Arab Monetary Fund, Eigth Meeting of the Arab Regional Fintech Working Group, 23-24 November 2022 (on-line)
Ladies and Gentlemen,
I would like to thank the organisers of the conference very much for the kind invitation. In my brief remarks I shall focus on international payments and the possible role of central bank digital currencies (CBDC). The Arab Monetary Fund has of course been a pioneer in seeking new approaches to international payments in particular with the Buna platform. CBDC offers an alternative approach. It aims to introduce new functionalities to enable new settlement processes. The success of CBDC will rest in large part on its ability to produce a more efficient and diversified payment system by mediums, actors and geographic distribution of central bank money. It is therefore the design of CBDC that will determine its success.
The case for CBDC is an important international one. International payments rest on highly intermediated payments relations and inter-bank cross-border clearing. The process tends to be opaque, slow and unduly costly. An international transfer normally involves an adjustment of credit and debit balances with correspondent banks. This may sometimes involve long so-called payment chains and gives rise to risks through exposures to foreign banks. There is broad-based policy consensus that international payments need to improve.
Central bank money is the safest money in any currency area and the recommended medium to settle wholesale transactions typically in the country’s large value payment system. Access to the large value payment system is normally only available to resident financial institutions and can therefore only serve to conduct domestic transactions. Buna rests on connecting existing domestic large value payment systems and therefore enable cross-border payments in central bank money. CBDC is about building a new settlement ecosystem.
The innovation with CBDC is the adoption of a new medium, the digital token, and a new peer-to-peer financial market infrastructure. Digital tokens exhibit properties akin to bearer instruments and typically circulate on blockchain and other distributed ledger technology (DLT) platforms. Tokens allow instant transfers and atomic exchanges, that is, both legs of the transaction need to succeed or none does. DLT systems make all payments proceeds immediately reusable whereby payment and settlement are one and the same. DLT systems offer additional features like programmability and traceability that can respond to new use cases in payments. The design of a CBDC will need to comprise those elements to be attractive.
Two conditions are necessary to allow CBDC to enhance international payments. It needs to be held by non-resident institutions and enable on peer-to-peer transfers. The former is to allow CBDC to serve in international payments and the latter to establish more direct international payments relations. Both approaches have been deployed in CBDC projects Jura and mBridge.
Access to CBDC for non-residents extends the safety of central bank money to the international sphere. It is to recalibrate how payments relations are being formed, facilitate greater competition by establishing a level playing field between resident and non-resident entities and between large and small institutions that may typically not maintain direct correspondent bank relationships. If central bank money were available internationally, it would reduce risks and therefore likely costs, promote and facilitate international financial and economic integration.
The peer-to-peer nature of CBDC may be better adapted to accommodate adverse shocks than the highly intermediated system of today. The international financial system is subject to increasing stress amid rising geopolitical tensions. Country alliances are becoming less stable. Financial systems may require greater flexibility to adjust. In peer-to-peer relationships a change in counterparty is done quickly with few direct implications.
Smaller currencies should benefit as the functionalities and new infrastructure afforded by CBDC may make them relatively more attractive and usable in international payments. Traditional factors like very large network effects and deep financial markets may not be required in a CBDC environment. Greater diversification of the international financial system by currencies would likely add to greater stability.
CBDC in foreign exchange transactions would offer an entirely new architecture for the foreign exchange market. Foreign exchange represents one of the largest financial markets with more than US$7.5 trillion (BIS 2022 Triennial Survey) in daily trading volume. Transactions are typically over-the-counter between banks. Cross-border transactions are settled with foreign correspondent banks implying that the payee’s bank will assume a claim on the payer’s correspondent bank. Transactions also normally divorce payment and settlement and there can be important delays between the two. While foreign exchange trading through CLS Bank offers many advantages and mitigate settlement risks, payments relationships remain indirect and exposures are to commercial bank money only.
Foreign exchange in CBDC would be conducted in instant and atomic currency exchanges. Transactions would be payment versus payment eliminating all open positions and greatly mitigating risks. By allowing non-resident institutions to hold foreign CBDC, central bank money could serve outright in international payments. The instant and atomic transactions imply that no clearing and netting would be needed as pay and receive legs could be instantly reused.
CBDC in international securities trading would extend domestic settlement conditions to international transactions. Securities settlement in a domestic setting is typically performed against central bank money in the large value payment system. The same security may thus settle against central bank money or against commercial bank money depending whether it is traded domestically or internationally. This asymmetry in settlement implies that market conditions are for similar instruments differ between domestic and international trading venues undermining a level playing field between domestic and international actors and may impair orderly international financial integration.
The tokenisation of securities and settlement against CBDC would enable a token-based end-to-end securities trade lifecycle. While tokenisation of securities is not too different from dematerialisation, tokenised securities could be settled against CBDC in a direct token exchange in delivery versus payment transactions. There would be no settlement risk and proceeds could be instantly reused. In an instant and atomic environment, both trading partners would always be liquid as the securities buyer could instantly repo the security upon making the payment. Such conditions are set to change the very meaning and understanding of liquidity itself.
To conclude, CBDC is a catalyst and driver for change in financial markets. It is about conducting financial transactions differently. It is above all to ensure central bank money is available across a broader range of financial market infrastructure to advance diversification and competition. It is also about new actors and business models that may adapt more swiftly to the new opportunities afforded by CBDC. Naturally CBDC will matter most where central bank money plays a key role as settlement medium.
CBDC is not necessarily about existing use cases like foreign exchange and securities settlement. It is about addressing future use cases, many of which we may not know today, and equipping the financial system to accommodate new payment needs. The design of CBDC needs to ensure such objectives can be met.
Thank you very much for your attention.