Bejoy Das Gupta, Chief Economist, eCurrency
How should central banks respond to private sector initiatives challenging the role of sovereign states as the sole provider of money in the digital age? This question has taken on greater urgency following the announcement of Facebook’s Libra initiative in June, although the challenge was increasingly evident in recent years with the growing popularity of e-money, and development of cryptocurrencies and stablecoins.
Sovereign states acquired the monopoly of fiat money more than a century ago, when the Riksbank, the world’s oldest central bank, got the exclusive right to issue bank notes in Sweden in 1897, with all private currency having to be withdrawn from circulation by end-1903. Thereafter, the Federal Reserve Banks Act was passed in the US in 1913, while central banks around the world also gradually established their own fiat currencies. Over time, the twotier banking system took shape, with central bank-issued cash complemented by private money created by the banking system, but linked to and backed by reserves and settlement accounts with central banks.
This model has increasingly been challenged by rapid digitization, which has accelerated in recent years. First came the retail digital payments revolution, with private e-money or mobile money developed by telecom-led providers such as mPesa in Kenya, and tech start-ups such as Venmo in the US. This was followed by offerings from ecommerce and big tech firms, such as Alibaba and Tencent in China, and eBay/PayPal, Apple and Google in the US. These firms also acquired many of the initial disrupters. Cryptocurrencies then emerged, of which the most wellknown is Bitcoin, promising to offer a supposedly more trusted private alternative to sovereign money.
More recently, prompted by the failure of the first generation of cryptocurrencies as a reliable means of payment and store of value due to price volatility, stablecoins were developed, promising stability by linking their value to an asset or pool of assets. Stablecoins were sponsored by large financial or technology firms. The latest is Libra, to be launched in 2020, linked to a basket of fiat currencies, operated by the Libra Association of payments and technology companies, led by Facebook.
The private sector innovations were aimed at delivering faster and cheaper payments services for retail users. They also sought to foster financial inclusion, by bringing access to formal financial services to the unbanked, currently around 1.7 billion people world-wide. Libra, which has been categorized a global stablecoin (GSC), is aimed specifically at the cross-border retail payments market. The World Bank reports that global remittances amount to around $700 billion a year, with an average cost of around 7% of transaction value. The UN’s Sustainable Development Goal calls for lowering the average cost to 3% by 2030. As such, Libra aims to bring about large efficiency gains for cross-border retail payments. These are currently expensive, time-consuming and lack transparency because of complex and antiquated payment and settlement processes, involving multiple entities, jurisdictions, and regulatory requirements.
While the private sector innovations have generated welfare gains, the shift to private digital money has brought forth heightened concerns as well. First, mobile money firms are subject to credit, settlement and technology risks. They may also operate within large closed networks, which can limit competition as well as bring stability concerns. For example, mPesa’s annual transactions amount to more than half of Kenya’s GDP, and the lack of data protection laws means that the company is free to use and sell subscriber data. In China, annual volume of big tech-controlled payments services such as Alibaba and Tencent amounts to around 16% of GDP. Customer balances in payment service platforms of big tech companies in China and invested in their money market funds rose rapidly to $360 billion by end-2018. While these are still relatively small compared with other savings vehicles, amounting to only 1% of bank deposits and 8% of outstanding wealth management products, these payments companies are big enough to be systemically important in case of failures or frauds.
Meanwhile, cryptocurrencies are neither private nor public liabilities. They are also volatile, speculative and could be utilized for money laundering and other illicit activities. Some of the blockchain technologies underpinning cryptocurrencies are costly in terms of excessive use of energy and computing power, besides being prone to cyber breaches. In addition, stablecoins raise serious concerns around data privacy, protection and portability as well as money laundering, consumer protection, anti-competitive behavior and financial stability risks. To the extent that they were to operate across borders, as planned by Libra, the risks would be magnified, including the potential to undermine national currencies, the international monetary system, monetary policy, and financial stability. In short, the risks of private mobile money may outweigh the benefits.
Regulatory and supervisory authorities have taken some steps to mitigate risks, but more needs to be done. So far, to guard against the downside risks, the authorities have required payments operators in individual countries to back mobile money with escrow accounts with commercial banks, and more recently, directly in reserves kept with the central bank, as evident in the recent actions by the People’s Bank of China (PBoC). Authorities have also sought to promote interoperability through the introduction of public switches. Cryptocurrencies have been regulated in some jurisdictions, while in others they have been banned altogether.
The announcement of Libra has also precipitated stepped-up discussions at the G7 and the G20 since mid-year, culminating in the G7/IMF/BIS report (“Investigating the impact of global stablecoins”) at the IMF/World Bank Annual Meetings in October 2019. The report calls for careful global assessment of the risks before any regulatory approval is given, along with strengthening of supervisory frameworks, with a final report due by July 2020. The October report also calls for “efforts to promote faster, more reliable and less costly payment systems for both domestic and cross-border purposes, using new technology where appropriate, and in a globally consistent and coordinated manner.” “Finally, central banks, individually and collectively, will assess the relevance of issuing central bank digital currencies (CBDCs) in view of the costs and benefits in their respective jurisdictions.”
Photo: Big Tech and the Future of Finance sessions at the IMF/World Bank annual meetings, October 2019
Meanwhile, the BIS has established an Innovation Hub to foster international collaboration on innovative financial technology within the central banking community and help create public goods. The Hub’s “mandate is to identify and develop in-depth insights into critical trends in financial technology of relevance to central banks; to develop public goods in the technology space geared towards improving the functioning of the global financial system; and to serve as a focal point for a network of central bank experts on innovation.” Initially, three centers are being established in Basel, Hong Kong and Singapore, in collaboration with the Swiss National Bank (SNB), the Hong Kong Monetary Authority (HKMA), and the Monetary Authority of Singapore (MAS). The Basel center will focus on CBDC innovations, the Hong Kong on supply chain management innovations, and the Singapore on regulation and supervision innovation, utilizing big data and artificial intelligence.
As part of the public sector response, two types of CBDCs, for wholesale and retail transactions, are being considered. Wholesale CBDCs take the form of tokens for more efficient settlement and payments involving financial intermediaries. The real-time gross settlement (RTGS) systems for high-value low-volume payments for interbank transactions are already a type of accounts-based CBDC using central bank money, and past experiments with wholesale CBDCs by the Bank of Canada, among others, did not show much material improvement. Nevertheless, the first project of the BIS’s Basel Innovation Hub will focus on the creation of a wholesale CBDC using the Distributed Ledge Technology (DLT) underpinning blockchains, aimed at facilitating the settlement of tokenized assets between financial institutions.
Meanwhile, retail CBDCs are being planned by a growing number of central banks. They are digital payment instruments, issued by the central bank, which circulates alongside physical cash and are used to execute low-value, high-frequency payments for individuals and businesses. They can be accounts-based, with individuals/businesses holding accounts directly with the central bank, but the consensus is increasingly towards value- or token-based retail CBDCs, with cash-like properties.
Both wholesale and retail CBDCs can also be utilized to execute cross-border transactions for efficiency gains. They can be issued by individual central banks or groups of central banks or authorized agents of central banks. These can be in national currency or basket of currencies such as the SDR or baskets of regional currencies, and should be integrated seamlessly with international banks/settlement systems. The need for cross-border CBDCs is probably greater for high-volume or retail transactions, which can be made faster, cheaper and more inclusive. The operationalization of such instruments would also be the most effective response to the challenge from Libra.
While wholesale and cross-border CBDC initiatives are still only on the drawing board, several leading central banks are moving ahead on retail CBDCs in the first instance for domestic use. During the course of 2019, Riksbank, PBoC, and the South African Reserve Bank (SARB) announced retail CBDC pilot projects to be launched in 2020. While further details and technology choices are awaited, they are being designed as value- or token-based CBDCs. The architecture calls for the central banks to be the issuer of the CBDCs, the banks and nonbank payments services intermediaries to be the distributors, and individuals and small businesses to be the users. Accordingly, they will help create a risk-free digital payments system backed by the state as a public good; bring efficiency gains from sharply reduced transaction costs; and expand markets. As they are not limited by physical denomination of currency, allow long-distance transactions, and can be accessed by the unbanked through different mobile networks, they will truly advance financial inclusion.
The Public-Private Partnership architecture also brings a number of additional important benefits. First, it should be easily scalable and adaptable to changing external conditions as the architecture builds on and spurs innovations by payments services providers in response to changing current and future retail user needs. Second, by ensuring interoperability and final settlement, the architecture also bolsters a competitive environment between service providers. Third, it can be used by any payment system and does not depend on any specific payment system technology, thus combating network externalities. Fourth, the ability to issue and settle off-line helps ensure robustness of the system, should the existing payment infrastructure be disabled/non-functioning. Fifth, the projects should also help in the development of common international standards governing CBDCs.
Appropriate design will help mitigate downside risks for retail CBDCs worrying some central banks. For example, the Federal Reserve has stated that it will not rush into untested approaches, preferring to learn from CBDC pilots in other countries while investing in existing payments infrastructure. The Fed is concerned by “legal, policy, and operational questions with regard to CBDCs for individual use.” Legal issues stem from discomfort with individual payments information being recorded by a government entity, and being unsure about the authority to issue CBDCs and establish digital wallets. On monetary policy, the Fed stated that it could use existing tools for negative interest rates, and did not need CBDCs for this. It was also worried by financial stability considerations. Operational concerns stemmed from the Fed having to manage hundreds of millions of individual accounts as well as counterfeiting and cyber risks. It was also troubled by the use of blockchain technology, including the lack of clear, predictable, and final settlement.
The Fed’s concerns primarily related to the assumption that retail CBDCs would be based on individuals and businesses opening accounts directly with it, and that DLT would be used, as is the case for cryptocurrencies. In reality, the preferred approach by most central banks is a token- or value-based CBDC, which does not have the same shortcomings. Moreover, with regard to technology choice, there are other technologies available, including the one provided by eCurrency, which does not have the same scale, settlement and other limitations of DLT. Also, as trust is centralized and resides in the monetary authorities, it is not at all clear why central banks in properly run monetary systems should give up control and shift to the decentralized trust model underpinning DLT.
In addition, financial stability and banking disintermediation concerns for retail CBDCs are overstated, and limited in the case of token-based CBDC systems. There could also be design adjustments such as limits on CBDC holdings and making them non-interest bearing to alleviate concerns. In this regard, it should be noted that it is already possible in the existing system for individuals to switch from bank deposits to government securities digitally. Token-based retail CBDCs are also unlikely to significantly alter monetary policy transmission and nor are they inflationary, as asset prices/collateral values/exchange rates are not altered, monetary base is controlled and existing policy-setting system is preserved. Policy transmission may actually improve. Financial integrity is also strengthened with the CBDC design calling for anonymity to be maintained for small transactions below a certain threshold, and regulatory compliance (AML/KYC/CTF) remaining the responsibility of the intermediaries.
To conclude, the official response to the accelerated development of private digital money is likely to be fivefold. First, a tougher regulatory and supervisory environment for the private sector. Second, central banks will step up efforts to improve the functioning of RTGS systems along with existing payments systems for retail users. Third, central banks will monitor the progress of the SNB CBDC proof-of-concept in the BIS Hub before deciding whether wholesale CBDCs can bring about meaningful improvements. Fourth, and more importantly, retail CBDC pilots will get under way next year in Sweden, China and South Africa, which should have a powerful demonstration impact for other central banks. Fifth, expect the public and private sectors to work together to try to fix the inefficiencies of the cross-border payments system, which could lead to CBDCs for cross-border use. Clearly more needs to be done rather than placing regulatory hurdles to fend off the challenge from Libra, which has cleverly positioned itself as the Robin Hood of the poor, harbinger of new technology reminiscent of the shift from wagon trains to railroads, and defender of American values, the dollar and free expression against the rise of the China.
In sum, there is a growing need for a strong public response in support of more inclusive growth, efficiency gains, reduced concentration/technology/credit/settlement risk, and preserving a trusted state-backed payments system, while continuing to spur innovation and competition in private payments services. To quote Stefan Ingves, Governor of the Riksbank, speaking on “The Future of Money” in Washington DC in October 2019: “If central banks adapt and start using new technologies themselves, then central banks will continue to be around for a long, long time to come. Had we stuck to 45lb copper coins from the 1600s until today, we would probably not have existed.” In essence, central banks need to act more forcefully and quickly to keep abreast with the private sector on technology and innovations to maximize the full positive impact of the digital revolution, while minimizing its risks.
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