New financial challenges and central bank digital currencies

UBS Central Bank Reserve Management Seminar, 20-24 June 2022, Wolfsberg

Ladies and Gentlemen,

Thank you very much to UBS for the kind invitation to speak to you today. In my presentation, I will provide an overview of central bank digital currency (CBDC) projects against recent financial market challenges to highlight possible drivers of CBDC adoption. To start, I will cover some high level elements on blockchain and argue that recent geopolitical tensions may make introduction of blockchain-based capabilities even more urgent.

I consider blockchain a critical innovation for financial markets. Please be reminded that the debate about new approaches to payments and settlement and existing payment system deficiencies arose due to blockchain-based applications like bitcoin and libra. I see blockchain mostly as a complement to existing financial applications and while blockchain can serve certain use cases particularly well, there are many others where it is unlikely to become dominant. Blockchain-based applications are believed to be an integral part of a broader trend towards a more diversified and resilient financial system. The current adverse market developments for crypto currencies, I do not think will divert from the utility of blockchain.

New financial market challenges

Innovation has of course always had a profound impact on finance. It is driven normally by a motive of reducing costs or producing real efficiency gains. The invention of the steam press during the second half of the nineteenth century enabled the adoption of the gold standard. Regulation and taxation, think Eurodollar market and long-dated deeply discounted corporate bonds, have often been seen as key impulses for financial innovation including the proliferation of financial products. Blockchain offers a different approach by targeting the organisation itself of financial markets.

Blockchain and other distributed ledge technology (DLT) platforms enable trust to migrate away from the transacting parties to the blockchain where validation rests on blockchain wide validity rules or contracts and an agreed consensus mechanism. Blockchain offers strong out-of-the-box functionalities to facilitate the adoption of digital tokens with properties akin to digital bearer instruments supporting peer-to-peer trading relations. It creates an immutable record and projects new forms of risk sharing, spatial transfer of resources, lower transaction costs and reduces and to some extent eliminates information asymmetries.

These blockchain features seem particularly well adapted to meet new financial market challenges. The Russian war in Ukraine will likely bring forward an increasing divergence in the international economy and financial markets. Financial fragmentation could mean increasing isolation of particular countries from a set of financial markets but also fewer stable relations and a greater need for monitoring financial transactions.

The increasing geopolitical tensions have already led to mounting warnings about deglobalisation but also calls for adapting proactively to the new challenges. Recent claims include to rethink the international financial architecture itself. The last time there was an ambitious agreement on a new international financial architecture was in 1944 during World War II at Bretton Woods, New Hampshire that led as is well known to the establishment of the International Monetary Fund (IMF) and gold exchange standard. A new financial architecture being more flexible to accommodate more frequent recalibrations of financial relations may now be needed. U.S. treasury secretary Janet Yellen recently evoked the spirit of Bretton Woods urging a rethink of an international financial architecture better suited to meet the shifts in globalisation. There has been an underlying assumption that the world is on a path of permanent convergence. This seems no longer to be the case.

Blockchain is well suited to equip currencies and financial assets with capabilities to meet the new financial transaction demands and use cases. These include peer-to-peer payments, decentralised transaction validation, traceability and local custody. In the future we may need to know even more about who we deal with and who that entity had dealt with and ensure there are no unwanted dependencies when performing a trade.

Central bank digital currencies

The innovation with CBDC is the adoption of the digital token as a new format of central bank money to complement banknotes and reserves or scriptural monies. It is the same dollar, euro, rand, rupee but just in a different format. Tokens allow to collapse payment, clearing, netting and settlement into a single transaction. Similar with tendering a banknote, the payment with a digital token is the settlement. It promises to reduce the social costs in payments.

Central bank money today only exists for cash and account-based financial market infrastructures. CBDC aims to serve as settlement medium on alternative payment systems and as such advances choice and diversification in payments. It helps to ensure that access to central bank money remains equitable and not unduly limited to incumbent payment actors.

CBDC addresses new use cases existing payment systems cannot meet or where needed adaptation would be unduly inefficient. Key use cases are those where central bank money can play a special role including as settlement layer for ACH and card networks, as settlement medium for security tokens in large value payments, as settlement medium in foreign exchange transactions and to settle international inter-bank payments.

The international monetary system relies on a narrow set of national currencies to conduct international payments. When the ECB announced in October 2020 considerations to issue a digital euro, it stressed that the digital euro shall strengthen the strategic autonomy of the Euro Area, affirming the role CBDC will likely play in redefining international payments relations and shifting the relative attractiveness of currencies to lead to a more diversified international monetary system.

CBDC would allow central bank money to be held outright as reserves. The bearer instrument properties would mean central banks could use CBDC directly in foreign exchange market interventions. It may lower the threshold for adopting alternative currencies and could be an essential element in bringing about the use of local currencies in international payments.

Different CBDC use cases have been tested. CBDC projects have been evolving from relatively simple proofs-of-concept to transactions in a pre-production like setting. Of course, several countries have already launched versions of CBDC including China, Nigeria and the Bahamas. The following examples of CBDC projects shall therefore merely serve to illustrate what CBDC functionalities are being explored that will likely represent motives for adoption:

CBDC is expected to have its biggest impact in international payments and settlement. Three approaches have been emerging for the deployment of CBDC that will likely co-exist and reflect different governance arrangements:

The multi network and foreign network approaches need to address the interoperability of different CBDCs across different networks. This has largely been solved through the use of synchronising the different networks temporarily to allow bi-directional transactions, e.g., payment versus payment, to take place across networks.

To illustrate how the future of wholesale CBDC may look like, I would like to briefly explain the setting of project Jura. Jura combined four platforms to conduct payments and settlement: The large value payment systems Target 2 and SIC in France and Switzerland, respectively, an issuance platform for tokenised non-listed securities and other financial instruments in France called the Digital Asset Repository operated by Natixis and the trading platform in Switzerland being a test platform by Swiss Digital Exchange SDX. The commercial banks participants in the transactions were Credit Suisse, Natixis and UBS. The DAR and SDX platform used as primary layer the DLT platform Corda by R3. Accenture led the consortium of the private sector participants.

The Banque de France and Swiss National Bank issued wholesale CBDC tokens on the SDX test platform against reserves of the commercial banks debited in Target 2 and SIC, respectively. Natixis issued a commercial paper denominated in euro on the DAR. The commercial paper was mirrored through reissuance of a token on the SDX test platform. On the SDX test platform the commercial banks performed transactions in simple token-for-token swaps to exchange the commercial paper against euro wholesale CBDC on a delivery versus payment basis and transactions to exchange euro wholesale CBDC for Swiss franc wholesale CBDC on a payment versus payment basis. These transactions were atomic, meaning each leg of the transaction has to succeed or none does. The approach thus eliminates all open positions when trading currencies and financial instruments. I would like to stress that this is a payment versus payment transaction between end-beneficiaries unlike most existing arrangements.

Jura thus projected the settlement of a commercial paper in central bank money in cross-border and offshore transactions and the settlement of foreign exchange in central bank money in cross-border transactions. The pilot allowed for the first time non-resident banks to make and take delivery of a home wholesale CBDC whereby a French bank was able to hold a Swiss Franc CBDC and a Swiss bank a euro CBDC. It outlined nothing less than an entirely new architecture for the use of central bank money.

To conclude, blockchain and other DLT-platforms offer new features that are set to significantly expand what money can do. Blockchain significantly facilitates deployment of peer-to-peer payments, decentralised transaction validation, traceability and local custody that strengthen adaptability and resilience in payments.

As next steps, central banks may consider testing features necessary to use CBDC as international reserve assets. CBDC would be a new instrument in most official reserve portfolios. It would make a critical contribution to advancing diversification of the financial system, help meet future use cases and preserve the competitiveness of central bank money.

Thank you very much for your attention.

Economics Advisory, June 2022