed to study CBDC
because it can draw on its in-house experts. More so, a potential world with multiple CBDC
would bring about questions of cross-border payments and international monetary system, which
are part of the IMF’s core functions.
Secondly, the IMF is well-positioned to help foster cooperation among countries and relevant
parties. The IMF can make do of its universal membership to disseminate information about

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rapidly evolving developments across advanced and emerging market economies. Being a public
international institution, it can bring together central bankers and regulators, as well as investors,
entrepreneurs, and academics from around the world for an open dialogue.
And Thirdly, the IMF can help countries evaluate policies that regards to CBDC as well as
investigate alternative means to improve payment systems. The IMF can do so through its
surveillance work, its Financial Sector Assessment Programs, and its technical assistance, which
it has a long tradition of providing.
The IMF can help countries think through the implications of CBDC and its attendant potential
benefits and risks, including through regional workshops leveraging knowledge in central banks
at the frontier of CBDC development, and bilateral technical assistance missions.

III- PROBLEME STATEMENT:

-The idea of Central Bank Digital Currency is nowadays subject to many interrogations and even
sometime controversy, as it is a complex and multidisciplinary topic.
- It requires profound analysis and debates for reasons related to the number of questions it raises
specially when some of these questions remain unanswered or rather, are still subject of
controversy and/or debates. Questions such as the implementation of monetary policy, central
bank operations and payment system, financial stability as well as legal foundation and
regulation
- The point is, at the era of this 4th industrial revolution, how a central bank digital currency will
exist and fit into this new digital age and what could be its impact on the financial system.
- In any cases, something must be done by the authorities and regulators, as cryptocurrencies-
with all the risks and uncertainties related to their lack of legal status - are gaining in power in
our financial system or at least in our day to day activities in the financial markets.
IV- LITERATURE REVIEW:

Introducing a CBDC in the economy requires much more analysis, studies and meetings than
expected when the idea was evoked for the very first time. The point is that there is a certain
variety of design susceptible to be adopted. That goes from how people will be allowed to get
access to the currency, to the degree of anonymity as well as its interest-bearing features. Hence,
up to now, the questions related to the technological and economic impacts of issuing CBDC
need to be answered. As the Bank for international Settlement (BIS), tries most recently, in its
research on the CBDC to define a model that can better characterize different types of digital
money. Referred to as the “Money Flower”, this model attempts to introduce four different sub-
segments, nonexclusive mutually and which are trying to define the nature of money (such as
bank deposits, digital tokens and cash) along four axes:

• Token-based (or not): meaning transaction occurring directly between the payer and the
payee or if there is a need for a central intermediation (clearing authority for example);

• Central bank issued (or not): whether it should be a public legal tender or a private
currency.

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 • Digital (or not): Whether it is electronic or physical form;

• Widely accessible (or restricted): Whether the currency is intended for everyone’s use
or for specific institutions (Wholesale only).

The figure below shows the design.

Source: Bank for International Settlement (BIS)

That is being said, it is important to mention that numerous countries are actively engaged in
finding the most suitable model for their ecosystem as the CBDC, according to studies already
conducted will have several implications on both local economies and the world financial
system. This situation is particularly profound and interesting for small advanced economies as
they are looking at CBDC. Also, the fact that a government money’s value is determined by its
unique legal status and as well as by some political characteristics will play a major role in the
success of the new coming digital currency. And that is why the CBDC must fulfil the
requirements of all the other forms of government issued money for it to meet the participants of
different countries economy’s expectations. Yet, for that purpose it should be able to respect the
following criteria:

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 - Availability to the public, without any form of restriction and recognition as legal
tender for the whole country;

- Central bank should directly guarantee the at part convertibility of the currency
into cash and/or reserves;

- Central bank would provide lending facilities for holders of the currency

- Central bank may choose to pay an interest rate on the CBDC liabilities consistent
with the interest rate structure of other government liabilities, and the Central
bank’s broader monetary policy and the financial stability objectives.

In any case, the CBDC can be made available either to a predefined group of users, such as
commercial banks and non-banking financial institutions or widely accessible to the whole
economy where access is granted to households and non-financial firms.
Our proposal of model will be focused on a type of CBDC that take into account the Distributed
Ledger Technology as Blockchain nowadays is the technology underlying digital currencies in
general but also the one susceptible to improve the future of our financial system because of its
link with fintech ecosystem. However, we will split the DLT-based model into two forms:
1- Retail form of CBDC based on DLT:
With much more popularity among emerging economies, this form is particularly interesting in
promoting financial inclusion and accelerating the process of a cashless society with a potential
impact on reducing cash printing and handling costs. Furthermore, it also encompasses the
feature of anonymity, traceability and availability as well as doable regarding interest rate
application. Some countries- including Ecuador, Israel, Uruguay, Lithuania, the Marshall of
Islands, Tunisia, China, and Venezuela- have examined and/or conducted related experiments
(Shirai 2019). In contrast to emerging economies, advanced economies are not in favour of this
form for reasons related to their internal situation as there is not such needs of more financial
inclusion and because they want to avoid competitions between central bank money and private
sector money.
2- Wholesale form of CBDC based on DLT:
Having the potential to improve the existing wholesale system, this form is viewed as more
convenient to central banks as well as to some international financial institutions such as the
Bank for International Settlement (BIS) as from this institution’s prospective, the settlement
system for financial transactions would be more efficient and more secured not only in term of
cost reductions but also in term of collateral and liquidity. Hence, some central banks have been
conducting researches in order to have better understandings about DLT as it is the technology
that is supposed to support the wholesale payments system and their functioning. And their

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expectations were based on the improvement of real-time gross settlement system, delivery
versus payment system, cross-border interbank payments, settlement system etc….

A PROPOSED WHOLESALE CBDC MODEL

CENTRAL BANK
ACCOUNTS

Bank A account Bank B account Bank C account

PERMISSIONED
BLOCKCHAIN

Bank C wallet
SYSTEM

Bank A Wallet Bank B wallet

BLOCKCHAIN

V- DIFFERENT IMPLICATIONS OF A CBDC:

▪ Monetary policy challenges:
Until now key questions remain unanswered on how the monetary policy will be conducted if a
CBDC is issued or at least how it will affect the power of central banks in term of conducting
such policies. In addition to that, the likelihood of affecting the ability of the central bank to act
as lender of last resort will be restricted since the only policy of the central bank will be focused
on the e-money issuer’s policy.
▪ Effect on interest rate:
Interest bearing or not? And if interest bearing, at what rate? These are actually matter of
questioning as an interest bearing CBDC would improve the monetary policy more effectively
since the pass through of interest rate changes by the central bank would be more direct.
However, the overall impact on the term structure of interest rates will depend on many factors.
▪ Reduce the effective lower bound:
The CBDC in general way will allow the central bank to implement the negative policy interest
rate anytime the economic situation will require it. The effective lower bound is related to
depositor’s willingness to hold cash instead of interest-bearing assets so that they can avoid

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negative interest rates. Hence, to increase the cost of storing cash, central bank will have to
reduce the effective lower bound.
▪ Helicopter money:
This expression is based on the idea that the government may have the power to inject money in
people’s bank accounts in the belief that will bring about higher inflation. So, with the issuance
of CBDC, the payment to individuals can be much easier since all the citizen would have a bank
account with the central bank instead of the government having to pay a check to all individuals.
▪ Financial stability:
Transactions in a general manner would be safer with a CBDC than with a bank having
commercial risks as commercial banks, even though evolving under the guidance of central bank
still remain at their own account when it come about managing their activities. A CBDC will
surely offer an alternative lower risk options for risk adverse households.
▪ Disintermediation of banks:
This is related to the fact a CBDC will be likely to put commercial banks out of retail payment
from the moment deposits from commercial banks to CBDC would impact negatively the bank
funding and liquidity. This situation will threaten the sustainability of current bank business
model.

VI- CONCLUSION:
There is interest in exploring new technology for critical infrastructure, as a risk reduction play,
and interest in exploring letting businesses and households have digital access to real central
bank money, which has economic implications.
A central bank using a modified private fork of Bitcoin or Ethereum’s protocol software doesn’t
mean the price of Bitcoin or Ethereum will go to the moon, nor does it mean that the central bank
endorses the public cryptocurrencies. It does mean, however, that institutions are taking interest
in distributed ledger technologies to find out what these new tools can do for their operations.
The reality is that there is no time for hesitation in the side of monetary authorities. The new
financial architecture must be chosen, and this choice must be made by monetary authorities and
regulators in choosing either:
1- Central bank managed digital currency, or
2- Riskier private digital currency
In any cases, Central banks have the strongest interest to maintain control over the payment
system as well as the financial sector more broadly and to defend the attractiveness of their home
currency.

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