Central Bank Digital Currencies - Part 2

Podcast Transcript

Jacqueline Powell: Hello, and welcome to the Payments Podcast. I'm Jacqueline Powell, and today I'm delighted to host, yet again, Marcus Hughes, who's Head of Strategic Business Development at Bottomline.

Currently, one of the most highly debated topics in the payments industry is central bank digital currencies, or CBDCs. Today I'm chatting with Marcus on this very topic, so welcome back, Marcus.

Marcus Hughes: Thanks for inviting me, Jacqui.

Jacqueline Powell: In our last episode, we covered the basics of CBDCs, its advantages and risks. We looked at some examples of how major economies are handling this. In today's episode, we're going to chat about how CBDCs work in practice, its impact on cross border, and what advice you might have for corporate treasurers, as well as your take on CBDCs in the US.

Kicking off with my first question, I'd like to flip over to the practicalities. One thing that nags at the back of my mind is data privacy. It looks like that is a big concern in the CBDC debate, especially in Western economies, because it has been suggested that the central bank will amass a huge amount of data on our spending habits. Do you think user privacy could stop the development of CBDCs certainly in Western countries?

Marcus Hughes: Privacy is definitely a controversial topic in this CBDC debate. Central banks want to ensure data protection and privacy, by offering a safe alternative to private stablecoins, which might want to monetise end users’ data – and to cryptocurrencies, of course, as well.

In a way, central bank digital currencies are the central bank's response to big tech’s incursion into digital payments, as a way of preventing them from getting a strong market share and exploiting consumer data. This potential for the abuse of data by big tech is a major driver for central bank digital currencies. This is one of the reasons why CBDCs may actually prove more attractive than stablecoin.

Central banks have no commercial interest in storing, managing, or monetising the data of users. This is very different to the opportunity which a tech company might see in issuing a private stablecoin to its large customer base. There are many ways in which such a company, maybe in social media, could manipulate and capitalise on this huge database on people's spending habits, along with their likes and dislikes.

It's worth mentioning that the European Central Bank has completed a proof of concept which demonstrates that it's possible to build a CBDC payment system which safeguards users’ privacy. That's for low-value transactions, but at the same time this would still ensure that higher-value transactions are subject to the usual mandatory anti-money laundering checks and controls.

A key element of this proposal is the use of anonymity vouchers, which would allow users to process low-value transactions without revealing their identity. Every user would be recognised on the network by a reference or pseudonym, and they'd be allowed a certain number of vouchers per month.

When users process low-value transactions, they can spend those vouchers and avoid revealing their personal information to either the central bank or to any other intermediaries. But when they make a higher-value transaction which exceeds the threshold of those permitted anonymous transactions, then a dedicated anti-money laundering authority would be able to oversee transaction data and ensure that they meet current compliance rules.

Jacqueline Powell: How will CBDC work in practice in terms of distribution channels and control systems, for example?

Marcus Hughes: This is a really important question. The Bank for International Settlements, which is often described as the central bank for other central banks, has been doing a lot of work on this subject.

They're actually big advocates of central bank digital currencies. They’ve highlighted three recent trends which makes the development of CBDCs more pressing than ever. First is the growing popularity of Bitcoin and other cryptocurrencies. Then we've got the emergence of the private sector stablecoins, and finally the incursion by big tech firms into payment services.

The Bank for International Settlements believe that CBDCs should be structured, most likely, in a two-tier system. That's a high hybrid system whereby the central bank operates the core of the system and ensures its safety and efficiency. Then, meanwhile, the private sector, so commercial banks and payment service providers, they would compete to develop innovative use cases and value propositions to better serve customers.

In this way, consumers could pay with a CBDC, just as today with potentially a debit card, and certainly online banking tools or smartphone apps, all operated by a bank or other private sector payment service provider.

Treasury management system providers would also have a big role to play here to help corporates manage their payments using CBDCs. However, instead of the entities like banks and payment service providers actually booking the transactions on their own balance sheets, as is the case today, they would simply update the central bank's records. So, the CBDC itself would be a cash-like claim on the central bank. In this way, the central bank records retail balances and transactions.

Jacqueline Powell: You mentioned the Bank for International Settlements. Do you think CBDCs could prove to be the answer for instant cross-border payments, and could CBDCs replace the current correspondent banking model?

Marcus Hughes: A lot of valuable work is going on to address this exact question. Partnering with four central banks – that’s China, Hong Kong, Thailand, and the United Arab Emirates – the Bank for International Settlements has developed a prototype of multiple central bank digital currencies, or MCBDCs.

This has demonstrated the great potential of digital currencies to deliver cheaper and instant cross-border payments, completing multi-currency, international transfers and foreign exchange transactions within seconds, on a 24/7 basis. The cost of such operations to users can be reduced significantly, according to the Bank for International Settlements.

In a separate project, it's again the Bank for International Settlements that's working with central banks of Malaysia, Singapore, Australia and South Africa, to test the use of CBDCs for international settlements. This initiative, actually called ‘Project Dunbar’, is developing prototypes of shared platforms for cross-border transactions, using multiple CBDCs. These eliminate the need for intermediaries, and cut the time and cost of transactions.

Yet another project, back in August, the Monetary Authority of Singapore and the Bank of France completed a cross-border, digital currency simulation across a single shared ledger. The simulation involved using smart contracts to enable automated foreign exchange market-making and liquidity management in order to deliver real-time, cross-currency, cross-border payments in euros and Singapore dollars – on a 24/7, real-time basis, of course.

Now, although this experiment was actually limited to two central banks, the design of the network means it could actually be scaled up to support the participation of multiple central banks, different currencies, and multiple commercial banks, all located in different locations. So, for me, it's quite striking, actually, that Asian central banks are leading much of this innovation.

Jacqueline Powell: Certainly. Both from a domestic and a cross-border perspective, then, do you have any advice on what corporate treasurers should be doing about CBDCs?

Marcus Hughes: It's definitely still early days, but I would suggest these treasurers should at least be following closely this debate on CBDCs and starting to think about the best way to use them. Just to help kick off some of that thinking, and assuming that a CBDC does not pay interest, which is debatable, but then it would not be particularly valuable as an investment or deposit account, so apart from having a central bank guarantee and security.

We actually may find that commercial banks need to increase the interest rates they offer on deposits. That's to ensure they have sufficient funding for their loan positions. So, keeping cash in a commercial bank would continue to make sense as a short-term and medium-term investment, even if it's slightly more risky than with the central bank.

On the other hand, we've seen there are significant advantages both in the real-time nature and the low cost of CBDCs for payments, whether they be domestic or cross-border payments.

A treasurer might, therefore, decide that the optimum strategy is to keep spare cash deposited at a commercial bank, to ensure the best return, but for payments it would be best to convert that commercial bank deposit into CBDCs, in order to reduce the time and cost of those payments.

With that in mind, it makes a lot of sense for corporate treasurers to think about selecting only those commercial banks which can automatically switch funds into and out of CBDCs when they’re initiating and receiving payments. This approach, I think, looks set to become best practice for corporate cash management.

I did see some research very recently by Oliver Wyman and JPMorgan which suggests that a full-scale, multi-currency, central bank digital currency network could potentially save global corporates up to US$100bn a year in transaction costs.

The report estimates that, of the $24tn in wholesale payments that move across borders via the correspondent banking network in B2B payments, those global corporates incur more than $120bn of total transaction costs. This excludes the potential hidden costs in trapped liquidity and delayed settlements, so there’s a big gain to be made there.

I think we can all recognise that in this new world of multiple CBDCs, all connected on a blockchain, it's some years ahead, but it's exciting to work towards that common goal, given the huge value that could be unlocked.

Jacqueline Powell: Thanks, Marcus. That's hugely insightful. From what I'm hearing, are Western central banks falling behind the pace on the development of CBDCs?

Marcus Hughes: I think that, compared to Asia, major central banks in Western economies have actually been quite slow to respond to the challenge of Bitcoin and other private digital assets like stablecoin. This position is in contrast with policymakers in developing economies, where projects around the central bank digital currencies are at a more advanced stage, I would say.

In contrast, it was only in August this year that the European Central Bank launched its own investigation phase of a digital euro project. The investigation is going to last for 24 months and aims to address key issues regarding the design and the distribution of a CBDC, as well as the use cases that would be appropriate.

The European Central Bank say that a digital euro must be able to meet the needs of Europeans, while at the same time helping to prevent illegal activities and avoiding any unintended impact on the financial stability and monetary policy of the European Union.

The European Central Bank has also emphasised that a digital euro would complement cash and not replace it, but these timelines suggest that Europe is still quite a long way off launching their own central bank digital currency.

Jacqueline Powell: Okay, so what can you tell us about the US’s thinking on CBDCs, then?

Marcus Hughes: I'm sorry to say that the US is probably even further behind the pace on this very hot topic. During the summer, the Fed’s chairperson, Jerome Powell, admitted to the Senate Banking Committee that he’d not yet made up his own mind on the pros and cons of a CBDC. He also declared that he would need authorisation from Congress before taking any action to create one.

Importantly, he did acknowledge that one of the stronger arguments for the Fed to create a CBDC is that it would reduce the need for private alternatives, such as cryptocurrencies and stablecoins.

Powell’s remarks reflect this unease among Fed officials about developing a digital version of the dollar, at a time when a growing number of other central banks are pressing ahead with their own central bank digital currencies.

A number of Fed officials have even questioned the need for a US-dollar central bank digital currency. Powell himself has repeatedly said, “The Fed is not eager to be the first with a central bank digital currency, but it wants to get it right if it does eventually go down that road after all.”

According to PwC’s central bank digital currency global index, which tracks various CBDC projects from research to development and production, the US actually ranks 18^th in the world.

America's potential efforts actually trail countries like Sweden, Russia, South Korea, and China. It’s also countries like the Bahamas, Ecuador, Eastern Caribbean, and Turkey. So, there is a risk that, while central banks consider and prepare for possible central bank digital currencies, private stablecoins could still gain a dominant position during this multi-year waiting period.

Jacqueline Powell: It has been suggested that the US dollar has most to lose, then, if central bank digital currencies gain traction. What do you think of that, Marcus?

Marcus Hughes: I do tend to agree that the US dollar’s position as the preeminent global currency could be impacted if non-US central banks begin to issue their own digital currencies. After all, 90% of the world's foreign exchange is based on the US dollar, meaning it affects the economies of almost every country in the world, more than any other currency.

If, as widely anticipated, China gains first-mover advantage as the first major economy to issue a central bank digital currency, then this could be a catalyst to reduce demand for US dollars in the foreign exchange markets. It could potentially accelerate the decline of the dollar’s dominance as the world's leading reserve currency. It could also fast-forward the acceptance of the Chinese currency as the principal rival to the US dollar.

A number of analysts – highly respected analysts, like Accenture and others – are recommending that the US needs to future-proof the US dollar by developing its own central bank digital currency. This would protect the US dollar’s status as the world's reserve currency.

For China, the adoption of a CBDC, both within and beyond its borders, would allow its financial system to reduce its reliance on the dollar. Some users outside China, particularly in the US, may refuse to use a digital currency which is controlled by China. However, early adoption in parts of Asia, Latin America, and Africa, are likely to be significantly faster.

China accounted for 16% of global gross domestic product in 2019, but their currency only represents 2% of global reserves. If China is the first major economy to meet the world's apparent demand for digital currencies to settle international financial transactions and to own digital assets, then the appeal of China's central bank digital currency could rise sharply.

The security and geopolitical rationale for holding yuan, or e-yuan, has become significantly stronger due to programmes like China's Belt and Road Initiative, which is financing numerous infrastructure products in a whole range of developing countries – about 70 countries, as far as I recall.

Jacqueline Powell: Interesting. Thank you for that insight, Marcus. As we draw to the end of part two of our CBDC podcast discussion, do you have any concluding remarks that you'd like to share with us, Marcus?

Marcus Hughes: Thank you, Jacqui. I think I'd finish by making reference to McKinsey's 2021 ‘Global Payments Report’. They highlighted that banks must prepare for inevitable changes, in anticipation of widespread digital currency adoption. They suggest there will be some form of coexistence between CBDCs and stablecoins, and that we’ll see different flavours, which will be determined by geography and politics.

On the one hand, it may be that central banks, like the People's Bank of China, want to exert greater control over monetary policy and citizen surveillance by issuing their own central bank digital currency. On the other hand, we could also have ecommerce and social media giants in the US deciding to offer stablecoins to their huge customer bases.

I'd also mention that Capgemini predicted timelines on CBDCs. They think we'll see more countries running CBDC pilots in 2024 to 2025, and with initial rollout in 2026 to 2027. In this exciting new world of CBDCs and stablecoin, we will certainly find a whole lot more innovation.

The growth of stablecoin will also create challenges on how to best regulate this private sector digital money, but I'd actually like to finish with a quote from Bill Gates, in his book ‘The Road Ahead, published in 1996: ‘We always overestimate the change that will occur in the next two years, and we underestimate the change that will occur in the next 10. Don't let yourself be lulled into inaction.’

Jacqueline Powell: Isn't that the truth, for sure? Thank you so much for sharing your thoughts with me and with our listeners, Marcus. It has been great chatting to you.

Marcus Hughes: Thanks very much, Jacqui, always a pleasure.

Jacqueline Powell: This brings to a close our two-part series on CBDCs and is all we have time for today. We'll be back soon with more insights on the changing payments landscape, so stay posted, but for now it's a wrap. So, thank you and goodbye.