Will digital currency disrupt payments?

In February 2022, the Central Bank of Kenya (CBK) released a discussion paper on central bank digital currencies (CBDC). Through the paper, the CBK is basically soliciting public comments on the applicability of a potential CBDC in Kenya. But where is the CBK coming from? There has been a growing discontent with the current fiat system, especially among the youth.

Essentially, you have a world of young people who want their own financial system and their own culture. In the fiat system, governments issue money, by way of printing, that is backed by absolutely nothing (except for the faith that populations have in their governments).

Because central banks have always been about money - how money is created, how money is held, how money is exchanged and how money or monetary value is moved, the fiat financial system is centralised (and controlled by governments).

The discontent with centralised fiat system gave birth to cryptocurrencies, a system of decentralised money that is not under the control of governments. The technology underlying cryptocurrencies is distributed ledgers and blockchain.

It is a technology that operates on the premise of having no central authority to manage and authenticate transactions.

This role is instead managed and validated in separate records (or “blocks”) based on consensus among the participants. The underlying blockchain technology has been applied in a number of areas in the field of payments, most notably, the emergence and subsequent proliferation of various forms of cryptocurrencies, cryptoassets, decentralised finance and stablecoins.

There has been significant rise in the types of cryptocurrencies with the primary features broadly the same. This includes the use of distributed ledgers (or records) as the basis for transacting and validating transactions, without reference to any single, central authority.

As of 2018, it was estimated that there were more than 1,500 cryptocurrencies globally. It’s such an active space that central banks globally are beginning to capitulate to the fear of missing out (FOMO) on digital currencies.

Several central banks have begun research on CBDC, with some already undertaking proof-of-concept experiments and pilot tests in preparations for launch.

They include Canada, Japan, Norway, European Central Bank, Sweden, Switzerland, United Kingdom, the United States, Brazil, China, Turkey, Russia, Saudi Arabia, Ukraine and The Eastern Caribbean Central Bank.

Countries like Nigeria, Bahamas, and Venezuela have already launched a digital legal tender. Through this discussion paper, the CBK wants to join the bandwagon (ostensibly driven by FOMO).

A digital currency in Kenya may not entirely be a new concept. Strictly speaking, M-Pesa is already a form of digital money (e-money); and we all know how M-Pesa has transformed Kenya’s domestic payments space since launch in 2007.

With this in mind, a CBDC in Kenya should address current and future challenges in the domestic payments ecosystem. Most notable challenges are affordability and interoperability.

Apart from cost, M-Pesa, for example, remains excruciatingly ringfenced that it is impossible to achieve cross-platform interactions. Just think about sending money from an M-Pesa wallet to Airtel Money wallet.

This then informs an optimal CBDC design. Broadly (and as per CBK literature), the main design options that have emerged thus far include: direct model where nearly all aspects of a CBDC are managed by a central bank; hybrid model where some functions are shared with third-party or private sector institutions such as banks; and intermediated model where the central bank role is purely to process wholesale transactions.

The second consideration is the state of development of the domestic payments ecosystem and architecture. Countries with more developed payment systems can leverage private sector capabilities by using intermediate or hybrid models.

This allows the central bank to focus on providing the core infrastructure while private sector focuses on distribution and account management aspects of CBDCs.

To address the two envisioned challenges of affordability and interoperability, as well as considering the current state of development of the domestic payments ecosystem and architecture, it, in my view, would be best if the CBK adopted the direct models in its roll-out.

Nonetheless, a CBDC in Kenya would present a number of benefits to the domestic payments scene: a reduction in use of physical cash; a much cheaper access and maintenance of electronic money; simplified recordkeeping and improved end-to-end processing.

Consequently, current e-money providers must get ready to adapt or die a natural death.