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Jacqueline Powell: Hello, and welcome to The Payments Podcast. I’m Jacqueline Powell, and today I’m delighted to host Marcus Hughes, Head of Strategic Business Developments at Bottomline. Currently, one of the most highly debated topics in the payments industry is central bank digital currencies or CBDCs if you prefer.
In today’s Payments Podcast we’re going to explore what exactly is a CBDC, why we need them, what advantages they would bring, what are the risks and how they would work. Welcome Marcus. Thank you for being with us today.
Marcus Hughes: Hello, and thanks for inviting me of course, Jacqui. I’m always delighted to share my thoughts on a topic like this, a hot topic that has got great potential to dramatically change the payments landscape.
Jacqueline Powell: And it’s always a pleasure to have you. Marcus, can we begin this podcast by going back to basics please. Let’s start with what is CBDC?
Marcus Hughes: Perfect question, a great starter. So, a central bank digital currency is a new form of electronic money which is issued by a central bank. It’s therefore a direct liability of that central bank and it’s denominated in the currency of that country.
So, in this way a CBDC is different to the liability of a commercial bank and therefore it’s considered as completely secure because it’s fully guaranteed by a central bank.
At present, there are basically three types of money. First we’ve got physical cash, which means bank notes and coins, usually issued by a central bank, there are a few exceptions to that. Then we’ve got commercial bank money. This is a form of electronic money which individuals and businesses hold in their accounts at normal commercial banks, you know, like NatWest or HSBC.
And, finally, we’ve got central bank money. This is electronic money or reserves which are held by commercial banks in their accounts at their central bank, like the Bank of England. And this central bank money is used for moving money between banks as part of a country’s clearing and settlement systems.
The difference between a CBDC and existing electronic central bank money is that this second form of digital money is only available to commercial banks which participate in the payments system, but in contrast a central bank digital currency would also be available to all businesses and individuals.
So, if a UK central bank digital currency were introduced, it would be denominated in pounds sterling just like bank notes and coin. So, £10 of our CBDC would always be worth the same as a £10 note.
A CBDC is sometimes thought of as the equivalent of a digital bank note, although in some respects it also has much in common with a bank deposit. In most used cases, a CBDC would only be introduced alongside rather than replacing cash and bank deposits. It’s really important also to note that a CBDC would be interoperable with other forms of money, the ones I’ve just mentioned on a one to one basis.
The next important thing to understand is that a CBDC could take two forms. First, there is the retail version, which is the one that is nearly always talked about. This would be a widely accessible and public electronic money which would be used for retail transactions by consumers and businesses.
Then there is the wholesale version. This would be a restricted electronic money, which is only available for large transactions like buying and selling bonds and securities in the capital markets.
But the retail form of a CBDC would play the same role as any country’s currency in circulation today, whereas the wholesale form would be like the reserves that are held by banks and other financial institutions at their central bank.
Jacqueline Powell: That’s helpful, thank you Marcus. In order to help us navigate through this complex topic, I would like to ask you to explain, at a high level of course, how CBDCs are different from stablecoin and cryptocurrencies.
Marcus Hughes: Yes, exactly. So, when it comes to cryptocurrencies like Bitcoin, so far these digital assets haven’t really lived up to the initial hype that they were going to become an instant payment instrument.
Using cryptocurrencies as payment instruments has faced strong resistance from regulators, and that’s because the parties making and receiving cryptocurrency payments are anonymous. This means that, rather worryingly, there is no way of preventing these cryptocurrencies from being used for money laundering or as funding for terrorism and financial crime.
And there is plenty of evidence, unfortunately, that this is precisely what many cryptocurrency payments are being used for today, but it’s almost impossible to trace this criminal activity.
Other practical barriers which are preventing more widespread adoption of cryptocurrencies for real time payments are scalability challenges. This is due to crypto validation requirements, strangely known as proof of work or mining, which can be quite slow and costly and uses high levels of electricity in order to validate these transactions.
So, for example, Bitcoin, probably the most famous of the cryptocurrencies, is only capable of processing around seven transactions per second. This has resulted in transactions taking a long time to process and fees can actually be quite high.
For Bitcoin to become a viable alternative to existing large scale payment systems, it must resolve this challenge. And by a way of comparison, Bitcoin’s processing speed is, sorry to say, feeble when measured against Visa’s average of 24,000 transactions per second, and their capacity of 50,000 transactions per second.
Furthermore, the volatility of cryptocurrencies has meant that it is frankly way more popular as a speculative investment instrument, effectively a commodity, but not really as an instant payment instrument for regular citizens or businesses.
Recently, we’ve seen the emergence of a new form of digital money known as stablecoin. These new digital coins have potential to overcome the volatility issues of cryptocurrencies because they’re supposed to be paid one to one against fiat currencies such as the US dollar or the pound sterling.
Ironically, this matching is actually quite controversial because it has recently come to light that Tether, actually the largest stablecoin is not matched one to one against US dollar deposits despite its original claims that it was fully pegged.
Instead, it has significant investments in corporate commercial paper, which is clearly more volatile than a 100% match against dollar deposits at a central bank for example. Nevertheless, we have seen a number of major banks and other private sector entities begin to issue properly pegged stablecoin. For example, we’ve got a JPM coin, Wells Fargo digital case and also Sygnum’s digital Swiss francs.
Finality is actually a good example of a wholesale stablecoin designed for capital markets transactions, but probably the most famous stablecoin is Facebook’s Diem initiative, which in reality is still actually work in progress instead of being a live payment instrument today.
That’s mainly because it’s still trying to gain the necessary regulatory approvals. Despite this Diem has still attracted a huge amount of publicity and controversy.
Jacqueline Powell: Okay, so that helps to clarify things for me and our listeners, Marcus, thank you. Coming back to CBDCs then, what are the advantages and benefits?
Marcus Hughes: Advocates say that a CBDC would create a more resilient payments landscape with a new set of payment rails which meet the needs of a modern digital economy. It would therefore provide individuals and businesses with a reliable payment system that makes payments faster, cheaper, and more efficient, and it would protect against the risk of private payment systems potentially failing.
By linking up different countries’ CBDCs there is great potential to radically improve cross border payments in multiple currencies by making them real time 24/7 without holidays.
So, one of the most important used cases for me is cross border payments. Settling cross border payments in central bank digital currency through direct connections on a blockchain would avoid the delays and costs which are typically associated with cross border payments currently being processed through a correspondent banking network.
Using a CBDC for cross border payments could reduce the time taken from days to seconds. A retail CBDC would be available to consumers, easy for bank consumers to use, but also designed for unbanked consumers to use as well. This is because many governments want to offer an alternative to cash and to promote financial inclusion for those people who do not currently have bank accounts.
A central bank digital currency is likely to have an anonymous option for low value transactions. It would be person to person friendly, and it’s intended to be able to support offline transactions so that payments could still happen between two smart phones or other devices, even if the internet is not available.
A central bank digital currency could become a powerful tool in managing a central bank’s monetary policy, particularly during times of crisis. This would be an important way to maintain financial stability and a CBDC would make it easier for governments to undertake helicopter money or people’s quantitative easing.
This means central banks could actually distribute newly created public money directly to citizens, rather than going through the financial markets and buying back bonds as part of a quantitative easing that we’ve seen in recent years.
A central bank could also apply negative interest rates on CBDCs in order to encourage spending, so it has lots of benefits. It would be a way of enforcing competition for deposits amongst commercial banks.
For instance, increasing the rate of interest paid on a CBDC would actually force commercial banks to increase the interest rate that they’re offering in order to attract deposits themselves.
Another important macroeconomic reason for introducing CDBCs is that central banks are worried about losing control of the monetary system. So, with the rise of stablecoins and other cryptocurrencies there is a danger that individuals and businesses might decide to stop using national currencies and instead decide to use other forms of digital money.
As a number of central bankers are increasingly stating, if there is demand for a digital currency, then it might be sensible for a central bank to provide it instead of leaving this open to the private sector.
So, in this way a CBDC could counterbalance the risk of mass adoption of new forms of private digital money such as Facebook’s stablecoin, which was originally named Libra and has now more recently been rebranded as Diem.
If private stablecoin become dominant, this might impact financial stability because it would limit the central bank’s ability to control the country’s monetary policy. Some analysts describe this situation as the risk that private sector crypto assets would actually undermine a country’s monetary sovereignty.
In contrast to cryptocurrencies like Bitcoin a CBDC would not be subject to volatility, so it might put an end to the debate over whether cryptocurrencies are suitable as a payment instrument.
A big advantage of a CBDC versus a private sector stablecoin is that the central bank or state would have no reason to sell data on individual transactions and people’s spending habits for marketing and commercial purposes. Some of the issuers of private stablecoin maybe far more interested in capitalising on this rich source of information on people’s likes and dislikes.
Jacqueline Powell: Okay, so plenty of benefits in CBDCs then. Do you think we are going to see any of the major economies launching a central bank digital currency in the near future though?
Marcus Hughes: Well, I do sense that the market is reaching the next level in the evolution of blockchain and crypto assets, especially relating to digital currencies. But recent work by various central banks means it is increasingly likely that quite soon one or more central banks will issue their own central bank digital currency.
Although a few small economies have already launched their own local central bank digital currency, we’re now seeing central banks of several major economies announcing initiatives to test or even create their own digital currency.
For political reasons and economic reasons, China’s rapid progress towards launching their own CBDC is increasing the focus of other central banks on issuing their own digital money. I think this reaction is partly due to a fully understandable fear of missing out or FOMO as it’s sometimes called.
Ironically, another important driver is the hype and controversy surrounding Facebook’s stablecoin Diem. This has galvanised central banks around the world into exploring the creation of their own digital currencies.
Concerns about a big tech company like Facebook via their Libra association having their own digital coin has actually made the launch of a central bank digital currency more likely than ever. So, for me it’s now more of a question of when not if a central bank actually launches their own digital currency.
Jacqueline Powell: If it’s a given, which one of the major economies will be first in your opinion? And can you give some examples more specifically of central banks testing CBDCs?
Marcus Hughes: So, yes, the first CBDC in the world was issued by The Central Bank of The Bahamas back in October 2020, but the total GDP of the Bahamas is about $12bn as far as I know, and they’ve got a modest population of nearly 400,000 people, and that’s spread over 700 islands, so a very exciting setup there.
But their CBDC is known as the sand dollar and it’s paid to the US dollar, so arguably it’s a digital US dollar but backed by The Central Bank of The Bahamas and not The US Federal Reserve Bank as I hasten to emphasise.
But moving on to larger economies, a number of major central banks are now exploring the best way to approach digital currencies and which model to adopt. The Central Bank of Sweden is quite advanced in developing a retail E-krona, so Sweden maybe one of the early adopters.
They’ve been running a pilot with Accenture, and the Swedish government wants to migrate Sweden to become a cash free society, partially by March 2023, quite soon, and entirely by 2030. They therefore want to ensure that the general public has access to central bank money by developing an E-krona as a state guarantee payment instrument.
The Dutch Central Bank is the first central bank in the Eurozone with a pilot for a retail CBDC. And The Bank of France, for that matter, is piloting a wholesale CBDC which is aimed at streamlining clearing and settlement in the capital markets.
In fact, the bank for international settlements found that 86% of 65 central banks which they surveyed are actually engaged in some form of CBDC research and testing.
But it has to be said that it is probably the People’s Bank of China which is the most advanced of all. They’ve been running large scale pilots for their digital money known as the yuan in the various cities across China.
Used cases have been widely tested, including things like bill payments, public transport, shopping, and government services. Anecdotally, well known global brands like Starbucks, McDonalds and Subway are all participating in these pilot schemes.
And to give an idea of the impressive scale of these tests, at the end of June 2021, consumers and businesses in China had opened 24 million yuan wallets and they had already spent £5.4bn US dollars equivalent in 71 million transactions, that’s according to the People’s Bank of China.
And it does look increasingly likely that China will launch, or at least test, it’s yuan at the Beijing Winter Olympics which start in February 2022, so very soon. This event provides a great opportunity to become the first major international test of China’s new digital currency with tens of thousands of athletes and tourists visiting the city.
It has been suggested that athletes maybe given tech enabled gloves, badges, or even uniforms which they can use to spend their yuan. So, for me, after many years of experimentation and seeing huge sums of money invested in blockchain, central bank digital currencies are now emerging as one of the most exciting and practical applications of this technology. In tech terms, CBDCs might finally prove to be the killer app for blockchain.
Jacqueline Powell: So, China certainly sounds like it’s far more advanced than others when it comes to piloting. What I’m interested to know, you have spoken about how far they’ve come, how will China’s yuan currency work and what are its benefits?
Marcus Hughes: So, the yuan will have a number of important advantages which should be great for business such as faster and cheaper, and it’s cheaper than cards, because they are instant payments with zero fees for the merchants.
The government has stated that their intention to replace all cash and coins, and they’ll even ensure that the yuan works offline by using NFC, that’s near field communication between smart phones and devices.
So, probably even more important, the People’s Bank of China will be able to access data on all transactions in what they describe as controllable anonymity. They claim this approach will ensure that all transactions comply with KYC and anti-money laundering requirements, and this will also prevent tax evasion.
But this model means that eventually, not just Chinese citizens and businesses, but also even the foreign organisations doing business with China in yuan would have their transactions monitored by the People’s Bank of China.
So, another driver for China’s interest in the yuan is the government’s desire to exert greater surveillance over transactions, businesses, and citizens. I think we can be sure that this approach is going to cause plenty of controversy.
And it's very important to note that the digital yuan could potentially be adopted outside of China. So, China has a strong interest in increasing the role of their currency in global trade. The obvious starting point will be China’s trading relationship with the 70 countries or so that are part of the Belton Road initiative, which is China’s ambitious global infrastructure investment programme.
Much of China’s international trade is currently denominated in US dollars, and it would therefore be in China’s interest to shift more of that trade into their own currency. This would cut bank fees and provide real time settlement 24/7 and internationally.
It’s expected that the yuan will have a two tier system. On the first layer, the People’s Bank of China issues and redeems central bank digital currencies via the commercial banks. On the second layer commercial banks are responsible for distributing the digital money to the retail market participants. This two tier model would help avoid disintermediation in the financial sector.
Under a one tier model, People’s Bank of China would issue the central bank digital currency directly to the public. By adopting the two tier system, the People’s Bank of China would achieve its goal of replacing paper money and coin without affecting the bank’s ability to lend, that’s the commercial bank ability to lend, of course.
By distributing digital currency through commercial banks, China is giving its large state owned institutions an important opportunity to overtake the payment technology of those Fintech rivals like Alipay and WeChat Pay.
So, it’s quite possible that the launch of the yuan could help the government to reduce the dominance of Alipay and WeChat Pay, which between them currently process 90% of the $20tn of mobile payments in China.
Jaqueline Powell: Wow, it’s fascinating to hear about China’s rapid progress there, thank you Marcus. Bringing this a little closer to home, if I may, what is the Bank of England’s position on CBDCs?
Marcus Hughes: HM Treasury and the Bank of England are actively exploring a UK central bank digital currency. This will be a new form of digital money, issued by the Bank of England and for use by individuals and businesses for their everyday payment needs. The Bank of England has emphasised that it would exist alongside cash and bank deposits rather than replacing them.
Back in April 2021, the Bank of England and HM Treasury initiated a joint CBDC taskforce with the objective of evaluating the potential use of a UK central bank digital currency. Their main objectives are to future proof sterling against cryptocurrencies and to modernise our payment system. This initiative is intended to ensure the UK stays at the forefront of financial innovation.
The new currency, as you might expect, has been nicknamed Britcoin by Rishi Sunak, our Chancellor of the Exchequer, who has been closely involved here. And, for me, this is an important reflection of the level of interest which CBDCs are actually receiving in the UK in high political circles, of course.
In 2022, HM Treasury and the Bank of England are going to launch a consultation which will set out their assessments of the business case for a UK CBDC, including the merits of further work to develop an operational and technology model for this digital money.
They have also emphasised that no decision has been made on whether to introduce a CBDC in the UK or not. Now this consultation in 2022 is going to help the UK reach a decision on whether the authorities wish to move forward into a development phase which will span several years.
If the results of this development phase conclude that the case for a CBDC is made and strong, and that it’s operationally and technologically robust, then the earliest date for the launch of a UK central bank digital currency would be in the second half of the decade, that’s according to the UK government, so sometime after 2026 or during or after 2026.
One notable innovation of CBDCs, which the Bank of England has highlighted, is that they could become programmable. This means a central bank digital currency could effectively allow the state to control how the money is spent by the recipient. One potential use case could be control of the benefits payments, for example restricting the recipient to spending only on essentials, maybe rents, clothes, and food, but, you know, sorry to say, perhaps not tobacco or gambling and so on.
The Bank of England recognised that this is a delicate debate and that it needs to be decided by the government, not by the central bank.
Jacqueline Powell: So, despite many countries looking at digital money then, surely there must be some potential disadvantages, it’s a completely new ball game to be fair. Marcus, what can you tell us about the risks of issuing CBDCs?
Marcus Hughes: That’s a good question, of course. So, the impact of the introduction of CBDCs at scale is highly uncertain. One of the main concerns about central bank digital currencies is that they could potentially disintermediate commercial banks.
By that I mean people might choose to hold their money directly at the central bank instead of at a commercial bank. That’s because they might understandably consider it to be safer at a central bank than deposited with a commercial bank.
This scenario will have a big impact on the franchise of commercial banks. Just to explain what I mean, a CBDC would be perceived as safer than the commercial bank money that we use today because it would be backed or guaranteed by the central bank, by the government effectively.
So, in the UK instead of being protected by the Financial Services Compensation Scheme for up to £85,000 in the event of a UK commercial bank collapsing, the central bank digital currency would be guaranteed at any level.
So, if households or businesses were worried about their ability to access money in a normal commercial bank or have more than £85,000 in their accounts, they might decide to switch this into central bank money instead.
Several central banks, including the Bank of England have warned that if significant deposit balances move from banks, commercial banks that is, to central bank digital currencies, then the balance sheets of both central and commercial banks could be impacted.
A major shift might also have an impact on the amount of credit which banks can make available to the wider economy. And in turn this could affect how a central bank implements monetary policy and supports financial stability.
The movement of money from commercial bank accounts to a central bank digital currency would have an impact on the commercial banking system. If a bank has less deposits, it would need to find other sources of funding for its loan portfolio. As a result, loans could become more expensive following the introduction of a central bank digital currency.
And for this reason, most central banks are looking to have a zero interest rate on central bank digital balances, effectively making them digital cash in order to dissuade individuals from using them as a store of value but only as a method of payment.
An alternative solution to avoid too much money migrating to central bank digital currencies could be to remunerate these balances but at below market rates. This would incentivise depositors to leave their savings in the commercial bank deposits rather than on central bank deposits.
Yet another option is a tiered remuneration system. The first tier could serve as a means of payments, and the central bank would have to refrain from setting a lower or negative interest rate in order to keep a central bank digital currency attractive to the public as a means of payment.
But the second tier could serve as a store of value, and there the central banks could discourage people from using it by potentially setting unattractive interest rates or even negative interest rates.
At an extreme, where central bank digital currencies prove highly popular, this might seriously impact financial stability. And uncertainty around the demand for new forms of digital money is why central banks like the Bank of England are considering the probable need for limits to manage the transition period if a CBDC were ever to be introduced.
The European Central Bank is considering imposing a €3,000 limit on consumer central bank digital currency accounts at central banks. The idea is that this low limit would discourage users from transferring all their cash from commercial banks to the central bank.
Naturally, the ECB isn’t at all interested in competing with the commercial banks, in fact it wants to protect the commercial banks if anything.
Credit card volumes, interchange fees, payment transaction fees, and deposit interest margins could all be effected by a central bank digital currency. This would disrupt the current two tier system of central bank and commercial banks. Some degree of disintermediation is an inevitable consequence of a successful central bank digital currency.
So, commercial banks need to consider how to react to a prospective loss of deposit funding. Two possible solutions would be to pay a higher interest rate on deposits in order to limit further outflows to a central bank digital currency or to replace lost deposits by funding it with alternatives such as longer term deposits or wholesale funding.
In any event, both options would raise the cost of funding for commercial banks. And assuming banks want to maintain their profit margins, this could lead to banks deciding to raise the cost of credit which they provide to the economy. And this in turn might lead to a lower volume of lending by banks as demand would probably reduce. That in turn will, of course, impact economic activity in a negative manner.
Furthermore, a large scale central bank digital currency, such as the major initiative being tested in China could potentially challenge the dominance of the US dollar and it could even bypass existing cross border payment networks like SWIFT.
Jaqueline Powell: Thanks for sharing those risks Marcus. 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 immerse a huge amount of data on our spending habits. Do you think user privacy could stop the developments 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 and use as 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 gaining a strong market share and exploiting consumer data.
This potential for the abuse of data by a big tech is a major driver for central bank digital currencies. For me, this is one of the reasons why CBDCs might 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.
And there are many ways in which such a company maybe in social media could manipulate and capitalise on this huge data based 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 is 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 would 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 thresholds 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, so they’re planning in detail for these changes.
Jacqueline Powell: Okay, thanks for covering off that concern for me and our listeners, Marcus.
Marcus Hughes: My pleasure Jacqui, of course.
Jacqueline Powell: And that’s all for today. We’ll be back soon with more insights on the changing payments landscape, and, of course, our next episode on CBDCs. For now, it’s thank you and goodbye.
Marcus Hughes, Head of Strategic Business Development at Bottomline, shares his insights on the current adoption the evolution of Open Banking to Open Finance and the process behind the information sharing and payment initiation services.
In this part 2/3 in the Open Banking to Open Finance podcast, Marcus Hughes, Bottomline's Head of Strategic Business Development discusses about the various countries adapting the new data rights and sharing.
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