This is the second article in a 3-part series on central banks. We begin with a look at how central banks are turning to digital solutions to address new risks, and conclude by asking, What if central banks screw this up?
Central bankers and senior executives at commercial banks cite the need for “interoperability” when they discuss digital sovereign currencies and stablecoins.
It’s a key factor in making central-bank digital currencies (CBDCs) relevant and useful in blockchain-based finance.
The starting point for central banks is to issue central bank money in digital format in order to render private stablecoins irrelevant. Central banks and senior executives at big commercial banks are skeptical of stablecoins because they are not regulated and are not adequately reserved, making them anything but “stable”.
But the allure of companies like Facebook issuing their own stablecoins is too big a threat to ignore. Therefore, central banks are now either launching CBDCs or taking a very close look. They are mulling design options, but also trying to determine if a CBDC is actually going to add value – by ensuring system security and stability, as well as by encouraging innovation.
Why interoperability matters
To that end, whether a CBDC is designed to be retail or wholesale, the bigger question is how it interacts with the rest of the world.
“Interoperability is critical,” said Tom Mutton, director of the Bank of England’s CBDC unit, at Sibos. “We must avoid fragmentation, [which] causes inefficiency and poor outcomes. Whether it’s a retail CBDC or wholesale CBDC for payments platforms, interoperability is crucial.”
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Commercial bankers agree. “Interoperability is hard to crack, but it’s a prerequisite for [CBDCs] to be fully operational, and to be an efficient solution compared to what already exists,” said Florence Lubineau-Henric, head of central banks coverage at BNP Paribas in Paris.
But as central banks design digital versions of their currencies, do they make them compatible with private blockchains such as Ethereum? Or do they make their own bespoke systems?
Soon Chong Lim, group head of global transaction services at DBS, puts the question this way:
“Blockchain is a record of financial transactions and the data related to them is posted in many places simultaneously. This creates peer-to-peer networks that can transfer value or settle financial transactions across a range of instruments, including commercial-bank coins, CBDCs, stablecoins, securities, or [tokens representing illiquid assets]. All of these can exist on a blockchain network. Do CBDCs operate on the same blockchain networks as other forms of money, or do central banks orchestrate their own financial networks? [emphasis added] That is the question.”
Retail versus wholesale
The most basic design questions that central banks face is whether to keep a digital currency at the wholesale level or retail level. A wholesale CBDC would let them rely on commercial banks or other organizations to interface with merchants and consumers. A retail CBDC is essentially cash in digital form, issued directly by the central bank.
Although Cambodia has already launched a retail CBDC, most central banks are looking at wholesale structures. For monetary authorities, digital cash is a leap too far from a security and safety point of view, while they are skeptical it will provide innovation in payments that the private sector isn’t already developing. After all, telcos, banks and fintechs have been moving cash via mobile phones for years.
On the other hand, central banks are keen on digital currency as an efficient way to upgrade clearing and settlement for wholesale payments and for capital markets – partly because central banks already provide these functions in electronic form.
This raises the question of whether even a wholesale CBDC is necessary, or if existing electronic money can simply be placed on a closed, permissioned distributed ledger, if that enables banks to process tokenized assets.
Lubineau-Henric notes that banks can already fully net such instruments. The challenge is to settle the cash leg of tokenized assets, which by definition sits outside the blockchain unless the cash itself represented as a token too.
It’s about tokenizing assets
The lack of CBDCs is therefore an obstacle to asset tokenization, which can today only occur using stablecoins or other private currencies.
“Stablecoins are not optimal,” she said. “Their credit risk is not equal to that of central-bank money.” The cash leg can be settled off-chain, but then it doesn’t benefit from settling on the blockchain, sacrificing much of the efficiencies.
“This is why we are talking about wholesale CBDC, but this puts liquidity fragmentation at stake,” she said. “Multiple blockchains require multiple pockets of liquidity. Netting between blockchains is not yet possible, which fragments liquidity. Therefore banks need more cash and more collateral to conduct the same business we do already [traditionally]. We need interoperability, and smart tools to manage intraday funding.”
Government officials seem to agree: Howard Lee, deputy CEO at Hong Kong Monetary Authority, says of CBDCs: “At the wholesale level, if we have a currency that has the potential for delivery-versus-payment transactions with digital assets, we can support financial innovation.”
Sounds nice in theory
In practical terms, the idea of such interoperability is pure theory. Tony Mclaughlin, managing director at Citi, told Sibos the bank is advocating for the idea of a “regulated liability network” – a single distributed ledger in which central banks, commercial banks, and other authorized entities can manage tokens that represent central bank liabilities.
This is meant to avoid the fragmentation he sees now taking place, as Facebook, banks like J.P. Morgan, and fintechs are launching their own digital currencies. It is also meant to transform stablecoins into regulated assets, to ensure their safety and backing, as well as to mitigate the splintering of liquidity.
Crypto enthusiasts might point to Ethereum and the principle of a “world virtual machine” that underpins it. But within crypto there is now a bevy of competing blockchains with different consensus protocols that are meant to operate more efficiently, as Ethereum struggles with scale and speed – making it an unlikely candidate from the perspective of a bank or central bank.
The regulated world would be more interested in creating their own permissioned distributed ledger that has the qualities of immutable recordkeeping, time stamps, and enabling smart contracts.
It seems unlikely that the world’s governments will come together to form such a platform. The ECB has yet to decide if it is even allowed by its charter to launch a CBDC, while the United States Federal Reserve has shown little interest one way or the other.
Digital land grab
Those central banks that are keen are therefore launching their own CBDCs, as is the case with China, or forming consortia to create the building blocks that others can plug into.
It’s a strategy that combines first-mover advantage with a collaborative mentality.
For example, DBS, Temasek and J.P. Morgan launched Partior, which is meant to serve as core infrastructure for a future Singapore CBDC. The Monetary Authority of Singapore has also launched Project Dunbar, an experiment in CBDC interoperability with counterparts from Australia, South Africa, and Malaysia.
In Hong Kong, the HKMA is working with Bank of International Settlements and ConsenSys to develop its “M-CDBC bridge”, connecting with central banks of mainland China, Thailand, and the United Arab Emirates – a project that includes a retail aspect of its currency, and aims to reduce Asia’s reliance on the dollar for trade and payments.
These initiatives underscore the importance of interoperability. Financial leaders in the West are right to highlight its importance. But Asia’s leading central banks are the ones building pilot versions – and thereby setting the standards for the future of tokenized finance.