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Why you should be watching the development of Central Bank Digital Currencies

Our Chief Engineer Anthony Culligan, in conversion with Robin Amlot, Editor of IBS Podcast 

To listen to the full podcast recording, follow this link.  

We are still only at the beginning of the blockchain journey, aren’t we?

That’s true, we are. We’ve seen a lot of innovation in this space and a lot of interest in how the technology can be applied in markets and market infrastructure.

SETL was established in 2015 and we completed a couple of live infrastructures, most notably as CSD, which is linked to the European Central Bank and several commercial paper issuers and investors on the T2S system. The second live infrastructure we have is a transfer agent business, which is a registrar of fund ownership, called IZNES, and that is live and up running today as well. 

There was a big fanfare in January with the use of the experiment with Banque de France, tell us a little bit more about that.

Banque de France asked for expressions of interest earlier last year. What they wanted to do, was to have real tests of central bank digital currency on a real infrastructure. There were about 80 applications for the Banque of France and they chose eight. SETL, with a consortium which comprised Citibank, CACEIS, IZNES, Groupama Asset Management, OFI Asset Management, and DXC Technology, put a proposal together and we were the first to be selected for that test. We concluded the test in December and announced the results in January. 

After the successful test, what happens next?

It raises a number of issues. Firstly, the Banque of France has seven other tests that they now need to carry out to the process. I expect they will finish that sometime this year, maybe third quarter of this year, at which point they will look at the lessons they’ve learned on exercising central bank digital currency in live market infrastructure. The lessons they’ve learned, I think include there’s a number of changes needed to legislation, they’ll be recommendations, I expect around how central bank digital currency will be held by banks and other financial institutions, which actors will play a role in CBDC, and how even mundane things like, how will central bank digital currency will be accounted by users of CBDC.

What are the implications that will come of it? 

Broadly speaking, central banks have managed their own currency, so every Central Bank has their own real time gross settlement system. What that means is when large banks want to settle transactions between themselves, they may do one half of the transaction on market infrastructure like Crest, and then they have to settle the other half of the transaction and movement of money on a completely separate system, which is the RTGS system. Technically, that’s a complicated thing to do and it requires a lot of coordination between these two market infrastructures. 

What CDBC allows, and one of the things that allows, is for central banks to project their currency into market infrastructures. For example, the Bank of England could be projecting its currency into Crest, LCH or other market infrastructures, and that allows those market infrastructures to move CDBC as part of their operation. It means you could do settlements much more easily. You could do settlements of large transactions between banks which involve stocks and cash being moved at the same time. 

For example, in large clearing houses where there are literally trillions of pounds of assets being moved on a weekly basis, it means that those larger transactions could be done in central bank money instantaneously and very frequently on an automated basis. That reduces exposure between banks if they can have final settlement within a market infrastructure. 

There’s no interbank exposure, it’s reducing systemic risk across the board in financial services. That would make a very big difference to the speed of the underlying, and the safety of the underlying infrastructure. People would start to see a lot more real time activity in the front end at the moment they have lots of very fancy apps and web apps that behind the scenes, there’s still a little bit of lead piping, which needs to be replaced to really supercharge what’s happening on the surface.

So, more security, efficiency, presumably because of both those things, a cheaper way of doing business for central banks.

It should be a cheaper way of business for financial services, as a whole, because it’s not necessarily the central banks that bear the cost of the complications of manipulating money in one way and securities in other assets in a completely different way. That sort of coordination is expensive and difficult.

Clarify the understanding of what a central bank digital currency actually is for someone,  because the digital currencies everybody are more familiar with is Bitcoin or Ethereum and all the other digital currencies that are floating around. What’s the CBDC compared to one of thoses?

A central bank digital currency compared to cryptocurrencies, is something which is issued by the Central Bank of a country. So the Bank of England could issue a central bank digital currency in Sterling and the Federal Reserve could issue a CDBC in US dollars. They’re useful for day to day transactions because we all live and transact in dollars, pounds and euros. 

We don’t live and transact in Bitcoin, because it’s really difficult to understand how much a Bitcoin is worth in a day to day. Individual national currencies are much more useful on a day to day basis than cryptocurrencies because they’re issued by the Central Bank. It has the power to create and redeem that individual currency. They are free of any default risk. There’s no constraint on central banks actually meeting the obligations of a CDBC. They are, if you’d like to use perhaps an inappropriate word, the gold standard of digital currencies. They have the convenience of the cryptocurrencies in the way that they can be instantly transferred between parties, they have the stability of the currencies that we use every day.

You did touch on this but would this be something that only ever appears on the account of major banks during major interbank settlements, or would I, as an individual, in the future end up with two bank accounts, one that has pounds in it and one that has e-pounds in it?

That is a very good question. At the heart of that is the difference between the account you have to take with your bank and with CDBC. The account you have with your bank is a promise from that bank, and is only as good as the credit worthiness of that bank. So the bank intermediates between you and your money and then they have some other assets on the other side of the promise they’ve made to you. So to you and I, maybe that doesn’t mean much in stable times, but certainly when it comes to the CDBC, the promise is directly from the central bank to you. There is no credit risk between you and your money. 

That has large implications for institutions, because they tend to hold things in custody. They hold their shares in custody. If an institution holds 100 million pounds worth of BP shares, they have a custodian and if the custodian goes bankrupt, those shares are protected. In other words, they’re not owned by the custodian, they’re held in trust for the institution. What CDBC allows is for money to be held in trust, in the same way these shares are held in trust. There would be money in custody and that’s a new concept for institutions, that will protect their cash balances.

We said at the beginning of our conversation that we’re only at the start of the journey. What does the end of the journey look like?

I think the end of the journey is, if we look back at how we used to use cash, 20, 30, 40 years ago, it was very prevalent in our day to day lives. We could hold cash. The cash in the form of notes and coins is directly on the balance sheet of the central bank and we are able to exchange that freely amongst ourselves without a banking system, not just the technology, but also the relationships, the credit between participants. I think that there is a role for that sort of money in society, it’s been diminished a lot as we’ve moved to electronic money but our electronic money has pushed banking and payment rails together into one institution. In 2008, when we talked about systemic risk, we had failing banks but they were connected to payment rails. Failing payment rails would have been a disaster for consumers. So separating out payment rails and banking is what I think the future is going to be. Central bank digital currencies is more about offering an electronic payment rail, which is not banking, and just allows us to move money around electronically in a way, which is similar to how we used to pass bank notes between to each other.

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