CBDC Risks and Mitigation


Last week the paper ‘Central bank digital currencies for cross-border payments’ was published, authored by the Bank for International Settlements (BIS), the International Monetary Fund (IMF) and the World Bank. It gives a glimpse into the implementation of Central Bank Digital Currencies (CBDC) by looking at the risks and benefits of various designs.

The benefits of CBDCs include faster and cheaper transactions. But the use of blockchain-based fiat currencies brings compliance risks, privacy issues and macroeconomic dangers. Here Coinfirm takes a look at those potential threats and the outlined recommendations.

Tax Avoidance and Circumvention of Sanctions

FinCEN roles as a ‘global’ AML authority may be hindered. 

Section 3 of the PATRIOT Act – which expanded the scope of AML in the U.S. – gave oversight to financial regulators of clearinghouses. Because of the U.S. Dollar’s current role as the world’s reserve currency, the deep liquidity and stability of the system are regularly used to conduct international fiat currency swaps (USD’s share of currency reserves reported to the IMF was 59.5% in Q1 of this year).

However, with mCBDCs (multiple CBDCs, i.e. projects that central banks share) or CBDCs that are interoperable with one another, the need of correspondent banks or clearinghouses for foreign banking institutions with higher risks of illicit fund flows will diminish, possibly opening up avenues for sanctioned entities to easily circumnavigate U.S. restrictions.

CBDC Risks
Source: BIS CBDC for cross-border payments

Although the BIS paper notes the “integration of capital markets has supported […] growth for at least half a century”, it realizes the “decline of cross-border banking relationships for the past decade might leave some jurisdictions with inadequate access to the global financial system.” A possible nod to the recent trade wars and sanctions followed by counter-sanctions of major economies.

Faster Settlements, Faster Crashes

The intertwining of the global financial system is so strong that crashes in one jurisdiction quickly spread contagion and fear to others, leading to most stock indexes crashing in synchrony. 

With the benefits of CBDCs’ cheaper and faster settlement rates (i.e. a system operating 24/7 vs. one dependent on differing operating times of originating, respondent, correspondent and receiving banks to transactions), this reduced timeframe, according to the BIS paper, opens the door to “runs on both domestic banking sectors and currencies. Currency substitution, as in runs away from a currency, could be rapid. For many emerging markets and developing countries, even at present, a run on the banking system is often effectively a run on the national currency as funds leave the country.” 

CBDC Risks
Source: BIS CBDC for cross-border payments

The paper offers the possibility of mitigating this risk through design choices, such as “requisite onboarding protocols for users and merchants, or tactical pricing mechanisms (eg fees on very large or frequent cross-border transactions) could limit cross-border use.”

This ease of use of a foreign CBDC in a certain economy could also lead to more increased currency substitution – foreign currency deposits are above 50% in more than 18% of nations worldwide. There is a possibility that central banks themselves can step into this void to conduct FX conversion operations themselves, with 14% of central bank respondents noting they are considering this. 

CBDC Risks
Source: BIS CBDC for cross-border payments

CBDC Cross Border Flow Risks

The BIS paper notes that the volatility of capital flows may grow as “herd effects” materialize, adding that the remedy for this could be to “preclude or limit their use outside the issuing country, or wallets in recipient countries could be designed to allow local authorities to implement certain capital flow management measure. In addition, the programmability of CBDcs could potentially be used to limit their circulation.”

CBDC Risks

Retail, Wholesale and mCBDC

The paper covers the benefits and risks of mCBDC (multiple Central Bank Digital Currencies), and looks at the difference between retail and wholesale CDBC projects. 

A multiple Central Bank Digital Currency is a project that is shared by a number of central banks.

A retail CBDC entails the use by all individuals and companies, seen as a digital version of cash.

Wholesale CBDCs on the other hand are only able to be utilized as a settlement asset in the interbank market by certain institutions.

CBDC Risks
Source: BIS CBDC for cross-border payments

CBDC KYC and AML Risks

Compliance oversights on Know-Your-Customer (KYC) can lead to further issues down the line, as the BIS report notes it “guarantees the system’s safety and integrity, by preventing fraud and bolstering efforts to counter money laundering and other illicit activities.”

To counter unwanted volatility in cross-border flows and the balance of payments, restrictions of the CBDC’s use by foreigners among other limitations could be instituted, with an imposed “digital identity” inbuilt by design, becoming a policy choice for central banks. This digital identity may make it easier for cooperation between central banks of “know-your-customer (KYC) processes, AML/CFT monitoring and, relatedly, agree on the level of privacy granted to users when making/receiving cross-currency payments.”

CBDC Risks
Source: BIS CBDC for cross-border payments

The paper laments on the lack of uniformity of Anti-Money Laundering and Countering the Financing of Terrorism regulatory oversight between jurisdictions, noting that “cross-border payments suffer from low traceability and lack transparency, causing frictions regarding AML/CFT checks”, which is further hindered by the lack of “interoperability and standardisation” in cross-border transactions.

Privacy Risks of CBDC 

How effective AML tools are with the various CBDCs could depend on the design. If a CBDC operates with a permissionless (public) blockchain AML tools will be strengthened whilst a permissioned (private) distributed ledger may be detrimental to the monitoring of AML/CFT. 

Whilst the BIS paper stresses the “safeguards on data privacy“ due to the “Hippocratic Oath for CBDC design”, another central bank’s paper looks specifically at the privacy concerns around CBDCs. The European Central Bank (ECB) in its research paper ‘Exploring anonymity in central bank digital currencies’ – issued in December 2019 – looked over the concept of “anonymity vouchers”, where users are given vouchers by the AML authority that are spent at a “ratio of one voucher per CBDC unit transferred”. This novel concept allows some anonymity that can protect some users’ privacy. The European Union’s privacy law, the ‘General Data Protection Regulation’ is one of the most comprehensive pieces of legislation around the world dealing with privacy rights, thus it is unsurprising the ECB would explore the concept of privacy around CBDCs so closely. 

CBDC Risks

Programmable money certainly raises some privacy concerns, with a notable example. The People’s Republic of China has trialled the use of expiration dates of its e-CNY CBDC – opening the door to another option of a more effective fiscal stimulus. In addition, the tying of the e-CNY to individuals’ social credit scores means the ability to collect fines as soon as they are imposed. Programmable fiat enables the tracking and analytics of how money is spent. For instance, the disbursement of farming subsidies can more effectively know if the money is actually being spent on agricultural goods, or indeed, the restriction of the ear-marked funds to only be spent at agricultural goods vendors. 

Whilst the examples above are seen by many in the crypto community as anti-theoretical to the concept of Satoshi’s vision of blockchain, private stablecoins give rise to other risks. These concerns by central supervising bodies were covered by Coinfirm previously and alluded to in the BIS paper on risk mitigation of remittance corridors and currency substitution in that the “level of collaboration is likely easier among national authorities than it is among private issuers of money.” 

The volatility of the wider crypto markets make them difficult for the majority of those in an economy not prone to hyperinflation to earn, spend and save in them. 

Analytics of Funds Flows

Crypto analytics continues to demonstrate on a daily basis how AML controls are more powerful. As everything on the blockchain is traceable, crypto compliance controls have shown how the approach is more efficient. 

Coinfirm aids government bodies on an ongoing basis, such as curating a tailor-made blockchain service to record transactions of all Polish government bonds and helping the government of Gibraltar to combat illicit crypto fund flows.