Bank Indonesia and De Nederlandsche Bank conference Payment system in the digital era, 26-27 October 2022, G20 side event, Yogyakarta, prepared abbreviated remarks
Ladies and Gentlemen,
I'm most grateful for the invitation to speak at this conference in the city of Yogyakarta. Since this is a conference co-organised by the central banks of Indonesia and the Netherlands, Yogyakarta has of course a special place in the monetary history of Indonesia. In was here, at the time the Indonesian capital, in October 1946, when Vice President of the Republic of Indonesia Mohammad Hatta announced on radio the issuance of the first Indonesian currency, the Oeang Republik Indonesia (ORI) that was also printed first in Yogyakarta to replace the colonial currency by De Javasche Bank as an important expression of Indonesian sovereignty. Central bank digital currencies (CBDC) may not quite have the same historical significance as the introduction of a new currency, but they could define the continued utility of a currency. In my remarks I shall focus on the next generation of CBDC projects with a view on how a CBDC could transform liquidity in financial transactions and hereby support the very foundations of market stability and our understanding of liquidity itself.
CBDC is a new format of central bank money, a digital token, to complement banknotes and scriptural monies or reserves. It is the same rupiah but just a different representation thereof. The historical parallel is the introduction of paper currencies to complement silver and gold coins.
Digital tokens exhibit properties akin to bearer instruments, that is like coins and banknotes, and typically circulate on a blockchain and other distributed ledger technology platforms. They offer new functionalities to enhance what assets and money can do. Token encapsulate all properties needed to perform a transfer of ownership. An exchange of tokens can greatly simplify and enhance settlement efficiencies.
CBDC is therefore about diversification and competition in payments and equipping the financial system with a new medium to do new things and address actual but in particular future use cases. It is to ensure access to central bank money is equitable and available across a broad range of financial market infrastructures. It is not so interesting as a payment instrument but especially in settlement of large value transactions. CBDC above all is to advance financial innovation.
CBDC projects have moved forward from proof of concept towards pilots with some though very small implementations. Most basic functionalities have been tested. It seems fair to say that CBDC works and that the underlying DLT platforms can meet most payments demands. There has been less work done on exploring how programmability may change some fundamental aspect of market liquidity. This I think will form core part of the upcoming generation of CBDC projects.
Programmability enables new approaches to foreign exchange and securities transactions and transform the meaning of market liquidity. Liquidity is generally understood to mean that an asset can be sold at or near its previous market value. Liquidity of an asset therefore determines its marginal utility or price and expected return. If liquidity conditions change, asset price formation is set to change.
Liquidity in today’s markets is highly constrained. Trading and settlement are separate and there are significant lags towards settlement. Post trade processes typically involve clearing, where assets are being aggregated to establish mutual liabilities between trading parties and netting to determine marginal amounts owed followed by settlement where assets are delivered for cash. Trading implies open positions and risk mitigating measures through margining and collateral. Additional counterparties may be involved like a central counterparty (CCP) to novate trades between trading parties becoming the counterparty to both buyer and seller. In foreign exchange transactions, trade settlement takes typically place in two separate large value payment systems, including for transactions settled by CLS Bank, where there can be long lags between trade execution and settlement and where transacting parties assume a claim on their correspondent bank.
Programmability can make token exchanges instant and atomic and allow to embed complex business logic and processing. Atomic transactions mean both legs of the exchange have to succeed or none does. It implies there would be no open positions in trading, no need for clearing and netting and no need for risk mitigation measures or entities like CCPs. Trade execution and settlement become a single transaction, that is, the execution is the settlement. Buyer and seller would no longer be short liquidity.
In foreign exchange, a payment versus payment transaction, trade execution would imply an outright instant exchange of a set amount of rupiah for a given amount of say dollars. If both legs of the trade were available as CBDCs—central banks would have to grant access to their CBDCs to non-residents—the transaction would be entirely riskless. It implies that there would be no liquidity constraint as traders would be able to instantly resell the receive leg of the transaction.
In securities trading, a delivery versus payment transaction, assets could be borrowed instantly and repaid instantly. Central banks could offer instant repo windows. If a buyer is short cash, he or she could borrow CBDC, pay the seller, obtain the security, repo the security and repay the CBDC instantly. If a seller is short the security, he or she could borrow the security, transfer it to the buyer, obtain CBDC and cover the security. There would have to be no need for pre-funding of assets or cash, as either could be borrowed instantly to trade. The underlying transactions would be programmed as nested transactions—a flash repo—to establish a chain of simultaneous interdependent transactions.
To conclude, the next generation of CBDC projects is expected to focus on programmability to deepen understanding of an instant and atomic environment to explore new possibilities to manage market liquidity and assess market stability. The importance of or supply of liquidity will likely change and hence the price financial markets are willing to pay for liquidity. It would bestow financial markets with greater efficiency and safety. In foreign exchange, supply of currencies would improve, aiding more efficient exchange rate formation. While not all financial market actors may desire instant settlement, for reasons of trading strategy, token-based exchanges would be able to offer a sliding settlement window too.
CBDC can be a catalyst towards facilitating new market and trading conditions. The ORI was a considerable innovation but finally did not last long. In 1951, the Indonesian rupiah was introduced. A rupiah CBDC may now be the next big step in the history of money of Indonesia.
Thank you for your attention.