Remarks delivered at Blockchain Centre, Distributed Finance Roundtable
Vilnius, 25 November 2019
Ladies and Gentlemen,
I'm most grateful to the organiser for the invitation to speak to you today. I work for Accenture co-heading its digital currency campaign globally focusing on adoption and dissemination in particular of blockchain-enabled central bank digital currencies. Accenture is one of the largest consulting firms in the world with more than 490,000 employees, operations in 50 countries including in the Baltics in Latvia. It is a leader in blockchain-related themes including payments, identity and supply chain management and in technology with more than 100 applied and granted patents around blockchain.
I was asked to focus today on Accenture's recent publication the (R)evolution of Money 2 and in particular on the notion of broadening access to central bank money and its potential effect on financial markets developments. My argument shall rest on the assumption that more equitable access to central bank money would support more diversified, resilient and deeper financial markets helping in particular start-ups and small and medium sized enterprises to raise needed resources. I will claim that the best solution to offer broader access to central bank money while fostering innovation and preserving the existing banking infrastructure is a central bank digital currency in token format.
Central bank money has seen few if any innovations since widespread adoption of bank notes and introduction of cashless payments during the nineteenth century. New financial technology can equip central bank money with new functionalities that may expand its utility and possibly serve as catalyst to establish new financial ecosystems. Central banks have been instrumental in shaping modern monetary standards with the adoption of unified coinage. They now face a historical opportunity to set a standard for digital currencies.
I shall offer a brief overview of central bank money and why it matters, develop the idea of broader access to central bank money and then outline and discuss introduction of a central bank digital currency or CBDC and its possible impact on financial markets.
Why central bank money?
Money does not equal money. This seems an unusual statement but the distinction between central bank money and other monies matters greatly in particular for large value transactions. To understand why it matters let's start with distinguishing between central bank and commercial bank monies.
Most monies are liabilities of the financial sector. When a non-bank, the general public, holds a demand deposit at a bank in Lithuania, it holds a claim on the bank. We are in the Eurosystem, so that claim is commercial bank money denominated in euros but is not euros. The deposit can be converted on demand into euros. Only upon conversion, does the non-bank public hold euros, that is central bank money.
Euros are issued only by the national central banks, in Lithuania, the Bank of Lithuania. Central banks provide bank notes and reserves and sometimes coins. Bank notes are available to the general public as settlement medium for retail transactions. Reserves can be held by banks as settlement medium for inter-bank payments to conduct large value transactions in the national payment system or in the Eurosystem in Target2 including liabilities arising from securities trading. It is an international recommendation that all financial market infrastructures should offer settlement in central bank money.
For the non-bank public, the distribution of central bank money occurs via the banking system. Banks distribute currency to the non-bank public against commercial bank deposits through their networks of branches and ATMs. Non-banks, apart from settlement in bank notes, can only settle against commercial bank claims.
Central bank money is special. It is the highest quality of money in a given currency area. There is a presumption that central banks can always meet their liabilities. By tendering central bank money, all debt is settled immediately with finality. It therefore matters who has access to central bank money.
Access to central bank money is highly restricted by design and only available to institutions, normally banks, having a reserve account with the central bank. It implies that access to central bank money depends on banks. In Lithuania, 14 institutions have access to Target 2. For large value payments it means that only banks can settle in central bank money amongst themselves. Only banks have access to liquidity facilities, including intra-day credit, central banks normally provide for large value payment platforms.
Two observations are worth highlighting:
Decline of commercial bank lending: In the Eurosystem, banks have accumulated large amounts of reserves following the policy of quantitative easing (QE) of the ECB holding excess reserves of around EUR1.4 trillion (11 percent of Eurosystem GDP) (Figure 1). The aim of QE was to lower interest rates and expand lending. It achieved the former but not the latter. Since the financial crisis of 2010, bank claims on households and non-financial corporations including debt securities and shares in investment funds have declined from 134 percent of GDP in 2009 to 108 percent in 2019. While prior levels may not represent an appropriate benchmark, it appears that banks have not fulfilled their intermediation function. Given the importance of the banking system in the European Union generally, banks may no longer be an effective transmission channel for monetary policy.
Figure 1. Bank asset decline and reserves
Central bank money reduces settlement risks: The advantage of transacting in central bank money can be estimated as the relative opportunity cost of holding central bank versus commercial bank claims. Taking as an example Switzerland, the difference in terms of yield between government bills, as a proxy for the central bank, and commercial bank bills is both relatively high and increasing (Figure 3). Settlement in commercial bank money is more risky and costly amid counterpart and other market risks associated with banks. It highlights possible disadvantages for entities not able to settle in particular large value payment transaction in central bank money.
Figure 2. Settlement risk
Broadening access to central bank money
Commercial banks as gate keepers for the central banks, may prevent equitable access to central bank money and distort markets and ultimately access to financial resources. A more equitable access to central bank money may therefore be needed.
The limited access to central bank money has distributive and competition implications. If entities other than banks were to have access to the central bank balance sheet, the central bank would have to open up to non-bank users. Some central banks like the Bank of England and the Swiss National Bank already allow access for non-banks.
The advantage of broader access to central bank money rests on the assumption that the use of central bank money for settlement reduces risks and would give confidence to alternative payment platforms that the central bank stands ready to ensure payments can operate smoothly. It would also allow new large value payment platforms to be at a level playing field with conventional settlement channels. It would likely lead to greater competition and efficiency in payments and would also change banks' behaviour possibly increasing pressure to mobilise their resources.
CBDC is a tokenised central bank money to serve token-based financial market infrastructures as settlement medium. Token-based CBDC appears the most effective way to broaden access to the central banks' balance sheets without unduly disrupting existing financial market infrastructures and preserve the prevailing two-tiered banking system. CBDC is simply a different format of central bank money and would be issued against reserves similar to bank notes.
The innovation with CBDC is its token format. Tokens allow central bank money to become a bearer instrument that can live outside the central bank, that is , it is portable, and preserve its property as central bank money irrespective of space and time making central bank money portable in digital form for the first time.
CBDC is not about fast payments. It is about new functionalities bank notes and reserves cannot offer and to allow end-to-end settlement in tokens. Blockchain or distributed ledger technology (DLT) represent the best technologies to issue and manage tokens.
Token-based CBDC can offer simultaneously diversification of payment rails, settlement innovation, off-line functionality while preserving the two-tiered banking system. The establishment of alternative and more decentralised payment channels increases resilience and security of the payments infrastructure and affords complete autonomy of payment execution continuously 24/7. Tokens may enable new payment functionalities including through programmability and in cross-border transactions and support new token-based financial market infrastructures. Tokens also offer strong security for conducting payments off-line amid peer-to-peer capabilities being able to serve as a contingency payment mechanism. Only the portability of tokens enables using existing distribution channels and implies that commercial banks maintain all related customer services and controls raising incentives to support and integrate CBDC into existing banking functions. The latter preserves a fundamental central bank operation principle of issuing central bank money only against the highest quality collateral.
Central banks have worked on several CBDC-related projects. SIX of Switzerland initiated the establishment of an entire token-based financial market infrastructure, Swiss Digital Exchange (SDX), to start operating during the second half of 2020 and the Swiss National Bank (SNB) is to undertake a project on the use of wholesale CBDC as settlement medium on the SDX platform. The Bank of Canada undertook project Jasper to show that DLT can be used in securities settlement. The U.S. Depositary Trust and Clearing Corporation (DTCC) demonstrated that a DLT-enabled clearing system can meet existing peak requirements for U.S. equity trading affirming that DLT provides adequate performance and scalability levels. Sweden is scheduled to launch in pilot for a retail CBDC in January 2020. China has repeatedly indicated that it is well advanced to introduce CBDC and is expected to do so in early 2020. There are a number of other projects with dozens of central banks conducting work around CBDC.
There are least four critical CBDC themes
Diversification: Token-based financial market infrastructures offer diversification in payments to provide greater resilience, choice and safety. It may also operate as a contingency network in times of significant financial distress and grant payment autonomy to the central bank.
Settlement: CBDC can serve as settlement medium on token-based financial market infrastructure to allow end-to-end settlement in tokens. It can enable delivery versus payment in simple asset for currency token swaps. It can operate 24/7.
Access: CBDC offers the possibility to have wider access to central bank money while preserving the distribution of central bank money through the banking system. Token-based financial ecosystem may foster financial deepening by integrating new asset classes, issuers and investors fostering integration and more diverse financial resources. CBDC may allow for the first time to conduct settlement in central bank money off-shore and in cross-border transactions.
Co-existence: The emergence of privately issued digital currencies may transform financial ecosystems and usher the co-existence of private and national currencies including possibly in overlapping currency spheres
The range of alternative digital currencies point towards a demand for new types of settlement media. Bitcoin was the first of a new era of blockchain-enabled currencies and initiated a complete reassessment of the role and functions of money. Facebook-supported libra has elevated the urgency with which consideration is being given as to how private currencies may challenge incumbents and possibly lead to a completely new architecture of currencies. Stable coins have been adopted in large part to offer national currencies in token form amid the absence of CBDC. Large commercial banks have initiated issuance of digital coins that could act as substitutes for deposit and allow bank liabilities to become portable settlement media. Consortia like the Utility Settlement Coin (USC) aim to mimic central bank money to serve as settlement medium for large value payment transactions.
CBDC may alter existing currency success factors. Adoption of currencies in the past had been based largely on the intrinsic value of currencies. Under the gold standard prior to World War I, bank notes were reserved with gold to convey confidence that their value was stable. Subsequently with the abandonment of the gold standard or its later iteration the gold exchange standard during the 1970s, the credibility of the central bank became the defining factor to determine confidence in a given currency. Today fintech may offer new features that make some currencies more attractive than others by offering functionalities conventional currencies do not. In international transactions, it may allow smaller currencies possibly to play a greater role by offering advanced features the major currencies do not. The relative attractiveness of currencies may thus shift towards functionality as a defining criterion for adoption.
Could the Bank of Lithuania issue CBDC?
The Eurosystem is of course a special arrangement. The ECB authorises national central banks to issue currency but issuance of currencies rests with the national central banks. There is nothing a priori to prevent the Bank of Lithuania to issue CBDC to serve as settlement medium on a token-based exchange platform. In that context an earlier announcement by neighbouring Estonia to issue an Estcoin, I think was misunderstood as an alternative currency when it may have been simply the euro in a different format. Naturally there will be some coordination and agreement between national central banks and the ECB on any important initiative. The Bank of Lithuania already announced it will be the first central bank to issue numismatic digital coins.
Central banks should be technology neutral and not unduly favour the incumbent. The adoption of CBDC would enable alternative payment system to thrive while making adoption and eventually dominance of one format over another a market outcome.
To conclude, the special role of central bank money means central banks can be catalysts for enabling new financial market infrastructures to emerge. By making central bank money available more widely, there is an opportunity to promote a more diversified payment system that be able to cater to different needs more effectively. The high barriers of entry imposed by the existing payments environment means that in particular small and medium sized enterprises and start-ups may be unduly constrained in raising needed finance. CBDC may become a key driver in making access to central bank money more equitable and allow a broader range of market participants to benefits from its special features.