Towards an Understanding of CBDC in the Financial System

 

Towards an Understanding of Central Bank Digital Currencies.

In a previous post General Views on the Nature of Digital Currencies I delved into the various types of digital currencies that have evolved in recent times. Basically, my discussion highlighted the two broad types of digital currencies, namely virtual currencies and central bank digital currencies (CBDC).

With respect to virtual currencies, I explored closed virtual currencies, such as those used in member-controlled gaming networks. I also took a look at open virtual currencies in the form of unregulated and volatile cryptocurrencies, such as Bitcoin and the more centrally controlled and hence less volatile stablecoins. I also introduced the concept of the digital asset known as Central Bank Digital Currencies (CBDCs).

Regarding these open virtual currencies, I discussed the various ways that the three types of digital assets – cryptocurrencies, stablecoins and CBDCs can be distinguished. The distinctions can be conceived as coalescing around two dimensions each of which is a continuum in its own right. The first dimension is Denomination and Backing. The second is Governance and Technology.

In this post I will focus in on the notion of CBDCs in a bit more detail. I will discuss the distinction between wholesale and retail CBDCs. I will take a look at the dialogue being conducted within the European context to clarify certain misconceptions as to the nature of wholesale CBDCs; how the infrastructure that supports wholesale CDBC can be adapted to take advantages offered by innovations that are happening in the digital technology.

General Advantages of CBDC

I begin by drawing your attention to a post entitled Central Bank Digital Currency (CBDC). This post was published by the Corporate Finance Institute (CFI) Team January 24, 2022. Updated June 28, 2023. This post offers a general definition of CBDCs:

“Central Bank Digital Currency (CBDC) is a form of fiat currency issued by the central banks of various countries. A fiat currency is considered any form of currency that is not backed by an underlying physical commodity. This digital fiat currency is issued by central banks in token form or with an electronic record associated with the currency and pegged to the domestic currency of the issuing country or region.

Since this digital currency is issued by central banks, the central banks maintain full authority and regulation over the CBDC. The implementation of a CBDC into the financial system and monetary policy is still in the early stages for many countries; however, over time it may become more widely adopted.”

The CFI Team highlight the benefits of CBDCs:

·         Increase payment efficiency

·         Complement current forms of money and financial services

·         Deter criminal activity

·         Improve international payment options

·         Potentially reduce net transactions costs, benefitting lower-income households

There are also risks and shortcomings:

·         Overhauling the current financial system could create instability

·         The effectiveness of monetary policy may deteriorate

·         Operational difficulties

·         Cybersecurity risks

·         Privacy as there is a loss of ability to transact anonymously

General Definition of the Two Categories of CBDC

The CFI Team classify, and offer a general definition of two different categories of CBDCs:

·         Wholesale CBDC

·         Retail CBDC

Wholesale CBDC

Hosted by financial organisations such as banks wholesale CBDCs would enable banks to automate, speedup and improve the reliability of payment and cross-border transactions.

Existing payment settlement systems operate in single jurisdictions or with a single currency. The utilisation of blockchain technology could potentially make transactions quicker, more even, and more reliable at a lower cost.

Retail CBDC

Retail CBDCs can be conceived as digital cash that would be used by members of the public. People would be assured that the currency has the backing of a nation’s central bank. Such currencies would also be convenient in that they will replace physical currency.  Retail CBDCs will also have the effect of reducing the economic rents related to transactions that are reaped through the legacy financial system.

The CFI team as well as many other financial and business websites provide similar general descriptions of wholesale and retail CBDCs.

Fabio Panetta is a member of the European Central Bank (ECB) Executive.  He delivered a speech entitled Demystifying wholesale central bank digital currency (europa.eu) delivered to a Symposium at Frankfurt am Main, on 26 September 2022.

Mr. Panetta in this speech referred to the implications of technological innovation and change involving payment systems within the monetary system.  Digitisation has extended the range of payment infrastructure of the financial system.

Having said this Mr. Panetta stressed the need to secure the stability of the monetary and payment systems in Europe from any disruptions that could arise from technological change. The purpose of what he calls the digital euro project is to ensure this stability while working to modernise the payment infrastructure that supports the financial system. In making these comments Mr. Panetta was cognisant of the types of shortcomings listed by the CFI Team.

In this context of technological change, according to Mr. Panetta the pivotal role of central bank money as a safe asset must be maintained. Confidence in central bank money is important to the stability of the financial system.

Wholesale CDBC has provided the financial system with digital infrastructure that efficiently supports the settlement of transactions between banks using central bank money. Mr. Panetta pointed out that attention should be given to how these wholesale CDBC infrastructures need to be adapted to take advantage of new technologies and technological choices to better meet user demands. Before this evolution can begin, we need to be clear about what we mean by wholesale CBDC.

Mr. Panetta pointed out that there is a level of confusion as to what constitutes a wholesale CBDC. This confusion according to Mr. Panetta manifests in three ways. To quote Mr. Panetta:

“Let me start by clarifying some frequent misunderstandings about wholesale CBDC. First, there is confusion surrounding the term ‘wholesale’. Second, there is a widespread misconception that wholesale CBDC does not yet exist. Third, wholesale CBDC is sometimes seen as a substitute for retail CBDC.”

Regarding the first confusion concerning the notion of “wholesale”. 

Mr. Panetta put forward a general definition of wholesale CBDC that restricts this kind of CBDC to the “… settlement of interbank transfers and related wholesale transactions in central bank reserves.”

He in turn defined these central bank reserves as “…. liabilities of the central bank owned by commercial banks”. With respect to the financial system these are the most risk-free and liquid assets.

In the light of this narrower definition of wholesale CBDC, he pointed out:

“But some misinterpret “wholesale CBDC” to mean any large-value payment in central bank money, regardless of who is making and receiving the payment.”

Regarding the second confusion that wholesale CBDCs do not yet exist

Mr. Panetta dispelled the confusion that rests on the assumption that wholesale CBDC transactional systems are a new phenomenon. They have been around for several decades. There is a common misconception that wholesale CBDC run on Digital Ledger Technology (DLT) platforms. This is not the case as wholesale CBDC can be built on any digital technology.

Mr. Panetta offered the example of the Europe’ s TARGET Services that runs on a centralised ledger as a way of supporting the settlement of wholesale digital transactions.  The ECB in conjunction with national central banks (the Eurosystem) have built a unified system that supports the management of assets used as collateral in Eurosystem credit operations.

TARGET services as a system consists of several components: TARGET2 (T2S) for real-time wholesale payments, TARGET2-Securities that handles the settlement of securities and TARGET Instant Payment Settlement (TIPS) for instant payments.

The ECB has a link TARGET Services (europa.eu) that provides more detail about TARGET Services.

Briefly regarding DLT, this technology according to the World Bank Blockchain & Distributed Ledger Technology (DLT) involves a network of:

“Distributed ledgers use independent computers (referred to as nodes) to record, share and synchronize transactions in their respective electronic ledgers (instead of keeping data centralized as in a traditional ledger). “

Furthermore, Blockchain technology is built on DLT infrastructure and protocols.

Regarding the third misconception that wholesale CBDCs are occasionally viewed to be a replacement for retail CBDC.

According to Mr. Panetta wholesale and retail CBDCs are complementary. Together they can meet the various needs of different users.

Operating in the wholesale sphere central banks offer the best payment mechanism for financial organisations; a payment system that diminishes uncertainty in the financial system. According to Mr. Panetta, in the retail sphere the provision of very secure and timely payment functionality supports public trust in money by facilitating the at face value exchange of private types of money for safe central bank money.

REtipster in posing the question What Is Private Money?  describes private money as:

“…. a private individual or entity's loan or equity contribution to a company or investor. Private money can be a vital source of capital when other conventional sources of funding (such as traditional lenders) are not available.”

The International Monetary Fund (IMF) describes private money redemption into central bank currency in the following terms Public and Private Money Can Coexist in the Digital Age:

“In short, the option of redemption into central bank currency is essential for stability, interoperability, innovation, and diversity of privately-issued money, be it a bank account or other.

Mr. Panetta pointed out that wholesale and retail CBDC schemes are different in other respects. Firstly, they arise from different beginnings. Historically central bank money has been obtainable by the general public in the shape of physical cash. The purpose behind retail CBDCs is to generate digitally based central bank money that can be universally utilised.

Digitally based central bank money is currently available for wholesale use. Wholesale CBDC projects, in comparison to retail CBDCs are concerned with ensuring that digital interbank transactions are even safer and offer more efficient processing. This efficiency would better facilitate securities settlements and cross-country payments.

Secondly, as a result of these differences, according to Mr. Panetta different players participate in wholesale and retail CBDC projects.

Retail CDBC is a new phenomenon. As a result, retail CDBC projects include a broad range of stakeholders ranging from law makers, retail payment systems and the public at large.

Mr. Panetta warned that careful consideration needs to be given to the manner in which retail CDBC are designed and distributed. This will make sure that retail CBDC respond to the objectives set by public policy and do not unintentionally affect the financial intermediation performed by financial institutions. For example, the flow of funds through financial intermediaries, such as investment banks, commercial banks and pension funds that involve lending, investing, placing (sale of) funds or securities.

In contrast wholesale CBDCs involve a smaller set of stakeholders like banks and central security depositories. Security depositories are financial organisations that hold securities (such as government bonds) that currently utilise central bank settlement infrastructures. There is future potential for new stakeholders to get involved in the wholesale settlement chain employing the new DLT technologies.

Mr. Panetta having shown the wholesale CBDC are not a new phenomenon in terms of the supporting digital infrastructure said that:

“So when central banks talk about wholesale CBDCs, we are not debating whether to introduce them. We are discussing how to improve and modernise services that we already offer today.”

Within the context of the European Union Mr. Panetta, in his speech explored efforts to modernise wholesale payments systems. A move to DLT would involve a movement on the part of the financial system from centralised databases to decentalised networks when transferring money. With the future in mind the European Central Bank is appraising DLT technologies to determine the degree to which they can make settlement processes in wholesale CBDC more efficient and secure

In his speech Mr. Panetta went on to point out the various benefits of DLT. Instant transaction settlement continuously for twenty-four hours is one. These transactions represent a broader spectrum of assets and a broader range of financial and non-financial corporate organisations. Another benefit revolves around how DLT platforms enable the programming that triggers automatic transaction settlement when predefined conditions are met.

Stakeholders foresee the use of DLT as a means to reduce costs, processing time and facilitate reconciliation in areas like securities post-trade processes. Some proponents envisage these efficiencies can be leveraged across the security lifecycle.

As an aside, I would like to say that post-trade processing refers to the actions that happen between buyers and sellers after a security trade is concluded. For example, trade clearing and settlement. For more detail see: Post-Trade Processing: Definition, How It Works, and Examples

With respect to the discipline of wholesale payments market Mr. Panetta related how participants recognise the possibilities that DLT can offer that may improve cross-border and cross-country fund transactions. Such improvements will ameliorate frictions associated with corresponding banking processes.

Note that wholesale cross-border transactions usually involve financial institutions facilitating the cross-border activities of their customers as well as their own activities like foreign exchange and securities trading as well as borrowing and lending. For more details see: The ultimate guide to cross border transactions.

Mr. Panetta went onto document the potential drawbacks inherent in DLT.

One disadvantage is how consensus is implemented in some DLT networks. Consensus in DLT operates with the aim of validating transactions. More specifically consensus in a DLT is a collaborative and consensual arrangement that determines how transactions in the distributed ledger are ordered.  This consensus is needed to ensure the integrity and consistency of data that is recorded in the ledger. It is this consensus between the participants that is the basis of the trust that the participants have in the ledger.

To find out more about consensus in DLT have a look at this post: A Primer on Consensus in DLT. Distributed Ledger Technology (DLT)

The drawback is that consensus mechanisms can be inefficient both from the environmental perspective as they can use up large quantities of electricity; they are also inefficient with respect the speed of transactions and scalability. Such inefficiencies are more evident in permissionless DLTs like a bitcoin. Some permissioned DLTs are less energy-intensive. These also compare well when compared with centralised infrastructures.

A helpful discussion that explains the difference between permissioned and permissionless blockchain DLTs can be found here: Permissioned vs. Permissionless Blockchains Explained

Mr. Panetta raised another drawback and that is to do with the governance of DLT and networks. From the Euro systems point of view the governance actors are either not known or are based beyond European boundaries; this brings up concerns revolving around strategic autonomy.

For a report on how DLT governance architecture for the financial industry you can take a look at the following report: Governing Blockchain or DLT Networks

Regarding European market participants aiming to adopt DLT; the Eurosystem is exploring ways of integrating DLT with TARGET Services to settle the euro cash part of transactions of these participants in central bank money.

 Mr. Panetta informed us that the ECB is investigating two options:

The first option would be to construct a bridge that would integrate market DLT platforms with central bank systems. Such an integration would enable a security transfer originating in a DLT platform to trigger a settlement in central bank currency. Within the context of the Eurosystem instead of building a purely DLT solution a hybrid solution, based on TARGET Services that leverages DLT could be implemented more rapidly.

The second option for Eurosystem would be to build a new wholesale settlement service based on DLT using DLT-based central bank money. Mr. Panetta cited the example of the experimentation made by the Banque de France in this regard.

To learn a bit more about these experiments I refer you to a speech given by the Governor of the Banque de France Central bank digital currency (CBDC) and bank intermediation in the digital age; in this speech Mr. François Villeroy de Galhau refers to a proprietary DLT called DL3S. This DLT has been developed by the Banque de France. This is a permissioned blockchain the aim of which is to provide efficient settlement services using CBDC.

Drawing inspiration from the Banque de France Mr. Panetta suggested that the Eurosystem could build its own central bank money settlement system constructed on a DLT platform. Another option would be to allow DLT platforms run by market stakeholders to have access to central bank currency; the transfer of cash and assets would thus happen on these market platforms.

To sum up Mr. Panetta’s speech. Mr. Panetta challenged the prevailing narrative that wholesale CBDC is a new phenomenon made possible by DLT. In fact, wholesale CBDC has existed for decades offering effective services for the settlement of transactions involving central bank money between banks. During this time the already established payment system is based on digital infrastructures.

Mr. Panetta does help demystify the discussion revolving around wholesale CBDC. He does so within the context of the European monetary system’s payment structure and the goal to modernise this. He addresses at a high level the challenges and opportunities posed by technological change with the respect to the digitalisation of finance and the digital Euro in particular.

The Eurosystem is not the only place that is investigating how digital technologies can be used to leverage CBDC platforms. The Reserve Bank of Australia (RBA) is currently conducting a pilot CBDC called eAUD.

For details of the RBA’s pilot CBDC see the white paper Australian CBDC Pilot for Digital Finance Innovation White Paper

This white paper explains the purpose of the pilot CBDC project:

“…. is to explore innovative use cases and business models that could be supported by the issuance of a CBDC. The project will also be an opportunity to further understanding of some of the technological, legal and regulatory considerations associated with a CBDC. The project commenced in July 2022 and is expected to be completed around the middle of 2023”.

The white paper states that it will pursue any compelling real-world wholesale or retail use cases submitted by Australian industry stakeholders that participate in the project. These participants include financial institutions, financial technology companies, agencies representing the public sector and technology providers.

To conclude my post, I would like to make the observation that the trend around the world and in the online media is to investigate how a CBDC can be designed to benefit market economies. It appears that investigations in such economies revolve around the role of a central bank in participation with the private sector in leveraging the potential benefits of CBDC for the financial system.

How can blockchain benefit other aspects of life such as reducing inequality in society or tackling climate change?  In a future post I will investigate how this digital technology can be used to advance knowledge and underpin new ways of organising society. On the other side of the debate are those that see CBDC as a threat to democracy or a form of financial control. I also hope to discuss these aspects in future posts.