In a new paper, I examine the legal issues surrounding a “retail” central bank digital currency (“CBDC”), one that is used by consumers on a day-to-day basis as an alternative to cash. Most discussions about CBDC focus on its purported benefits and initial design. Little is written about how existing laws and regulations will extend to CBDCs or what new regulations will have to be implemented. My paper engages in that analysis.
The analysis assumes that future retail CBDCs will be account-based, meaning the currency will be represented by book entries in accounts that are held and managed by banks. The central bank will prescribe interest rates on these accounts and rules and regulations for their governance and use. Much of the existing infrastructure of both central and commercial banks – as well as the widespread application of that infrastructure to so-called “wholesale” electronic funds transfers between businesses and financial institutions – is already account-based, and much of the recent literature on CBDC assumes the account-based system.
Significantly, a retail account-based CBDC could use technologies largely already in place at banks and merely extend their access to more users. That is because any account-based digital currency, whether wholesale or retail, would operate through electronic funds transfers. To that extent, digital currency transfers are synonymous with electronic funds transfers.
This calls into question why retail CBDC should be regulated any differently than wholesale electronic funds transfers. As my paper shows, it should not generally be regulated differently – with relatively few exceptions, such as consumer protection.
Two primary sources of regulation currently govern wholesale electronic funds transfers. Those funds transfers are governed in the European Union by the European Directive on payment services in EU internal markets, and in the United States by Article 4A of the Uniform Commercial Code (“UCC”). Article 4A is the more relevant regulatory precedent because it covers in much greater depth the rights, obligations, and liabilities of banks and other intermediaries involved with the transfers. Article 4A’s regulatory framework for wholesale wire transfers also has been widely influential both within the United States and internationally.
Article 4A’s framework also includes a consistent vocabulary for describing funds transfers and a precise allocation of rights, obligations, and liabilities among participating financial institutions and their customers, who initiate and receive wire-transfer payments. Transferring funds from one customer’s electronic bank account to that of another customer should be the same, in principle, whether the transfer is retail or wholesale. A retail customer would initiate a funds transfer by sending a payment order to his bank; that bank would then (provided its customer’s account has sufficient funds) send a payment order through, for example, Fedwire to the beneficiary’s bank; and the beneficiary’s bank would (again, subject to receiving funds) credit the beneficiary’s account.
Thus, while Article 4A is designed for wholesale wire transfers, it should – at least with certain consumer-protection provisions – provide a suitable regulatory framework for retail CBDC transactions. To understand why, consider the key legal issues of a retail CBDC: 1. risk of loss; 2. counterfeiting protection; 3. privacy and data keeping; 4. anti-money laundering; and 5. consumer protection.
1. Risk of loss. Risk of loss includes at least three risks: mistakenly transferring funds to the wrong person; fraud risk, including fraudulently transferring funds to a wrong person; and credit risk, including the risk of the receiving bank paying out before being paid. The paper explains how Article 4A covers all of these risks.
2. Counterfeiting protection. Counterfeiting is defined as “the replication or manufacture of a financial instrument … with the intent to defraud an individual, entity, or government.” Traditionally, the counterfeiting risk for money has been concerned with illicit production of physical representations of the money, such as the unauthorized reproduction of U.S. dollar bills. The protections involve increasing the complexity and markings of bills. These concerns have no obvious parallel for an account-based CBDC.
There are two possible ways to counterfeit an account-based CBDC, although both also could be classified as fraud: by double spending and by making transfers involving an unverified account. Double spending can occur when a payor uses the same money in an account to make two purchases before the transactions clear in the payment system. Transfers involving an unverified account can occur when a payee causes the bank to credit money from a phantom account, which only appears to exist, to the payee’s account and then quickly withdraws the money. To the extent an account-based CBDC makes use of existing banking technology and systems (which is likely), these counterfeiting risks should be comparable to counterfeiting risks in current wholesale electronic banking. The paper explains how Article 4A covers both of these counterfeiting risks.
3. Privacy and data keeping. Central bank digital currencies may help to centralize data about the money supply. To the extent CBDC affects privacy – for example, by making funds transfers easier to trace – privacy and access to capital should be balanced. The paper argues that governments generally protect their citizens’ privacy better than do private entities, such as a non-government sponsor (e.g., Facebook) of a digital currency.
4. Anti-money-laundering laws. AML laws generally follow the recommendations of the Financial Action Task Force (FATF), an inter-governmental body. The FATF seeks to set standards and promote effective implementation of legal, regulatory, and operational measures for combating money laundering, terrorist financing, and other related threats to the integrity of the international financial system. To this end, it makes recommendations for an AML legal framework in member countries.
If the introduction of a CBDC leaves the commercial banking sector as the retail depository institutions, no change should be needed, in principle, to AML laws because the CBDC would not affect the FATF recommendations. In practice, however, a retail CBDC might require certain changes to AML laws. For example, FATF Recommendation 10 creates an obligation for financial institutions to conduct customer due diligence (also known as Know-Your-Customer (“KYC”) laws). If this recommendation requires every retail transaction to be scrutinized, it would impose high transaction costs due to the sheer volume of those transactions. To reduce these costs, AML laws could place a floor on the value of transfers that would trigger the need to conduct customer due diligence.
5. Consumer protection. Although UCC Article 4A covers many domestic and international electronic funds transfers, it was designed for use by relatively sophisticated parties, such as businesses and financial institutions. In contrast to Article 4A, the Electronic Funds Transfer Act (“EFTA”) focuses on consumer protection in electronic funds transfers. For example, the EFTA limits consumer liability for unauthorized transactions, ensures that banks adequately inform consumers of their rights, protects consumers from being charged excessive fees, and gives consumers a means of redressing erroneous transactions.
CBDC regulation thus should draw from Article 4A to the extent such regulation governs how electronic funds transfers should occur – through a series of payment orders between clearly defined parties – and how generally to allocate rights and obligations between those parties. CBDC regulation also should draw from the EFTA to the extent regulators regard retail users of CBDC to need overriding consumer protection.
Finally, my paper shows why the technology required to manage a real time, low-cost, retail CBDC should be feasible.
This post comes to us from Steven L. Schwarcz, the Stanley A. Star Distinguished Professor of Law & Business at Duke University and senior fellow at the Centre for International Governance Innovation. It is based on his recent paper, “Central Bank Digital Currencies and Law,” available here.