| 14-04-2020 | Carlo de Meijer | treasuryXL

The European Banking Federation (EBF), the European Association of Co-operative Banks (EACB) and the European Savings and Retail Banking Group (ESBG) point out that the crisis has brought to the fore the importance of well-functioning payments services.

The three groups have put together their vision for payments in the EU over the next five years, as they “seek to meet changes sparked by a mix of evolving customer needs, regulatory action, technology and innovation, and increased competition”.

Top of the list of priorities is the importance of developing instant payments across the EU that allows for both the differentiation of EU companies and the reduction of dependency on the dominant non-EU payment card schemes.

But reading the document not one single word was mentioned about using  blockchain or distributed ledger technology. It seems banks are increasingly getting in the defensive mode worrying the disruptive impact of this technology on their business.

Some critical remarks

Looking into the report the focus is rather limited. It shows a rather isolated EU-oriented view. It does not take into account the new realities such as globalisation of the payments world, the upcoming of new technologies and the global role of organisations  such as Visa and MasterCard, but also the likes of Facebook and Google.
It is too much EU but above all too much euro-area focused, while not taking into account the cross border element especially towards non-euro EU countries.
The report also does not go into more detail towards the various technologies including Big Data, Artificial Intelligence and above all blockchain.

Present state of EU payments market

But let us first look at the present state of the EU payments market. And what blockchain could mean to improve. As EU banks you cannot deny the outside world. I agree, most European domestic payment systems are pretty efficient. But not where one has to transfer money cross-border, especially where it relates to non-euro countries.

Most established centralised payment systems were designed decades ago, in a completely different world. While they are considered to be reliant, secure and stable domestically i.e. inside individual EU countries, these centralized systems have not been able to catch up with the needs of our digital, open and hyper-connected world.

Banks have continued to use the old-style correspondent banking systems for international payments – despite their inherent weaknesses. Notably, these systems are expensive, slow, and complex. In the correspondent banking system, both the originating bank and the foreign bank retain their own ledgers, from which they make reconciliations and settlements. This may lead to a lack of transparency, but also make them vulnerable for hacks.

According to a SWIFT and EuroFinance joint survey, lack of payments traceability, invisibility on banking fees, and amount discrepancies are the key concerns in cross border payments. It can take days to clear traditional cross-border wire payments, which carry fees as high as 10%. According to a McKinsey Research, cross border-payments take 3–5 days, which is quite long for corporates seeking to receive money. In the event of a dispute or investigation, the duration can be longer.

Disruption

New technologies are revolutionizing the way we pay and transfer money all over the globe. With the advent of mobile banking, e-commerce, and digital wallets, banks have to rethink their correspondent banking system of making cross-border payments. Blockchain is another area that – if adopted in a more massive way – could majorly transform the global payment systems and disrupt banks, causing them to realign  or rethink their products.

SWIFT defensive stance

So it is not that strange banks are increasingly in the defensive. SWIFT is still the dominant payment-processing ecosystem with more than 11,000 banks. Blockchain, through its distributed ledger, however may disrupt SWIFT’s operations in the future. To neutralize the rapid adoption of blockchain in the cross-border payments industry, SWIFT developed a cloud solution called Global Payments Innovation (gpi) to connect all clients in the payment chain. Currently, gpi accounts for more than 55 percent of SWIFT cross-border payments. Half of these transactions are reaching the recipients within minutes, but all of them within 24 hours.

Although SWIFT plans to rely on common standards, core architecture, and APIs to be a leader in the industry, it is also slowly embracing blockchain technology. SWIFT has launched a proof-of-concept (PoC) trial with R3′s Corda platform, which is blockchain-powered, to initiate payments that then go to gpi.

How can blockchain improve payments?

Though blockchain is still in its early stages, this technology has a number of inherent characteristics  presenting a fundamentally new way to transfer information and value over digital networks.

This technology could play a huge and central role in payments, underpinning core market infrastructure as well as end-user products, as a source of efficiency, innovation and competitive advantage.

As it is slowly maturing, blockchain technology could gain the trust of banking institutions and adopted widely in the coming years. From large banks and enterprises optimizing global liquidity, to retail stores accepting payment in digital currencies, to new forms of customer identification for retail transactions, blockchain could permeat the payments landscape at an accelerated space.

New forms of payment rails could “blur the lines” between currencies and countries, while cryptography solutions like zero knowledge proof could shift paradigms in areas such as identity, compliance and data privacy.

What are the real benefits?

Blockchain is a promising technology for payment processing. The broad implications for payments, especially improving settlements’ times, removing the middleman and security of cross-border transactions are hard to ignore.

The ability to speed up the payments process, improve capabilities when it comes to cross-border payments, reducing fraud by using smart contracts and making the whole payment processes more efficient and transparent are all elements that may impact its future potential and use.

Efficiency

Blockchain’s primary feature is its efficiency. Because the core idea of a decentralised ledger technology (DLT) is to forego centralised institutions, paying on a blockchain is “as easy as clicking send.”  The distributed ledger facilitates the bilateral, immutable distribution of value with the assistance of a settlement agency. Blockchain, allows the sender and the receiver, as nodes in the network, to have a complete copy of the ledger. In such a scenario, there are no correspondent banks/intermediaries involved, eliminating any chances of manipulation. The results are no money transfer waiting periods or unnecessary third-party processing fees. Blockchain-based cryptocurrencies can be transferred (and recorded for auditing purposes) instantaneously across the world, increasing liquidity and efficiency in the markets.

Security/Safety

Another important feature of blockchain technology is safety. Blockchain allows for the safe transfer of money between different individuals, currencies and countries by securing all transactions on the network with cryptography. The crux of many of its purported benefits for the enterprise is its decentralized nature, which promotes visibility and makes it more difficult for data to be manipulated. The transactions are linked with previous transactions and are distributed to all the participants in the network. For a hacker to tamper with any transaction, he/she must alter all the previous ones, which is (almost) impossible. Additionally, the use of blockchain smart contracts can halt payments when agreed terms are violated.

Cost reduction

And blockchain may support real-time domestic and cross-border payments at lower costs compared to traditional payment services. Blockchain technology completely eliminates the need for intermediaries and facilitate a direct transfer over the platform, thereby eliminating foreign exchange fees while increasing speed of transfer. Instead of incurring these fees, blockchain allows customers to pay only a nominal fee or sometimes no fee at all.

The present state of blockchain adoption in payments

Of course, blockchain technology is still in their early ages and largely still immature. Blockchain payments are not (yet) mainstream and many banks and payment service providers are just testing it, trying to combine the so-called old monetary system with the new one (blockchain solution based values or solutions). Most institutions are still reluctant to embrace blockchain fully until there is broader support for it.

But what about Ripple?

A leading player in the blockchain payment world is Ripple. Its RippleNet blockchain platform facilitates transaction of global payments at a rapid speed, allows users (mostly small business) make payments across the globe and send and receive money in local currency, requiring lower capital amounts for cross-border payments. The company’s ledger technology secures, tracks and reconciles payments, so small businesses have a transparent history of all incoming and outgoing payments.

RippleNet has a product called xRapid, that is already providing low-cost liquidity to financial institutions responsible for facilitating cross-border payments. xRapid can facilitate the process without relying on mandatory pre-funded nostro accounts, as is the case in a correspondent banking system for the execution of cross-border payments, thereby lowering the cost of cross-border transactions. As a result, the transactions occur in a matter of minutes, saving time on recipients.

Currently, the network of banks and commercial platforms has grown to 365, and they are now able to resolve problems that delayed cross-border payments, such as missing data and compliance checks. As more banks join the network, payment delays will reduce importantly.

The Ripple payment system is still in strong competition with SWIFT but is super-fast and can settle a cross border transaction in a matter of few seconds where SWIFT takes more than 3 days at times. Ripple is much more cost effective as well.

Along with this also blockchain platform Corda R3 is helping financial institutions to settle payments.

From hype to more realism

The excitement about blockchain has subsided over the last couple of years. The blockchain hype is over and we are now in the trough of disillusionment, according to Garner’s Hypecycle. Lots of experiments and R&Ds have been taken place from start-ups to central banks, however no full scale working use case has been presented at the moment.

We now moved into a stage of “rational practicality”. However, that is not all bad for the further development of blockchain, as “in the trough is where the real work gets done”. The industry knows what is possible, but also is learning what is practical given the complexity of cross-border payments. Blockchain — assuming it is attached to relevant, pragmatic use cases — can add incremental value to a business or other organization.

Regulatory barriers

One of the primary barriers is the complex global regulatory framework surrounding money and its underlying infrastructure. Central banks, governments and regulatory bodies around the world have varying perspectives and attitudes towards blockchain and its implications to critical matters such as money supply, privacy and financial crime.

As a result, most payment-related innovations either get trapped in ‘proof-of-concept’ mode with limited options for global scale, or end up buried in complicated cross-jurisdiction approval processes. The question now is not will blockchain work, but rather how do we put it to work to create more efficiency in global payment systems and can we get regulatory bodies on-board.

What should banks do?

Inevitably, banks will have to re-evaluate and revamp their existing payment systems to meet the needs of their customers with or without blockchain. However, it is increasingly clear that the scale seems to be tipping towards blockchain given the various benefits including its transparency, speed, and cost of transactions. In the realm of cross-border payments, some financial institutions are already working with blockchain providers to give their customers fast, secure, and cheap services.

When applied correctly, it has the ability to significantly change the way organizations do business with one another. As the global payments ecosystem continues to transform in response to a rapidly shifting commerce landscape, we may see the number of blockchain applications in payments exponentially growing.

A growing number of financial institutions world-wide have reached the point where they recognize blockchain as something that’s not going away and realize that they have to be involved in it if they don’t want to be disrupted by other payments players that use blockchain to bypass slower-moving banking infrastructure.

So, European banks, if you can’t beat them, join them.

By the way, a joint effort of ECB and European banks in creating a European digital currency would be a great step forward.

Carlo de Meijer

Economist and researcher

Source

| 24-03-2020 | Carlo de Meijer | treasuryXL

Blockchain consortia are creating a massive hype in the market. Many enterprises are highly interested in this type of network willing to join these consortia in order to gain optimal benefits of this technology. However, there is still a large uncertainty among them how these consortia work and how they are governed.  Up till recently the focus was mainly on governance solutions for public blockchain platforms like Hyperledger and Ethereum. Consortium blockchain governance however will become as or even more important to enterprises than public blockchain governance because they will work with this level of governance on a daily basis.

People in the field are increasingly aware that consortium project blockchain governance need to address quite different issues from public blockchains. But what are the main governance issues enterprises should think about ? So let’s take a deeper dive.

What are blockchain consortia?

Before going into more detail in the governance issue, it is good to say that there is no universal sort of blockchain governance. First of it all it depends on the type of blockchain solution that companies can use. Here we can distinct in fact between three main types of blockchain systems: open or public, private or permissioned and consortium or federated blockchains. While the public and private variant are ‘pretty self-explanatory’, the consortium blockchain needs more nuancing.

Blockchain consortia are defined as a type of network where multiple organisations maintain the system  A group of companies thereby collaborate on advancing the state of blockchain technology adoption in the industry, establishing industry standards, drafting use cases, developing key infrastructure and also operating commercial blockchain platforms.

Consortium blockchains are in fact hybrid solutions, in-between public and private, i.e. between fully open, decentralized systems and fully centrally-controlled, thus taking the best of both worlds.  Instead of only one organization, multiple organizations take part in the consortium. As a result, every organization gets similar treatment. So, there’s no single entity ruling over the network.

Types of blockchain consortia

There is however not one uniform type of blockchain consortium. Basically we can distinct between three types at present: technology-focused, business-focused and dual-focused.

The first type of blockchain consortia is the technology-focused. These offer reusable blockchain platforms, solutions based on technical standards. Mainly these have multipurpose use cases. This type of blockchain consortium exists solely for the purpose of helping blockchain reach global recognition. Quorum (based on Ethereum), R3 Corda and Hyperledger have emerged as some of the most popular blockchain development platforms. Each is suited to different industries and types of solutions, and developers are working with them around the world.

The second type is pure business-focused. These tend to develop blockchain solutions for a specific business issue. Instead of offering open-source platforms, many of them go for commercial purposes only. While the majority of these consortia so far are from the financial sector, many other industries like supply finance, trade finance, life science, healthcare etc. are joining in to work on blockchain-based systems and reap such benefits as shared resources, decreased development time and increased communication. Examples include consortia like  Bankchain, We.Trade, Marco Polo, B3i etc.

The third one is dual-focused. Here, they focus on both technology and business when offering a platform or solution, combining the best of both worlds. So, in a way, they would offer an open-source platform suitable for any kind of solution but also commercial products as well.  An example of dual-focused consortium is R3.

In this blog I will focus mainly on the second and third type with from a blockchain governance point-of-view the dual-focused blockchain consortium being the most interesting.

Benefits of blockchain consortia

Joining such a blockchain consortium could bring enterprises a number of interesting benefits, including cost savings, shared (and lower) risks, build critical mass of adoption and offer influencing standards.

First of all such a blockchain industry consortium would help enterprises cut all the expenses quite impressively. Instead of each company building their own solution from scratch, by being part of a consortium, they can share the development costs and time with other organisations.

As these consortia are mainly suited for industrial purposes, enterprises can easily link these up with their existing network more efficiently than public or private blockchain. This can lead to shorter development times and economies of scale. This allows smaller organisations to take advantage of the same system as larger ones. Another significant aspect of this blockchain industry consortium is that they can give a lower transactional fee. As it is a more controlled environment, and only permissioned people can get in, it would be much more stable.

What is blockchain governance?

But what is governance in general and why is it important?  The term ‘governance’ is used in many ways. In the business environment it is often defined in the context of process and IT control. Governance is thereby a structure that every user or participant agrees to follow. It refers to all actions such as decision-making processes that are involved in creating, updating, and abandoning formal and informal rules of a system.

In the context of blockchain consortia we define governance as a set of rules that govern this partnership both organisational and operational. These rules focus on what is the subject of the regulation, who is involved, i.e. what are the roles and what are they responsible for, and, how will decisions be made? These rules can be code (e.g. smart contracts), laws (e.g. fees for malign actors), processes (what must be done when X happens), or responsibilities (who must do what).

Why is proper governance important for blockchain consortia?

One of the aims of governance is to establish a foundation of mutual trust, which allows companies to carry out their business processes using the blockchain solution. Its core purpose is to meet the user or participant’s needs with available resources as efficiently as possible and achieve the long-term sustainability of the structure. There are various reasons why good governance for blockchain consortia is urgently needed.

First of all: from an acceptance point of view.
As the size and complexity of blockchain have grown, better management calls for proper governance. Since the strategic value of the blockchain networks lies in its scaling, it is important to consider that an increasing network size correlates positively with an increase in coordination complexity. Hence, for the few high-potential applications in trade finance, insurance, supply chain and mobility services a proper establishment of sustainable governance principles for the deployment of a blockchain consortium is key.

Second: no one party can exert dominant control
Consortium blockchains have many of the same benefits of private blockchains. But there is something more. That is they could employ a group governance model over their network so no one party can exert dominant control over the others. This increases the trust of a consortium network significantly over a single entity private blockchain, while still maintaining the benefits of a private blockchain. Additionally, consortium blockchains are not restricted to only being visible to network members. Their transactions can be openly seen by the public, engendering increased trust.

Third: to solve the Coopetition Paradox
The strategic value of blockchain technology can only be realised through the respective adoption at scale. These blockchain consortia are thereby effectively obliged to address the so-called Coopetition Paradox through collaboration between natural competitors in a particular industry. The Coopetition Paradox forces blockchain consortia to break up fierce competition between industry rivals in order to access the strategic value of such a business network. Obviously, there is no one-size-fits-all solution to this topic.

Fourth: as a mean to achieve efficient change
The biggest motivation behind Blockchain governance for blockchain consortia is the goal of efficient change. That means the ability to fix issues as fast as possible and change where change is needed. These issues can be of all kinds, including changes to blockchain parameters, the recovery of lost coins due to hacks.

Governance is especially needed in blockchains with enterprise or end-user use cases. Quick updates could enable enterprise and mass market end-user use cases.
An update/change that takes too much time could cause corporates to abandon the service or not participate in the consortium. Changes could also divide the community and lead to even more uncertainty and hesitation to participate. Conceptually, this is where centralized applications are advantageous.

Fifth: governance mitigates indirect dependence on incumbents
Another motivation to use blockchain governance in blockchain consortia is that it could mitigate indirect dependence on incumbents, such as the likes of Facebook, Amazon, Google that determine their own rules, such as the publicly criticized use of personal date. Publicly accessible and governable blockchains could mitigate that indirect dependence. Everybody who is interested in how those systems are set up, could purchase the respective tokens and suggest changes including changes in regards to how personal data is handled.

Sixth: Governance as a competitive advantage
A sixth but not final motivation is that it could improve competition. Given the fact that most blockchain projects are open-source, copying them is a waste of effort. Thus, the biggest competitive advantages for blockchain projects stem from the community’s size and speed of adaption. The more supporters a project has and the quicker the developers can react to issues and competitors, the greater the chances of survival.

What governance model for blockchain consortia?

Governance in blockchain consortia is quite different from that in pure public or private blockchains. A private blockchain is mostly controlled by normal IT governance, while the issue of specific blockchain governance only applies to open and permissioned platforms

Before enterprises can develop governance of the blockchain consortium, they first need to determine the business goals and business model of the blockchain project. So will the blockchain project operate as a service provider (so no direct customer contact) with a relatively limited number of participants, or will it act as a market participant, directly reaching the ultimate customer. The business model may also be affected by regulatory issues in the business.

Key factors to consider
When starting a blockchain consortium it is important to agree on a number of rules right at the outset, such as access to the platform and rules to perform activities. In the context of a permissioned blockchain solution used by a consortium business partner network, there remains the question of what exactly it is important to control.

In order to ensure the reliability, integrity and transparency of the solution, one needs to consider more than just goal-oriented governance issues (such as changes to data structure, codes and technology). One should also define the various stakeholders and their specific roles, as well as assess how to control the ecosystem. But also what entity should represent the blockchain consortium and what legal issues to consider

One should at least agree on a number of questions
There is no best practice here, so there are many open questions and a lot of unknown territory, such as who can decide what, and when?, how should decisions be made? (using people and committees, or using smart contracts?), which data should be visible to whom and what is allowed, what is not allowed, and what do people want?

Governance structure: issues
When thinking about the governance structure, one should address some main  issues. First of all one should ensure that all stakeholder groups in the blockchain eco-system are represented. One should also focus on implementation of the business model for the blockchain consortium (B2B or B2C). While determining intellectual property ownership and licensing as well as how to raise and spend funds to support the blockchain project

Shared values
The governance system should be based on a number of shared values. First of all there should be no dominance by a single player: i.e. as decentralised as possible.
The partnership and the distribution / exercise of power should be governed by rules. It should be an open value-added chain: i.e. – intellectual property is available to the consortium and can be exploited by its members. Relating to collaboration between companies, the process and data standards for the consortium should be defined together and used. And it should be a neutral platform, meaning that  the solution should be ‘open’ whereby all members should have access to the process, data and interface definitions.

Blockchain consortium governance architecture

Governance of blockchain consortia should be looked at on various layers. business network; protocol level and data level.

Business network layer
One of the key challenges of forming a blockchain consortia is balancing the interests of the initiators and the later-joiners. One should take account of the early investments made by the initiators as well as the incentivisation needs for later-joiners of blockchain consortia. This becomes even more crucial if the initiators are industry leaders or key competitors. In such cases, the coopetition paradox urges the operators of the business network to open up towards competitors to materialise the strategic value of the network for all contributors.

A centralized legal entity for the business network, a so-called network operating company governed by open governance principles is the preferred standard. The network operating company would be in charge for the development, administration and commercialisation of the blockchain application. This central entity approach enhances transparency within the business network and compliance with respective laws especially in the field of anti-trust and data protection. However, not every network member has similar interests. Some like to assume a more active role in the management and technical deployment of the network while others just simply want to use the blockchain application as a service through an API-access.

The organisational governance must account for the interests of both the equity holders and the community. The equity holders of the network operating company would elect the members of the board of directors representing their respective interests. The board itself appoints an executive management team in charge of the day-to-day operations of the business network and thereby the platform.

Non-equity holding customers should be given a voice by establishing a so-called community council. This body can be approached for consultation in case of key product development issues, changes to membership admission policies or protocol and data privacy related matters.

In order to ensure maximum reach and acceptance within the ecosystem, the platform should be open-sourced to the community. This means that basic access to the platform is granted for free, provided that the node operation is handled by the respective member. Next to that a tailor-made subscription-based API-access model could be offered.

Protocol layer
The initial protocol layer is normally defined by the initiators of the business network during the assessment undertaken in the proof-of-concept. In general, the framework used should be based on an open-source standard (such as Hyperledger Fabric, R3 Corda or Ethereum). This would facilitate the integration into legacy systems for the users. Furthermore, the above-mentioned blockchain frameworks also enjoy prominent support by companies operating in the ecosystem. Moreover, in case changes to the protocol become necessary, the network operating company can consult the community council for consent prior to its implementation.

Data layer
And there is the data layer. The blockchain application should be built upon the principle of privacy by design. That means that any data should only belong to its original owner and can only be transacted in agreement with the data owner. Moreover, the network operating company should act as the data controller and data processor in line with the applicable data protection laws, while the data storage would ideally be decentralised (e.g. point-to-point communication or IPFS), although the relevant solutions need to mature further.

Some concluding remarks

What has been written in this blog is just a starter. Blockchain governance is an ongoing discussion and will certainly involve a wide range of different opinions. There is no best-practice. Solutions described here for blockchain consortia governance are still far from complete.

The challenges of governance in blockchain consortia are very similar to those solved (and continuing to be solved) by open source software (OSS) projects, such as Linux and OpenStack. Blockchain project consortia should therefore look to the experience of OSS projects to take advantage of their experience (and avoid their errors).

Carlo de Meijer

Economist and researcher

| 21-2-2020 | Carlo de Meijer | treasuryXL

In one of my earlier blogs, I mentioned that Facebook’s efforts to launch its Libra cryptocurrency triggered intense debates over who would control money in the future. It has also forced Central Banks to think about and explore their own digital currency.

According to recent research, at least 18 central banks are currently developing digital currencies. But up till recent that was just done on an individual stand-alone basis. The most effective way to counter private digital currencies however is via a collaborative approach.

This year we are seeing more collaboration between central banks, aimed to think about the impact of such a digital currency for monetary policy and financial stability and what could be the optimal design of such a currency.

Why a central bank digital currency?

There are various reasons why central banks may introduce their own digital currency. First of all as a defensive move. The rise of crypto currencies like the Libra could create tensions among central banks and regulators as these can make it difficult for central banks to manage their foreign exchange controls and implement a sound monetary policy.

Another reason is the optimisation perspective. Current central bank operated money systems work well, but could certainly benefit from improvements e.g. in settlement. They see this technology as ‘optimizing or improving the rough edges on a system which is already great, and which they have no desire to fundamentally change’.

Central Bank Digital Currencies versus Crypto currencies

While central banks recognize digital money may be an improvement over physical money, a central bank designed digital currency will not resemble a decentralized cryptocurrency.

Though both CBDCs and cryptocurrencies, to a varying degree, are based on blockchain technology, CBDCs are – fundamentally – different to cryptocurrencies. CBDCs are traditional money, but in digital form, issued and governed by a country’s central bank, whereas cryptocurrencies are decentralised. The Central Bank consensus is that decentralization is not a desirable property in a CBDC as it could aid tax avoidance and enable criminal payment systems. Cryptocurrencies are neither recognised as legal tender – which CBDCs, by definition, would be. And unlike central bank money, both traditional and digital, the value of cryptocurrencies is determined entirely by the market, and not influenced by factors such as monetary policy or trade surpluses.

BIS Survey

Early this year the Bank of International Settlement (BIS) published a paper that presents the results of a survey that asked central banks how their plans are developing in the area of central bank digital currency (CBDC).

It shows that a wide variety of motivations drive extensive central bank research and experimentation on CBDCs. According to the survey about 80% of the central banks are engaging in some sort of work in this area, with half looking at both wholesale and general purpose CBDCs. About 40% of central banks have progressed from conceptual research to experiments or proofs-of-concept while another 10% have developed pilot projects.

Every central bank that has progressed to development or a pilot project is an institution in an emerging market economy. Globally, emerging market economies are moving from conceptual research to intensive practical development, driven by stronger motivations than those of advanced economy central banks.

Nonetheless, plans of central banks in advanced economies appear to be accelerating compared with earlier expectations.

Central banks need to collaborate

The BIS survey also showed the urgent need for collaboration by central banks on CBDCs. To find an optimal design of a central bank digital currency cooperation between these institutions is a must. Collaboration through international vehicles, such as the BIS Innovation Hub, will be necessary to avoid any unforeseen international consequences.

The collaboration on understanding the impact of CBDCs need to intensify. The survey shows that more central banks should be looking at the risks outside the financial system while also exploring ways to improve the system with CBDCs.

Collaboration initiatives

Since this year we see a shift from more stand-alone projects towards working with other central banks in the CBDC field. It is seen as critically important for central banks worldwide to join the discussions and take part in a more global coordinated approach for CBDCs.

1. Group of six leading central banks

Last month the Bank of International Settlements (BIS) announced that it had created a group involving six leading central banks including Bank of Canada, Bank of England, Bank of Japan, Central Bank of Sweden, Swiss national Bank, as well as the ECB.

The group will be co-chaired by the Head of BIS’ Innovation Hub, Benoît Cœuré, and the Deputy Governor of the Bank of England and chair of the Committee on Payments and Market Infrastructure, Jon Cunliffe. Senior representatives of other bank members will also be included.

These central banks have joined forces to explore digital currencies, assess the potential for central bank digital currency (CBDC) in their respective jurisdictions, share experiences as they assess the potential cases for CBDC in their home jurisdictions and look at ‘cases for central bank digital currency’. The members will thereby work closely with the Committee on Payments and Market Infrastructures (CPMI), an international standard-setter for payments and clearing, and the Financial Stability Board (FSB).

“The latest decision [by the six central banks] is not just about sharing information. It’s also an effort to keep something like Libra in check.” “Something like Libra would make transactions costs much cheaper. Major central banks need to appeal that they, too, are making efforts to make settlement more efficient with better use of digital technology.” Yamaoka, Bank of Japan president

2. World Economic Forum CBDC Toolkit

The World Economic Forum (WFO) and a community of over 40 central banks, international organizations, academic researchers and financial institutions have created a framework to help central banks evaluate, design and potentially deploy CBDC. The framework, dubbed the “CBDC Policy‑Maker Toolkit”, is intended to help accelerate critical and rigorous analysis of CBDC.

The framework provides a guide for central banks around the world. The toolkit provides information on retail, wholesale, cross-border and “hybrid” CBDCs, for all sizes of emerging and developed countries.

It is aimed to help policy‑makers within central banks confidently evaluate whether CBDC is the right fit for their economy and guide them through the evaluation, design and deployment process. It describes a step‑by‑step evaluation process for CBDCs, including potential benefits and challenges, could help “identify trade-offs between benefits from the use cases and their associated risks across different dimensions.” For those who are already researching, it helps them “make progress quickly”.

“Given the critical roles central banks play in the global economy, any central bank digital currency implementation, including potentially with blockchain technology, will have a profound impact domestically and internationally.” “The toolkit can serve as a springboard as central banks progress with their CBDC investigation and development.” “The intricacies of implementing CBDC are complex and the implications are wide‑reaching. As a result, policy‑makers may find themselves in uncharted waters when attempting to evaluate the potential benefits and trade‑offs.” Sheila Warren, Head of Blockchain and Distributed Ledger Technology at the World Economic Forum

3. European Central Bank Task Force

At the end of 2019 the ECB created an expert task force to look into and analyze the feasibility and potential outcome of establishing a central bank digital currency (CBDC). Central banks should consider the merits, which may include public goals such as financial inclusion, consumer protection and payment privacy.

The group is a result of efforts by Christine Lagarde, the new ECB president, who has pushed the European Central Bank to dedicate significant resources to studying the merits of CBDC. She explained that this task force was aimed at ensuring the European Central Bank plays an active role in fostering cheap and speedy payment transactions, likewise exploring the benefits of having a CBDC. With this development, Europe would join the rest of the world in their pursuit of having a central CBDC.

“In terms of the road ahead, the ECB will continue to assess the costs and benefits of issuing a central bank digital currency (CBDC) that would ensure that the general public remains able to use central bank money even if the use of physical cash eventually declines”. Christine Lagarde

The task force will work closely with the EU national central banks to study the feasibility of a euro area CBDC in various forms, covering all the practical aspects, including how to minimise possible unintended side-effects.

Lagarde agrees that pursuing a CBDC is a legitimate goal for the ECB but does not rule out competitive solutions that may come from private companies pursuing platforms that utilize digital currencies to expedite cross-border and domestic transactions.

“We are looking closely into the feasibility and merits of a CBDC, also because it could have major implications for the financial sector and for the transmission of monetary policy”. Lagarde

Optimal CBDC design

Interesting question is: what is the most optimal CBDC design? Certainly, a digital central bank currency has the potential to impact the financial system in a significant way. But for an optimal design one need a good cost-benefit balance and mitigate – as far as possible – potential unintended side-effects.

In this blog the focus is on so-called general purpose CBDCs accessible to the broad public. Wholesale CBDC are seen as of more limited scope and does not really question the established structure of the monetary base. General purpose CBDC could be implemented in two alternative ways: they could be offered in the form of deposit accounts with the central bank to all households and corporates. Alternatively, the central bank could offer a digital token currency that would circulate in a decentralized way without central ledger.

But for security and privacy reasons this latter alternative is not the favourite of central banks especially in the well developed countries.

Opportunities and challenges of CBDCs

Central banks have started to analyze intensively the benefits and negatives of introducing central bank digital currencies (CBDC). They are especially looking at what is their potential impact on monetary policy, financial stability and the financial system. It is imperative that central banks thereby proceed cautiously, with a rigorous analysis of the opportunities and challenges posed.

Opportunities    

In various studies a number of quite diverse benefits of CBDCs have been put forward.

More efficient payments

CBDCs could address problems like inefficient payments that cryptocurrencies seek to solve, while maintaining state control over money. Central banks think CBDCs could make payments systems more efficient, reducing transfer and settlement times and thus promoting economic growth. Other advantages could include making available efficient, secure and modern central bank money to everyone, and strengthening the resilience, availability and accessibility of retail payments. This is especial true for the countries with underdeveloped banking systems, and/or without a secure and efficient payment system.

More security

A widely adopted CBDC would allow better control of illicit payment and saving activities, money laundering, and terrorist financing. It would thus place users at less risk of violent crimes that target holders of cash, and potentially reduce security and insurance costs associated with keeping cash on business premises. This however would requires the discontinuation of banknotes (or at least of larger denominations). Obviously, this motivation of CBDC would not apply if CBDC circulates as anonymous token money even for high amounts.

Improve overall effectiveness monetary policy

CBDCs could provide significant competition for traditional monetary instruments. Such a competition would present monetary policy with challenges but also with opportunities. Central bankers fear that Libra and other crypto currencies could quickly erode sovereignty over monetary policy. CBDCs could counter the rise of cryptocurrencies issued by the private sector.

Next to that CBDCs could allow relaxing the so-called zero-lower bound constraint on nominal interest rates as negative interest rates can be applied to CBDC. If digital cash is used to completely replace physical cash, this could allow interest rates to be pushed below the zero-lower bound, which could promote macro-economic stability. CBDC could also widen the range of options for monetary policy. Variable interest rates on CBDC would provide for a new, non-redundant monetary policy instrument that would allow improving the overall effectiveness of monetary policy.

Improve financial stability

CBDCs could also improve financial stability and macroeconomic stability and reduce so-called “moral hazard of banks“ by downscaling the role of the banking system in money creation via sight deposits, as CBDC would take over to large or full extent sight deposit issuance by banks. By providing competition for bank deposits, the adoption of a CBDC could limit the practice of fractional reserve banking, thereby strengthening financial stability.

Safer financial system

A CBDC could have profound implications for the banking sector, either positive or negative. CBDC can also make the financial system safer as. Under a central bank digital currency scheme, citizens and business would be permitted to open and hold interest paid accounts with the central bank. It would allow individuals, private sector companies, and non-bank financial institutions to settle directly in central bank money (rather than bank deposits). A CBDC, therefore, would compete directly with commercial bank deposits, likely inducing a partial shift of deposits away from commercial banks towards the central bank.

This may significantly reduce the concentration of liquidity and credit risk in payment systems, resulting in a safer financial system, with less scope for impairment in monetary policy transmission.

Potential costs of CBDCs

Most of the proposed advantages of CBDCs however are not that straight forward and are mostly subject to controversial debate. Overall, one may conclude from reviewing the arguments in favor of CBDC that the merits of CBDC i.e. contribute to an efficient, resilient, accessible and contestable payment system seem relatively uncontroversial, without this per se being sufficient to justify CBDC. But that is not the case for other arguments.

Disintermediation of the banking sector

It remains uncertain to what extent and in what direction a sovereign digital currency would impact the banking sector and financial stability. Different outcomes are conceivable, with different policy implications, but with no clear indication as to which is most likely. Some warn against the structural disintermediation of banks that could be caused by CBDC. This disintermediation has been considered as one of the major drawbacks and risks of CBDC.

De-funding of the banking sector

Too widespread a substitution of bank deposits by CBDC could lead to a significant de-funding of the banking sector. If CBDCs replace private deposits, that could erode commercial banks’ credit channels, having negative spill over effects on credit creation and economic activity. Another danger associated with CBDC, is that it would facilitate runs out of bank deposits into central bank money in times of financial crisis situations.

Impact on financial stability

A substitution of bank deposits by CBDCs could also weigh on growth prospects if it compromised bank lending activity. First, even if banks were both willing and able to attract alternative funding, the adoption of a CBDC as a very easily safe asset could make credit supply more volatile, facilitating a flight to safety. It might act as a vehicle for bank runs, undermining financial stability. Second, the de-funding risks of banks associated with a CBDC might push the private sector into shadow banking activities.

Forward looking: are CBDCs close to becoming reality?

There is growing consensus that central bank digital currencies have a big chance to become a reality. But it is still guessing when and how it will look like. Most CBDC projects are still in very early or conceptual stages.

While the creation of the group of six leading central banks in the developed economies demonstrates that central banks are moving forward in their research on the costs and benefits of digital currencies at the global level, present findings are not (yet) enough to justify a central bank digital currency. It is still too early to say what would be the optimal design for CBDCs.

There are still many open questions such as, what will be the effect on monetary policy? How will it impact financial stability? And what about the position of financial institutions?

For that there are still too many controversies in the various arguments pro and con. It remains uncertain to what extent and how CBDCs would impact the banking sector and what that means for financial stability. It is also unclear how CBDCs really impact monetary policy.

More research should be devoted to better understanding and assessing the pros and the cons associated with the use of such a CBDC. Only than balanced decisions can be made.

Carlo de Meijer

Economist and researcher