LocationsHow can CBDCs be Designed to Drive Financial Inclusion?
August 30, 2024
As a new form of national currency, central bank digital currencies (CBDCs) hold the potential to be a transformative innovation that can enhance financial inclusion. However, the realization of this potential is very much contingent on their design. The realization of the benefit is also influenced by the barriers to financial inclusion that were identified in our first blog such as financial literacy, digital divide, and complexity.
This second blog will explore CBDCs’ intentional (inclusive) design, first delving into the perspective of users; then shifting to the viewpoints of key decision-makers, like central banks, focusing on trade-offs. A note to readers: there are many CBDC design features, and this blog does not intend to provide an exhaustive list of these. This blog for example does not cover technology considerations (e.g. blockchain considerations). Given that accessibility is a key marker of financial inclusion, this blog will focus on the accessibility of CBDCs by users, including individuals and merchants. Here, accessibility concerns the “software” (e.g. knowledge, education, other support from the state) and “hardware” (e.g. device, infrastructure).
Designed for users
If CBDCs are used as a digital payment innovation to promote financial inclusion, the CBDC adoption rate (including the acceptance of CBDC payments by merchants) is a key indicator of their accessibility. In this section, we will explore how CBDCs can be designed to promote accessibility; there is an array of theories that could be applied for this exercise, and this blog utilizes sociologist Everett M. Rogers’ innovation adoption framework. Rogers’ framework identifies five attributes of an innovation that affect the adoption of an innovation, and these attributes align closely with the context of CBDCs. The accompanying graph illustrates these attributes from the perspective of CBDC users, and is followed by an analysis with design suggestions that may enhance financial inclusion.
Five attributes of an innovation that affect the adoption of an innovation, from the perspective of CBDC users
(i) Relative advantage
Relative advantage refers to the degree to which an innovation is perceived as superior to the current practices. CBDC designs should ensure that CBDCs offer low-cost and safe electronic payment services to unserved and underserved populations, reducing costs (e.g. cash withdrawal and management costs). The low-cost and safe CBDCs are important for individuals and merchants such as those marginalized by the prevailing financial infrastructure. That said, such advantages may already exist in the form of various mobile money and real-time payment systems. Therefore, CBDCs need to show other potential advantages such as offline payments, accessibility by the public (including vulnerable people such as people with motor, cognitive, or sensory disabilities) to direct claims over a central bank in the digital age, and programmability. Another critical issue is whether CBDC users should receive refund for losses caused by fraud, unless the loss is due to the user’s own fault.
Beyond cost savings, CBDCs can serve as a gateway to more sophisticated financial services. Design variables include allowing non-banking financial institutions to distribute CBDCs, which could improve access to credit information. With customer consent, transaction data from CBDCs could be shared with financial institutions (e.g. credit providers) as an alternative to traditional collateral or detailed credit histories, while ensuring data protection. Such credit information could enable financial services to be tailored to users’ needs (e.g. loans). Integration with other initiatives, such as open banking and instant payment systems, can also enhance their utility and reach. Through integration with e-commerce, CBDCs can provide access to a wider range of products and services at more favourable prices, encompassing e-commerce options that often reduce the costs of goods and services. Meanwhile, the design of CBDCs necessitates robust privacy protection to address privacy concerns, and the provision of digital public infrastructure to facilitate such services.
(ii) Compatibility
Compatibility means the extent to which an innovation aligns with the values, experiences, and needs of potential adopters. To serve the varied user base, it is critically important to understand the specific needs (e.g. money needs such as conducting transactions and getting credit, and the needs of users with disabilities) and concerns (such as privacy, safety, the possible lack of technical preparedness) of the user population. For example, stakeholders in certain economies may worry that programmability (the ability to embed automated and conditional functionalities) could limit the users’ spending choices.
To illustrate, safe and resilient CBDC designs should be explored for consumers living in remote areas and for situations where internet connectivity is limited, too expensive or unstable and advanced phones are not widely used. These designs should enable CBDCs to work smoothly in online and offline scenarios, and ensure performance is not compromised by natural disasters and/or cyber-attacks. It is essential to consider offline solutions for CBDCs from the get-go, even if they are not immediately implemented. The e-krona pilot shows that offline function needs extensive cooperation efforts across regulation, technology, and processes.
(iii) Complexity
Complexity refers to the degree to which an innovation is regarded as difficult to understand and use. Careful design is necessary to prevent unintentional or inadvertent exclusion, especially taking into account the financial literacy gaps mentioned in our previous blog. This is relevant for the end-to-end processes of CBDC, ranging from CBDC issuance to dispute settlement. Efforts are needed to provide awareness and capacity (digital competencies) for the populations. Simplifying access to CBDCs, including for vulnerable groups, is also essential. This involves ensuring easy access to CBDC wallets, designing CBDC interfaces that are easy to use, and explaining the terms and conditions in simple language. Access requirements (such as whether and what proof of identity is needed to open CBDC wallets), user interfaces (e.g. easy and straightforward instructions for people with low literacy) and terms and conditions (such as ones with simple and clear explanations) should meet user needs. This includes catering to users with disabilities and those new to financial services. CBDC users should also be aware of which agencies handle complaints and disputes, and resources should be provided to support users in seeking remedies. Looking at the bigger picture, as inclusion can also be driven by social or gender norms, these must be taken into account throughout the design process.
(iv) Trialability
Trialability means the extent to which an innovation can be tested. Trialability involves the comprehensive test of use cases (e.g. offline payments which are useful for users without internet access), assumptions, safety, and user feedback to refine CBDCs. Taking safety as an example, it includes a reporting mechanism for problematic attempts and threats.
Trialability could be conducted in various ways, ranging from pilots to sandboxes. Pilots may determine if advanced phones are necessary for CBDC applications or if offline CBDC payments can be facilitated on feature phones. Pilots can test existing infrastructure (e.g. telecommunication connectivity such as internet access) and new infrastructure (e.g., potential cloud-based infrastructure that supports CBDCs) to see if a seamless user experience is ensured. Sandboxes could be used, in which regional sandboxes shall consider different national regulations and practices.
(v) Observability
Observability refers to the extent to which the outcomes of an innovation are apparent to other people. Observability is how well CBDCs are publicized and understood, and how users can see their outcomes, such as in user reviews. The visibility and outcomes of CBDCs are significant factors in promoting financial inclusion and better financial health (e.g. the easier access to digitally-enabled financial services by the public). This also means, among other things, that CBDCs need to be improved quickly based on users’ feedback and that education is needed.
To build trust in CBDCs, it is advisable that CBDC designs ensure the transparency of the CBDC system, privacy protection, and measures against possible problems. These problems include fraud faced by individuals and firms (including PINs being compromised), users forgetting or losing PINs, and users not protecting the PINs’ confidentiality.
Status of CBDCs worldwide
Perspectives of decision-makers
Now let us turn to the perspective of key decision-makers, particularly central banks and regulators. Regulation is needed to prevent and address financial exclusion and other risks (e.g. cyber risks including identity theft, privacy intrusion).
Regulation applies to merchants, including service providers such as payment operators, and other non-central-bank actors. Relating to accessibility, the potential involvement of new actors in the CBDC system such as telecommunication operators and technology firms can help expand access to CBDCs. This also necessitates regulation including that of CBDC outsourcing, internal controls of the actors, including those conducting Know Your Customer (KYC) checks, and consumer protection. Consumer protection measures include the disclosure requirements of fees and costs if any required for CBDCs, arrangements to prevent fraud (such as in economies without a well-developed national ID system), the ceilings for CBDC holding and transactions, and dispute settlement mechanisms.
In particular, CBDC design and regulation need to make trade-offs. Trade-offs are crucial to address different considerations as discussed below.
Trade-offs
If the decision to issue a CBDC is made based on a careful assessment of its pros and cons, decision-makers must navigate trade-offs that will affect CBDCs and their potential to enhance financial inclusion. Examples of these trade-offs include:
Lessened KYC requirements vs. combating crime: CBDCs can improve access to financial services at the grassroots level by, for instance, reducing KYC requirements for low-value transactions. However, they may also be exploited for illegal activities (e.g. money laundering, terrorism financing, proliferation financing). In particular, how will the lack of identification of certain groups be addressed?
Limited resources vs. the high demand of CBDCs for resources: Many countries, especially developing countries, have limited resources (e.g. technical knowledge, regulatory experience, financial ecosystem engagement capacity, sandboxing infrastructure, supervisory technology) to manage the complex technological and regulatory demands of CBDCs.
Data sharing vs. data protection: Data includes a large amount of personal, transaction, and financial data. If properly managed, data sharing may be used for purposes such as developing new applications and facilitating AML/CFT checks. This brings benefits such as efficiency gains and cost recovery. Such benefits shall be carefully balanced with the imperative to safeguard privacy (including the protection of personal data) and prevent irreversible data loss. Privacy protection would likely lead to tiered CBDC wallets: lower tier wallets have lower physical or digital user identification requirements and low ceilings for CBDC holding and transactions, higher tier wallets have higher user identification requirements and high ceilings for CBDC holding and transactions. Data governance deserves special attention. This involves the question of whether a central bank will hold the records of CBDC holders, how and where to store data and update the records, and whether users can delete their CBDC data.
Low fees vs. cost recovery: Low-cost or free use of CBDC would help to promote CBDC accessibility. However, cost recovery is important to ensure the accessibility in the long run. CBDCs are likely to be resource-intensive. They require funds and expertise to develop ever-evolving CBDC infrastructure that is secure and resilient (e.g. upgrading of software and hardware such as data centres and terminal devices of merchants), and provide resources for different purposes (e.g. the education of users, the fight against fraud, dispute settlement). CBDCs call for the continuing investment of not only central banks, but also other actors (such as commercial banks and merchants). Therefore, low fees need to be balanced with cost recovery.
In navigating trade-offs, it is crucial to engage both the broader financial ecosystem and the public, and coordinate policies. This ensures that national objectives surrounding anonymity, risk mitigation, and financial inclusion can be adequately met. For example, the trade-offs between financial inclusion and combating crimes require coordination between central banks and different agencies (e.g. law enforcement agencies) to mitigate risks (e.g. money-laundering, terrorism financing, double spending, digital counterfeiting).
Joint efforts (e.g. joint development of CBDC technology, the sharing of regulatory experience and expertise, technical assistance) at the international and regional levels will provide public goods, reduce regulatory arbitrage, and avoid other undesirable effects (e.g. increased digital divide with the use of CBDCs). For example, knowledge sharing is essential for overcoming capacity limitations. Since there is no universal approach to CBDCs, strategies must be tailored to individual countries, considering their contexts (such as risks). That said, minimum regional or international standards could be explored for crucial issues such as privacy protection. Moreover, international guidelines may be developed and best practices if any could be shared over time. These efforts are necessary to foster financial inclusion.
In our first two blogs, we have explored the state of play on financial inclusion, related key challenges and opportunities, and the potential of CBDCs to address these issues. We then delved into how CBDCs can be intentionally designed to drive financial inclusion. In our next and final blog, Professor Wang will illustrate a practical guide to driving financial inclusion through CBDCs. Stay tuned for a multifaceted assessment that includes practical considerations from policy environment, to legal framework, privacy and cost factors, tech readiness, and complementary policies to help design CBCDs with inclusivity.