Central bank digital currencies (CBDCs) are undoubtedly a hot topic. Mid-way through 2021, it’s fair to say that not a week goes by without news from at least one central bank of their latest plans for tests, pilots, and live trials. In the UK, Rishi Sunak’s announcement on 19th April this year of a joint HMT-Bank of England taskforce to “coordinate exploratory work on a potential central bank digital currency”, has led to a range of reactions from the media: excitement, bewilderment, confusion, a misguided perception that the UK is about to create its own cryptocurrency, and a heartfelt plea of “could someone please explain what this all means for us” being foremost amongst these. For financial markets participants, it’s particularly important to understand the potential for CBDC to transform the ways in which wholesale payments are made, and the potential opportunities for innovation and evolution of financial markets.
Check out our podcast episode: CBDC and the Future of Wholesale Payments on Spotify
Let’s start with the basics. What is a CBDC, and how does it differ from the digital forms of money that we have today? Isn’t money already effectively digital, given the increasing move to a cashless society, and the advanced state of electronic interbank payments? The answer is yes, with a few caveats. The digital payments infrastructure that we have today has been evolved incrementally over many decades, and many of the design features underpinning that infrastructure embody technological constraints at a point in time. The principle behind CBDC is that it is digital-native – it’s designed to meet the requirements of a modern and increasingly digital economy, and it can be implemented using frontier technologies that enable these requirements to be fulfilled.
CBDCs are often associated with distributed ledger technology (DLT, or blockchain), and this has led to frequent misunderstanding in the media around their relationship to cryptocurrencies. A CBDC is not a cryptocurrency – it is a central bank-issued digital native form of fiat currency. Whilst many CBDC pilots around the world are being built on DLT, it certainly isn’t a prerequisite, and some are being built on more traditional architecture. Stablecoins – such as JPMCoin, or the most famous of them all, Facebook’s Diem – are tokenised forms of e-money that can fulfil similar functions to CBDCs, but are issued by private firms and therefore retain an element of counterparty risk exposure that isn’t present with CBDCs.
A distinction is usually drawn between wholesale and retail CBDCs. These aren’t necessarily different types of CBDC as such (although some countries might choose to implement them differently); rather, they refer to the primary use cases for which the CBDC is intended, and may involve different delivery channels, payments systems or payments intermediaries. Retail transactions are those undertaken by individuals or businesses, for everyday payments purposes. Wholesale transactions occur between financial institutions, such as banks, to settle their liabilities to each other. There are overlaps between the two as well, as retail payments may give rise to wholesale settlements being required between two banks, for example.
So what can we do with CBDC in the wholesale markets, that we couldn’t do before? Like other forms of digital money, including stablecoins, CBDCs can be used to make payments more efficient and reduce friction, at a fraction of the cost. This has great potential for cross-border payments in particular, given the current fragmented nature of payment systems globally and the high degree of intermediation required, providing that a means can be found to implement interoperability between different CBDCs. In financial markets, it also has the potential to make securities settlements more efficient. A more streamlined, fast and efficient payments process will lead to obvious savings in operational costs.
We can go one step beyond this as well, looking to the future of digital assets and securities. We are now seeing the development of tokenised, digital-native forms of traditional securities, which can be settled instantaneously – bypassing the need for layers of clearing and settlement infrastructure – on a distributed ledger. These are implemented using smart contracts, which can automatically manage events and payments throughout the lifecycle of the instrument. However, instantaneous settlement of the securities leg of a trade is rather meaningless in the absence of a capability for instantaneous settlement of the payments leg as well. Stablecoins can fill this gap but lack the trust and systemic resilience of a central bank-backed form of digital currency, which would be the ideal solution to wholesale settlement on ledger and would enable the transition to fully digital capital markets.
The Bank of England has made clear that no decision has yet been taken as to whether the UK will have a CBDC. Nevertheless, it has been actively researching, consulting on and experimenting with digital currency for a few years. A CBDC would also take time to implement, and to realise its full benefits, to be interoperable with both existing payments systems and other CBDCs. In the meanwhile, private operators are powering ahead with stablecoins and innovative payment systems and laying the foundations for a truly digital economy. As these become more widely used, the Bank and other regulators are acutely aware of the potential for systemic risk to arise, and are working on strengthening the regulatory regime around these systemically important stablecoins. It’s quite likely that, in the UK at least, the future of payments and settlements will involve a combination of private and public forms of digital money.