The use of digital currencies in legitimate commercial settings took a sizeable step forward recently with the first ever live settlement of a fund using Central Bank Digital Currency (CBDC) tokens. What is the impact of this successful transaction on the real economy?
When Banque de France (BDF) successfully completed a Central Bank Digital Currency (CBDC) transaction on 17th December 2020, it marked a moment of great importance for the entire financial world. This was the first ever successful live settlement of a fund using CBDC tokens.
As part of this experiment, shares of the money market fund, Groupama Enterprises, were subscribed and then redeemed using CBDC tokens created by BDF. The transaction, valued at over €2m, was executed on IZNES, the pan-European record-keeping platform for fund transfer agents. IZNES was built and is maintained by SETL – a blockchain-based multi-asset, multi-currency institutional payment and settlements infrastructure – and four asset management firms.
In undertaking this experiment, BDF also collaborated with commercial banks Citi and Groupama Asset Management, CACEIS (the custodian of Groupama funds), OFI Asset Management. IT services were provided by DXC Technology (the merged entity of CSC and Hewlett Packard Enterprise Services).
Although this was the first execution in a programme of eight planned by BDF, the central bank was insistent that the transaction was executed on a live infrastructure. This is why IZNES was used, says Anthony Culligan, Chief Engineer, SETL.
“We made changes to the live infrastructure of IZNES to be able to accept CBDC, and we built infrastructure for BDF to manage the issuance and monitoring of CBDC,” he explains. This setup also enabled the two commercial banks, Citi and Groupama Asset Management, to drive money from their account-based infrastructures into CBDC.
Following the initial CBDC transaction, Culligan reported “no hiccups”. However, a number of action points arose, including the need to address central bank digital money’s availability only to a limited number of participants.
Currently, direct access to electronic central bank money requires an account on the TARGET2 real-time gross settlement (RTGS) system (a new platform consolidating TARGET2 and T2S, its securities counterpart, will be launched in November 2022 as T2).
Legislation dictates who has access to T2, and therefore electronic central bank money. This means the legal framework must be updated to ensure the momentum of the BDF experiment is not lost. For all FI participants, clarity is necessary on the accounting treatment when moving client money into central bank digital money.
Notwithstanding these matters, the BDF experiment signals great change in the wider financial space. Key here is the difference between holding securities and holding cash, says Culligan. A large institution will hold a security with a third-party custodian. This legally keeps it remote from bankruptcy; if the custodian goes under, the asset is safely ring fenced. However, cash is held directly in custody by a bank. If that bank gets into trouble, the owner of the cash risks losing all, or at least having to stand in line with other creditors.
When a central banks issues money electronically, in the same way a large corporate issues shares electronically, it is available to be held in custody and is bankruptcy-remote. “That has some very interesting implications for the way financial services work at the wholesale level,” notes Culligan.
Traditional securities are typically traded on one system (such as CREST, Euroclear or Clearsteam), and money is moved through a different system (such as RTGS or T2). This creates complexity when moving cash at a central bank, even around fairly standard transactions like delivery-versus-payment or if a clearing arrangement (through the likes of LCH or Eurex) is used.
Electronic money, however, enables central banks to issue cash to market infrastructures and custodians, allowing direct and instant settlement on a platform such as IZNES by book entry, and without having any ‘daylight’ exposure to bank intermediaries. “In this setting, money becomes functionally the same as securities and so can operate on the same platform.”
It necessitates working through the regulatory framework, but it also means clarifying the roles of participants, says Culligan. Indeed, while it is not the position of central banks to undertake client management roles such as KYC and AML – this will remain commercial bank territory – central banks will be drawn closer to the market. “The model which is emerging is that of the commercial bank still owning the customer, but the customer, as an owner of central bank money, having a direct balance-sheet relationship with the central bank,” he says.
The BDF experiment focused on the use of CBDC in the wholesale market space. “Outside of this experiment, my own view is that we will see the eventual use of CBDC in a retail environment,” says Culligan. His view stems from the fact that ‘payment’ and ‘banking’ are two distinct notions.
A large proportion of payments used to be handled through notes and coins. These payments could stand independent of banking services. As electronic payments have gained traction, so payments have been tied ever closer to the banking system. However, when a financial crisis develops, it can threaten the payment rails. Indeed, the 2008 crash alerted many to the risk inherent in tying payments too closely to banking.
There is a need for payment rails where money can be moved electronically but is not reliant upon the survival of certain institutions where complex instruments are often housed on the other side of customer deposits. The rapid emergence of such systems outside of CBDC, such a payment apps and digital wallets, shows the readiness of consumers to separate payments from banking, says Culligan.
In business circles, there is well-documented concern around the legitimacy of using digital currencies. Recent substantial Bitcoin investments by firms such as Tesla and business intelligence company MicroStrategy have created waves in the crypto market. This is not least because both have since suffered stock price hits.
There is much conjecture as to what this may mean (even that Tesla, through its sizeable investment, has inadvertently tied its stock price to the ebb and flow of Bitcoin’s worth). For now, Culligan believes it would be “difficult to live your life by Bitcoin when it still exhibits huge swings in value”.
What’s more, with the almost universally required AML and KYC processes of the financial sector having been derived from international treaties, it would, he notes, be difficult, if not impossible, to fit a major crypto currency such as Bitcoin into the multiple legal frameworks that support such regulations.
There is a further interesting point arising from current CBDC experiments, and that, says Culligan, is the privacy desired by people when spending money. Coins and notes require no disclosure in use. “Any digital currency or CBDC system has to have a certain amount of anonymity,” he says, “but only to the extent that it doesn’t support large legal enterprises or even governments harvesting transactional data at an individual level.” Attending to this issue may not be a concern in some jurisdictions, but others, like Germany, are keen to uphold such freedoms.
“Interesting and technologically fascinating” though crypto currencies such as Bitcoin are, Culligan sees no way currently in which they will become a significant part of the mainstream monetary system.
CBDCs, as agreed social mechanisms of exchange that align with national laws therefore appear to be “the best way” to engage with the market. In fact, as experiments and further enhancements by the likes of BDF continue, there is every chance that CBDCs will become part of the way we all do business.