Replacing cash: Binance assesses the economic impact of creating a digital ruble

The digital ruble marks a step in the evolution of Russia’s wholesale and retail payment systems, but the potential benefits depend on the ultimate form of the asset’s implementation, according to an analytical report by the cryptocurrency exchange Binance and Mindsmith.

Key findings

CBDC offer clear advantages in convenience, efficiency, stability and access to retail payments.

As demand for cash declines and there is no alternative in the form of CBDC, citizens will lose access to central-bank money. In that case, trust in the national currency will depend on the authority of financial intermediaries.

Among the positive results of implementing the digital ruble are:

• providing an effective substitute for cash in combination with control over illicit use of the asset;
• ensuring financial stability;
• reducing banks’ role in money creation.

Preferred model of the digital ruble

The model of the digital ruble described in the Bank of Russia’s report envisions that commercial banks will gain more powers in terms of managing user wallets. In a sense, this would constrain the flexibility of the centralised model.

Public accessibility and traceability: how the Bank of Russia sees the digital ruble

On the other hand, such a format would create favourable conditions for active involvement of fintech companies in improving convenience and efficiency of operations for end users, and would become the basis for rapid development of market competition.

The account-based implementation of the digital ruble appears to be a much simpler alternative to the proposed model and could help combat money laundering. This option could also ensure a high level of security and control of CBDC issuance without requiring solutions with complex architecture and costly computations.

Impact of the digital ruble on other market participants

CBDC could potentially destabilise deposit funding at commercial banks. Even if the digital currency project is primarily designed as a payment instrument, during crises there could be large-scale outflows of economic agents toward the central bank.

Under a stable financial system, commercial banks could offer the public an effective alternative to the digital ruble: compensating credit risk with higher interest rates or a broader range of services.

However, in an economic shock, higher deposit rates are unlikely to stop transfers to other banks, to cash, or to central-bank accounts that would become available with the digital ruble.

Given the multifaceted risks, potential participants in the project should begin by agreeing on each party’s role and legal responsibilities.

The Bank of Russia could diversify risks and task an independent third party with the development, integration or operation support of the digital currency. Or it could create an independent governing body to reduce workload and related expertise requirements.

Privacy of the digital ruble

The desire to preserve anonymity is not necessarily tied to illicit activity. While even a stable, trusted and fully confidential digital currency could be used for illicit transactions.

If CBDC transactions become fully public, such a digital currency is unlikely to reduce demand for private forms of money and will raise concerns about excessive surveillance.

Anonymity of the digital ruble is not a binary trait. In intermediate variants, users can register using their identifiers to create CBDC accounts. Data can be stored anonymously if, for example, transactions do not exceed a threshold or regulators have no grounds to suspect that an account is linked to illicit activity.

The design of the digital ruble should be carefully balanced to avoid competing with banks’ deposits and to reduce the risk of degradation of financial intermediation.

Key properties of the digital ruble

Accessibility

Existing retail and wholesale payment systems ensure stability by restricting access. In cryptocurrency systems, barriers to participation are minimised, and stability rests on a system of economic incentives and technical measures to deter attacks.

This does not mean CBDCs should fully adopt cryptocurrency approaches to create a completely open system. The Bank of Russia could benefit from models of cryptocurrencies such as Bitcoin.

Use of distributed ledgers

Choosing the infrastructure for implementing various CBDC models is one of the key design questions, as requirements differ substantially across deployment scenarios. The use of blockchain within CBDC can significantly contribute to creating a technological environment and expanding the use of financial technology.

In the context of models considered by the Bank of Russia, decentralisation could occur at two levels: access for new participants to the system (wallet-opening level) and the processing of transactions (settlement level).

A token-based system can provide universal access and privacy, since any user can obtain a digital signature. One serious drawback is the high risk of loss of funds if end users do not safeguard their secret keys. Issues can arise in developing an effective anti-money-laundering system.

Even if the Bank of Russia decides to abandon blockchain as the base infrastructure for CBDC, some features of the technology may still be useful.

Smart contracts and programmability

The digital ruble should have sufficient functionality to enhance the usability of central bank money, support innovation and interaction with other payment systems. Therefore, experiments with the asset should begin with the minimum programmability required to implement the necessary functions.

At the same time, the digital ruble should be designed with future scalability in mind.

Should the digital ruble be adopted everywhere?

In the stage of broad commercial deployment, universal adoption by retail and service enterprises is a prerequisite for effective popularisation.

Potential integration of the digital ruble with payment systems MIR, Visa, Mastercard, UnionPay and others would have strong mutual synergies. They could become powerful partners in ensuring the mass diffusion of the digital ruble.

How to secure the digital ruble and its users?

The digital ruble must meet high security standards in terms of technology and user characteristics.

Acceleration of financial-sector digitalisation will present new opportunities for cybercrime. Decentralisation via blockchain could increase the number of attacks, and a new level of automation via smart contracts could foster threats.

To secure it, the following should be provided:

• Accessibility of the digital ruble — ease of use, and the system’s ability to withstand large-scale classic and blockchain-specific cyberattacks.
• Integrity — protection against double spending, fraudulent debits and unauthorised access to hardware devices.
• Privacy — features that minimise both the amount of stored information and multi-level access to it.

What about offline payments?

To align with key features of cash, the digital ruble should allow autonomous online payments, be easy to use and provide a sufficient level of privacy protection.

In the early stages of CBDC development, it could be implemented without offline-payment capability. However, as wide-scale testing progresses, such a capability should be ensured for all market participants on equal terms.

Why the digital ruble is needed?

The deployment of CBDC potentially addresses a range of challenges whose relevance has grown significantly in recent years:

• declining popularity of cash and rising share of cashless payments amid fintech development;
• increased competition to national currencies from cryptocurrencies, DeFi tokens, and projects such as Diem (formerly Libra);
• central banks achieving an effective lower bound on interest rates and reducing monetary instruments;
• the obsolescence of many payment infrastructures.

What should the digital ruble be like and what will it deliver

The Bank of Russia has identified two models of owning the digital ruble. The first is based on central-bank deposit accounts for all households and businesses. In terms of functionality, they would resemble ordinary bank deposits, including online-solutions and mobile apps, and commercial banks could offer services to exchange bank deposits for CBDC with a possible fee.

As an alternative, the Bank of Russia could offer a token-based digital currency with minimal regulator influence. Such a concept could be popular among central banks due to potential anonymity of CBDC. In this case, the regulator would not know who currently holds issued tokens, as with cash.

Enhancing the efficiency of retail payments

There are several arguments that support CBDC’s importance for enhancing the efficiency of retail payments:

• reduction in demand for banknotes;
• low household access to the commercial banking system, which can occur both in the least-developed countries with underdeveloped banking sectors and in countries with relatively high income inequality;
• unstable or overly concentrated retail-payment infrastructure.

For central banks, the most common reasons for adopting CBDC are its security, the improvement of financial stability and the accessibility of financial services.

Replacing cash and controlling illicit use

Some researchers analysing privacy issues of payments and anonymity of CBDC worry that the lack of anonymity would substantially limit citizens’ freedom.

Overcoming the lower bound on interest rates

If CBDC is used to fully replace cash, this could theoretically push interest rates to the effective lower bound. A CBDC-powered economy could enhance the effectiveness of monetary policy during financial crises.

This would help in addressing recessions, unemployment or deflation, and in the need to resort to unconventional monetary policy measures.

Developing monetary-policy tools

CBDCs could potentially broaden the toolbox of monetary policy and raise its overall effectiveness through adjustable interest rates.

This does not mean that paying interest on the digital ruble is a necessary and sufficient condition for the instrument’s effectiveness. However, such a scenario should be considered at least within an experimental study of the digital ruble concept.

Optimising stimulus measures

CBDCs could be used as a tool to boost aggregate demand. For example, by direct distribution of created digital money among the population, which could in the longer term facilitate achieving price stability.

Ensuring financial stability

CBDCs would enable the concept of sovereign money – a system where banks would no longer create demand deposits and new funds.

Settlements in central-bank money could potentially reduce credit risk in payment systems. This would reduce the importance of large banks, the need for government guarantees on deposits and adverse externalities of financial destabilisation.

CBDCs could effectively replace cash in contexts of retail points with stable internet connection. However, applying CBDCs to autonomous peer-to-peer payments requiring a robust and fault-tolerant network infrastructure remains a matter of debate.

In the context of a “narrow” banking system, CBDCs gain significance as an alternative to deposits, combining zero credit risk with a digital format.

Advantages and drawbacks

Given the uncertainties around CBDC adoption for commercial banks, a number of potential advantages and disadvantages stand out.

Advantages:

• streamlining and speeding up interbank settlements could boost customer loyalty;
• reducing barriers to becoming a payments provider because of moving from a multi-tier banking system to a CBDC-based distributed system would increase competition in the payments sector. In the long run, this would lower transaction costs;
• potential replacement of correspondent banks with a single CBDC-based transaction platform would increase transaction speed and transparency of payments;
• introducing a peer-to-peer direct interbank payment mechanism would reduce credit risk and settlement risk for counterparties, freeing up substantial collateral.

Drawbacks:

• the initial cost of implementing a CBDC-based interbank settlement system would exceed the costs of using real-time gross settlement systems at the early stages. During the transition, the traditional and new infrastructures would need to operate in parallel;
• potential simplification or elimination of correspondent relationships between banks and a reduction in transaction costs could erode banks’ profits;
• lowering barriers to becoming a payments provider and intensifying competition among banking organisations could reduce the revenues of providers of traditional services.

The above drawbacks are largely tied to the very transition itself. Yet higher competition and lower costs are a persistent trend among existing payment systems, driven by technological and regulatory innovation.

If the digital currency were built on blockchain, the effects would be as follows:

Benefits:

• strengthening trust in the national monetary system through greater transparency and traceability of transactions, and the effectiveness of anti-money-laundering procedures. In the CBDC context, blockchain can address concerns about privacy through secure distributed storage and cryptographic protections;
• CBDC potentially serves as an alternative to tools for absorbing excess liquidity (for example, [simple_tooltip content=’Purchase of securities with a resale obligation’]repo operations[/simple_tooltip] or [simple_tooltip content=’An auction in which the central bank takes deposits from commercial banks’]deposition auctions[/simple_tooltip]), and expand the central bank’s liquidity-management capabilities;
• modernisation of the settlement system will lead to substantial optimisation in terms of flexibility, scalability and resilience, since any validator can verify the validity of a transaction;
• The CBDC settlement system could function as an alternative to existing payment systems, promoting greater diversification of payment processes and currency systems.

Negative consequences:

• risks of compromising confidential payment data. The CBDC project will require significant efforts in fine-tuning the degree of transparency and traceability of transactions;
• increased legal risk due to additional complexities connected with harmonising regulatory frameworks across jurisdictions;
• reduced income, stemming from the simplification of correspondent relations, could force commercial banks to compensate via riskier lending.

Key anti-money-laundering functions should be performed by banks and financial intermediaries themselves. However, such a model would raise the risk of misbehaviour by market participants. Therefore, the Bank of Russia should pay enhanced attention to standardisation and the creation of unified centralised platforms and KYC-questionnaire databases.

One of the incentives for developing the digital ruble is to curb demand for private forms of money.

In the deployment phase, when demand for CBDC relative to bank deposits may still be subdued, the central bank must pay attention to the consequences of dispensing with intermediary banks. In any concerns about a bank’s condition, the simple ability to convert deposits into CBDC could trigger outflows and affect financial stability.

Privacy of user information will also be a stumbling block in choosing the final design of the digital ruble. The initial design should embed characteristics that minimise both the amount of stored information and multi-level access to it. The ultimate success of the digital ruble depends on the anonymity provided.

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