Five minutes on… Central bank digital currencies

As digital mirror images of domestic currencies, CBDCs are poised to overhaul the way our money works. Matt Packer finds out how they are developing

The future of money was high on the agenda on 21 January, with the Bank of England (BoE) launching a wide-ranging exploration of use cases for central bank digital currencies (CBDCs) within several jurisdictions.

Partners in the initiative are the Bank of Canada, the BoE, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank – along with the Bank for International Settlements.

Together, these bastions of the financial system will consider a set of potential economic, functional and technical-design choices for CBDCs, including cross-border interoperability. They will also share knowledge on any emerging technologies in the field.

In addition, the organisations will closely coordinate their work with relevant institutions and forums – in particular, the Financial Stability Board and the Committee on Payments and Market Infrastructures.

What actually is a CBDC?

A CBDC is not to be mistaken for a cryptocurrency or virtual currency. It is a centralised entity, denominated in domestic currency, operated with State oversight and functioning as fiat money.

By contrast, cryptocurrencies and virtual currencies are issued and operated by technology developers, and are therefore not legal tender.

Have any CBDCs been fully implemented?

Not yet – but the nation that has come closest so far is Uruguay.

In 2017, Mario Bergara – head of the Central Bank of Uruguay – announced a wave of CBDC tests, saying: “We are fairly close to launching… a pilot programme for a limited number of digital-currency users, which is an experiment in transforming physical bills into electronic ones.”

Addressing an industry gathering, Bergara said that “instead of carrying around a leather wallet with paper currency”, the CBDC version of the Uruguayan peso would enable citizens to have “bills in the cellular” so they could “pass them on from one user to another”.

He added: “It will be a process of trial and error, success and failures. This must have the same soundness as normal currency – but sooner or later it will be implemented in Uruguay.”

According to City AM, more recent efforts to develop CBDCs have taken place in China – although details are scarce – and at the Riksbank, one of the participants in the BoE’s study.

But one particularly interesting development is a recent joint venture between the Hong Kong Monetary Authority (HKMA) and the Bank of Thailand (BOT). In May last year, the organisations signed a memorandum of understanding to create proof-of-concept (PoC) CBDC blockchains as a means of addressing pain points in cross-border payments.

By interlinking Hong Kong’s system LionRock with its Thai counterpart Inthanon, the partners sought to create a CBDC-based ‘blockchain corridor’ between the two territories, with the aim of seeing whether it would raise efficiency.

To test out this PoC, the HKMA and BOT recruited eight banks from Thailand and two from Hong Kong to coordinate the required transactions.

Sounds ambitious. Which particular pain points did the PoC explore?

In January, the HKMA published a review of the project in the form of a slide deck outlining those very points – and how the corridor tackles them:

• Access to competitive FX pricing Instead of having to take the potentially non-competitive FX rate offered by the correspondent bank, paying banks can choose between the competitive FX rates quoted by participant banks in the corridor’s cross-border network.
• Liquidity management and saving mechanisms The corridor provides automated tools for liquidity management to smooth out the payment process, such as transaction queuing and netting, conversion (from local CBDC to liquidity for settlement within the corridor) and borrowing arrangements (from other corridor participants).
• Monitoring Central banks can observe cross-border fund transfers and FX transactions in real time.
• Regulatory compliance with Thai baht (THB) specific regulations To comply with the relevant rules, a number of alerts were built in for monitoring excess of regulatory limits, such as the daily, outstanding THB balance held by Hong Kong banks.
• Auto-reduction of Hong Kong Banks’ outstanding THB balances The corridor is designed to perform automatic reduction from Hong Kong banks’ THB accounts at the cut-off time, in case any of their aggregated balance exceeds THB200m.

All looks very treasury friendly! What was the verdict on how the initiative played out?

The HKMA’s review noted: “Cross-border funds transfers can occur [in] real time with fewer intermediaries or settlement layers. Therefore, the benefits discussed previously can be achieved – ie, efficiency is enhanced, cost reduced, settlement risk lowered, transparency and compliance enhanced.”

However, it added in a somewhat muted fashion: “Given the highly efficient and trusted retail and wholesale payment infrastructures in Hong Kong, value of CBDC at both retail and wholesale levels in local market appeared to be limited.”

In other words, Hong Kong’s existing system is pretty good – so even though the experiment went very much to plan, its overall effects in that territory didn’t quite manage to distinguish themselves.

Even so, there remains a clear appetite to build on this work. As the HKMA review points out: “While it only tests a THB-HKD corridor with 10 participating banks from Thailand and Hong Kong, the model is designed to be scalable and can be further extended to other jurisdictions or markets.”

Watch this space.