Coming soon to your e-wallet: central bank digital currency

In June, the Banque de France will begin interviewing applicants to work with it on experiments in the use of a digital euro in interbank settlements. These experiments will also explore integrating central bank digital currency (CBDC) into the clearing and settlement of tokenized financial assets.

Such prototypes could bring CBDC to the heart of payment versus delivery in conventional equity, bond and other listed and unlisted securities markets in the eurozone and test payment of one country’s CBDC against another’s.

Blockchain pioneers have been making the case for real-time payment by moving fiat currency in tokenized form since 2015. It may now be close to happening. Central banks that dismissed Bitcoin and attacked Facebook’s Libra are starting to embrace the underlying technology.

In May, a large component of the Italian banking system adopted a new application to reconcile discrepancies in the separate ledgers for the nostro and vostro accounts that Italian banks hold for each other. It operates as a permissioned network on R3’s Corda blockchain platform.

Behind the scenes the Banca d’Italia, long concerned by difficulties in reconciling interbank transfers, encouraged the project. By November, it is set to encompass the entire Italian banking system.

Far more radical would be widespread adoption of retail CBDC as an alternative to notes and coins.

“Many central banks have already run pilots on wholesale payment systems between commercial banks,” Kenneth Bok, head of growth and strategy at Zilliqa, a blockchain platform business in Singapore, tells Euromoney. “The Monetary Authority of Singapore [MAS] tested real-time gross settlement in 2017 with project Ubin phase 2; that then moved onto cross-border payments in phase 4 and is now in phase 6.

“Can distributed-ledger technology [DLT] increase efficiencies in RTGS [real-time gross settlement] systems? Yes, it can. But that is a technical solution for the most part.

“Retail CBDC is much more complex,” he continues. “If a central bank looks to augment M0 – what counts as cash and a promise to pay the bearer on demand – it will require a vast network of users and intermediaries to operate on the same new protocol.

“That is a much bigger question of monetary mechanics beyond the commercial bank level. It requires the consultation of many more stakeholders in the financial ecosystem.”

The first phase of the Covid-19 crisis – panic, lockdowns, job losses and government transfer of emergency support payments – saw a form of this consultation playing out. People are much more likely to want digital currency now than at the start of the year.

In a speech in May, Yves Mersch, member of the executive board of the European Central Bank (ECB) and vice-chair of its supervisory board, made clear that the bank will be prepared if populations express a clear preference for digital cash over physical.

The ECB is looking far beyond the experiments the Banque de France is about to conduct.

“A wholesale CBDC, restricted to a limited group of financial counterparties, would be largely business as usual. However, a retail CBDC, accessible to all, would be a game changer,” says Mersch.

And he makes clear: “A retail CBDC is now our main focus.”

There would be important design choices.

“A retail CBDC could be based on digital tokens, which would circulate in a decentralized manner – that is without a central ledger – and allow for anonymity towards the central bank, similar to cash,” says Mersch.

This is a central bank-blessed version of fiat currency on blockchain. That sounds radical, but it could be the best choice.

“Alternatively, a retail CBDC could be based on deposit accounts with the central bank,” adds Mersch.

This would not be particularly innovative from a technological viewpoint, but it would be an enormous undertaking and a dramatic change to the financial system.

“For the euro area, it would basically mean increasing the number of current deposit accounts offered [by the ECB] from around 10,000 to between 300 and 500 million,” says Mersch.

In the process it just might disintermediate the entire banking industry. Instead of only the banks having accounts with the ECB, all their customers would.

Why are central banks pushing ahead with CBDC now, amid a health and economic crisis when they, world governments and established banking systems have been pre-occupied with channelling financial support in the form of cash grants and subsidized loans to individuals and businesses?

There are two reasons. First, the crisis has renewed long-standing concerns over the efficiency of the existing financial system and its payment rails.

“Watching the Small Business Administration try to distribute Paycheck Protection Program loans to the small businesses for which they were intended has been like witnessing a slow-motion train wreck,” one US banker tells Euromoney. “Meanwhile, some individuals are still waiting for cheques in the post.”

Similarly, a UK banker described the first month of operating the Coronavirus Business Interruption Loan Scheme (CBILS) to Euromoney in four short words: “It’s been a nightmare.”

Policymakers are asking why moving money in an emergency has been so painful.

“Retail CBDC certainly has the potential to make the distribution of financial support much more efficient,” says Bok.

Early drafts of what eventually became the US Coronavirus Aid, Relief and Economic Security (Cares) Act had plenty of mentions of a digital dollar.

“There was an enormous amount of lobbying on the Hill and a lot of talk that technology companies might get money into consumers’ digital wallets faster than the banks could into their bank accounts,” another source tells Euromoney. “A lot of people were saying: ‘Let’s get Venmo and Square to do this’.”

That didn’t happen. But those early draft bills drew further attention to the potential for digital forms of central bank currency, not just as numbers in bank accounts, but as value that can be transferred immediately ­– from government to citizen, from peer to peer – and received instantly in an e-wallet on a mobile phone.

“Digital currencies may reduce the cost of friction in the current financial system – the logistics and security apparatus which surround conventional forms of money transmission,” says Dixit Joshi, treasurer at Deutsche Bank. “The cost of this friction sometimes hits hardest those who are most disadvantaged, for example, high charges on low-value payments back home for migrant workers.”

None of this payment innovation is going away, even though some established financial intermediaries may wish it would. Rather, it is accelerating.

The case for digital cash is becoming urgent in troubling ways.

As the initial panic over the new coronavirus intensified in the early months of 2020, fears quickly grew that it might survive for days on banknotes and coins that had passed through many hands. Could the deadly illness be transmitted through cash?

Back in February, the Peoples Bank of China began to take banknotes out of circulation in Wuhan, saying that it would destroy some and sterilize others. On March 6, the US Federal Reserve confirmed that it too had been quarantining dollar bills returning from Asia for seven to 10 days before releasing them back into circulation.

Central banks around the world began to announce a variety of inventive ways to disinfect banknotes, some exposing them to ultraviolet light, others to intense heat. Newspapers ran the inevitable comedy stories about people accidentally incinerating their cash in ovens and microwaves.

But nobody was laughing terribly hard. Assurances that notes are free of pathogens when they leave the central banks hardly inspire confidence.

The Bank of England rather sniffily announced in mid April that: “The risk posed by handling a banknote is no greater than touching any other common surface, such as handrails, doorknobs or credit cards.”

Maybe they still had sterilizing wipes and hand sanitizer in Threadneedle Street. In April, UK supermarkets had neither and were limiting how many bars of soap shoppers could buy. Handrails and shop doorways are precisely what everyone tries to avoid touching.

“Today, as social distancing measures become increasingly vital in the fight against a pandemic, the limitations of cash as a means of exchange become clear,” says Joshi.

Banks increased the limits on contactless payments, and although central banks pointed out that touching cards onto merchants’ payment devices and pressing PIN numbers into keypads might be just as dangerous as handling paper money, the notion quickly took hold that physical cash itself will be a victim of this pandemic.

By mid April certain central banks began to worry that things were going too far. The Bank of Canada, for example, urged retailers to continue to accept cash from those without debit or credit cards, wheeling out a medical expert to make its case. 

“We know that SARS-CoV-2 [Covid-19] can stick to surfaces for a few hours to a few days and this may include hard currency,” said Dr Isaac Bogoch, an infectious diseases physician and scientist at the Toronto General Hospital Research Institute. “Still, we can find ways to ensure that all Canadians have access to essential goods and services, even if they are using cash. Risk can be mitigated in retail settings using a variety of methods, including ensuring access to hand hygiene for all employees.”

Presumably the Bank of Canada has been sharing best practice with the Bank of England. It helpfully added that anyone still wishing to take additional precautions might apply a little soap and water to its new polymer banknotes, although it cautioned Canadians against this approach with the older, paper ones.

The Bank for International Settlements points out that – irrespective of whether such concerns are justified or not – perceptions that cash could spread the disease may change behaviour.

The pandemic thus brings recent and growing calls for CBDC to the fore.

Central banks were already increasing experiments with digital currencies in 2020, even before the pandemic took hold, spurred on by Facebook’s announcement last year of its Libra stablecoin.

That threatened their role at the heart of the monetary system, making it more urgent for central banks to get on top of both the technology and the attendant practical, legal and political issues relating to a potential restructuring of financial systems.

Pilot schemes had already gone beyond just emerging market central banks to include developed markets such as Sweden. And activity continues to intensify now as central banks look to get money to those usually paid in hard cash, who still make up a large part of the grey economy in, for example, southern Europe.

The BIS points out that “in the context of the current crisis, CBDC would in particular have to be designed allowing for access options for the unbanked and (contact-free) technical interfaces suitable for the whole population.”

Augustín Carstens, general manager of the BIS, noted in March that “the most transformative option for improving payments is a peer-to-peer arrangement that links payers and payees directly and minimizes the number of intermediaries. Many peer-to-peer arrangements use distributed-ledger technology.”

To become a trusted and widely usable medium for retail payments, any such systems require scalability, accessibility, convenience, resilience and privacy.

“The challenge,” says Carstens, “is to design a CBDC that combines the virtues of a direct claim on the central bank with the convenience offered by intermediaries.”

Where does this leave us?

“We first started thinking about central bank digital currency back in 2016, and it is still one of the top use cases for distributed-ledger technology that we have identified,” Todd McDonald, co-founder and chief product officer of R3, tells Euromoney.

He sees three groups that need to be engaged: issuers, users and intermediaries.

“On the one side, central banks are looking to update their tool kits to address the digital world. Some prominent figures who were politely dismissing digital currency three years ago are now starting to get serious about it. Bitcoin and Libra were a threat. But central bank digital currency is an opportunity. It potentially gives them powerful new tools to do their job.

“Of course, central banks have to move at the right pace on digital currency. This should not and cannot be rushed. But central bankers who were saying this might be something they could look to do in five years’ time are now stepping up the urgency significantly.”

Joshi points out other attractions for a centrally issued digital currency.

“Changes in interest rates can pass through immediately into the economy, reducing the dampening effect of cash hoarding. Interest rates applied to a digital currency may improve a central bank’s ability to stabilize across business cycles and reduce reliance on tools such as quantitative easing,” he says.

And there are more futuristic possibilities as new technology for money seems to take on a life of its own.

“Programmable money is now possible with smart contracts: money that is smart and knows how to distribute itself,” says Bok. “It is now technically possible for consumers to have accounts with the central bank directly with an app. This has already been implemented in Cambodia with ‘Project Bakong’.

“He or she walks into Starbucks and pays for a coffee while automatically splitting out the local sales tax. You can see why governments and central banks would love that,” Bok adds.

“We are seeing fundamental changes in how central banks look to manage economies. By tightening the feedback loops between economic data and monetary policy, as well as coordinating monetary and fiscal policy, central bank digital currencies can add an enormous degree of insight to the management of the economy.”

McDonald, looking beyond central banks to the next key group, explains: “On the other side, digital wallets might have helped those who have been particularly hard hit by this crisis – individuals, sole traders and small business owners, for example – to receive the government assistance they desperately need more efficiently and swiftly.

“Potential usage of a digital dollar is now in the public record as a consideration for early versions of the Cares Act. And that has increased the conversation about central bank digital currencies.”

In between the central banks that control the supply of fiat currency and the individuals and merchants who use it stand the intermediaries – banks, payments service providers and, potentially, big technology companies.

“For the service providers, it is both a threat and an opportunity,” says McDonald. “A financial system that transfers fiat currency in tokenized form will still have bank-shaped holes within it that need filling. This creates an exciting and diverse playing field. To become a digital-wallet provider you might be an existing bank, but you certainly don’t have to be.”

Gavin Smith, chief executive of Panxora, a group that includes a fund investing in cryptocurrencies and an exchange, says: “There is one school of thought that central bank digital currency might move within the existing banking model, with customers having wallets instead of accounts, but deposits sitting on intermediary balance sheets and retaining government protection, with it all operating rather like Apple Pay.

“But there is another, more revolutionary school where my assets would remain in my wallet and not go to a bank intermediary with deposit insurance. That would remove exposure to bank failure.

“In this model, the intermediaries might not be banks but they would still perform key functions, such as KYC [know-your-customer] and AML [anti-money laundering] checks to ascertain that a customer is a good actor.

“It would be a game changer if, instead of being aggregators of assets, banks became specialist service providers.”

The debate that Mersch identifies between token-based and account-based versions of CBDC will continue to run.

A system where corporations and individuals have accounts at central banks, instead of, or as well as, accounts at commercial banks, raises big worries of massive and immediate runs in a crisis tipping banks over.

Central banks could charge negative returns to customers depositing CBDC with them in order to keep banks in business during normal times. Central banks don’t want to handle hundreds of millions of retail and business accounts, let alone perform credit underwriting to extend loans. A banking system has evolved over centuries to do this.

Central banks are the wholesale distributor of money, but banks are more than just the retail store front and account managers. They are also outsourced creators of money.

The present crisis has only emphasized this. All those companies that drew down their revolving credit facilities in March and April and deposited the proceeds back into their business accounts are now pointing to cash on hand. That is cash the banks simply created for them.

This is the core of fractional reserve banking; creating money through credit extension in a system backed-stopped and overseen by central banks but not operated by them.

It may be costly and inefficient. It may have too many rent-seeking intermediaries that offer no value. But we disrupt it at our peril.

So do we really need to fix it?

An account-based retail CBDC could overthrow the banking system. That is an enormous risk, of the type that governments and central banks do not usually take.

“Banks could still offer a service to lend money, if owners move some of their CBDC into a central pool that banks lend out,” says Smith. “Margins would become much more transparent. Lending would become a service.”

But it would also bring new and direct risk exposure for depositors to debtors. The present system offers savers zero return but also zero risk.

And then there are privacy issues. Yes, criminals use large denomination bank notes. But law-abiding citizens may not wish central authorities to see every detail of what they spend their money on or who with.

“If a central bank digital currency needs to resemble as closely as possible physical cash in your wallet, that probably means it should be token-based,” McDonald says. “And distributed-ledger technology, which is designed to prevent double spending, is well suited to that.”

Bankers are not opposed to CBDC, even though it has obvious risks for them.

“Failure to explore the option is the greatest risk of all,” says Joshi.

Over 400 banks have signed letters of intent to join JPMorgan’s Interbank Information Network (IIN), a platform on the Quorum blockchain for sharing information on cross-border payments, which participant banks can use to reconcile mismatches and chase down missing identifiers that prevent completion.

Those 400 include 28 of the 50 largest banks in the world.

It is not a network for moving money, although the possibility that it might become one has lurked in the background ever since JPMorgan announced its dollar stablecoin in February 2019.

“Moving money between JPMorgan branches was one of the first things we thought of for blockchain back in 2015 and 2016,” says John Hunter, global head of IIN at JPMorgan. “Even without going that far, the IIN network is highly valuable.

“There is a lot of talk about central bank digital currency right now. I am not sure the world banking system is ready to dismantle a pretty effective book transfer network and move onto a decentralized ledger system. But we do have JPM Coin, which provides the ability to move tokenized money if use cases emerge that require a settlement token.”

Stablecoins pegged to fiat currency and backed by deposits but moving swiftly over new rails are a potential intermediate step towards CBDC. Bankers say that Tether, a US dollar stablecoin, is increasingly being used by companies in southeast Asia, for example.

The worry for central banks is that they can’t see this activity clearly. They need to keep on top of payments technology as it evolves.

Zilliqa is a partner in Xfers, a regulated e-money and e-payments provider in Singapore whose digital wallet is approved by MAS. Xfers runs a stablecoin called StraitsX, pegged 1:1 to the Singapore dollar, that runs on the Zilliqa blockchain. MAS has taken close interest.

“The StraitsX team has had several consultations with MAS on many aspects of the XSGD project, including stringent cybersecurity and operational protocols,” says Bok. “There are currently certain limits with e-money as defined in the newly enacted Payment Services Act.”

For example, you might buy a coffee with your stablecoins or groceries but not a house or a car.

“The MAS is a very forward-thinking and technologically sophisticated regulator,” continues Bok. “It wants a robust framework around e-money and stablecoins but not at the expense of stifling innovation. Stablecoins hold the promise of disintermediating legacy financial infrastructure and, by demonstrating adoption, could well be the way CBDCs eventually take off.”

However, stablecoins have not won over everybody, even in the crypto world.

“I don’t like them. They are opaque,” says Smith at Panxora. “They may claim to be fully asset backed, but actually they may not be. You will see stablecoins break the buck. I would much rather transact into a central bank-issued digital currency. In fact, I can’t wait for the central banks to do it.”

Banks are constantly telling us that in the Covid-19 emergency they have been part of the solution, not part of the problem. However, the slow pace and inefficiency in payments distribution raises questions over that claim.

Is there a better way? Could big tech have distributed money more efficiently to more people in a shorter time? The time may come when central banks have to decide whether or not their prime responsibility to citizens overrides their mandates to maintain the current financial system and the banks.

“Crises are drivers of innovation and change,” says Neil Sheppard, a former Nomura banker and now chief operating officer of financial services at Diginex, a digital financial service and blockchain solutions company. “More and more pilots for central bank digital currency force many more people operating within financial services to recognize the emergence of a new financial infrastructure.

“Now, the thought of unplugging legacy infrastructure is daunting. Securities markets are already electronic, but they no longer need to operate on T+2 with three ops staff for each trader. Technology evolves. There was a time when you would go to the bank and ask to take your gold out, until everyone started to accept the pieces of paper that represented the gold.

“Is it really so radical to move from an account at a bank to a digital wallet on my phone, where, by the way, I already have my bank app? Go to China,” says Sheppard. “Shops rarely have cash registers anymore. They have QR code readers.

“Of course in an ideal world, the planning stages would involve coordination between consortia of central banks to ensure at least interoperability and low friction, if not a single common infrastructure. But look at all the studies. They suggest CBDC as one of the most beneficial use cases for the new technology. It’s not even a marginal discussion.

“Some in the banking industry seem to think they are being pushed towards a technology cliff edge and urged to leap off. When they get there, they will likely find it is smaller than stepping off a curbstone.”