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What's up with central banks' craze around digital currencies?

Whilst it may improve payment systems, card firms and payment platforms won’t be happy with the potential new competition.

July 2020 marked the conclusion of Project Ubin, a five-year industry-wide project launched by the Monetary Authority of Singapore (MAS) to study blockchain technology with the aim of developing simpler and more efficient alternatives to current payments’ systems based on central bank-issued digital tokens. The fifth and final phase saw the regulator, in collaboration with state-owned investment firm Temasek, create a prototype for a cross-border blockchain-based multi-currency payments network.

Whilst Singapore has just concluded its study on central bank-issued digital tokens, regional neighbor China was already far ahead in its study of central bank digital currencies (CBDC). Just this January, the world’s second largest economy is reportedly eyeing rolling out its digital currency to the masses. It has recently concluded the second phase of its CBDC pilot program, with a total of over $3.1m of digital yuan given to over 100,000 citizens in Suzhou to spend on participating merchants.

Other central banks are not to be left behind. Thailand’s Vachira Arromdee, the central bank's assistant governor, claimed on July 2020 that the Bank of Thailand (BoT) is already using a CBDC for transactions with select businesses. South Korea and Japan are also reportedly planning to roll out their own CBDCs in the next two years.

But what exactly is the appeal of digital currencies for central banks? And what does its adoption entail for the financial sector? Asian Banking & Finance spoke with finance experts to learn more about the CBDC craze.

Curiosity, competition
More than eight in 10 central banks, or 86% of regulators globally, are now actively engaged in some form of of work relating to CBDCs in 2020, according to a survey by the Bank of International Settlements (BIS). This is a massive jump from only around one third of central banks worldwide having a CBDC-related project in 2019.

Regulators are notably curious in what problems CBDC can solve for their payments and financial infrastructure, says Varun Mittal, EY global emerging markets fintech leader.

“They're curious. They want to see, ‘what would this mean for them?” Mittal told Asian Banking & Finance. “From a regulator’s perspective it's important to be abreast of what's happening. Whether they were gonna do it or not do it is a secondary thing—but to be aware is important.”

Each market is looking to adopt CBDCs in different ways, analysts noted. Singapore is looking at it for a for cross border use cases. In particular, it is looking to use digital currency for large value cross border transaction use cases. Taiwan and Thailand are exploring options to issue digital currencies for wholesale banking and business transactions.

Meanwhile, other countries are looking at using CBDCs for domestic payments to bring about financial inclusion and get over cash collection.

BIS’ survey found that amongst regulators’ the most cited reasons for studying the use CBDCs include financial inclusion, domestic payments efficiency and payments safety as key motivations. However, for emerging markets and developing countries, financial stability and monetary policy are noted as more important factors.

The topic of central banks exploring issuing digital currencies to improve payment infrastructure and processes was also noted by Harry Hu, banking analyst of S&P Global Ratings, in an exclusive correspondence with Asian Banking & Finance. In particular, it could bring more convenience to residents.

However, one market that may not be happy with CBDCs are existing payment service providers and card companies, Hu added.

“CBDCs give rise to another payment option that consumers can select to settle a transaction. This could squeeze the market share of existing payment service providers, whilst also offering opportunities to innovators that can better weave CBDCs in their customer value proposition,” Hu explained.

“If merchants find it cheaper to accept CBDCs as opposed to, for example, having to pay fees on credit card transactions (similar to ‘pay cash pay less’ concept), this has the potential to cut fee revenue of associated card companies,” he added.

CBDCs could also give central monetary authorities additional and more timely visibility on consumption information.

Another positive effect is that it could also lead to enhancement of enhance economic policy implementation, such as example fiscal initiatives to directly transfer benefits to residents impacted by COVID-19. “The replacement of cash could reduce ATM numbers and costs associated with money printing,” he said.

However, if considering financial inclusion, CBDCs are more likely a substitute rather than a replacement of cash.

Three models
Hu identifies three models of CBDCs: the first being the disintermediated model where accounts are opened and managed directly by the central bank; the second, an intermediated model where banks or other financial intermediaries would take on this role; and finally, a hybrid model where accounts are opened by the central bank but managed by banks or other financial intermediaries.
Depending on the model selected, CBDCs could have a meaningful impact on how intermediation occurs with a banking system, and potentially have an effect on bank deposits and funding, says Hu.

One thing’s for certain: It’s going to cost money.

“The development of the technological infrastructure would cost some money. If this is not a public good and participating payment service providers have to pay for entry, then some smaller players with less resources may be excluded and this would be unfavorable to their customer value proposition,” Hu noted, regarding challenges on take up of CBDCs.

CBDCs are also not likely to use cryptography or distributed ledgers. However, in the scenario that the latter is used, Hu expects that transactions will be validated centrally and not by other users.

Policy upheaval
Despite its plethora of positive potential for the enhancement of the payments infrastructures and even financial inclusion, issuing digital currencies presents many challenges for regulators. Notably, it could lead to an overhaul of monetary policies as we know it.

“It's not as simple as just launching it tomorrow, because this impacts the monetary policy,” Mittal said. “This is not just a tech product, it's a monetary policy decision.”

Financial regulators have financial products which they have developed and have been using for hundreds of years, from capital adequacy ratios, to interest rates, to methods of measuring the money supply of banks, amongst other elements used to ensure the health and stability not just of the financial system but also the economy. According to Mittal, the moment that digital currencies or a digital way of issuing [or] not issuing moving money is added, regulators are also facing having to change this toolkit.

Not all regulators are prepared for this, says Chris Lim, partner at E&Y.

“If the regulator cannot build a framework to regulate, supervise and build trust, the ecosystem will not accept and use the digital currency, and much less cross border related use cases would take off,” Lim said.

In particular, Lim notes challenges in cross border transactions. “There is no one regulator across the different regions or countries. The question is then, how will a market start normalizing and thinking about how will they trust and use digital currencies as it goes across cross border? Market forces will then come into play. That's another huge element around demand and supply. Those are things that are significant structurally, and very difficult to move on.”

S&P’s Hu also highlighted the risks of counterfeits as well as risks related to fake wallets or accounts, which he says cannot be totally ruled out.

“Whilst we understand that such risk is minimal as the CB is the one controlling the supply and amount of CBDC in circulation, operational risk and digital security would require some investment,” he said.

Photo courtesy of Gabby K (Pexels)

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