Fransiska Ari Indrawati: CBDC as a financial inclusion toolkit and preparing the relevant legal framework

Throughout most of history, money as a tool of payment has taken the form of tangible objects such as coins and banknotes. However, the rapid development of digital technology has changed the payment landscape. In the UK, for example, most of the liquid funds used in payments nowadays consist of intangible bank deposits. So far, these are all privately-created forms of money rather than state-issued legal tender.

However, this may be about to change. Many central banks are seeking to expand the supply of state-issued intangible money by introducing central bank digital currencies (CBDCs). CBDCs are a form of digital fiat money issued by a central bank. It is simplest to think of them as traditional coins or banknotes issued by a central bank but existing in a purely digital form. CBDCs thus circulate alongside tangible forms of money and perform their traditional functions, i.e., as a unit of account, medium of exchange, and store of value.

As of August 2023, central banks in the Bahamas, Nigeria, Jamaica and Eastern Caribbean Currency Union have issued CBDCs, while the remaining central banks are at various stages in their exploration of CBDCs. China might be leading the way in developing and trialling CBDCs, driven by its motivation, among others, to promote financial inclusion and backed by its strong technological capabilities (Buckley et al., 2022). In the UK, the investigation of the Digital Pound by the Bank of England is still in the design phase, and as of yet, no decision has been made as to whether to issue such money (see Bank of England, 2023).

One of the main reasons for central banks’ expanding role in providing new digital payment media has been to promote financial inclusion. Financial inclusion is usually explained as the ability of people and businesses to access financial products and services in order to meet their needs in a useful and affordable way (see Auer et al., 2022, p.3). Once people have access to financial services, they are better able to satisfy their financial needs, which include conducting transactions, making payments, and accumulating their savings.

The current dominance of private money and payment systems provided by the commercial banking sector can undermine financial inclusion. People need to access a bank account in order to take advantage of the payment systems that it affords, and people living in rural and remote areas, including the poor, are most likely to miss out. One of the strategies for increasing financial access is to introduce digital payment systems which allow people to gain access to the financial system with greater ease and at a lower cost. The argument runs that when people can fulfil their financial needs, they can participate in economic growth. Additionally, financial inclusion can also help to lift the poor out of poverty.

This blog entry looks beyond the UK to consider how CBDCs can enhance financial inclusion and to discuss key elements in formulating legal frameworks to support the issuance of such CBDCs in various countries.

CBDC as a tool for financial inclusion

Digital payment systems can significantly enhance financial inclusion, as demonstrated by the successful implementation of the Pix system by the Banco Central do Brazil and the Unified Payment Infrastructure initiated by the Reserve Bank of India. These national digital payment systems have considerably facilitated online transactions. They have been instrumental in reducing the number of unbanked individuals, particularly during the pandemic (Banco Sentral do Brazil, 2020; Alonso et.al, 2023; Roy, 2022). Another illustrative case involves the implementation of M-PESA, mobile money accounts in Kenya, which has notably improved per capita consumption levels, particularly in remote and rural areas. The initiative has been instrumental in lifting an estimated 2% of Kenyans out of extreme poverty. The use of this digital payment system has been recognized for its substantial time and cost savings (see Dawson, 2016; Matheson, 2016), underscoring its potential in fostering financial inclusion and eventually playing a crucial role in poverty reduction, as evident in the case of Kenya.

Based on these examples, it is likely that CBDCs would also significantly increase the use of digital payments. CBDCs would be made available to a large share of the population, and their use by all manner of people and businesses would support financial inclusion. Populations, including the poor, who live in remote areas are most likely to encounter barriers when accessing financial services. In many cases, commercial banks or other private financial institutions do not find it profitable to broaden their financial services to these areas (Auer et al., 2022). By issuing CBDCs, the state will be directly involved in providing financial access through systems or platforms to the broader economy, which means to all households, including those who live in remote areas. This argument has been explicitly recognised in China, where the CBDC system would enable unbanked people residing in rural areas to access basic financial services and, thus, it can eliminate costs for travelling to commercial banks (see PBOC, 2021, p.5). The services for CBDC could even be offered at no cost since the expenses of operating the system may be recovered by the central bank through its seigniorage income (see Auer et al., 2022, p.17).

However, the successful implementation of CBDCs in rural areas requires careful consideration of technical challenges. One such challenge pertains to issues surrounding data connectivity and the reliability of electricity. The design and infrastructure of CBDCs must be adept at surmounting these geographical and technical barriers by, among others, incorporating features for offline transactions. Offline features in CBDCs would allow peer-to-peer payments without being connected to the internet, while the settlement would be done in real-time (see Minwalla et al., 2023). In some populous nations like China and Indonesia, central banks plan to equip their CBDCs with offline features to reach precisely underserved regions (see Bank Indonesia, 2022, p.3 and PBOC, 2021). However, there are not just technical challenges.

Preparing legal framework for CBDC

To construct CBDCs as an effective tool for financial inclusion, the issuance, distribution and transfer of CBDCs must also be supported by an adequate legal framework. There would need to be a legal authority in place for the central bank to issue CBDCs. The legislation would need to define the different kinds of media used for conducting the transactions, such as sim cards and tokens, and confer legal tender status on them. It would need to define and regulate the methods of transfer between holders of the currency. A crucial aspect of this last point would be the finality of settlement in payments.

At the initial stage, the state should proclaim CBDCs as legal tender money. There would therefore be no doubt about its legal capacity to discharge debts. This special status conferred on CBDCs would be in line with the state theory of money promoted by the early twentieth-century monetary theorist, G.F. Knapp. Knapp argued that the state has the authority to define its monetary unit and to choose its means of payment, which it would then denominate in terms of the unit (Georg Friedrich Knapp, The State Theory of Money, 1924; For further analysis on Knapp’s theory and CBDCs, see Indrawati, 2022, p. 382-386).

To ensure that CBDCs can be used in remote areas, we saw earlier that it would need to deploy offline features. It would be important for the regulations governing CBDCs to provide that it was still effective as a means of payment, even in offline transactions. The legislation would need to define the consequences of any fraud or error in offline transactions and decide whether the system would allow them to be corrected. There would need to be some legal regulation of problems arising from double spending. All these measures would help establish the trust in the system that would be essential to its adoption and use.

Concluding reflections

Central banks must carefully design CBDCs to cater for the specific needs of their economy within their own jurisdictions. As a result, the objectives behind issuing CBDCs may vary from country to country. If it is to be used as a way of promoting financial inclusion, then it would need to be tailored for retail rather than wholesale use, which would make it essential to be given legal tender status. Each central bank would need to identify barriers to financial inclusion that are specific to its own country. These might be geographical in nature, but they would also need to include gaps in financial literacy or inadequate payment service infrastructures.

Trust plays a pivotal role in ensuring the successful implementation of CBDCs. The creation of robust legal frameworks accompanied by stringent enforcement would be essential to building that trust. Without it, the aim of improving financial inclusion is likely to fail.

Fransiska Ari Indrawati is a PhD candidate at Edinburgh Law School. This article was first published on the Edinburgh Private Law Blog and is based on a presentation delivered at the Berkeley Poverty Law Conference in Berkeley, USA, on 10 March 2023.