Central Bank Digital Currency and Payments


Globally, the means through which payments are made has changed drastically in the last ten years. In Africa, the unbanked have been enabled to make payments using their mobile phones. 

In Asia, there has been a move to reduce the number of cash payments, by reducing large denomination notes in India to removing coins in South Korea. In Europe and the US, the use of cash has reduced through online transactions and the increasing use of card payments. In South America, both Argentina and Venezuela have made use of Bitcoin to make monetary transfers and as a store of value as an alternative to the hyperinflation of their fiat currency. 

With a changing payments landscape, Central Banks have recognized that they too need to develop to aid this transition and incorporate new technology. If a private e-money issuer was to control the majority of payments in a country and there was a clear move away from the fiat currency, the CB would lose its ability to implement monetary policy. Against this backdrop, Central Banks are trying to understand the financial and economic impact of introducing their own digital currency. Introducing CBDC would have a seismic effect on the retail banking system.

Some Central Banks have started to analyze the potential to issue digital currencies of their own. This research has been driven by the success of new technology in the financial sector, the declining use of cash, and the rise of digital currencies. 

Image source - Bank of England CBDC Paper
According to a January 2019 report by the Bank for International Settlements (BIS), at least 40 central banks around the world are currently, or soon will be, researching and experimenting with central bank digital currency (CBDC).

CBDC is a commonly proposed application of blockchain and distributed ledger technology (DLT), it surely has attracted much interest within the central banking community for its potential to address long-standing challenges such as financial inclusion, payment efficiency, and payment system operational and cyber resilience. Including but not limited to CBDC, central banks are researching and experimenting with at least 10 specific use cases of DLT, exploring where they can potentially unlock new possibilities and improve inefficient processes.

One of the use cases focusses on the issuance of new money equivalent to – and redeemable for – its domestic currency, often simultaneously removing the equivalent amount of currency from the money supply. It may be issued for general use (“retail” CBDC) for peer-to-peer payments and payments from consumers to merchants, or for use by commercial banks and clearing houses (“wholesale” CBDC) for more efficient interbank payments that occur outside traditional correspondent banking and other payment systems. CBDC may or may not be issued using DLT, it can alternatively operate on traditional centralized technologies.

Distributed Ledger technology

A distributed ledger (also called a shared ledger or distributed ledger technology or DLT) is a consensus of replicated, shared, and synchronized digital data geographically spread across multiple sites, countries, or institutions. The distributed ledger database is spread across several nodes (devices) on a peer-to-peer network, where each replicates and saves an identical copy of the ledger and updates itself independently. The primary advantage is the lack of central authority. When a ledger update happens, each node constructs the new transaction, and then the nodes vote by consensus algorithm on which copy is correct. Once a consensus has been determined, all the other nodes update themselves with the new, correct copy of the ledger. Security is accomplished through cryptographic keys and signatures.

The difference between a centralized and decentralized ledger- Tradeix 

So, Why CBDC in Payments? 

Cash use is increasingly reducing due to the ease of payments using cards, apps and contactless. It is not envisaged that there will be a move to ban notes and coins but as the number of digital transactions increases and the withdrawal of cash from ATMs declines. Although it is very unlikely that a CB would remove cash from the payments system, it may occur due to negative externalities of cash. By its nature money is difficult to trace which makes it attractive for tax evasion, money laundering and illegal transactions.

Improve the efficiency of Payment Systems -
A CBDC could improve the efficiency and safety of both retail and large-value payment systems. On the retail side, the focus is on how a digital currency can improve the efficiency of making payments—for example, at the point of sale (POS), online and peer-to-peer (P2P). There could also be benefits of having a CBDC for wholesale and interbank payments; for example, it could facilitate faster settlement and extended settlement hours. 

Improve cross border payments efficiency -

A joint study published by the Central Banks of Canada, the U.K. and Singapore [3] focused on the potential for a CBDC to improve counterparty credit risk for cross-border interbank payments and settlements. The wholesale version of CBDC limits its use to only financial institutions and markets. The current model for cross-border payments relies upon CBs operating the RTGS infrastructure within which commercial interbank obligations must settle. There are limitations to this system as there are time lags for cross-jurisdictional payments, during which counter-parties are exposed to credit and settlement risk from their correspondents. 

The study analyses the use of wholesale CBDCs as an alternative approach to cross border payments and found: 

- A jurisdiction-specific wholesale CBDC which cannot be exchanged across borders offers little benefit over the existing model.

- A jurisdiction-specific wholesale CBDC which can be exchanged across borders could significantly improve counter-party credit and payment and settlement risks. 

- A single universally accepted wholesale CBDC could also significantly improve counter-party credit and payment and settlement risks. The benefits of these CBDCs include 24-hour availability, anonymity, and eliminating counterparty credit risk for participants. 

However, all of the wholesale CBDCs were found to perform worse than the existing governance framework. The wholesale CBDCs would lead to a mix of benefits and drawbacks for Central Banks’ future role and oversight. The study did not provide any analysis on cross border payments for a widely accessible CBDC.
Meanwhile, the European Central Bank (ECB) and the Bank of Japan conducted a joint pilot Project Stella beginning in 2016, which explores whether the technology can improve domestic interbank payments and settlements (phase 1) and facilitate rapid interbank trading and settlement of securities for cash (phase 2). 

Early Implementations 

While research and innovation with blockchain technology have been underway for the past several years, few organizations have actually deployed the technology. Although central banks are among the most cautious and prudent institutions in the world, they are, perhaps surprisingly, among the first to implement blockchain technology. The Bank of France implemented Project Madre which has fully replaced its centralized process for the provisioning and sharing of SEPA Credit Identifiers (SCIs) with a decentralized, blockchain-based solution. The project began as a proof-ofconcept in June 2016 to learn more about DLT with a simple use case. The central bank identified an opportunity where DLT could be valuable to automate and digitize a manual and time-intensive process that requires coordination and information sharing with multiple banks. 

The below table in the WEF report summarizes some of the noteworthy benefits and downsides to retail CBDC that are discussed in research today. 


Conclusion:

The impacts of a CBDC will be influenced by the availability and design of the CBDC, the form of which is open to many different options. The CBDC implementation will also be impacted by the regulatory regime introduced by the CB to support commercial banks. At this stage, dozens of central banks from across the world are actively investigating whether blockchain and DLT can help solve long-standing interests such as banking and payments system efficiency, payment security and resilience, financial inclusion and more. 

Excerpts from WEF Report and actuaries.Org