CBDC and the security–financial inclusion dilemma

In an article entitled “the Restructuring of the UK Financial Services in the 1990s” and published in 1993, two geographers – Leyshon, A. and Thrift, N., coined for the first time in history the term “financial exclusion”. They were worried about the effects of bank branch closures in the access to banking services. Nowadays, the definition of financial exclusion is more general. Financial exclusion is understood as the situation in which citizens cannot or are not able to access or use financial products and services in standard markets. 

While money is a social convention, financial exclusion can be seen as a social problem. Its consequences are dramatic: it tends to isolate individuals and communities creating a loop that reinforces the risk to face other problems such as social exclusion. Those suffering financial exclusion will also have to deal with the fact that not having a bank account reduces credit scores and makes finding a formal job much more difficult – employers usually require a bank account to pay employees. Financial inclusion could enhance income and increase savings. This would enable people to invest in necessities such as healthcare, education, and manage financial risk. Access to the financial system also enables paying via debit or credit cards which is safer than paying via cash and in some jurisdictions are subject to fraud protections and consumer purchase protection(i.e., extended warranties and insurance). Moreover, financially excluded people are also unable to take advantage of the benefits from the discounts offered in the digital era – consumers may earn rewards using debit or credit cards in some countries around the globe.

According to the 2017 Global Findex Database, provided by the World Bank, more than 1.7 billion people in the world do not have access to financial institutions. Although this number is in decline – in 2014, it  was 2 billion –  still leaving much to be done. The emergence of new types of digital public money, i.e., central bank digital currencies (CBDCs), have been seen as an opportunity to remedy this problem; however, a CBDC alone will not solve the financial inclusion problem. CBDCs cannot be implemented in a society with no access to the internet or smartphones. In addition, it is likely that the financially excluded do not have a digital identity. In many developing countries, there is poor identity management which exacerbates the financial exclusion problem. Nonetheless, CBDCs can help to address some of these challenges. 

Various CBDC designs offer differing levels of security, which affects their ease-of-use or user experience. This may be translated to a  security – financial inclusion dilemma.  An increase in the level of security of CBDCs is likely to make their use more complicated. To operate with public digital money, users may need a private key – which could be difficult to recover in case of loss, to have access to an account. CBDCs with greater security features may include two-factor authentication (2FA) and sound know your customer (KYC), anti-money laundering (AML) and combating terrorist financing (CTF) procedures. In societies with low levels of financial literacy and technological understanding, a CBDC with robust security features could lead to reduced adoption and use.

In the case of a DLT-based CBDC, it is interesting to consider the debate about custodial wallets versus non-custodial wallets. Custodial wallets will have to be compliant with KYC, AML and CTF procedures, posing a threat to widespread adoption and  therefore, financial inclusion. KYC requirements may require digital identity integration and will thus present significant hindrances for populations without proper identity documentation from accessing digital wallets. The question of how to accomplish payment privacy and enforcement of compliance rules with mass adoption is challenging.

According to The Economist’s 2021 Digimentality Report,  the three most important factors that consumers cite as barriers to their countries going cashless are, habitual use of cash, lack of technological literacy, and data privacy. Therefore, it is plausible that the elderly and the financially and technologically illiterate will not use a CBDC if it is difficult to use it. People tend to choose not to use something they do not understand or consider too complicated.

If a CBDC can be stored in a wallet, it may be necessary that the wallet safely stores value and can be easily set up and accessed like any other traditional mobile app. All in all, central banks should try to find the optimum CBDC design which combines an acceptable level of security with a seamless and enjoyable user experience if they want to achieve widespread adoption.

This article was prepared by the author. The views expressed in this article are the author’s own and do not necessarily reflect the views of the Digital Euro Association.