It Is All About Trust

Danmarks Nationalbank held a conference on 9 March in Copenhagen that looked at crypto assets and Distributed Ledger Technology (DLT), and then Central Bank Digital Currencies (CBDCs).

Setting the Scene

The Governor, Signe Krogstrup, set the scene. For currency to be trusted, it must hold its value over time. The central banks’ commitment to maintaining the value of money is more than just matching the demand and supply of money but, transparently, ensuring the whole monetary and financial system delivers stability.

A central bank has two levers to control value – the price of money and the quantity of money.

The declining use of cash is not in itself a threat to financial and monetary stability. The Governor does not see the much discussed value anchor role of cash – the ability of people to exchange their commercial bank money for banknotes – as a reality. People, particularly young people, just do not think that way.

Later in the conference, the speaker from the European Central Bank (ECB) acknowledged this but made the comment that it would take a brave central bank to test this hypothesis.

Crypto assets: Unbacked crypto assets accounted for on decentralised ledgers are not linked to the real economy. As such they are speculative instruments. On the other hand, stablecoins can, when backed and properly regulated, be regarded as a form of private money and may, therefore, prove to be useful. They would need to be treated like today’s bank deposits with guarantees. The focus should not be on the technology, but the services provided.

Wholesale CBDCs: Wholesale CBDCs are actually a continuation of reserve bank money but based on a different technology. The challenges are around interoperability, cyber security and making them commonplace.

Later in the conference there was a suggestion to the Bank for International Settlements (BIS) that the term wholesale CBDC should not be used anymore. The BIS agreed in principle but made the point that in terms of ‘marketing’ it was effective and useful to differentiate them from today’s reserve bank money.

Retail CBDCs: Retail CBDCs are different because technology is only part of the conversation. The design decisions around cyber security, privacy, financial inclusion, competition and innovation, the critical infrastructure and the monetary anchor role are very significant.

The BIS made the point that retail CBDCs won’t be a monopoly in the way cash is, which may explain why the uptake of the few live CBDCs is so low.

Crypto Assets and DLT

Hello Metaverse! Aaron Frank provided an introduction to the Metaverse to help the conference consider the future. He suggested that if one inserted the word ‘internet’ instead of ‘Metaverse’ all would make sense. Spatial computing, games engines, virtual worlds and virtual economies have been with us for nearly two decades.

Second Life is probably the best known and most successful virtual world and economy. $650 million is spent today each year on Second Life on everything from social status to express identity and membership of groups, to give personal meaning and pleasure and for utility.

The size of the virtual item economy is, on a conservative estimate, worth $40 billion. If one wonders how this could be right, consider that 75% of 9-12 year olds in the US are on Roblox. An example of a $4 billion US real estate company was shown, that only functions by staff and customers using Avatars.

Perhaps there is the need for CBDCs.

Crypto industry needs regulation to thrive: The Concordium Foundation argues that rules, regulations, standards, compliance and their policing are needed to protect consumers and to allow crypto assets to thrive.

While cryptocurrencies such as Bitcoin provide a way for tokens to be exchanged, products such as Ethereum are designed for smart contracts. They allow listings exchange. Initial Coin Offerings (ICO) are a way to raise money by selling investors either payment or governance tokens. If they are to be regarded as ‘securities’, then they need regulating. Smart contracts are the dream of a regulator since controls (anti-money laundering, know your customer etc.) can be pre-defined.

Challenges mentioned were that the definition of decentralisation is not agreed and there is a major challenge of software written in different languages to talk to each other.

IT start-ups are looking for guidance and smart regulations, and standards. This allows them to proceed with confidence and to demonstrate to investors that their work and ideas are likely to be approved of by the regulator.

Visa’s view: Blockchain apps work. Blockchain offers a single source of truth and represents digital assets on a chain, allowing proof of ownership. These strengths mean blockchain based solutions are more efficient than interacting with lots of individual databases.

In the form of stablecoins, blockchain makes fiat currencies more usable, offering the opportunity to do business-to-business transactions, cross-border transactions and high value regular payments such as salary payments more efficiently.

Regulation is nascent across the world and achieving a balanced approach managing risk but allowing innovation is a challenge. It should be possible to provide enhanced transparency through flags that identify crypto transactions.

ECB/EC view: the European Central Bank and European Commission (EC) speakers were positive about CBDCs, stablecoins and the atomic exchange of good for money. Unbanked crypto assets are not anchored and that, along with their volatility, makes them a problem. The ECB discourages buying cryptocurrency but regulations cannot eliminate their risks.

The EC has recently released the Markets in Crypto-Assets (MiCA) framework, which sets out regulations for crypto assets and services within the EU. The regulation, which is the first of its type in the world, should be adopted by the European Parliament and the European Council in June/July this year and be implemented in 2024. It aims to establish a harmonised regulatory framework and promote transparency, good governance, and consumer protection in the market.

MiCA is regulating a combination of activities in this new space, which is a challenge. The connection points between crypto assets and the traditional systems is being worked on.

Decentralised Finance (DeFi), which operates without intermediaries, is a major regulatory challenge.

CBDCs

BIS CBDC innovation: Morten Bech, from the BIS Swiss Innovation Hub, introduced its work on CBDCs. The innovation hubs work on more than just CBDCs with other examples being green finance, next generation financial market infrastructure, supervision and regulations etc.

Cryptocurrency: These were dismissed as being a bubble, a Ponzi scheme and an environmental disaster.

Wholesale CBDCs: There may be a need for these since they would allow the private sector to move to tokenised securities, tokenised deposits and improve cross-border transactions. The BIS has a range of projects looking at future securities settlement across reserves, stablecoins/bankcoins and wholesale CBDCs. A matrix of traditional and tokenised solutions for each of these areas is in hand. These have been summarised in the Payments Strategy and Systems Journal this month.

Project Mariana brings together DeFi and wholesale CBDCs. Swiss, euro and Singapore dollar denominated wholesale CBDC tokens are exchanged across bridges that deliver interoperability between national and regional platforms and supra-regional foreign exchange hubs. An Automated Market Maker (AAM) creates a liquidity pool which smart contracts manage, including the counter-party for foreign exchange. The AMM works with a bonding curve to manage exchange price.

ECB: Ulrich Bindseil explained that the ECB sees CBDC as a source of innovation and a public good, although it should not crowd out banks or hinder innovation. The test of money is its convertibility. It is the glue of the financial system.

The ECB Digital Euro project is currently working on defining the compensation model, access to the Digital Euro ecosystem, value added services, advanced functionalities and the delivery approach and form factor. Critical questions, particularly in terms of defining uptake and usage by consumers, merchants and banks. The ECB sees containing overall costs as an important success factor.

Pan-European reach is an important objective. European banks have a small footprint in e-commerce payments and the ECB wants to change this.

Other design comments:

• There will be a limit on its store of value function,

• The ECBs co-legislator will define what privacy is appropriate,

• The Digital Euro will not be programmable, but it will allow for conditional or automatic payments.

What the panel thought: Dirk Niepelt of Bern University, Per Jansson, Vice Governor of Sveriges Riksbank, and Per Callesen, Governor of Danmarks Nationalbank, gave their thoughts on CBDCs as a panel.

Dirk Niepelt agreed that efficiency was at the heart of new types of payment but argued that the two tier system is not a natural system. Central banks need to think carefully about replicating what exists today or more radical change. The mere existence of CBDCs may prove the stimulus to lower costs and new innovations in payments.

There are no direct consumer benefits of a CBDC but the implications are significant.

Danish view: Per Callesen suggested that while wholesale CBDCs are a technology issue, retail CBDCs are an institutional issue. What is the market failure that a retail CBDC is solving? If a country has instant payments, deposit guarantees and access to accounts, domestically what is the benefit?

The Real Time Gross Settlement systems are the core of payments. If this works well, along with good banking regulations, central bank liquidity provisions and a central bank commitment to price stability, trust in payments is likely to be high. Few problems in the banking system relate to bank deposits. Equally the reduction in cash transactions is a choice made by people.

The Governor went on to give some examples of areas where the payment system could be improved:

• Cross-border payments

• The slowness of the settlement of securities

• The cost of payments

• Security against criminal attacks.

One benefit is that CBDCs may impose competition and innovation pressures on the private sector.

Central banks should think carefully about the cyber security costs of a CBDC. Ultimately central banks cannot delegate operational responsibility for CBDCs even if the financial responsibility is theirs.

Specifically for Denmark, if a Digital Euro exists and if Danish companies could hold Digital Euros, this could be a game changer for them.

Swedish view: Central banks need to future proof the system now. Reversing what has already happened is a hard thing to do. The consumer benefits of a CBDC are real, but abstract and therefore hard to explain or see. If CBDCs do not carry an interest rate, a CBDC is just a modern currency similar to cash.

Cash is being squeezed out, not necessarily through choice but because, in particular, organisations and people cannot deposit it anymore.

Final word

Governor Krogstrup summarised by describing a number of crypto and CBDC related challenges highlighted during the conference:

• The crypto landscape is changing fast, bringing significant uncertainty.

• A role of regulation is to ensure a level playing field, which is challenging considering that crypto is global and DeFi is decentralised.

• What is the market failure needing a CBDC? What is missing in the payment system?

• The cross-border opportunity of CBDCs is potentially revolutionary.

• There is no precedent and no research currently about how a CBDC will establish trust and the monetary anchor core needed for trust in the financial system.

• Countries can’t stay with the old monetary system, but should the design of CBDCs be limited by the old payment solutions?