The (Potential) Digitisation of Legal Tender

Setting up a robust legal infrastructure is still the biggest challenge in adopting central bank-backed digital currencies

Central Banks worldwide have been making substantial progress over the past few years in setting up digital currencies – a process that has been considerably accelerated owing to the COVID-19 pandemic. Although recent research has carefully analysed the economic and institutional motives behind the setting up of a Central bank digital currency (CBDC), its adoption as legal tender still seems to be a fair bit away in most countries. In fact, almost 80% of the world’s central banks are not even allowed to issue digital currencies under their existing legal frameworks.

Digital First?

Based on recent research by the International Monetary Fund: of its 174 member nations, only 40 are allowed to issue digital currencies that can be used as legal tender; whilst 61% are limited by legislature to issue only banknotes or coins, i.e. physical currency. Given the fact that the issuance of money is essentially a form of debt for the country’s central bank, a solid basis must be established to mitigate financial, legal and reputational risks. Essentially, any significant (and potentially) contentious innovation needs to be in line with central bank mandates to avoid political or legal challenges. This is, of course, easier said than done.

The IMF discusses astutely why banknotes and coins are the most commonly used form of currency: “To legally qualify as currency, a means of payment must be considered as such by the country’s laws and be denominated in its official monetary unit. A currency typically enjoys legal tender status, meaning debtors can pay their obligations by transferring it to creditors. Therefore, legal tender status is usually only given to means of payment that can be easily received and used by the majority of the population.”

It, of course, goes without saying that the biggest challenge standing in the way of CBDC adoption is setting up of an adequate digital infrastructure – connectivity, laptops, smartphones – to support it. Since democratic governments cannot impose digitisation on their citizens, granting legal tender status to central bank digital instruments is rather challenging. Yet, several such means of payment (e.g. commercial book money) is already in use in several advanced economies.

Legal Challenges Galore

The main challenge in setting up either an ‘account-based’ or a ‘token-based’ digital currency is legal: the first would mean the digitisation of the balances held in existing accounts on the central bank’s books; the second implying the designing of a new digital token not connected to existing accounts held by commercial banks with the central bank.

According to the IMF: “From a legal perspective, the difference is between centuries-old traditions and uncharted waters. The first model is as old as central banking itself, having been developed in the early 17th century by the Exchange Bank of Amsterdam – considered the precursor of modern central banks. Its legal status under public and private law in most countries is well developed and understood. Digital tokens, in contrast, have a very short history and unclear legal status. Some central banks are allowed to issue any type of currency (which could include digital forms), while most (61 percent) are limited to only banknotes and coins.”

Another important demarcation would be to consider whether digital currency would be used only at the ‘wholesale’ level by financial institutions or at the ‘retail’ level by the general public. Commercial banks are currently the only ‘traditional’ clients for central banks. To incorporate private citizen’s accounts as well would require several major tectonic changes to the central bank legal framework. Currently, only around ten central banks in the world are allowed to do so.

The setting up of central bank-backed legal tender is still a while away; and will potentially raise legal issues in several areas such as property contracts, taxation, payments systems, insolvency laws; privacy and data protection and ‘most fundamentally’ in ‘preventing money laundering and terrorism financing’. Robust legal foundations will be crucial in this regard, to ensure smooth integration of the CBDC into the financial system whilst maintaining credibility and acceptance by a country’s economic agents.

It would, yet, be prudent to pay heed to the words of Professor Dolores Umbridge addressing the students of Hogwarts for the first time: “Progress for the sake of progress must be discouraged. Let us preserve what must be preserved, perfect what can be perfected and prune practices that ought to be prohibited”