What does central bank digital currency mean to us?
In June last year, at a payment conference called Payments Panorama, Bank of Canada unveiled, for the first time, a project called Jasper which is an experiment to produce its own central bank digital currency called CAD-COIN. In June this year, they have concluded from the experiment that Distributed Ledger Technologies (DLT) have no net benefit for critical financial market infrastructures such as wholesale payment systems. Distributed Ledger Technologies (more colloquially called “blockchains”) are a myriad of technologies that are derived or inspired from blockchain designs.
CENTRAL BANK DIGITAL CURRENCY
In recent years, many countries have announced research into central bank digital currencies and probably the most notable one comes from Mark Carney, Governor of Bank of England(BoE), “In the extreme, a DL for everyone could open the possibility of creating a central bank digital currency. On some levels this is appealing.” Since then, many countries have followed suit from Singapore, China, Iceland and Russia
What does central bank digital currency mean to us? Nothing anytime soon. For a start, let us understand what these experiments are really talking about and what are the challenges to be faced.
WHOLESALE PAYMENT SYSTEMS
Most central bank digital currencies projects focused on wholesale payment systems called real-time gross settlement (RTGS) systems operated by the central bank. This is different from the retail payment systems such as card payment or bank transfers that we are familiar with. RTGS is the settlement backbone for high value inter-bank fund transfers and operates like a bank of the banks. It is conceivable that a combined retail-payment and wholesale-payment platform makes use of DLT at the same time. However, that is not likely, given the risk and security profile between high-value low-volume transfer is very different from that of low-value high-volume transfers. As such, it is unlikely that man on the street will get to use “central bank digital cryptocurrencies” any time soon.
TECHNOLOGY RISK FACTORS
A migration onto DLT will carry a much higher implementation risk and cost to replace its traditional hub and spoke model. Fundamentally, the whole premise of using DLT is to reduce data replication work by using a shared database in an ecosystem. That means fundamental architectural back-end change (not integration) in order to benefit from its purpose. This constitute a major high risk change from a production perspective. The impact of downtime in a systemically important payment system can derail the entire nation’s economy. To put things in perspective, on 20th October 2014, the RTGS operated by the Bank of England (BoE) suffered an unprecedented outage of approximately 9 hours. A total of GBP289.3b was settled on the same day in spite of some delays. It has operated perfectly for 18 years and was processing half a trillion pound of bank transactions per day (about a third of UK’s GDP in a single day). According to Deloitte’s review, the root cause of failure was due to combination of two minor defects introduced by perceived routine maintenance to RTGS in April 2013 and May 2014. These upgrades are related to what is known as Liquidity-Saving Mechanisms (LSM) and Market Infrastructure Resiliency Service (MIRS).
Interestingly, in Bank of Canada’s report, they have also cited LSM as one of the the reason why RTGS cannot fully benefit from DLT. LSM is one of several critical and centralised components that RTGS depends which cannot be decentralised effectively.
WHAT IS LIQUIDITY SAVING MECHANISMS?
A modern wholesale payment system like RTGS is not just a high value transfer system. A crucial part of its design lies in managing intraday liquidity. Liquidity saving mechanisms is at the heart of it. There is no concept of credit risk in RTGS because every transaction between banks is settled in real-time, final and irrevocable. The only outcome is whether banks can or cannot send a payment. A bank cannot send a payment if it does not maintain enough funds (liquidity) in RTGS or it simply delay its payment and wait for funds to come in from other banks. This creates a liquidity problem that can choke up the system. Liquidity Savings Mechanism (LSM) exists to minimize the cost to banks with having to put up too much funds on RTGS. The most common approach is for the RTGS to implement a queue that temporarily builds up transactions for matching and offsetting and therefore maintaining lower level of intraday liquidity needs. This can be further supplemented with an intra-day credit facility that central bank can offer as loan to banks.
To be able to support a DLT design incorporating LSM, Jasper does it by aggregating inward transactions from all participants through a “inhale” process and distribute the multilaterally settled transactions through an “exhale” process. The LSM is inherently a centralised liquidity coordinator that cannot be decentralized on the DLT. Just like a couple of critical components such as identity storage, keys and permissions which are centralised as well. Centralised components cannot benefit from the decentralised architecture when it comes to resiliency and have to implement high-availability nodes which negate the benefits of having DL.
PRINCIPLES FOR FINANCIAL MARKET INFRASTRUCTURE
To implement DLT in production, developed countries’ financial market infrastructure (FMI) are governed around best practices known as Principles for Financial Market Infrastructure (PFMIs) defined by the Bank for International Settlements (BIS). BIS is like the central bank of central banks. The largest hurdle is likely not technology related, and getting the legal framework and operational risk acceptance to mature over this will take years to come. Besides the financial market infrastructure operator, the change can involve different areas of bank’s internal operations already well-oiled for a highly efficient, centralised and largely batch-based operations. As mentioned above, any change in order to truly benefit from DLT will likely be an architecturally fundamental one.
For countries that are already operating efficiently on centralised system, the gain from use of DLT may not be obvious. After all, what is the compelling value for using a decentralised system, over the risk and cost involved, when there are dependencies on multiple critical centralised components?
On the other hand, this could be largely relative when compared to low income developing countries that do not yet have an established and efficient financial market infrastructure ecosystem in place. DLT may provide the opportunity for creating an interconnected financial market infrastructure ecosystem at an early stage with ample room to grow and benefit from a combined utility value that outweighs the cost.