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Digital currencies go mainstream

In the latest in our series of blogs on the BPC annual client conference, we explore the evolution of digital currencies.

In order to shed some light on where digital currencies go from here, BPC invited Marten Nelson, founder of M10 - which specialises in building digital currency platforms - to talk about the next big thing in payments, with a particular focus on whether digital currencies can go mainstream.

Nelson starts by referring to the considerable amount of buzz in the market around CBDCs (central bank digital currencies), stablecoins and cryptocurrencies. He defines digital currencies as money that is stored or exchanged in a digital way and categorises digital money using the Bank of International Settlement’s ‘money flower’ - which separates types of currency into four different sections.

(The concept of the money flower is used to help define CBDCs in relation to other forms of money using four categories - retail and wholesale CBDC, and privately issued cryptocurrency in either a publicly accessible ‘permissionless’ form or a privatised ‘permissioned’ form).

He then discusses issues around technologies such as blockchain, including inherent performance challenges. It is his view that if someone is looking to offer a retail-based system that needs to have very low latency and high throughput, it is not necessarily the most suitable tool.

Nelson describes CBDCs and stablecoins as an exciting movement in the industry, noting that around 80% of central banks have performed or are performing CBDC research.

On the retail side, these currencies typically have similar characteristics to cash because they are often designed to replace cash, meaning the basic elements are trust in the issuing entity, legal tender status, guaranteed real time finality, and availability on a wide scale.

From a wholesale perspective the motivating factors are improving efficiency of payments and security settlements as well as fostering cross-border payments by reducing the number of intermediaries. When looking at various CBDC systems though, interoperability is a significant challenge. 

Nelson highlights China’s presence at the forefront of these developments, although he expects more countries to engage in 2022. He stresses the importance of understanding the motivating factors behind CBDCs, including what markets really need.

In developing economies this is typically improving financial inclusion, payment infrastructure, modernisation and perhaps responding to currency substitution threats. In developed economies - in Sweden, for example – it is about cash replacement and protecting the currency as a global currency while providing competition to private payment systems.

Nelson acknowledges that it is common for developed economies to think about tracking payments as a means of preventing fraud and money laundering.

He then went on to discuss the differences and similarities between stablecoins and CBDCs. The issuing party of a CBDC is usually the central bank and it is legal tender. Stablecoins are trickier since there has been tremendous growth in the last couple of years in USD denominated stablecoin, driven by trading of crypto assets. 

Nelson suggests that unlike e-money – which has a stable framework - with stablecoins there is uncertainty around who is backing it and to what level. Stablecoins are not regulated and pose risks, while CBDCs are regulated and legal tender.

According to Nelson, commercial banks are naturally a little nervous about the introduction of digital currencies in a way that potentially disintermediates the role of commercial banks. Key questions include if residents could open an account directly with the central bank, what would happen with their deposits? Would deposits flow from commercial banks to the central bank, which could impact the commercial bank’s ability to lend?

While most banks are taking a defensive approach, Nelson believes central banks are aware of this and don’t have the desire to disrupt commercial banks because they fill an important role in the financial ecosystem.

He explains that central banks are looking at addressing these issues by limiting the balance of the CBDC account, or not providing interest. Some commercial banks are experimenting with issuing their own stablecoins, although Nelson doesn’t believe this is the best approach.

One solution is to have a common platform where central bank reserves and commercial bank deposits are tokenised. This would solve the issue of fragmentation as they would all be fungible regulated liabilities and Nelson reckons we will see the first instance of a regulated liabilities network this year.

In conclusion, he expresses excitement about these new technologies and confidence in their security given that authorisation and identification is more complex and safer, making the overall transaction easier.