Future of Finance


The waiting for CBDCs is almost over and the ordeal of the incumbents is about to begin

A summary of the webinar of 23 November 2021 entitled The waiting for CBDCs is almost over and the ordeal of the incumbents is about to begin.

Interest in CBDCs at central banks is almost universal, but the spectrum of stages of development is wide. The most advanced jurisdictions are, with the exception of China, small and emerging economies with limited institutional constraints and powerful local incentives to adopt a CBDC. It is increasingly clear that central banks will rely in almost all cases on commercial banks to provide the customer-facing services in a CBDC-based financial economy.  Central banks are nevertheless likely to open access to CBDCs to non-banks, in order to stimulate competition and encourage financial inclusion.  Private alternatives to CBDCs such as Stablecoins are likely to co-exist alongside CBDCs, though they will almost certainly be brought within the perimeter of regulation.  CBDCs will probably be used to cut the costs of cross-border payments and securities settlements, which will disrupt the current business models of CSDs, custodian banks, correspondent banks and payments market infrastructures such as CLS and SWIFT.  Though concerns about privacy are a potential deterrent to mass adoption of CBDCs, and there are commercial reasons why a CBDC could fail in the marketplace, this will happen only if a CBDC fails to compete on price with existing methods of payment. CBDCs are expected to become an important bridge in the widely anticipated convergence of the traditional financial markets with the Decentralised Finance (DeFi) markets.

What is the current state of play in CBDC issuance and development?

Kiffmeister counts 20 jurisdictions where central banks have either launched a retail CBDC (2), launched or are about to launch or have completed a pilot CBDC (4) or have launched or completed a proof of concept (6), or are at an advanced stage of research and development (8). Another 44 are exploring the idea of a CBDC. 

The Bahamas and the Organisation of Eastern Caribbean States are the only jurisdictions to have actually launched a CBDC. 

The launch of the e-Naira pilot CBDC in Nigeria on 25 October 2021 means that four jurisdictions have now reached the pilot stage. The other countries are China, Jamaica and Uruguay (which completed its pilot ePeso in 2017 and has not progressed the idea since).

China is particularly far advanced and proceeding towards a formal launch in February 2022. Reuters reported in November that US$9.5 billion of payments between 140 million wallets and 1.5 million merchants had been processed. The Chinese central bank, which has worked on the CBDC since 2014, is also reported to have 100,000 software engineers working on the project. 

According to Kiffmeister, another 11 central banks have embarked on Proofs of Concept (PoCs), six are at an advanced stage of research and development, 31 are exploring the idea and 13 are reported to be exploring the idea – so 55 central banks are taking the idea of a CBDC with varying degrees of seriousness. 

Two central banks (Ecuador and Finland) have abandoned the idea.

What explains the lead in CBDCs being taken mainly by smaller countries and emerging economies?

The Caribbean consists of 13 independent countries and 15 dependencies scattered over a large area, which complicates trade between jurisdictions. Many people on Caribbean islands also lack access to a bank account. 

This hampers economic activity and also makes it difficult to furnish citizens with aid in a region where people are exposed to extreme weather events. A CBDC alleviates these problems by making it possible to move fiat currency between digital wallets accessible via smartphones. 

Similarly, in Nigeria, local factors applied. The government has clamped down on cryptocurrency as a means of hedging against inflation and evading exchange controls and taxation, and the CBDC represents in large part an attempt to regain control. 

The e-Naira is accessible only via a bank account and there are caps on how much e-Naira consumers can hold and how large payments can be. But expectations are that the e-Naira will be extended to the unbanked. 

Smaller countries can also proceed more quickly, both technologically and politically. They can buy rather than build a CBDC system, which enables them to introduce the CBDC more quickly. It also gives them access to any improvements or enhancements the vendor develops when working with other central banks.

Smaller jurisdictions have the further advantage of having fewer layers of complexity – such as the impact on existing systems and monetary stability, legal and operational factors, control of monetary policy and governance of the CBDC – to work through when designing and introducing a CBDC. 

How will labour be divided in a CBDC between central and commercial banks?

It has become clear that few central banks will want to provide customer-facing services. It follows that any CBDC is going to entail a strong measure of public-private cooperation. The likeliest scenario is one in which the central banks provide the operational infrastructure and the commercial banks provide the customer-facing services in the form of apps. 

Which types of institutions will have access to CBDCs?

An important consideration is how open private sector access to the CBDC will be. Unlike the early days of discussion about CBDCs, in the immediate aftermath of the Facebook announcement about the Libra Stablecoin, central banks are focusing less on control and more on the benefits of competition between providers to provide innovative and low-cost services and increase financial inclusion. 

Central banks may, for example, be prepared to open access to a CBDC to non-bank payment service providers (PSPs) with limited balance sheets which nevertheless reach client groups that are untouched by the major banks. 

This opening could take the form of a “synthetic CBDC,” in which PSPs gain access to central bank money in the form of central bank reserves, allowing them to hold and transact in central bank money.

Open systems do pose challenges in terms of participation, making Know Your Client (KYC), Anti Money Laundering (AML), Countering the Financing of Terrorism (CFT) and sanctions screening checks even more important. And it is the commercial banks and PSPs that must conduct the checks.

Despite the increased risk of financial crime, open systems are more likely to succeed because the services will attract more users and generate greater activity and liquidity. 

However, the choice between running an open CBDC system and a closed one is profound. Once a choice is made between running an open system and a closed one, the decision will be difficult to reverse because path dependencies set in.

Will CBDCs coexist with Stablecoins?

Crypto-currency market participants use Stablecoins because they offer a safe haven for cash without having to incur the cost and inconvenience of exiting the blockchain network into fiat currency. Central banks need to respond to that demand, or risk losing control of monetary conditions.

The initial reaction of major central banks to Libra was exactly that: a fear of loss of control of monetary conditions. However, unlike Libra, which was to be issued by the non-bank Facebook, Stablecoins issued by regulated financial institutions such as banks and asset managers ought in principle to cause regulators and central banks less concern.  Central banks also have tools (such as reverse repo) to inject liquidity into the banking system if deposit funding is adversely affected by either a CBDC or a Stablecoin.

Since Facebook backed down on Libra, some central banks have indeed got more comfortable with the idea that CBDCs can co-exist with Stablecoins, in much the same way that fiat currency exists alongside other forms of money and near-money, such as commercial bank money deposits, treasury and trade bills, commercial paper, repos and money market funds. Such diversity can be a source of resilience as well as competition.

Other central banks and regulators have taken a more cautious view. In the United States, for example, the President’s Working Group on Financial Markets (PWG) issued a joint paper with the Federal Deposit Insurance Corporation (FDIC) and the Office of the Comptroller of the Currency (OCC) on 1 November 2021 warning that unregulated Stablecoins could lead to destabilising bank runs, disruptions to the payment system, and unwarranted concentrations of economic power.  It advised Congress to bring Stablecoins within the ambit of financial regulation.

Likewise, the Bank for International Settlements (BIS) is planning to extend certain of the Principles for Financial Market Infrastructures (PFMIs) (governance, risk management, settlement finality, direct claims on the issuer or the assets) issued by the Committee on Payments and Market Infrastructures (CPMI) and the International Organisation of Securities Commissions (IOSCO), to Stablecoins. This indicates that the BIS sees Stablecoins as a potential threat to financial stability, not least by mimicking a problem raised by CBDCs: undermining the capacity of banks to make loans by reducing their access to deposit funding.

However, it is reasonable to believe that regulators can devise policies and regulations that are capable of preserving the benefits of Stablecoins while mitigating the risks. In this context, a synthetic CBDC, in which the CBDC is held and used by PSPs but backed by central bank reserves, is of particular interest. It would be equivalent to a Stablecoin, but within the regulatory perimeter. 

Are CBDC designs taking the securities markets into account?

By creating the potential to use central bank money to settle the cash leg of securities transactions, CBDCs will have an impact on the capital markets as well. Central securities depositories (CSDs), which currently settle securities transactions by delivery of securities between electronic accounts against delivery of cash between accounts at the central bank, may find their occupation is gone. 

The impact may be felt in cross-border securities transactions too. The Bank of France and the Swiss National Bank have participated in Project Jura, a successful experiment in which they collaborated with the BIS Innovation Hub Swiss Centre and a private sector consortium, by which tokenised asset and foreign exchange trades were settled in CBDC using payment versus payment (PvP) and delivery versus payment (DvP) mechanisms. 

Project Jura shows that allowing third-party securities trading platforms to settle cross-border trades in CBDC by giving non-resident financial institutions access to central bank money not only works but could reduce costs sharply. 

In the securities markets these developments have implications for CSDs and the custodian banks which act as gatekeepers to the services of the CSDs.

Are CBDCs a potential solution to the high cost of cross-border payments?

Cross-border payments are already under severe regulatory pressure to cut the notoriously high costs paid by users. The G7 Principles (Principle 12) and the G20 principles (Recommendation 19) both favour using CBDCs to make cross-border payments more efficient. The CPMI “building blocks” for cross-border payments efficiency also include linking central bank CBDC systems.

Central bank projects, such as Project Ubin (conducted by the Monetary Authority of Singapore and the Bank of Canada between 2016 and 2021) and Project Dunbar (being conducted between the Reserve Bank of Australia, Bank Negara Malaysia, the Monetary Authority of Singapore, the South African Reserve Bank and the BIS) confirm that central banks are already comfortable moving money between their own systems rather than continuing to rely on commercial banks and independent market infrastructures. 

In other words, CBDCs may be used to settle cross-border payments through inter-operability between central bank CBDC systems. Only foreign exchange bargains will be reserved for commercial banks – though BIS research has found a minority of central banks are prepared to execute foreign exchange bargains as well. 

These developments will have an impact on the correspondent banks that intermediate most cross-border payments today and on the market infrastructures – such as CLS and SWIFT – that they use to do so. 

Will concerns about personal privacy be a constraint on the adoption of CBDCs?

There is understandable concern (albeit in some countries more than others) that CBDCs will infringe personal privacy, by giving central banks access to information about the holdings and transactions of individual citizens. On the other hand, official access to this information in some form is essential to deter and detect financial crime.

Already, privacy considerations are influencing the design of a CBDCs. 

One reason it is proposed that commercial banks remain sole gatekeepers to CBDCs, and run all accounts and settle all payments, is that the identity of the CBDC wallet-holder can remain known only to them. The same logic dictates that central banks cannot be involved in KYC, AML, CFT and sanctions screening checks, but must rely on third parties. 

A number of technical fixes (Zero Knowledge Proofs, Secure Enclaves, blind signatures, “layered” data management) have been proposed to balance privacy with security, but ultimately privacy will be breached in any jurisdiction whose government chooses not to respect it. 

Could a CBDC be a flop?

A central bank could issue a CBDC but then find neither consumers nor merchants adopt it, and the commercial banks resist it as a threat to their funding and so to their ability to create assets by lending.  

It will also take a lot of work to make a CBDC available through retail points of sale and to make it compatible with all the existing devices and applications which consumers use, including new digital services. 

So failure is a real possibility. 

However, central banks do also have tools they can use to encourage adoption, including using interest rates to attract CBDC deposits and catalyse spending. They can also migrate different payments channels on to their CBDC network, by the passage of regulations or laws. 

Governments could also insist taxes are paid in CBDCs.  But the main method of encouraging the use of CBDCS will be price: consumers and especially merchants will use CBDCs if they are cheaper than current methods of payment.

How do CBDCS escape the criticisms Bitcoin has faced: lack of scalability and speed and excess energy consumption?

Digital currencies obviously rely on electricity. But there are modifications of blockchain technologies (such as proof of stake instead of proof of work) that reduce electricity consumption. 

Electricity consumption is also likely to diminish over time, as CBDC models are refined in the light of experience. Besides, by comparison with the electricity consumed to run the current financial systems, CBDCs might appear relatively cheap.

How will CBDCs interact with developments in the Decentralised Finance (DeFi) markets?

DeFi is often portrayed as a digital version of existing financial services such as deposit-taking, lending and borrowing, insurance and asset management. In fact, its opacity and ability to generate leverage argue for DeFi market activities to be brought within the regulatory perimeter. 

The challenge is to find an effective way of bringing DeFi within the ambit of regulation without crushing its capacity for innovation. One option is to adapt to DeFi institutions the risk-based approach already used to regulate traditional banks. 

CBDCs also offer an opportunity in which the products being manufactured in the DeFi markets could be made available more widely, at lower cost, and in a regulated way. One way to do this is for CBDCs to become the base pair currency in DeFi markets, so regulators can monitor transactions.

Highlights of 23rd November Webinar

If you would like more information or we can assist in any way or you would like to pose questions ahead of the discussion please email Wendy Gallagher on wendy.gallagher@futureoffinance.biz