CBDCs: a digital step change? - World -

Digital currencies sponsored by central banks are now being widely trialled. But what hurdles remain to slow down their development, and what role will climate change play? 

Coin on its own

Recent history has not been kind to the Marshall Islands. Located in the middle of the Pacific Ocean between the Philippines and Hawaii, the country was caught between Japanese and US forces in the Second World War. The US military subsequently used the country as a nuclear testing site in the decades after the conflict, leaving a legacy of radioactive contamination. The threats facing the Marshall Islands have not abated, even though military activity has waned; today, climate change represents an existential peril for an island state with an average elevation of just two metres above sea level. 

To compound this situation, the retreat of correspondent banks from servicing small and remote countries has left the Marshall Islands at risk of losing access to the global financial system. A lone domestic lender has one such relationship left to cater to a dollarised economy with no currency of its own. But as these worries and others weigh on the country’s future, the government is turning to digital finance in the search for solutions. To this end, the Marshall Islands is at the vanguard of efforts to issue the world’s first national digital currency. 

Known as the Marshallese sovereign, or SOV, the currency as envisaged will be decentralised and blockchain-based and will be the country’s new legal tender. Once launched, it will offer a glimpse of the ways in which state-backed digital currencies can improve livelihoods, offer solutions to socio-economic challenges and ultimately transform the conduct of finance. 

Defining terms

The SOV is one of a growing number of proposed digital currencies more typically known as central bank digital currencies (CBDCs), a fully digitised form of fiat currency. CBDCs, as defined by blockchain technology company ConsenSys, are a digital asset accounted for on a single ledger that represent a claim against the central bank, which also controls its supply. Two types of CBDC can be developed: a wholesale CBDC, covering payments between banks as well as other entities that hold accounts with the central bank, and a retail CBDC for consumers and businesses. In either case, a CBDC would exist alongside, and complement, a traditional currency. 

That the Marshall Islands lacks a central bank, or its own existing legal tender, makes its experience unique. Nevertheless, the rationale for its development is clear. “Many smaller countries are facing the challenge of de-risking because more stringent regulations are putting their correspondent banking relationships at risk. The SOV, once completed, will help the Marshall Islands address this problem,” says Peter Dittus, the chief economist for SOV and former secretary general of the Bank for International Settlements (BIS). 

“The Marshall Islands is also facing significant developmental challenges, not least due to climate change. And so far the country is being financed to a large degree by transfers from the US government under an agreement that comes to an end by 2023. That will lead to a huge loss to the budget and national income, and the authorities are looking at ways to reduce expenditures and raise money. The SOV is one option the Marshall Islands is exploring to address this challenge.” 

By launching the SOV, the Marshall Islands is positioning itself to weather these storms and look to a more prosperous future. The government intends to keep 50% of the initial supply of SOV units to be allocated among four trust funds, including the RMI National Trust Fund, the Marshall Islands Green Climate Fund and the Marshall Islands Nuclear Legacy and Health Care Fund. In doing so, the SOV will play a role in meeting the country’s climate-related and socio-economic development challenges.

Meanwhile, the Marshall Islands hopes that financial exclusion will be limited by developing its own currency with anti-money laundering and countering the financing of terrorism (AML/CFT) safeguards built in through user identity checks. Given that a large proportion of Marshallese live and work in the US and send remittances to their families, such moves are considered to be highly important. But there is some way to go before these complex aspects of the currency’s development are finalised. To this end, discussions are continuing with the US Treasury and the International Monetary Fund. A pre-sale of SOV placeholder tokens will begin in 2020, before the currency’s expected launch shortly after. 

A digital advantage

The experience of the Marshall Islands is instructive, illuminating both the opportunities and challenges for countries going down the digital currency route. For some time now, a number of central banks around the world have been researching the implications of launching their own digital currencies. The reasons and potential use cases are complex and vary from region to region. They include the declining use of cash in some markets, the need to improve and modernise payments systems, financial inclusion and the universal requirement of improving AML and CFT frameworks. What is clear, however, is that CBDCs have the potential to deliver meaningful advantages.

“When we explore the implications of blockchain technology, there is always a need to build bridges between the digital world and the legacy economy. The missing link is often the means of payment that is compatible between the two,” says Ken Timsit, managing director of ConsenSys. “What is exciting about CBDCs is that they make it possible to connect blockchain-based business models with the legacy world.”

In late 2018, the BIS conducted a survey of 63 central banks, representing markets that account for 80% of the world’s population. The study indicated that 70% of these institutions were actively researching CBDCs. About half of these central banks had moved beyond theoretical and conceptual research to what the BIS described as proof-of-concept-type activity based on testing different technologies. Nevertheless, the report notes that although CBDC research has reached an advanced stage in some jurisdictions, few central banks are considering plans to launch their own digital currency in the short to medium term. 

“Central banks generally fall into three camps when it comes to the development of digital currencies,” says Lynn McConnell, chief financial officer at Custody Digital Group. “There is a first group that has, for the most part, been conducting research and has internal projects. Then there is a second group that has seen the need for some light testing or active pilot programmes in order to understand what the payments impact will be in their environment, among other scenarios. And then there’s a final group that has no real desire to get involved and is just looking to improve the existing payments systems and infrastructure.”

Facebook steps in

Since the BIS study was published, however, the CBDC landscape has experienced a seismic shift: in June 2019, a Facebook-led consortium announced plans to launch a digital currency, Libra, tied to a basket of fiat currencies and capable of tapping into the tech giant’s global base of 2 billion users. The move was a wake-up call for central banks around the world. 

“Libra has been a game-changer,” says Teunis Brosens, lead economist for digital finance and regulation at ING. “Central banks have been dabbling in digital currencies for a while now. But it has always been an armchair debate – Libra changed all of that. Since that announcement you can see that central banks are very serious about looking into this.”

The Libra announcement sent tremors not only through central banks, fearful of losing their monetary sovereignty, but also through private financial institutions set to be undermined by a new financial order. 

“The Libra announcement was most definitely an inflection point in the context of CBDC development,” says Mr Timsit. “What we have seen in response is a flurry of activity from financial institutions reacting to a tech [giant] moving into the payments business. They are pushing central banks to take action and address this challenge.” 

Central banks around the world are now enhancing their efforts to research and develop use cases for CBDCs, though some apex institutions are well ahead in this regard. The People’s Bank of China, for example, has already filed patents covering the issuance and supply of its digital renminbi, as well as a system for interbank settlements and the integration of digital renminbi currency wallets into existing bank accounts, according to a report from the Financial Times

Enter the e-krona

Meanwhile, in January 2020, the Bank of England, Bank of Japan, European Central Bank, Bank of Canada, Swiss National Bank and the BIS established a group to share information and experiences on potential use cases for CBDCs, functional and technical design choices and cross-border interoperability, among other issues. The co-operation of these advanced economies points to the seriousness with which they are taking CBDC development. 

Sweden’s central bank, the Riksbank, boasts one of the most advanced CBDC programmes anywhere in the world. A precipitous decline in the use of cash in Sweden has stimulated the development of an e-krona, as the authorities respond to the prospect of cash no longer being accepted by retailers in the coming years. Over 2020 the Riksbank is running the e-krona through a test environment to determine how it would function. Among other things, the central bank will monitor payments with e-krona through mobile phones, watches and cards, while simulating payments with retail outlets and service providers.

“There are so many aspects of CBDC development that need to be looked into and that is why central banks want to run sprints, or pilot programmes, to test what the outcomes can be from an environmental perspective and a financial stability perspective,” says Ms McConnell. 

Emerging markets

Nevertheless, Sweden is something of an outlier among advanced economies. Few other developed markets are close to matching the progress achieved by the Riksbank, particularly regarding its focus on retail CBDC development. This partly comes down to market specifics, given that few other countries have experienced a decline in the use of cash comparable to Sweden’s, while payments systems and associated infrastructure are generally well established in these economies. 

“Many advanced economies haven’t had a need for a CBDC yet,” says Bhavin Patel, senior economist and head of fintech research at the Official Monetary and Financial Institutions Forum. “Consumers in these markets don’t tend to face many challenges when it comes to making payments and bank transfers. The need for CBDCs comes mostly from emerging economies.”

Though this may change, most progress on the work towards a retail CBDC is likely to occur among smaller emerging market economies. “Small island nations, such as the Bahamas, are where we will see the greatest progress. There are fewer political impediments and technical challenges, so a CBDC will be easier to implement,” says Mr Patel. 

Indeed, the Central Bank of the Bahamas is trialling a blockchain-based ‘sand dollar’ in a number of outlying islands until mid-2020. This digital version of the fiat currency, the Bahamian dollar, will permit citizens to enrol for a digital wallet through the central bank. In addition, the rollout of point-of-sale systems to businesses across the Bahamas is envisaged to support the currency’s necessary physical infrastructure. 

The sand dollar is anticipated to go nationwide in the second half of 2020, according to various press reports, though it is unclear whether this objective will be met. Similar to SOV in the Marshall Islands, the digital currency will help the Bahamas address a range of issues, from de-risking, to a lack of bank branches across a dispersed island nation, to the cost of maintaining and distributing cash. 

No boundaries?

Beyond domestic frontiers, for many analysts the real value of CBDCs lies in their potential to be used on a cross-border basis. This is particularly true for regions with high levels of migrant workers. 

“I think the need drives how fast the work towards a CBDC is conducted. Financial inclusion and remittances will be a big use case,” says Mr Patel. “In east Asia, where you have a lot of migrant worker flows, we could see central banks working together to create a new payments system just for these workers and their remittances in the next two to three years.”

Two central banks have already cooperated on cross-border and cross-currency digital payments. The Bank of Canada and the Monetary Authority of Singapore trialled a link up of their domestic experimental payment frameworks constructed from two different distributed ledger platforms in the first trial of its kind. The trial successfully executed a cross-border transaction without participation of a third party, involving a Canadian Dollar-Singapore Dollar payment. Nevertheless, more work is needed to determine how an approach of this kind would work at scale.  

Indeed, the issue of achieving interoperability between CBDCs, as well as between digital currencies and the existing financial and payments framework internationally, will be key to the success of CBDCs. While it may be, in relative terms, easier to deploy a CBDC within a domestic market, ensuring that the currency can be used and has value beyond national borders will be more difficult to achieve. 

“The domestic payment systems of many advanced countries work quite well, so the benefits of CBDCs are easier to explain and demonstrate when it comes to cross-border trade and payments. As a result, for individual countries to recognise the benefits, it is important for CBDCs to be interoperable,” says Mr Timsit. 

According to Mr Timsit, developing interoperability would be easier if central banks deployed the same blockchain networks to underpin their digital currencies, with Ethereum representing the most effective available option. “The open-source nature of Ethereum would make it more likely for this blockchain network to achieve interoperability between different markets,” he says. “In other words, developing a CBDC on your own and that only works within your borders is useless. You have to design it in a way that is interoperable. Ethereum is much more acceptable for central banks around the world because it is not controlled by any large company or country.” 

Maintaining stability

Though the benefits of CBDCs are clear, the questions around their mechanics and the ways in which they will disrupt or alter the existing financial sector landscape, as well as macroeconomic stability, remain unanswered. 

“In advanced economies, the focus will be on research and the debate around the financial stability impact,” says Mr Patel. “Right now we have regulations in place that work, payment systems in place that work, so in what ways would CBDCs come in and disintermediate or disrupt things that currently function?”

Understanding the ways in which central banks can manage the introduction of CBDCs in large and highly complex markets includes grappling with issues of monetary policy, AML/CFT frameworks, the potential disintermediation of actors in the payments ecosystem and, above all, the role that commercial banks will play with respect to the digital currency. Nevertheless, as CBDC trial programmes mature, some solutions are becoming clearer. In particular, the role of commercial banks, as well as payments intermediaries more generally, might look similar to their role in today’s market. 

“The existing payments infrastructure is a public-private partnership with the central bank overseeing operations,” says Mr Brosens. “Traditional cash offers a useful parallel. Cash is a central bank liability but the distribution is overseen by the banks. So I can very well imagine that this will serve as a blueprint as to how a CBDC would be implemented.” 

With a number of markets on the cusp of launching CBDCs in the coming years, the world of finance is set for significant change. It may be a slow revolution – and one that stems from the archipelagos of the Marshall Islands or beyond – but the introduction of CBDCs is now just a question of time.

“From my perspective I am positive about [the prospect of] CBDCs. I am more conservative on the timing,” says Oliver Bussmann, chief executive and founder of Bussmann Advisory. “[The full launch of a CBDC] will definitely happen but not until three to five years down the road. But this timeframe could be accelerated if one of the big countries were to issue a digital currency.”

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