Key Insights From This Interview
The global consensus on the need to regulate asset-backed Stablecoins, and in particular to restrict issuance to banks, means these instruments are effectively being brought within the regulations applied to the banking industry (1). Being regulated as a bank entails obligations but also brings privileges, such as access to central bank operated Real Time Gross Settlement (RTGS) systems, customer deposit insurance schemes and central bank Lender of Last Resort facilities.
Non-bank Stablecoins are by definition excluded from the regulatory measures, orchestrated by the G7, which are now being taken in the United States, the United Kingdom, the European Union (EU), Japan and elsewhere. Yet in terms of asset backing to maintain a currency peg even non-bank Stablecoins are similar to money market funds – which were bailed out twice by central banks in the recent past (in both 2007-08 and again in 2020) when they failed to maintain par value.
Non-bank payments services – notably Fnality, which is licensed by the Bank of England to operate an omnibus account within the sterling RTGS but there are other non-bank services that aim to settle in central bank money – have also secured the support of central banks. So access to central bank-operated services is not necessarily restricted to regulated banks. The line between what is inside and what is outside the regulatory perimeter of central banks is shifting.
Chief among the potential beneficiaries of this shift are institutional-quality Decentralised Finance (DeFi) services. There is interest in on-chain forms of settlement using Stablecoins and DeFi-style automated market maker (AMMs) smart contracts to cut the cost of cross-border, cross-currency transactions, for example, but also in using the technique in lending and insurance. Such services can be supported by Central Bank Digital Currencies (CBDCs) too, as R3 argued in a recent paper (2).
One destination of this line of thinking is that central banks reconstitute themselves as Decentralised Autonomous Organisations (DAOs) owned by all citizens of a country, making CBDCs de jure as well as de facto liabilities of all the citizens of the country, and the central bank writes smart contracts to perform its core functions of controlling the money supply, maintaining financial stability and operating the RTGS system. But this seems legal and politically impossible in the near-term.
A likelier outcome is that commercial banks become DAOs under the supervision of central banks. This “CeDeFi” combination might encourage controlled forms of innovation. Among them might be commercial bank-issued Stablecoins or tokenised deposits, which consumers can access and use to meet different payment needs. CBDCS would remain the securest layer in a hierarchy of monies, not unlike the current distinction between central and commercial bank money, but with more variety.
Giving businesses and consumers a choice of monies to use underpinned by a CBDC is becoming the consensus view. The Regulated Liability Network being tested by the New York Innovation Center (NYIC) of the Federal Reserve, in which both tokenised central bank reserves and regulated commercial bank money deposits are used to settle transactions between banks on a single blockchain network, is an indication that the controllers of the leading reserve currency are thinking this way.
Technical solutions are also emerging that make a hierarchical but variegated system of monies more probable. Audited proof of reserves (or proof of collateral) in real-time rather than monthly or quarterly, for example, would increase the confidence of merchants and consumers in the ability of a Stablecoin to maintain its currency peg. Fulfilling this need provides an obvious opportunity to use zero knowledge proofs, which can provide assurance without disclosing information.
The fact that CBDCs ultimately underpin the various monies available for use in different networks is essential. However, the monies also have to be interchangeable between those networks, which requires inter-operability between their operating systems (including Layer One blockchains as well as traditional RTGSs). Stablecoins are already making themselves available for use on multiple blockchain protocols. CBDCs do not need to follow suit in a layered system they underpin.
Interoperability can be achieved by cross atomic swaps (where ownership of a digital asset can change without needing to leave the network into which it is issued); or burning and minting (where a digital asset is burned on the network it was issued into and minted into the network where it is needed); or wrapping (where a token issued into one network mirrors the value of a digital asset on another network); or by putting a digital asset into escrow on one network and minting it in another.
Making CBDCs inter-operable so they can settle cross-currency transactions without central banks losing control of their currency is an interoperability challenge. Project Jura, a collaboration between the Banque de France, the BIS Innovation Hub Swiss Centre, the Swiss National Bank and a private sector consortium, found euro and Swiss franc CBDCs could be exchanged between French and Swiss commercial banks without the French or Swiss central bank issuing CBDC into a third-party network.
The benefits of new forms of money might include lower settlement transactions costs including lower “gas fees” on blockchain networks, though the performance issues with blockchain technology can be fixed by Layer 2 applications only. The benefits of programmability will be easier to capture, in the sense that controls can be built into the money itself, and not the digital wallet in which it is held. That is a substantial improvement on monies available today, where controls are all account-based.
Using CBDCs to underpin the monetary system, rather than own it, also alleviates concerns about privacy being breached by central banks. Businesses and consumers will have a choice over which monies to use to complete different types of protection. Furthermore, personal identities are likely to be concealed, without any diminution in the ability to transact, by the use of self-sovereign digital identities and by the likelihood that money is token-based rather than account-based.
(1) For more on this, see https://futureoffinance.biz/2023/01/23/stablecoins-will-be-regulated-what-are-the-implications-for-the-markets/ and the Future of Finance paper on Stablecoins (forthcoming).
(2) R3, The future of financial liquidity: CBDCs and Automated Market-Making, 2023.
The decision by regulators to bring bank-issued Stablecoins within the scope of regulation is helping to fashion a vision of the future of money in which central bank digital currencies (CBDCs) play a role not unlike the one existing forms of central bank money play in the money markets of today: underpinning innovation and experimentation in different forms of money and different ways of making payments by both banks and non-banks without putting monetary, financial and operational stability at risk. Dominic Hobson, co-founder of Future of Finance, spoke to Ricardo Correia, Head of Digital Currencies at R3, where he leads a team that is working with central banks, banks and financial market infrastructures on a variety of projects exploring the potential of CBDCs and fiat-backed Stablecoins.
A full recording of the interview is available on this page. A transcript of the interview, which follows the questions below, is also available if you click on “Read the Transcript.” If you click on any question you will be taken to the exact point in the recording where the question is asked and answered.
Is a central bank organised as a Decentralised Autonomous Organisation (DAO) in which citizens have an equity stake as well as a liability to back central bank money with their taxes, a viable proposition in the future if not now?
Can Stablecoins reach the point at which merchants and consumers use them because they trust the blockchain technology and techniques such as Zero Knowledge Proofs and Secure Enclaves and feel secure enough not to care about the issuer?
Can CBDCs play the same role in a Web 3.0 economy as notes and coins do in the Web 2.0 economy (i.e., guarantee privacy and anonymity) and does that mean they must be token-based rather than account-based?