Kenya gears up for a Central Bank Digital Currency

One day after the Russian government reached consensus with its central bank on how to regulate cryptocurrencies, the Central Bank of Kenya (CBK) is now laying ground for the creation of a national digital currency.

In what looks like warming up to a digital future where digital money will rule over fiat currency, in a press statement yesterday, CBK announced the issuance of a Discussion Paper on the viability of a Central Bank Digital Currency (CBDC) for Kenya.

Inviting Kenyans to give their comments on the paper, CBK said it had been monitoring global developments in digital finance with the adoption and regulation of cryptocurrencies now becoming inevitable.

“New digital payments have emerged to facilitate transactions, including CBDC, issued by central banks to serve as money in a digital form,” the statement reads.

CBK asks the public to submit their queries and concerns to the Bank Supervision Director or email them by May 20, 2022.

The Discussion Paper seen by the Nation explains the evolution of global payment transactions and discusses frontier payment methods such as e-cash, CBDC, cryptocurrencies and stable coins.

It also focuses on potential dangers and opportunities presented by the creation of a national digital currency.

CBK has reviewed 14 other CBDC projects in the world in its public paper and hopes the directions taken by other nations will help it navigate the world of digital currency regulation with ease.

IT has studied Sweden’s e-Krona, China’s digital Yuan, the United States Federal Reserve research on CBDC, India’s digital Rupee, Digital Turkish Lira, Singapore’s Project Ubin and Bahamas’s Sand Dollar among others.

The fundamental principles require CBDCs to incorporate core features such as ease of use, low transaction costs, convertability, instant settlement, continuous availability and a high degree of security, resilience, flexibility and safety.

“Whilst CBDC offers opportunities to reduce costs associated with digital payments, it also comes with risks particularly related to cybersecurity and unknowns on how it would impact central banks’ core functions of monetary policy, financial stability and payment systems oversight,” notes the research paper.

The regulator said key elements to be considered before issuing a CBDC will be legal and institutional preconditions such as infrastructure, regulatory and supervisory framework, governance, risk management, central bank resources and legislation.

With Kenya topping the world last year in peer-to-peer transactions according to global blockchain data platform Chainalysis, CBK said domestic payments indicate the existence of a digital currency that is robust, inclusive and highly active.

“Therefore, the consideration to introduce a CBDC in the payments system in Kenya could target cost reduction, interoperability and enhancing cross-border payments,” the paper says.

According to data published by cryptocurrency marketplace platform Paxful, there were at least 4.5 million Kenyans in the cryptocurrency trade business in 2020, thanks to fairly affordable internet, a high smartphone penetration and digital literacy.

Last October, Nigeria became the first country in Africa to launch a CBDC when it unveiled the e-Naira, with President Muhammadu Buhari projecting that it could improve economic activities and boost the Nigerian GDP by Sh3 trillion over the next 10 years.

Explainer: Just what is a Central Bank Digital Currency?

Central bank digital currencies (CBDCs) are new kinds of virtual currency that would make central banks’ digital money available to households and businesses, enabling its use in retail transactions.

The key difference between money issued by central banks and by commercial banks is that the former is safer and more liquid because it is legal tender money. That means any creditor is legally obligated to accept it for the repayment of any debt. 

By contrast, a very small (but non-zero) risk exists that commercial banks default and therefore the money they have issued – our checking accounts – becomes worthless.

This is a huge deal. If I could hold my savings at the Federal Reserve (or a representative financial institution) while getting the same interest rate and convenience (especially with money transfers) as with my commercial bank account, I would transfer my savings to the Fed immediately. And so would millions of US depositors.

That means CBDCs could become formidable competitors to commercial bank money ie deposits.

Central banks typically have a cosy relationship with commercial banks and tend to protect them from competition. They do this partly because they view banking competition as detrimental to financial stability. Why, then, are central banks considering competing with commercial banks?

Nine countries have already launched a CBDC (the Bahamas, seven Eastern Caribbean countries and Nigeria). Meanwhile, 14 have pilots underway, and 57 are in the research and development (R&D) phase (the Atlantic Council has a nice dashboard). Most developed economies are in R&D except Sweden, which has already launched a pilot. The US is a laggard, only recently publishing a concept paper.

The emergence of CBDCs reflects two key factors: ease of issuance and benefit.

First is the decentralized ledger technology (DLT) revolution has made it easier to issue CBDCs. DLT is a set of infrastructure and protocols that allow simultaneous access, record updating and validation across a network – the technology behind cryptocurrencies. DLT allows central banks to issue tokens, equivalent to digital bank notes (see below), to the public.  The alternative would be for central banks to issue deposits to the public, for which they have neither expertise nor capability.     

Second, central banks see considerable benefits to launching CBDCs. In some countries, cash use has declined, depriving central banks of revenues. The advanced economy with the most advanced CBDC project, Sweden, has the lowest banknote use in the world, about 1% of GDP. By contrast, demand for dollar and euro banknotes has been rising. This could explain why the US has expressed limited interest in launching a CBDC so far (Chart 1).

What Would a CBDC Look Like?

As discussed above, central banks would likely issue CBDCs as tokens rather than accounts. The validity of transactions in an account-based system depends on identifying the payor. By contrast, in a token-based system, the validity of transactions depends on the authenticity of the ‘money’ being transferred. For instance, cash and cryptocurrencies are token-based systems.

Validation of CBDC transactions would be a hybrid between the permissionless crypto system, where transactions are validated by a large number of unknown validators and the centralized validation of commercial banks transactions.  This is because, based on current technology, permissionless validation of CBDC transactions would be very expensive.  A more efficient validation system would be for selected permitted entities to perform the validation and updating of the CBDC ledger.

Finally, the central bank would likely avoid interacting directly with CBDC holders to preserve privacy and create space for financial innovation by private operators. Instead, the central bank could issue the token to custodians or intermediaries that could issue their own tokens, 100% backed by CBDC.

In the current legal environment, with Anti Money Laundering (AML) and Know Your Customer (KYC) rules, tokens would very likely be held in accounts linked to specific individuals. However, the identity of the account holders would not be needed to validate transactions.

Market focus on DLT-driven financial innovation so far has been mainly on various cryptocurrencies. Yet DLT could also completely reconfigure payment systems and fundamentally change the role of traditional financial intermediaries such as banks. 

Understandably, given the disruptive potential of CBDCs central banks want to proceed cautiously.  Nevertheless, the DLT revolution is unstoppable and central banks have no choice but to get involved.  That is why, while many issues related to CBDCs are still unresolved, CBDC issuance in major advanced economies is a matter of when rather than if.

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