Digital currencies inject new possibilities into cross-border payments

Digital currencies have been developing off the back of cryptocurrencies, with the private sector having spawned numerous stablecoins backed by fiat currencies.

Not to be left behind, most of the world’s central banks are investigating the prospect of launching central bank digital currencies (CBDCs). Depending on their usability, they could conceivably displace stablecoins. The Bank for International Settlements (BIS), which sits at the intersection of international CBDC co-operation, suggests that the technological innovations offered by crypto should be harnessed for CBDCs while adding trust. 

In a blog post on September 1, the International Monetary Fund (IMF) defined the main goal of digitising money as being about much cheaper, instantaneous domestic and cross-border payments.

And there is much at stake. The consultancy Oliver Wyman and bank JPMorgan note that global corporates shunt nearly $23.5tn across borders every year, equivalent to around 25% of global gross domestic product. Using the current legacy technologies directly costs them $120bn a year and that excludes costs related to exchanging currencies, trapped liquidity and delayed settlements. The two estimate that a full-scale CBDC network could hack 80% a year off direct costs.

Meanwhile, the Bank of England foresees overall cross-border payments hitting $250tn by 2027 from $150tn in 2017. 

For many observers, cheaper cross-border payments is the biggest advantage offered by CBDCs, particularly for developed countries, which already have very efficient domestic payment systems. 

“Incentives to improve cross-border payments exist for each and every single country,” according to Tara Rice, head of the secretariat supporting the Committee on Payments and Market Infrastructures (CPMI). “It helps trade finance, it helps households and businesses, so incentives to step back from the system of global payments or co-operation, they’re just not there.” 

Speaking at a virtual event on August 31 hosted by think tank the Peterson Institute for International Economics (PIIE), she said adapting CBDCs for cross-border payments is basically a technical issue.

The reality is that cross-border payments are currently time consuming, expensive and are often routed through complex networks with each layer adding to costs. Since the 2007-9 global financial crisis and greater vigilance over criminal finance, the global network of correspondent banking relationships has shrunk. 

According to a March 2020 BIS paper, the number of active correspondent banks fell 20% from 2011 to 2018 along with a 10% fall in the number of so-called payment corridors, a single routing system underpinned by a robust supervisory regime. 

The BIS worries that this could see users turn to less regulated shadow payment providers, such as in the crypto space, which would undermine global financial integrity. Another problem is this trend is choking off access to US dollars for some smaller emerging economies. This steady shrinkage erodes the positive network effects of correspondent banking. 

Such is the growing urgency of the issue, that in 2020 the Financial Stability Board (FSB) launched the cross-border payments programme in coordination with the CPMI.  “It’s a very ambitious response to these challenges. A lot of progress has been made. But we’re now at an interesting inflection point,” said Ms Rice. 

Implementation innovation 

She warns that implementing CBDC payment systems is going to require a different set of expertise than the CBDC design phase. 

The CPMI has identified 19 building blocks involving action from global standard setters, public bodies and the industry. Ms Rice said they are prioritising three broad themes, which include payment system interoperability and extension. “This is really a technical issue. We have the technology to do this, but it needs to be carefully thought about,” she said.

Beyond that there is a need to focus on legal, supervisory and regulatory frameworks, which requires some international harmonisation of regimes. “That’s a big lift. We also need to think about cross-border data exchanges and messaging standards,” she said. Other loose ends include engaging with non-G20 and non-CPMI jurisdictions and establishing public-private partnerships. The FSB will release a progress report on these topics in October.

“There's going to be a lot of innovation that’s required on many levels,” said Joseph Sommer, former counsel at the Federal Reserve Bank of New York, who participated in the PIIE event. “There’s going to be operational innovations.” He listed areas, such as security, interconnectivity, centralisation, straight-through processing and netting, which requires legal innovation, as among key areas to be tackled.

“It’s going to be hard. For instance, IT costs keep going up. The pecuniary costs of this are going to be extraordinarily high, but it’s probably worth it,” he said.

Though Mr Sommer said there should be benefits, such as the prospect of having 24/7 payments, they come with question marks. For instance, failing banks are typically wound down over a weekend when financial markets are closed. But in a 24/7 environment a ‘resolution weekend’ would be impossible. Though Mr Sommer did not have an alternative solution in mind, he is relatively optimistic that answers will be found. 

But that is not all. “If you design a system that doesn’t fail, its failure is going to be extremely catastrophic. That’s especially true for tightly interconnected systems,” he said.

Mr Sommer noted that payment systems worked well during the 2007-9 global financial crisis; however, that also meant not much was learned from that part of the financial system in terms of boosting its resilience. Other financial markets, meanwhile, such as derivatives and some financial infrastructures, underwent severe structural convulsions and have since been greatly improved. “There’s a huge tendency in this business to think that you’ve solved a risk when you haven’t,” he said, reflecting on possible lurking dangers from implementing new payment systems.

Turning to whether global political tensions could ruin global co-operation efforts to improve cross-border payment systems, Mr Sommer was relatively sanguine. He noted there are parts of the world that already work together and it is also where most of the transactions happen. “At the wholesale level, I'm not too worried,” he said. 

In that context, the PIIE event also discussed China’s work on CBDCs. Ms Rice noted that CBDCs are still in the early stages with only four countries being live including China, which is working with the BIS Innovation Hub. Despite growing geopolitical tensions with the West, the People’s Bank of China (PBOC) is sharing lessons and technical details from its CBDC pilot with the BIS. 

“Geopolitics is definitely a challenge, especially in this day and age,” said Ms Rice. “However, we try to take geopolitics out of some of these more technical decisions.” The PBOC is a member of the CPMI and participates in all its meetings. “At the level that we’re working at, to improve cross-border payments, I can say that coordination is good,” she said. 

“My opinion is that China wants to integrate and already has. If China wants a separate system, China will have a separate system,” said Mr Sommer. 

Following a volley of punitive sanctions following its invasion of Ukraine, Russia has pulled back from its participation in the CPMI. 

Stablecoin concerns

Another possible solution for making cross-border payments cheaper and faster are stablecoins. 

Chris Harmse, vice-president at BVNK, a crypto payments firm, believes that crypto-based stablecoins will emerge as the de facto currency for cross-border payments. He notes that they can conduct international settlements in a matter of hours and are much cheaper than traditional payment systems. Writing for online publication Finextra on July 12, he said major payment service providers (PSPs) are upping their use of stablecoins to settle with merchants thanks to their lower costs when compared with legacy systems. He added that some PSPs are now working on integrating cards, alternative payments and crypto payments into single application programming interfaces.

However, not everyone is so sure that stablecoins are the future of payments, not least as some central banks harbour some scepticism about them.

The payments consultancy Edgar Dunn & Co wrote in a blog on August 1 that stablecoins face formidable barriers before they are able to be used for cross-border payments. 

It raised issues such as the lack of interoperability between stablecoins and also some of the blockchains they run on. And should they overcome those limitations, the firm warned that they could quickly run into problems with regulators concerned about concentration issues.  

Other challenges highlighted in the blog post include the tendency of crypto exchanges to charge relatively high fees for swapping coins, such as going from a dollar to a euro stablecoin. Yet another hurdle is anti-money laundering rules, the costs of which undermine the transaction benefits of stablecoins. 

The European Central Bank believes that CBDCs hold the greatest potential to deliver instant low cost and secure cross-border transactions. The central bank is also concerned about stablecoins posing risks to monetary sovereignty and financial stability. Other central banks, such as the US Federal Reserve and the Bank of England, appear more relaxed about stablecoins, providing they are tightly regulated and supervised. 

On July 13, CPMI-International Organization of Securities Commissions published a final report on stablecoin arrangements with guidance about regulating them (see September's Global Risk Regulator: Stablecoins winning regulatory acceptance – but at a price).  

The main thrust of those recommendations is that stablecoins used as payments should be treated as financial market infrastructures for regulatory and capital purposes. Those deemed systemic should follow the full suite of financial market infrastructure principles and standards. This would amount to imposing requirements, making it costly for stablecoin operators. 

However, even that might not be enough for the sceptics. “There is a broad view that regulation, supervision and oversight of stablecoins alone might not be sufficient for them to be safe and efficient payments,” said Ms Rice, explaining that the BIS is concerned that they could lead to a fragmented and fragile monetary system due to their interactions with crypto and decentralised finance. The global standard setters continue to investigate the risks and benefits associated with stablecoins. 

Building momentum 

Momentum appears to be building behind CBDCs, partly over fears that a stablecoin could emerge from one of the big tech firms that could undermine central bank sovereignty.

On July 9, a joint report by the BIS, CPMI, IMF and World Bank concluded that CBDCs do have the potential to enhance efficiency – provided countries work together. And there is some uncertainty around that. 

The IMF blog post warned that the longer it takes to put in place the necessary regulation, the more national governments will become locked into differing regulatory frameworks. Indeed, senior staff at the IMF have called for globally coordinated regulation to bring order to markets, help instil consumer confidence and provide a safe space for CBDC innovation.

However, CBDCs for the major jurisdictions are far from being a given. Fitch Ratings, for instance, noted on August 26 that it is still not clear that CBDCs will be the most effective tool to improve cross-border settlements. It said incremental improvements to existing systems, for example, may be able to offer less disruptive paths for progress, which echoes remarks by some members of the Federal Reserve.

This article first appeared in Global Risk Regulator, a service from The Banker.