Future of Finance


CBDCs Summary ‘The message from CBDCs to payments banks is innovate or die’

[JUL 2021]


1. Is a two-tier system, in which central banks provide the infrastructure and commercial banks provide the customer-facing services a settled model for building a CBDC? 

In an article on CBDCs in its 2021 annual report the Bank for International Settlements (BIS) advocated a two-tier division of responsibility.

It is one in which the central banks provide will provide the infrastructure (issuance, liquidity, settlement finality, operational resilience and cyber-security) and the commercial banks and non-bank payments service providers (PSPs) will provide the customer-facing services (such as digital wallets, due diligence checks and payments apps).

The exact division of labour between the central banks and the commercial banks and PSPs will vary between jurisdictions. 

But it is clear that a large majority of central banks (especially in developed economies) are looking to preserve the commercial banks as part of the eco-system for deposit-taking, lending and running Know Your Client (KYC), Anti-Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks. 

The approach can be characterised as a public/private partnership, in which central banks and commercial banks will focus on what they do best. 

2. How stable is such a division of labour?

One answer is that it is too soon to say, and CBDCs must be launched in developed economies and allowed to evolve. Changes will take decades to occur, and the central bank CBDC systems will have to be flexible enough to accommodate them. Indeed, it can be argued that the division of labour will endure precisely because the central banks are able to change.

However, it can also be argued that the division of labour might prove unstable. One argument is that the central banks cannot allow CBDCs to circulate freely among consumers and corporates because of the risk of central bank money being used to launder money or finance terrorism or sanctioned individual and states.

The easiest way of solving this problem is to restrict circulation of CBDCs only to firms that have full KYC, AML, CFT and sanctions screening systems in place. This would reduce a CBDC to an inter-bank settlement token not unlike the present system, providing a limited basis for innovation and rendering a two-tier division of labour between a wholesale and retail functions unachievable in practice. 

A counter-argument is that the central banks can become nodes on CBDC networks, enabling them to perform regulatory checks on how CBDCs are used without inhibiting innovation by private sector firms. 

Indeed, supervisory “nodes” on CBDC networks could provide the ideal balance between central bank supervision of the system and private sector innovation, by allowing regulators to regulate actors and activities from within the system.

3. Doesn’t it make sense in the long run for central banks to disintermediate the banks from payments?

Another reason for believing the division of labour is unstable is that the blockchain technology that is likely to underpin CBDCs argues for the disintermediation of the banks, and their replacement by a single system of instant peer-to-peer payments in real-time. 

The counter-argument is that a single system of this kind is possible already, and it has not developed because the banks are needed to assume counterparty and other risks.

The TARGET Instant Payments Settlement (TIPS) service operated by the European Central Bank (ECB), the New Payments Platform operated by the Reserve Bank of Australia and the FedNow system being built by the Federal Reserve in the United States are all capable of delivering real-time gross settlement (RTGS) of retail payments, albeit in commercial money, yet all three preserve a two-tier system.

That is because a purely technological focus ignores what intermediaries exist to do. If central banks take care of systemic risk and the risk of financial instability, it frees commercial banks to manage counterparty, currency market and other risks.

4. Won’t CBDCs strip commercial banks of their deposit funding and this their ability to lend?

Concern that a CBDC will undermine the deposit funding of private commercial banks (and therefore their ability to lend) has dogged discussions about CBDCs since they began. The difficulty is not yet resolved.

The two techniques that have merged for managing this risk are unsatisfactory. One is to pay lower or negative rates of interest on CBDC deposits. The other is to impose quantitative caps on the amount of CBDC that anyone can hold.

Both are clumsy, limiting innovation by obstructing the natural flow of payments in a digital economy. Negative interest rates might also undermine the ability of a CBDC to function as a payment instrument by reducing its value below par.

5. Won’t CBDCs put personal privacy and commercial confidentiality at risk?

Some jurisdictions see a CBDC as advantageous for precisely this reason, but governments which respect civil liberties face a dilemma. After all, a retail CBDC can be token-based (i.e. anonymous) or account-based (i.e. users’ identities are known). 

At present banks and non-banks are subject to onerous and detailed obligations (laid down by the Financial Action Task Force (FATF)) to combat financial crime by establishing the identity of the beneficiary of any transaction. This makes it impossible for central banks to endorse a CBDC in tokenised form being exchanged between digital wallets, as opposed to accounts whose beneficial owners are known. 

A comparable concern is raised if the data associated with CBDC transactions and holdings was visible to private sector firms. This might allow excessive power to be concentrated in the hands of a few large private corporations and reduce competition for customers because new entrants cannot get access to the data they need to compete. It is for this reason that the BIS has advocated “data governance principles” and “privacy standards” to guard against this risk.

A quick-and-dirty solution is to allow low value transactions to be anonymous.

A more sophisticated solution is for consumers and companies to take ownership of their data and for any venture that wishes to make use of it to seek their consent. 

Cryptographical techniques such as Zero Knowledge Proofs and Secure Enclaves, which permit the examination and interrogation of data without the user having to see all the underlying data, can solve the inherent conflicts and difficult policy choices between privacy and due diligence checks. The Federal Reserve Bank of Boston is working with the Massachusetts Institute of Technology (MIT) to access these technologies.

Digital identities, in which users would prove their identity without having to share all their personal information repeatedly with different service providers, are one product which could solve the problem of duplicative KYC, AML, CFT and sanctions checks.

Purely technological solutions are probably not enough. Trust in cryptographical techniques still matters. A section of the public may not trust cryptographical techniques and will need to be persuaded the techniques are secure. 

That said, consumers in particular have so far shown a limited appetite to protect their data. They seem happy to trade it for “free” services and to consent to any form of intrusion to access services via the Internet by ticking consent boxes. Digital IDs might just become another box consumers tick to complete a transaction. 

6. Can CBDCs make cross-border payments faster and cheaper?

Cross-border payments are slower, more expensive and less transparent than domestic payments. This is because cross-border, cross-currency payments rely on correspondent banks to exchange currencies and access payment systems at the national level. This makes it difficult to track a cross-border payment in real-time. 

The price of cross-border payments also remains relatively high because banks are withdrawing from correspondent banking because of the KYC, AML, CFT and sanctions screening risks of making and receiving payments from banks whose underlying clients may be money launderers, terrorists or sanctioned individuals or companies or states. 

As a result, a correspondent banking oligopoly has arisen. Cross-border payments are now dominated by a small class of 15 large international banks which alone have the FX capabilities and willingness to accept the KYC, AML, CFT and sanctions screening risks of facilitating payments across national borders.

This has sparked interest at central banks in the possibility that CBDCs could improve the speed, cost and transparency of cross-border-payments. By facilitating direct connectivity between central banks, CBDC links could reduce the need for intermediation by commercial banks an enable direct transactions between participants. 

However, this would require central banks to execute FX transactions. Until now only commercial banks have assumed the risk of an adverse currency movement, but a BIS survey of central banks in June 2021 found seven central banks exploring the provision of FX services (the survey question read: “Would the central bank take on a novel role in the FX conversion process?”). 

Other BIS data identified 11 CBDC projects that are presently considering a cross-border component. And a BIS paper published in March 2021 (Multi-CBDC arrangements and the future of cross-border payments) put forward three models of how multiple domestic CBDC systems could inter-operate across borders: compatible domestic CBDC systems; inter-linked domestic CBDC systems; and a single system hosting multiple CBDCs.

Compatible domestic systems are hard to achieve, given that the design of every CBDC will be driven by local interests. Besides, it is hard even for systems built on the same underlying blockchain technology – say, Ethereum, or Corda – to inter-operate, not least because their identity assurance and transaction validation techniques vary. 

What is required is a standard protocol that allows CBDC systems to inter-operate, irrespective of the underlying technology. Without standardisation, bi-lateral links risk increasing rather than reducing compatibility. There is also the sheer difficulty of connecting and operating so many bi-lateral links. Point-to-point connections between the 20 central banks of the world, for example, would require 20,000 bi-lateral links. 

These difficulties can make a single central platform, with all central banks issuing their CBDCs on to it, seem easier to implement, at least from a technical point of view.  

The five-year, five-stage Project Ubin run by the Monetary Authority of Singapore (MAS), R3 and a group of banks between 2016 and 2021 to explore the use of blockchain technology in payments included (in Phases 4 and 5) a successful cross-border, cross-currency payment experiment between MAS and the Bank of Canada using a wholesale CBDC. 

It enabled issuance and distribution of CBDCs on a common network, allowing network participants (and their customers) to transact with other participants on the network directly, around the clock, and almost instantly, in a variety of currencies. 

Likewise, the system being tested by the central banks of China, Hong Kong, Thailand and UAE, in which a single system hosts multiple CBDCs (the so-called “mCBDC” system), has also boosted confidence in the viability of a single system. 

But bridges between small groups of central banks provide limited insight into the difficulties of linking larger groups of central banks, especially when many payments are linked to underlying transactions which require connectivity to third party systems. 

In its paper of July 2020 on how to improve cross-border payments, the Committee on Payments and Market Infrastructures (CPMI) listed 19 “building blocks,” of which “providing domestic CBDC implementations with the necessary guidance to enable cross border transactions via access by non-residents and/or interlinking with international infrastructure” was just one – behind adopting the ISO 20022 standard, using Stablecoins and linking domestic payments market infrastructures (PMIs). 

So a single platform is less realistic than a standardised protocol that allows different systems to inter-operate – and even that would not cover obstacles such as non-standardised laws and regulations and digital identity frameworks.

A number of private sector initiatives are aimed at making cross-border payments more efficient, most obviously Stablecoins but also non-Stablecoin initiatives such as Fnality (which plans omnibus accounts at multiple RTGS systems, starting with the Bank of England, to permit settlement 24/7/365 in central bank money) and Baton (which offers bi-lateral, pre-funded settlement  in commercial bank money in multiple currency pairs).

7. Will CBDCs displace Stablecoins?

It was Stablecoins – or at least the Facebook Stablecoin, known initially as Libra and now as Diem – which sparked the drive to create CBDCs. 

However, Stablecoin and non-Stablecoin initiatives (such as Fnality and Baton) are looking to do more than substitute for central bank money settlement. Provided they offer additional functionality that users find valuable, they will survive.

Not all Stablecoins are equal either. Those backed by high quality money or assets, as opposed to baskets of volatile assets or commodities, are more likely to survive too. Stablecoins backed by central bank reserves may emerge. 

The history of the United States shows that private issues of currency can fall to a discount, so a dollar from one issuer is worth less a dollar issued by another. This is why Scottish and Irish banks that issue pound notes must match them 1:1 with holdings of Bank of England notes.

One possibility is that central banks issue CBDC to banks, which then issue Stablecoins against their holdings of CBDCs.

8. How much private sector innovation can CBDCs encourage?

The two-tier division of labour means central banks look to the private sector to innovate. CBDCs also provide a natural opportunity for market participants to think about ways of doing things differently. 

One view is that banks do not need to innovate, at least for retail business, because retail consumers are indifferent to the speed, transparency and riskiness of making payments. 

However, innovation is often driven by the supply-side rather than the demand-side. In other words, innovators respond not to consumers demanding they fix problems but to opportunities to increase profit margins by reducing transaction costs, and to be paid more quickly, securely and with minimal to zero transaction costs. 

The strong likelihood is that CBDCs will exist alongside existing payments systems for many years. This will put pressure on the existing payments systems to innovate or die. The history of innovation shows that the old and new technologies will overlap, with CBDCs competing with existing payment systems, probably for decades. It is not unthinkable that the old systems eventually out-compete CBDCs.

Non-bank PSPs will continue to be a source of innovation beyond the banks. They can promote financial inclusion to the unbanked (5-6 per cent of the US population) and the under-banked (12-15 per cent of the US population) to rescue them from extortionate payday lenders. 

In the United States the Federal Reserve is consulting about the role of non-banks, and how they should be regulated, because transmitting payments in CBDC is not the same as today: a CBDC is not commercial bank money but a liability of the central bank.   

In the United Kingdom non-bank PSPs can already hold accounts at the central bank and participate directly in the RTGS system, provided they can meet the regulatory criteria set for banks, up to and including holding reserves at the Bank of England. 

9. Is a programmable CBDC a good idea?

Programmability means mainly conditionality. For example, a payment can be conditional on an account being funded, or an asset being delivered, or a contract being fulfilled, or on money – economic stimulus payments are an obvious case in point – being spent by a certain date or it expires.

Programmability can also transform fiscal policy. VAT, for example, could be paid to the government tax authorities at the point of sale. Or furlough payments could be distributed directly to the beneficiaries.

On the other hand, programmable CBDCs could be used to enforce government policies without consent, imperilling civil liberties. A CBDC could be programmed, for example, to make it impossible for the holder to buy alcohol or tobacco.

The dependence of programmable money on smart contracts might also create a point of technological vulnerability that is unacceptable to central banks.

It is likely that few CBDCs will adopt programmability because it would undermine the nature of central bank money as a public good. It would also undermine the conviction that innovation is best left to competition in the private sector.

This would not preclude a central bank publishing standards for programmable commercial bank money.

10. Do we actually need CBDCs? 

Major economies either have or soon will have instant payment (55 countries have it already, including TIPS in Europe, Faster Payments in UK and the upcoming FedNow system in the US) and Open Banking or Open Data initiatives (which open up payments markets, however partial their success so far).  

Wholesale CBDCs seem little different in practice from reserve banks. Project Helvetia showed that it is possible to settle security tokens using existing RTGSs, suggesting the benefits of CBDCs in imparting momentum to the security token markets might be exaggerated. 

It is also possible to send money directly to citizens (for example, as furlough payments or economic stimulus payments) using the existing financial system. The existing system has also shown that it can support negative interest rates. 

However, the near-disappearance of physical cash (as in Sweden) and the need to bring the unbanked within the scope of the financial system (as in the Bahamas and the eastern Caribbean) provide two clear use-cases for a CBDC. 

Importantly, the lack of obvious use-cases is not an argument for preserving the status quo. Existing payment systems may be relatively efficient, but they are not optimal. Once a CBDC is in place, innovations are bound to emerge, and market participants will wonder why it took so long to change the existing system.