Caspian Basin Central Banks Join the Central Bank Digital Currency Bandwagon

^{With digital currencies on the rise, our days of "popping into" the neighborhood bank may soon be over. Tehran, Iran - October 15, 2016. Image: Fotokon/Shutterstock}

People use money for three main purposes. As a medium of exchange, they use it to buy and sell goods and services. As a unit of account, money allows people to price real and financial assets. And as a store of value, they can use money as a measure of purchasing power. Not surprisingly, the concept of money was first developed by civilizations with high levels of trading activity, such as those along the ancient Silk Road, which passed through the Caspian region.

The first coins were invented in China between 800 and 700 BC, while around a century later, the first official gold and silver currency was minted in Lydia, an ancient kingdom in what is now western Turkey. Initially, the value of the coins would come from the value in the precious metals of which they were made. Around 1500 years later, it was China again that began using paper money currency. For a millennium thereafter, most banknotes were ‘representative’ currencies, i.e. their value was based on an explicit official promise that, on demand, they could be exchanged for the agreed value in gold, silver or other commodities. Fast forward to today, and we find that most countries use ‘fiat’ currency, the value of which depends on faith in both government and currency. This might still be in the form of bills and coins but is mostly transacted in electronic form, and its value is maintained by general agreement rather than based on a finite store of commodity reserves. What has remained constant until very recently is that state authorities, now generally known as ‘central banks,’ control the money supply in the economy. Even Marco Polo mentioned that China’s 13th-century emperors had a good handle on their country’s money supply.

Bitcoin and the Rise of Digital Currency

Today, money has evolved into a virtual form through the digitalization of contactless and cashless payments. We can transfer money from one country to another in a matter of days, if not hours. This comes with two issues. Firstly, traditional transactions involve multiple intermediaries and are regulated by central banks, slowing the transfer of money. Secondly, governments carefully regulate the amount of money in circulation, increasing or decreasing the money supply depending on whether they want to control inflation or stimulate the economy.

To circumvent these issues, in 2008, a pseudonymous individual, Satoshi Nakomoto brought the first cryptocurrency to life. In a 9-page white paper, he/she described a digital currency that would allow secure, peer-to-peer transactions without the involvement of any middleman, whether that be the government, financial system or a company. These transactions would go through a network-linked “distributed ledger” or a “blockchain” secured by cryptographic functions and viewed and approved by all network participants. The supply would be limited – there would never be more than 21 million Bitcoin. That’s in stark contrast to today’s fiat currencies, with which any central bank is free to print money at will, potentially undermining their currency’s value.

More than 60 central banks, including some in the Caspian Basin countries, are now working to develop a central bank digital currency (CBDC).

Today, Bitcoin is just one of over 4,000 cryptocurrencies that private parties have developed. Investors hope that at least some of them will one day be used as a medium of exchange. But for now, cryptocurrencies are bought almost entirely as a store of value. The growing popularity of privately-made cryptocurrencies has thus created a universe in which two very different forms of money can be digitally exchanged – fiat money supplied and reserved by commercial and central banks, and cryptocurrencies that are transferred through decentralized cryptographic functions. This forces central banks around the world to think outside the box. More than 60 central banks, including some in the Caspian Basin countries, are now working to develop a central bank digital currency (CBDC).

Two Main Forms of CBDC, “Retail” and “Wholesale”

Retail CBDC essentially tries to improve the process of making payments between individuals and businesses. Given that most of us are already using online payments daily for our household purchases, you might reasonably wonder whether that isn’t simply re-inventing the wheel.

The point, as mentioned above, is simplification. Currently, if you purchase something, the payment process goes through three stages: 1) the originator and beneficiary are verified and authenticated, and the payment instructions are validated; 2) Payment data is matched, verified, and cleared to make sure that funds are indeed available; 3) The funds are transferred, and the settlement process is completed with confirmation to both parties. Usually, this process involves commercial banks (or mobile network providers in areas of the world where the banking infrastructure is undeveloped). As you can see, this three-stage process involves many parties, not just the Central Bank.

Retail CBDC can come in two forms – simple deposit accounts in a central bank or digitally issued tokens. In the first case, businesses and individuals open an account in a central bank and make the payment. Digital tokens are e-bills or e-coins issued by a central bank. The first case does not depend on commercial banks as much as digital tokens, and the process is more straightforward than the current payments system. With direct retail CBDC, a central bank can validate the parties, approve transactions and carry out settlements with, in most cases, no intermediaries. There could be a hybrid version, where commercial banks still interact with individuals and businesses, but a central bank validates payment instructions and carries out settlements. In a nutshell, CBDCs would be faster, efficient, and more secure. In this, they share appealing aspects of cryptocurrencies like Bitcoin, but with the key distinction that they use centralized systems where a central bank regulates the money supply. That’s in contrast to cryptocurrencies, where encrypted algorithmic platforms regulate the coin supply in a decentralized fashion based on “necessary proof of work” procedures. These procedures require members (“nodes”) to validate new blocks of payments to be added to the blockchain, in essence keeping the central ledger in a decentralized form.

There could be a hybrid version, where commercial banks still interact with individuals and businesses, but a central bank validates payment instructions and carries out settlements. In a nutshell, CBDCs would be faster, efficient, and more secure.

Along with retail CBDCs, central banks are also working on “wholesale CBDCs” designed to transfer funds and assets between local and cross-border businesses. These are large-volume transactions involving institutional counterparties, some of which are “systemically important financial institutions.” The current payment system involves several steps and intermediaries. With the application of wholesale CBDC, this process can be conducted between two central banks that hold accounts with each other or between two banks that hold wholesale CBDC accounts in their respective central banks.

CBDCs and the Caspian Basin

Amongst the Caspian Basin countries, Iran, Kazakhstan, Russia and Turkey are ahead of the pack, being very active in the rapidly developing cryptocurrency universe. The Central Bank of Iran announced on 15 May 2021 that it had drafted an executive plan to issue an Iranian CBDC for discussion by a special expert committee. Kazakhstan, which already ranks among top countries for “block reward mining” (the cryptocurrency creation process that rewards intense computer-based virtual “digging” for value), has also announced plans to regulate the industry to bring all transactions to organized markets such as the Astana International Financial Center. In May, the Central Bank of Kazakhstan also released an early digital Tenge (the Kazakh currency) for comments and discussions. From the draft document, it appears that sometime in 2021, Kazakhstan plans to start a pilot project to test retail CBDC in the form of digital tokens where one token = one tenge.

On 14 April, the Bank of Russia announced a three-year roadmap for developing a CBDC on a hybrid platform combined with distributed ledger technology. The plan envisages a two-tier retail model with the Bank of Russia both issuing digital Rubles and operating the platform. Financial institutions will continue to serve their clients through digital wallets that they will be able to open through the central bank.

Turkey is among the top 10 countries making progress toward retail CBDCs designed to be held directly by citizens and corporate bodies. According to its Economic Reforms Calendar announced in March 2021, the Central Bank of Turkey… will develop the economic, technological, and legal infrastructure for digital Lira by the end of 2021.

Turkey is also leading the wave, which is not surprising given reports of the popularity of cryptocurrency trading in the country. In fact, according to PwC Global CBDC Index, Turkey is among the top 10 countries making progress toward retail CBDCs designed to be held directly by citizens and corporate bodies. According to its Economic Reforms Calendar announced in March 2021, the Central Bank of Turkey (in cooperation with the Presidential Office of Digital Transformation) will develop the economic, technological, and legal infrastructure for digital Lira by the end of 2021. Shortly after this announcement, the head of Turkey’s central bank, Şahap Kavakçıoğlu, commented that new regulations would be coming soon regarding cryptocurrency trading and its use for payments.

Among the South Caucasus economies, Georgia seems to be making the greatest strides. Earlier this year, the National Bank of Georgia announced that it is considering a publicly available CBDC to leverage new technologies, enhance payment efficiencies and promote financial inclusion. They are initiating a public-private partnership to engage private developers and fintech companies to join efforts to explore and solve issues facing CBDC adoption.

In 2016, Azerbaijan adopted a state program to improve the digital payments infrastructure and increase cashless payments. The program did not explicitly lay out plans for the development of digital currency. Still, it has been recently reported that the Central Bank of Azerbaijan is working on a project to create a platform for a digital Manat. The details of the project are not yet public, but it is expected that this will be in the form of a retail CBDC. There has been no public information regarding Turkmenistan’s CDBC offering.

Exciting Days Ahead for Region’s Financial Sector

The region’s countries all feel the urgency to regulate the cryptocurrency space and offer a faster, cheaper, and more secure payment infrastructure for their respective national currencies. The Covid-19 pandemic has also changed the attitudes of the financial sector regarding facilitating cashless payments and digitalizing financial space. According to a Merchant Machine report, Eastern European and CIS countries have the world’s highest levels of cash-based transactions. Only Russia (32) and Turkey (44) come relatively high among global fintech rankings. An “underbanked” population is also a problem. According to the World Bank’s Findex Report, only in Iran, Turkey and Russia do more than two-thirds of the population have a bank account.

The use of CBDCs should also shrink the shadow (unofficial) economy, which is a major problem in many developing economies.

By offering CBDCs, central banks will use blockchain technologies similar to the platforms used for cryptocurrencies but with added centralized features. Such technology helps central banks increase the effectiveness of their monetary policy to assess the degree to which funds flow between consumers and businesses as intended by their macroeconomic policies. Governments can also prevent illicit transfers, enforce tax collection, and monitor how their fiscal policies stimulate the economy. CBDCs should also shrink the shadow (unofficial) economy, which is a major problem in many developing economies.

No government anywhere in the world will want to lose authority over its money, so we should expect more regulations and restrictions over cryptocurrencies. Some will be harsher than others. For example, Turkey is already trying to ban payments using cryptocurrencies, whereas Kazakhstan has plans to regulate and organize crypto trading. This report details the various cryptocurrency regulations across the globe. It is hard to know which money, crypto or CBDC, will prevail in the long run, but based on Gresham’s law of “bad money drives out good money,” it is easy to see why governments are coming down hard on regulating or banning cryptocurrencies while offering CBDC options as alternatives. One can only hope that eventually, financial inclusion and equity will increase over time and that Caspian Basin economies can prosper through more efficient and secure payment and monetary systems.