Central Bank Digital Currency: Future or Rupture of Money?

Central Bank Digital Currency (CBDC), a digital form of fiat currency, has been a hot topic in recent years and is expected to be a game-changer in the financial services industry. In this article, we will explore two mainstream CBDC models, namely Retail CBDCs and Wholesale CBDCs:

• Retail CBDCs allow for transactions between individual parties such as Peer-to-Peer (P2P), Businesses & Consumers, or even Business-to-Business (B2B). Transaction value is generally low while transaction volume & frequency is usually much higher than for Wholesale CBDCs.
• Wholesale CBDCs typically enable the payment and settlement of transactions between large financial institutions, and could also be used to transfer ownership of other assets such as securities.

According to a survey by the Bank for International Settlements (BIS) published in 2021, over 80% of central banks across the globe have continued their research and development of CBDCs during the COVID-19 pandemic.

Central banks’ interest in CBDCs is undeniable, taking a variety of forms largely influenced by local circumstances such as the state of development of existing payment infrastructure, the degree of financial inclusion and the efficiency of cross-border exchanges. For instance, developing economies seem keener to develop retail CBDC to enhance payment effectiveness and increase financial inclusion, while wholesale CBDC is primarily gaining traction in more advanced economies with robust interbank systems. And Asia is definitely a region where such experiments are fast multiplying

Since 2014, the People’s Bank of China has invested significant resources in preparing the launch of its CBDC, Digital Currency Electronic Payment (DC/EP).

In 2020, China, therefore, became the world's first major economy to conduct a digital currency experiment at scale. The pilot kickstarted in four cities: Shenzhen, Suzhou, Chengdu and Xiong’an, and will be used as part of a trial with foreign visitors during the 2022 Beijing Winter Olympics. The institutions participating in this DCEP pilot are no less than the 4 major state-owned banks: China Construction Bank, the Agricultural Bank of China, Bank of China, and the Industrial and Commercial Bank of China. The initial phase aims to test the digital currency infrastructure and acquire the required confidence in the system's security and network efficiency. DC/EP will then be opened to tech giants such as Tencent and Alibaba to be used in WeChat Pay and AliPay in the second deployment stage. The pilot trials will eventually be extended to other regions in Hong Kong, Macao, Shanghai, and the Yangtze River Delta, Guangdong Province, and Tianjin. And volumes are already significant: at the time of writing, nearly two million residents in China have already applied to use this “Digital Yuan”, following a marketing campaign by the Suzhou municipal government. As of June 2021, over 2 billion digital Yuan (US$314 million) had been spent by Chinese consumers in shops, restaurants, and several online platforms. [1] [2] [3]

In 2017, the Hong Kong Monetary Authority (HKMA) commenced Project LionRock with a focus on evaluating the technical aspects of CBDC development. Considering that Hong Kong was already equipped with a highly efficient and trusted retail payment infrastructure, it was concluded that CBDC development would bring more net benefits by initially focusing on the wholesale cross-border payments use case [4].

To explore the applications of CBDC in cross-border payments, the HKMA and the Bank of Thailand (BOT) initiated Project Inthanon-LionRock in 2019, a joint study to develop a blockchain corridor network which connects the CBDC blockchains of Hong Kong and Thailand. The study has entered Phase 2 in 2021 to develop a CBDC software prototype and explore different real-life applications.

In June 2021, the HKMA reiterated its strategy to drive FinTech development in Hong Kong, which included strengthening Hong Kong’s readiness in issuing CBDCs at both wholesale and retail levels. With a cutting-edge THB-HKD cross-border corridor network prototype now developed, participating banks in Hong Kong and Thailand can perform fund transfers and foreign exchange transactions on a peer-to-peer basis, thereby reducing settlement layers. By leveraging the smart contracts technology, the cross-border fund transfer process is enhanced in real-time by an atomic payment-versus-payment (PvP), which was not possible in the traditional finance world to date.

In September 2021, the HKMA announced that the cross-border corridor network prototype of the Multiple CBDC Bridge (mBridge) project had demonstrated a substantial increase in cross-border transfer speeds, from literally days to seconds. Furthermore, the project has shown strong potential to reduce several of the core cost components of correspondent banking as well.

In Hong Kong’s main state-city rival, the Monetary Authority of Singapore (MAS) announced the fifth and final phase of Project Ubin back in November 2019. World-first accomplishments brought by this initiative included successful payment settlement across various currencies on the same network, as well as the validation of the use of smart contracts on the payments network prototype for a number of innovative use cases e.g. Delivery-versus-Payment (DvP) settlement with assets on private exchanges, conditional payments and escrow for trade. The outcomes of Project Ubin have demonstrated the commercial applications of the payments network prototype, which includes cross-border payments in multiple currencies, foreign currency exchange and settlement of foreign currency denominated securities.

The development of such a robust platform is helping accelerate the creation of a CBDC-based innovative ecosystem. Three examples of concurring initiatives are:

• The launch by MAS-backed ASEAN Financial Innovation Network (AFIN) of a sandbox on the API Exchange (APIX), which is a cross-border platform that serves as a global marketplace for application programming interfaces and financial institutions.        
• The successful completion by MAS and Banque de France (BdF) of a groundbreaking wholesale cross-border payment and settlement experiment using CBDCs on 8 July 2021. The experiment has demonstrated the interoperability across different types of cloud infrastructure where blockchain nodes were established across private and public cloud infrastructure in Singapore and France, as well as the potential use of state-of-the-art smart contracts to automatically manage the EUR/SGD currency exchange rate in line with real-time market transactions and demands.
• The upcoming test by the BIS Innovation Hub Singapore Centre of the use of CBDCs for international settlements with MAS, Royal Bank of Australia (RBA), Bank Negara Malaysia (BNM) and South African Reserve Bank (SARB) under a project known as Project Dunbar, which results would be published in early 2022. 

These developments have led MAS Chief Fintech Officer to state that the financial sector now has distributed ledger technology (DLT) platforms ready for digital currency mass deployment. Despite the central bank’s slow response to issue a digital currency into the network, Singapore’s trade finance platform “dltledgers” claims to have already reached the multi-billion mark. 

Emerging economies are not left behind in the CBDC race: the National Bank of Cambodia launched its first CBDC in October 2020, named Bakong, which was co-developed with Japanese Fintech firm, Soramitsu. The Cambodian government aimed to increase financial inclusion in the country, where close to 80% of the population over 15 years old remains unbanked. Bakong currently supports transactions in riel and dollars through mobile applications. The technology uses a KYC tiered security system to provide consumers with a centralised infrastructure that allows for multiple payment types smoothly and at no cost.

This successful case study is emulating similar ambitions across the world, from Ethiopia’s Cardano-driven project to… the USA, which are considering this model in the various scenarios being studied for the creation of a “Digital Dollar”.

Looking at CBDCs’ potential to facilitate financial inclusion, create future-proof payment rails and accelerate the transformation to a cashless society, no wonder why most countries are actively innovating in that space. Indeed, with visibility on such a high volume of money flow, central banks would be able to track financial transaction data more effectively while possibly capitalizing on lower costs related to cash management. The introduction of CBDCs could lower the barriers to entry in the payment industry, which ultimately increases competition amongst existing banks. Going beyond, CBDC may be a unique opportunity for governments and central banks to develop new monetary and tax policies, tailored to a diversity of use cases. The emergence of “programmable money” would only be one step away, opening up a new era where the future of money is yet to be invented. However, one must not forget about potential pitfalls as well.

Although CBDC are driving an exciting phase of financial innovation, a number of risks need to be anticipated and closely monitored:

Data privacy: With money becoming completely intangible, private data could potentially be exposed to those who hold the digital money, especially in the case of retail tokens. Storing a large amount of data in a centralized system is therefore always questionable, and the implications for transparency, traceability, and privacy can make CBDCs a double-edged sword.

AML/KYC: The potential of CBDCs to be used in violation of anti-money laundering and counter-terrorist financing (AML/CTF) laws and regulations deserves special consideration. New financial innovations, such as CBDCs, are expected to introduce new financial risks, necessitating the implementation of appropriate adjustments to sanctions legislation or due diligence procedures.

Cybersecurity: As the share of digital coins progressively overcomes physical money, the risks of cybersecurity breaches increase in tandem. To protect consumers and companies from new types of cyberattacks, it is of paramount importance to establish more mature and sophisticated cyber risk management practices too.

With high-profile investments in CBDCs such as DC/EP (China), Project LionRock (Hong Kong), Project Ubin (Singapore) and Bakong (Cambodia), there is no denial that most countries’ governments and central banks are lured into this new era of digital fiat money, that will soon become a widespread reality.

Public institutions, private companies and individuals alike, all parties connected to the financial system will be impacted – for better or worse!

Sia Partners will maintain a constant watch on this fast-changing trend and continuously share their insights and perspectives as and when future developments occur. We look forward to helping your organization explore added-value opportunities while managing the risks and challenges outlined in this article.

Please visit the Sia Partners’ website to find out more about Sia Partners’ banking, crypto-asset and blockchain capabilities.

Sources

1. Fintech News Hong Kong, Asia Leads the Way with Central Bank Backed Digital Currencies (CBDCs)

2. China Briefing, When Can I Buy, Use, and Trade China’s Digital Yuan?: When Can I Buy, Use, and Trade China's Digital Yuan? (china-briefing.com)

3. BOMINING, China’s National Digital Currency DCEP / CBDC Overview: China's National Digital Currency DCEP / CBDC Overview (boxmining.com)

4. Central Bank Digital Currency (CBDC) Research Report: Project Inthanon-LionRock