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 Central Bank Digital Currencies: Building Block of the Future of Value Transfer

As a financial services innovation, Central Bank Digital Currencies (CBDCs) are likely to play a pivotal role in shaping the Future of Value Transfer. Most Central Banks worldwide are now in various stages of their evaluation of launching their national digital currencies.


Interest in CBDCs has grown exponentially in the last few years in response to innovation in payments and technology, alongside the disruption caused by Covid-19. This shift has also been triggered by the growing interest and influence of cryptocurrency as a medium of exchange and as an asset class. As a region, APAC has been the frontrunner in this space, with seven out of the top ten global CBDCs projects being conducted in the APAC region alone.


With increasing globalization and digitization of financial services, CBDCs have the potential to create a Future of Value Transfer platform that contributes to a more resilient, innovative, and competitive payment system for households, businesses and economies.


CBDCs are likely to drive efficiencies and effectiveness of a jurisdiction's payments system by ensuring that its users access safe digital money. CBDCs will provide users with a sovereign option as compared to other less safe digital instruments, which may lead to less reliable payments, relatively volatile store of value and potentially erode monetary and financial stability. It may be especially important in the future as the use of cash declines and new forms of "value transfer alternatives" become more widely used in the payment cycle.


Banks and financial services players need to prepare themselves for this inevitability and plan for the impact that it is likely to have on their profit pools, customer propositions, technology models and balance sheets.

In this paper, we seek to provide an analysis of the progress made across Asia Pacific and to explore some of the considerations and implications that are relevant in tracking your journey in the rapidly changing and increasingly digital financial world.



Central Bank Digital Currencies – An early state of play and an inevitability
Central Bank Digital Currencies (CBDCs) have the potential to be the most pervasive innovation in the digital and payments space that will fundamentally impact all participants in the global financial services industry. A Central Bank Digital Currency is an innovation in the form of money issued as well as the underlying infrastructure on transactions can happen.


A CBDC is a digital payment instrument denominated in the national unit of account that is a direct liability of the Central Bank (BIS 2023). It is the legal tender issued by the Central Bank in a digital form as a medium of exchange, store of value and unit of account. It is a fiat currency issued in a digital form and has the same value as the fiat currency.


Currently, only commercial banks and certain permitted financial institutions can hold Central Bank money in the form of ‘reserves’ while the retail public can hold money issued by the Central Bank only in the form of physical banknotes. In their electronic form, CBDCs have the potential to be widely used by wholesale financial institutions, households and businesses to store value and make payments more securely.


With cash usage declining over most economies, CBDCs can play a role in maintaining and streamlining the Central Bank’s function of providing money, financial stability and ensuring continued access in a purely digital economy.


The following table provides an overview of the purpose of CBDCs and compares them to physical cash and alternate private currency.

Comparison of CBDCs with physical cash and alternate private currency


- Issuing Authority   

• Issued and backed by a central monetary authority (CBDCs).

• Issued and backed by a central monetary authority (Cash).

• Privately owned, governed by algorithms (Alternate private currency).

-Form

• Electronic/Digital (CBDCs).

• Paper/Physical (Cash).

• Electronic/Digital (Alternate private currency).

-Guarantee

• Issued by the Central Bank as their liability (CBDCs).

• Issued by the Central Bank as their liability (Cash).

• Privately issued (Alternate private currency).

-Payment acceptance

• Legal Tender (CBDCs).

• Legal Tender (Cash).

• Limited acceptance (Alternate private currency).

-Know Your Customer (KYC)

• Required in most cases (CBDCs).

• Transfer doesn’t require KYC (Cash).

• May not be required Anonymity is high (Alternate private currency).

-Structure

• Centralized or permissioned decentralization (CBDCs).

• Centralized issue (Cash).

• Decentralized (Alternate private currency).

-Risk

• Very low market, counterparty, liquidity risk (CBDCs).

• Very low market, counterparty, liquidity risk (Cash).

• Relatively medium to very high market, counterparty, liquidity risk (Alternate private currency).

economic impact and risks of CBDCs

Globally, the need for CBDCs is being driven by the push for faster payments, rapid digitization, better mitigation for clearing and settlement risk. There is also a demand for more efficient domestic and cross-border value transfers and financial inclusion.


These developments have resulted in many Central Banks and governments increasing efforts towards exploring a digital version of the fiat currency. A 2023 BIS survey of Central Banks found that 86% have been actively researching the potential for CBDCs, 60% have been experimenting with the technology, and 14% have been deploying pilot projects.


Besides leveraging CBDCs to drive monetary and fiscal policies, we have identified four key drivers pushing Central Banks to evaluate CBDCs.

economic impact and risks of CBDCs

Central Banks are becoming cognizant of the advent of new forms of digital money and the utility of non-fiat cryptocurrency. They are also increasingly aware that they may individually need to play a central role in the system rather than remain an observer. There is a need to provide the public with digital currencies that carry the legitimate benefits of alternate private currencies while avoiding economic consequences. While AML/CFT requirements are not core to the issuance of CBDCs, most Central Banks would design their platforms to conform to these requirements as well as requirements around data protection to create trust.

CBDCs have immense potential to bring efficiencies in the financial system

Payments using CBDCs are real-time, gross, and final. This reduces the settlement risk in the financial system; therefore, the need for interbank settlement and reconciliation disappears. CBDCs also potentially enable real-time and cost-effective globalization of payment systems. Time zone differences would no longer matter in currency settlements – there would be no ‘Herstatt’ risk. CBDCs can facilitate ‘programmable money’ in terms of smart contracts to enable ‘atomic’ transactions, where the transfer of CBDCs with another asset is contingent on the real-time transfer of the other asset. In a multi-currency CBDCs environment, this would enable a Payment versus Payment (PvP) for cross-currency transactions or, in the case of a domestic transaction, the other asset could be a physical or financial asset enabling Delivery versus Payment (DvP).


The cost of cash has been estimated to be between 0.5% of GDP (Gross Domestic Product) for countries such as Sweden to 1.7% of GDP for India. This cost, which does not include the ESG cost of printing money, is predominantly borne by four stakeholders – households, businesses, banks, and the Central Bank. Improving tax efficiencies, which in the case of India is expected to account for 3.2% of India’s GDP, is another area of consideration (Source: Accelerating the growth of digital payments in India, Visa).


CBDCs increase the efficiency of clearing and settlements and post-market activities. Currently, most security clearing and settlement processes have a multi-day lag. With the introduction of this form of digital money, there would be a significant increase in efficiencies and a reduction in associated reconciliation costs.

Improving financial access and financial inclusion

Many Central Banks look to CBDCs to provide last mile financial reach by eliminating all intermediaries and physical boundaries and democratizing financial access. However, the low-income groups' preference for cash, the technological challenges and costs associated with a truly digital currency may act as a barrier in achieving the CBDC vision. A recent study by ADB (source: Central Bank Digital Currencies, Asian Development Bank) suggests that CBDCs may offer a highly efficacious solution to the problem of high remittance costs and the broader financial inclusion challenges. Leveraging a two-tier CBDCs model (explained later) will also help in allowing Participating Institutions to leverage Open Banking frameworks to innovate more relevant customer value propositions.

Enhancing monetary and fiscal policy

The introduction of CBDCs could serve as an impetus to improve the monetary policies for Central Banks. Its architecture and structure could allow for the seamless and transparent distribution of government benefits to individuals, improving control over transactions.


CBDCs would improve and enhance financial stability by managing liquidity squeezes and providing the public with alternatives to cryptocurrencies.


CBDCs potentially reduce identity theft risk, as the digital trail would ensure traceability and enhanced security. CBDCs could enable Central Banks to protect purchasing power to maintain the real value of money in the economy. For example, under an indexation scheme, the nominal value of an individual’s CBDCs holdings may be incentivized during periods of higher-than-expected inflation. (Source: Future of Payments, Deutsche Bank, January 2023)


The digital nature of CBDCs will allow Central Banks to tap into more granular payment flow data across an economy which in turn would enhance macroeconomic data integrity and analytics. CBDCs are not expected to replace cash completely but to provide users with a new digital form of money and a way of making payments.





Central bank opportunities are provided to take advantage of CBDCs through :-

• Avoiding the risks of new forms of private money creation

• Supporting a resilient payments landscape

• As a building block for better crossborder payments

• Addressing the consequences of a decline in cash

• Improving the availability and usability of central bank money

• Making future payment needs in a digital economy

• Supporting competition efficiency and innovation in payments