Data, Digitalization, Decentialized Finance and Central Bank Digital Currencies: The Future of Banking and Money 9783111002736, 9783111001876

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Data, Digitalization, Decentialized Finance and Central Bank Digital Currencies

Institute for Law and Finance Series

Edited by Theodor Baums Andreas Cahn

Volume 25

Data, Digitalization, Decentialized Finance and Central Bank Digital Currencies The Future of Banking and Money Edited by Andreas Dombret Patrick S. Kenadjian

ISBN 978-3-11-100187-6 e-ISBN (PDF) 978-3-11-100273-6 e-ISBN (EPUB) 978-3-11-100323-8 Library of Congress Control Number: 2022944036 Bibliographic information published by the Deutsche Nationalbibliothek The Deutsche Nationalbibliothek lists this publication in the Deutsche Nationalbibliografie; detailed bibliographic data are available on the Internet at http://dnb.dnb.de. © 2023 Walter de Gruyter GmbH, Berlin/Boston Cover image: Medioimages/Photodisc Typsetting: jürgen ullrich typosatz, Nördlingen Printing and binding: CPI books GmbH, Leck www.degruyter.com

Foreword By Ted Moynihan, Global Head of Financial Services, Oliver Wyman We are pleased to introduce the proceedings of the Institute for Law and Finance Conference on Data, Digitalization, Decentralized Finance, and Central Bank Digital Currencies. Financial institutions have always had access to vast amounts of data, but they have historically used it for transactional purposes rather than as a source of intelligence to expand and improve their products and services. Digitalization has ushered in a new era, transforming the financial services world and introducing data-driven business models. Digital assets and decentralized finance have potential to create further upheaval and accelerate this transformation. Despite this paradigm shift, there are some issues around adoption. Fintech disruptors are driving progress and now it is up to incumbents to improve their capabilities. In some cases progress has been slow, with some more traditional players piling modern technology on top of legacy systems rather than transforming business models, and as a result they are failing to achieve their desired outcomes. Banks need to transform in a profound way or risk losing market share to the newer fintech players and to big tech. Although there has been some resistance to the changing of business models, one of the main barriers to progress has been a lack of regulation and frameworks designed to govern our new digital world. At the beginning of 2021, there were an estimated 100 million users of crypto assets, increasing to over 200 million by mid-year and to 300 million by the end of 2021. Regulation has struggled to keep pace with this growth. The prospect of major digital distribution platforms using fiat-linked stablecoin and of the arrival of central bank digital currencies within a few years means preparations need to accelerate significantly. Currently policy is fragmented, and alignment will be key to moving on from a system in which existing laws are applied to products that they predate and were never intended to cover. Without a convening body to manage the process at a global level, achieving consensus will be difficult — but it is vital for the financial system. There may be some scepticism of the future of digital assets due to the uncertainty around regulation, but the volatility is temporary, and they are here to stay. More traditional players need to adapt accordingly, and big tech and fintechs need to continue to deliver on the promise of digitalization. The financial services industry is undergoing profound change and the discussion around the future of banking and money is an important one. This is why we greatly appreciate the contributions in this book from leaders of financial instihttps://doi.org/10.1515/9783111002736-202

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tutions, central bankers, regulators, supervisors, and public officials. We thank the authors for sharing their perspectives. We would like to express our gratitude to Patrick Kenadjian, Dr. Andreas Dombret, and the Institute for Law and Finance for their partnership and their dedication to arranging this conference and furthering the conversation.

Preface The Future of the Financial Sector Series This book is the tenth in the series on the future of the financial sector sponsored by the Institute for Law and Finance (ILF) at Johann Wolfgang Goethe University in Frankfurt and published by De Gruyter, Berlin. Each book corresponds to a day long conference held by the ILF at which leading representatives from the public sector, industry and academia met to examine key issues of the day concerning the future of the financial sector. Together they trace the arc of our concerns for the sector following the Great Financial Crisis. The first three volumes, as well as the seventh, concern themselves with the resolution of financial institutions, as well as other potential solutions to the “too big to fail” dilemma in the wake of the crisis, and show the remarkable progress we have made in Germany and in Europe on that topic. The first volume was based on a conference held in November 2010, a point at which the term bank resolution was so unfamiliar in Germany that we felt it best to call the conference “Brauchen wir ein Sonderinsolvenzrecht für Banken?”, do we need a special insolvency law for banks. For the book, which appeared in 2012, we stuck in Too Big to Fail in the title. Contributors included Andreas Dombret, John Douglas, former General Counsel of the Federal Deposit Insurance Corporation, Thomas Huertas, member of the Executive Committee at the UK Financial Services Authority and Alternate Chair of the European Banking Authority (EBA), Martin Hellwig, Director at the Max Planck Institute for Research on Collective Goods and Charles Randell, who was soon to become external member of the UK Prudential Regulation Committee and later Chair of the UK Financial Conduct Authority. By May 2012 we were already able to discuss what was then being called the EU Crisis Management Directive, although the actual text itself had been delayed and was only published after the conference. By the time the book appeared in 2013 we were able to call it by its definitive name, the Bank Recovery and Resolution Directive, and actually deal with the text itself. It was clear that by then resolution had been adopted by the EU as its preferred solution to too big to fail, although its complexities were still being sorted through, especially the topic of “living wills” and the then very controversial “bail-in tool”. Contributors included Eva Hüpkes, advisor to the Financial Stability Board, Thomas Huertas, Charles Randell and Paul Tucker, Deputy Governor of the Bank of England. By January 2014 we were considering more radical proposals, as the recommendations of the Liikanen Commission joined the Volcker Rule and the conclusions of the Vickers Commission in the United Kingdom in pointing towards a variety of so-called structural reforms, separating various kinds of banking serhttps://doi.org/10.1515/9783111002736-203

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vices. So we asked “Should We Break Up the Banks?” Contributors included Paul Achleitner, Chairman of the Supervisory Board of Deutsche Bank, Jan Krahnen, member of the High level Expert Group on Structural Reforms of the EU Banking Sector and Adam Posen, President of the Peterson Institute for International Economics. At the end of the day, most contributors ended up advocating or conceding that, without a credible bank resolution system, structural proposals to break up the banks would not suffice to solve too big to fail. We returned to the question of resolution in the spring of 2018 with our program entitled “Resolution in Europe: The Unresolved Questions”, the fourth in our series on too big to fail, in which we narrowed our focus to Europe but broadened our scope to include insurance and central counterparties (CCPs). The book was published in 2019 with contributions by José Manuel Campa, the future Chair of the EBA, Benoît Cœuré, member of the Executive Board of the European Central Bank (ECB), Adam Farkas, Executive Director of the EBA, Levin Holle, Director General, Financial Markets Policy Department, German Federal Ministry of Finance, Felix Hufeld, President of the German Federal Financial Supervisory Authority, Elke König, Chair of the Single Resolution Board, Steven Maijoor, Chair of the European Securities and Markets Authority, Fausto Parente, Executive Director of the European Insurance and Occupational Pensions Authority and Sir Paul Tucker. The contributors concluded that significant progress had been made on bank resolution, although significant open issues remained, especially with respect to cross-border cases, but that less progress had been made on insurance and that CCP resolution required significant additional attention. In March 2015 we turned our attention from the past to the future to consider the European Capital Markets Union in response to the European Commission’s Green Paper in a session where we questioned whether it was a viable concept and a real goal. The book appeared, in the same year, with contributions from Benoît Cœuré, Sir Jon Cunliffe, Deputy Governor for Financial Stability of the Bank of England, Philipp Hildebrand, Vice Chairman of BlackRock, Anshu Jain, Cochief Executive Officer of Deutsche Bank and Wim Mijs, Chief Executive Officer of the European Banking Federation. There was a broad consensus on the desirability of the project, but considerable reservations on the tactics being pursued to accomplish it. In November 2015 – 2015 was a busy year for us – we turned our attention back to one of the nagging questions left over from the Great Financial Crisis: to what extent was the crisis due to culture and could we hope to restore public confidence in financial institutions without tackling the issue of ethics. “Getting the Culture and the Ethics Right, Towards a New Age of Responsibility in Banking” appeared in 2016, with contributions from Lorenzo Bini Smaghi, Chairman of Société Générale, John Cryan, Chief Executive Officer of Deutsche Bank, Georg Fah-

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renschon, President of the German Savings Banks Association, Douglas Flint, Group Chairman of HSBC Holdings, John Griffith-Jones, Chairman of the UK Financial Conduct Authority, Danièle Nouy, Chair of the Supervisory Board of the ECB Single Supervisory Mechanism, Jean-Claude Trichet, Chairman of the Group of Thirty, Sir Paul Tucker and Axel Weber, Chairman of the Board of UBS Group. There was unanimity among the contributors as to the importance of culture and ethics, but less clarity on whether the goals could best be reached through external pressure from regulation and supervision or bankers’ codes, or internally through boards of directors and structural changes. We had intended to hold a conference in 2016 on the final Basel III accord, scheduled for finalization by year end. When the negotiations collapsed we pushed our session back to December 2017 and the book, “Basel III: Are We Done Now?” appeared in 2019 with contributions from Claudio Borio, Head of the Monetary and Economics Department, Bank for International Settlements, William Coen, Secretary General of the Basel Committee on Banking Supervision, Andrea Enria, Chairperson of the EBA, Charles Goodhart, Emeritus Professor at the London School of Economics, Levin Holle, Stefan Ingves, Governor of the Swedish Riksbank and Chairman of the Basel Committee for Banking Supervision, Sabine Lautenschläger, Member of the Executive Board of the ECB, Christian Ossig, Chief Executive of the Association of German Banks, Isabel Schnabel, Member of the German Council of Economic Experts and Shunsuke Shirakawa, Vice Commissioner for International Affairs, Financial Services Agency of Japan, The contributors emphasized both the magnitude of the accomplishment Basel III represented and the issues which still remained to be resolved in the implementation of the accord as well as those items about which no agreement had been reached. In 2019 we tackled the questions standing in the way of completing the European Banking Union. The book, entitled “EDIS, NPLs, Sovereign Debt and Safe Assets”, appeared in 2020 with contributions by Andrea Enria, Chair of the Supervisory Board of the ECB, Edouard Fernandez-Bollo, Secretary General, French Prudential Supervision and Resolution Authority, Martin Hellwig, Levin Holle, Dominique Laboureix, Director of Resolution Planning at the Single Resolution Board, Christian Ossig, Fabio Panetta, Senior Deputy Governor of the Bank of Italy, Isabel Schnabel, Joachim Wuermeling, member of the Executive Board of the Deutsche Bundesbank and Jeromin Zettelmeyer, Deputy Director in the Strategy and Policy Review Department at the International Monetary Fund. In 2021 we opened up our aperture to tackle the global issues concerning climate change, operating for the first time on a fully virtual basis, with an audience of over 1,000 who were treated to an inspiring keynote address by Christine Lagarde, President of the European Central Bank. The resulting book, entitled, “Green Banking and Green Central Banking”, was published to coincide with

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COP26 in Glasgow in November 2021 with contributions from John Berrigan, Director General in DG FISMA, Günther Bräunig, CEO of KfW, José Manuel Campa, Chairperson of the European Banking Authority, Wiebe Draijer, Chairman of the Managing Board, Rabobank, Christian Edelmann, Managing Partner Europe at Oliver Wyman, Sylvie Goulard, Second Deputy Governor of the Banque de France, Philipp Hildebrand, Vice Chairman of Blackrock, Werner Hoyer, President, EIB, Otmar Issing, President of the Center for Financial Studies, Christine Lagarde, Valentin von Massow, Vice President of the Board of WWF International, Wim Mijs, Chief Executive Officer of the European Banking Federation, Daniel Mminele, former Deputy Governor of the South African Reserve Bank, Ted Moynihan, Managing Partner and Global Head of Industries at Oliver Wyman, Sirpa Pietikäinen, Member of the European Parliament, Deputy General Manager, BIS, Günther Thallinger, Member of the Board of Management of Allianz SE and Jens Weidmann, President, Deutsche Bundesbank. The full list of the titles and contributors is set forth below. We are very grateful for all of them for the efforts they put into these volumes, which we hope have contributed to advancing thinking in Europe on the various topics we covered. Andreas Dombret Patrick Kenadjian

Frankfurt Main, May 2022

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Institute for Law and Finance Series; Titles on the Future of the Financial Sector Vol. 9: Too Big To Fail – Brauchen wir ein Sonderinsolvenzrecht für Banken? Ed. Patrick S. Kenadjian (2012) Authors: Dirk H. Bliesener, Andreas Dombret, John L. Douglas, Martin Hellwig, Thomas F. Huertas, Patrick S. Kenadjian, Wolfgang M. Nardi, Klaus Pannen, Carl Pickerill, Leo Plank, Matthias Raphael Prause, Wolfgang M. Nardi, Charles Randell, Christoph Thole. Vol. 13: The Bank Recovery and Resolution Directive: Europe’s Solution for “Too Big to Fail?”, Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2013) Authors: Andreas Cahn, Dirk H. Bliesener, Andreas Dombret, Randall D. Guynn, Thomas F. Huertas, Eva Hüpkes, Patrick S. Kenadjian, Simon Gleeson, Mathias Otto, Charles Randell, Paul Tucker. Vol. 16: Too Big to Fail III: Structural Reform Proposals Should We Break Up the Banks? Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2015) Authors: Paul Achleitner, Andreas Dombret, Douglas J. Elliott, Simon Gleeson, Randall D. Guynn, Patrick S. Kenadjian, Jan P. Krahnen, Adam S. Posen, Miguel de la Mano, Debra Stone. Vol. 17: The European Capital Markets Union A viable concept and a real goal? Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2015) Authors: Cyrus Ardalan, Andrew Bosomworth, Benoît Cœuré, Sir Jon Cunliffe, Andreas Dombret, Alexandra Hachmeister, Philipp Hildebrand, Anshu Jain, Patrick S. Kenadjian, Wim Mijs, Christian Ossig, Dirk Schoenmaker. Vol. 20: Getting the Culture and the Ethics Right Towards a New Age of Responsibility in Banking and Finance, Ed. Patrick S. Kenadjian and Andreas Dombret, De Gruyter Recht, Berlin (2016) Authors: Lorenzo Bini Smaghi, John Cryan, Andreas Dombret, Georg Fahrenschon, Leonhard H. Fischer, Douglas Flint, Simon Gleeson, John GriffithJones, Klaus J. Hopt, Patrick S. Kenadjian, Jan P. Krahnen, Sylvie Matherat, Wim Mijs, Alberto G. Musalem, Danièle Nouy, Dominik Treeck, Jean-Claude Trichet, Sir Paul Tucker, Axel A. Weber.

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Vol. 21: Basel III: Are We Done Now? Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2019) Authors: Claudio Borio, William Coen, Andreas Dombret, Douglas J. Elliott, Andrea Enria, Michael S. Gibson, C.A.E. Goodhart, Stuart Graham, Paul Hilbers, Levin Holle, Stefan Ingves, Patrick S. Kenadjian, Sabine Lautenschläger, Laurie Mayers, Martin Merlin, Sandie O’Connor, Christian Ossig, Shunsuke Shirakawa, Isabel Schnabel. Vol. 22: Resolution in Europe: The Unresolved Questions, Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2019) Authors: José Manuel Campa, Benoît Cœuré, Andreas Dombret, Wilson Ervin, Joachim Faber, Adam Farkas, Helmut Gründl, Levin Holle, Thomas F. Huertas, Felix Hufeld, Patrick S. Kenadjian, Elke König, Daniel Maguire, Steven Maijoor, Fausto Parente, Giulio Terzariol, Sir Paul Tucker, Mark E. Van Der Weide, James von Moltke. Vol. 23: EDIS, NPLs, Sovereign Debt and Safe Assets, Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2020) Authors: Klaus Adam, Roland Boekhout, Thiess Büttner, Rebecca Christie, Andreas Dombret, Colin Ellis, Andrea Enria, Edouard Fernandez-Bollo, Martin Hellwig, Joachim Hennrichs, Georg Huber, Thomas F. Huertas, Patrick S. Kenadjian, Nikki Kersten, Slawek Kozdras, Jan P. Krahnen, Dominique Laboureix, Álvaro Leandro, Nicoletta Mascher, Sylvie Matherat, Wim Mijs, Arthur J. Murton, Charles Nysten, Christian Ossig, Fabio Panetta, Jörg Rocholl, Karl-Peter SchackmannFallis, Isabel Schnabel, Anita van den Ende, Nicolas Véron, Klaus Wiedner, Joachim Wuermeling, Jeromin Zettelmeyer. Vol 24: Green Banking and Green Central Banking, Ed. Andreas Dombret and Patrick S. Kenadjian, De Gruyter Recht Berlin (2021) Authors: John Berrigan, Jean Boivin, Günther Bräunig, José Manuel Campa, Andreas Dombret, Wiebe Draijer, Christian Edelmann, Ed Fishwick, Sylvie Goulard, Philipp Hildebrand, Werner Hoyer, Andreas Dombret, Otmar Issing, Patrick Kenadjian, Matthias Kopp, Christine Lagarde, Valentin von Massow, Wim Mijs, Daniel Mminele, Ted Moynihan, Simona Paravani-Mellinghoff, Sirpa Pietikäinen, Christian Sewing, Luiz Awazu Pereira da Silva, Jessica Tan, Günther Thallinger, Bouke de Vries, Jens Weidmann.

Contents Foreword Preface

V VII

Introduction

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The Authors

XXI

Agustín Carstens Digital Currencies and the Soul of Money

XXXI

I. Digitalization and Data: Can Incumbents Keep Up? Christian Edelmann Time for the Heavyweights – How established Financial Institutions can succeed in the Digital Assets Market 3 Bernd Leukert Data-driven Innovation in Financial Services – Opportunities and Prerequisites 11 Wim Mijs Banks in the Digital Space

17

II. Technology and Regulation: Are we Focused on the Right Things? Ashley Alder Coordinating the regulatory Approach to the new Technology Wave John Berrigan Who is afraid of the Blockchain? Towards a new EU Approach to Financial Regulation 31

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Michael J. Hsu Adapting to the Digitalization of Banking and Finance

35

III. Central Bank Digital Currencies: Cui Bono? Ulrich Bindseil The Case for and against CBDC – five Years later

45

Markus Brunnermeier and Jean-Pierre Landau The Digital Euro: Policy Implications and Perspectives

63

Stephen G. Cecchetti and Kermit L. Schoenholtz Central Bank Digital Currency: Is it really worth the Risk? Andreas Dombret and Oliver Wünsch The Case for Central Bank Digital Currencies

115

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Patrick Kenadjian On the Coming of Retail CBDCs: Public versus Private Money

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Andréa Michaela Maechler Wholesale CBDC as a possible Option for providing a Safe and Efficient Settlement Asset for Future Financial Infrastructures 173 Changchun Mu Theories and Practice of exploring China’s e-CNY

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Randal Quarles Does Basel Dream of Electric Sheep? Prospects for the Development of Central Bank Digital Currencies 191

IV. Decentralized Finance, Blockchain, Payment Systems, Tokens and Stablecoins, the Changing Rails of Banking and Commerce: In What do we Trust? Barry Eichengreen A Douse of Digital Cold Water

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Stefan Ingves Crypto Assets, CBDCs and Trust

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Steven Maijoor Changing Landscape, Changing Supervision: Preserving Financial Stability in Times of Tech Revolution 213

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Introduction On January 18, 2022 we organized the 10th Conference on the future of the financial sector for the Institute for Law and Finance (ILF) on the topic of data, digitalization, decentralized finance and central bank digital currencies, which we subtitled “the future of banking and money”. Due to COVID, the conference took place virtually and attracted over 1,200 participants from 66 countries, thus beating the record we had set in 2021 with our conference on green banking and green central banking. We are grateful for the support of the ILF staff, our knowledge partner Oliver Wyman and the support from Amazon Web Services as well as the 26 other speakers and moderators who generously donated their time to prepare for and speak at the conference. We were honored to start the day with an important keynote address by the central banks’ banker, Agustin Carstens, General Manager of the Bank for International Settlements on the topic of central bank digital currencies (CBDCs). Dr. Carstens provided a cogently reasoned argument in favor of CBDCs, an issue we returned to several times in the course of the day, on the panel devoted to that topic, on a number of other panels and in Markus Brunnermeier’s conclusion. The first panel, moderated by Wim Mijs, CEO of the European Banking Federation, was devoted to whether incumbent financial institutions, with their legacy systems, can expect to keep up with the increasing challenges posed by Fintech, with their targeted customer offerings, and Big Tech, with their technological edge and their huge resources, in a world marked by the increasing pace of digitalization and the use of new types of data to drive decision making, product design and customer experience. Our keynote speaker from last January’s conference, Christine Lagarde, President of the European Central Bank, has observed that the pace of digitalization has accelerated some seven-fold during COVID, putting ever greater pressure on financial service providers to adapt in order to survive. Bill Gates famously said some years ago that we need banks, but not banking. The panel was designed to test that proposition. It recognized that while incumbents face significant challenges, they also had accumulated strengths, including a reservoir of trust from their customers and the public in general and a mastery of risk management, which should not be underestimated. The panel also recognized that use of data is now the core business of banking, that customers will share their data where they see a benefit to themselves and that no one owns the customer anymore. The second panel was moderated by Andreas Dombret and asked whether we are focusing on the right things in regulating technology. In the past, this has not always been the case. In part this is because we have inherited an entity-based rather than an activity or business model-based regulatory structure, especially in https://doi.org/10.1515/9783111002736-205

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the United States. This has been slow to change, although it is now changing. In addition, new technologies have added new dimensions to traditional operational risks and new products such as stablecoins and cryptocurrencies require a fresh look at our regulatory approach, so as not to repeat past mistakes of regulating new technologies by analogy to existing products and services. After hearing from Jörg Kukies, State Secretary at the German Federal Chancellery, outline the German Government’s priorities for its Presidency of the G-7, the panel focused on the kinds of operating risk which emerged from remote working during COVID, the regulatory issues relating to the outsourcing of the technological support for financial institutions and the challenges presented by crypto assets and decentralized finance (DeFi), as regulators find themselves running to catch up with shape-shifting cross-border crypto operations and DeFi structures where the lack of a human point of control makes it hard to know where to attach regulation. While recognizing the attraction of many of the products involved, the panelists emphasized the dangers of allowing uninformed investors to invest billions, if not trillions in untested products. The third panel, moderated by Patrick Kenadjian, was dedicated to CBDCs with a particular focus on retail CBDCs. Retail CBDCs have the potential to change how we think of money. They also have the potential, if they are not designed carefully, to end up interfering with financial stability by disintermediating a portion of our current banking sector. While the central banks involved are clearly aware of the stakes involved, the concerns remain and that was reflected in the panel’s very lively debate during which representatives of central banks studying the issuance of retail CBDCs emphasized that they saw them as providing redundancy to rather than the replacement of private payment systems and that the tiered system under which CBDCs would be issued only through financial intermediaries would keep the latter in the system. They also emphasized that they saw CBDCs as driven by public demand for digital assets and as essential to guarantee the continued promise that private money issued by financial intermediaries would be convertible into public money. They characterised their dilemma as how to be successful in gaining public acceptance for CBDCs without being too successful and disintermediating incumbent financial institutions, which they saw as achievable if they focused on designing and promoting retail CBDCs as a means of payment rather than a store of value. They also explained the design choices available to reduce privacy concerns among users. The final panel, moderated by Monica Lopez-Monis, Global Head of Supervisory and Regulatory Relations at Santander Group, examined private sector initiatives in the payments area, which are the background to and also a key motivation for central banks considering issuing CBDCs. The panel focused on the extent to which our current payment systems remain fit for purpose, especially in the

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cross-border area and, if changes are needed, where we should start. The technology involved, although to a large degree still under development is fascinating and the prospect of eliminating layers of intermediation and costs through the use of distributed ledger technology, is clearly appealing. It was emphasized that the choice between public and private payments systems did not have to be seen as an either/or proposition in that, as suggested in the prior panel, it would make perfect sense for the public sector to provide a public backbone to the payment system, with the private sector providing the bridge to the “last mile” to the retail customer. One of the more memorable observations of the panel was the remark by Stefan Ingves, Governor of the Sveriges Riksbank, that money is about what we have in our heads rather than what we have in our wallets. The program concluded with a wide ranging set of reflections by Markus Brunnermeier of Princeton who returned to the issue of CBDCs, putting it in the broader context of technological and social trends and of the transition from our current system, which could be characterized as “one money, multiple issuers” to a three way system involving governments, banks and platforms, urging us to see the issue not just in the context of our current world, but in that of the new world whose outlines we are already starting to see. He noted how the old problem of “adverse selection” where the borrower was always deemed to know more than the lender, was being replaced by a system of “inverse selection” where through the use of big data, AI and deep learning, the lender, insurer or asset manager will soon know more about the borrower than the latter does about herself. He cautioned, however, about the tendency of platforms to develop into closed ecosystems and opined that the current “proof of work” system for validating block chains underlying crypto assets would not be able to support widespread payment systems. He also agreed with the central bank representatives on the third panel that CBDCs would be required to continue to anchor private money to public money once cash disappears, and added that the real danger of Facebook’s Libra was that it could have destroyed the unit of account represented by the fiat currencies. Andres Dombret Patrick Kenadjian

Frankfurth am Main, April 2022

The Authors Ashley Ian Alder Ashley is the Chief Executive Officer of the Securities and Futures Commission (SFC) of Hong Kong. He was first appointed in October 2011. In May 2016, Ashley was elected as Chair of the Board of the International Organization of Securities Commissions (IOSCO), and was re-elected for a further two-year term in June 2020. Ashley was previously Chair of the IOSCO Asia-Pacific Regional Committee and Vice Chair of the IOSCO Board. Ashley has represented IOSCO as a member of the Financial Stability Board Steering Committee and Plenary since his election as IOSCO Board Chair. Ashley started his career as a lawyer in London in 1984. He moved to Hong Kong in 1989 with the international law firm Herbert Smith, practicing corporate and business law. He was Executive Director of Corporate Finance at the SFC from 2001 to 2004, before returning to Herbert Smith, where he became head of the firm’s Asia Region. John Berrigan John Berrigan is the Director General in DG FISMA (Directorate-General for Financial Stability, Financial Services and Capital Markets Union) of the European Commission. DG FISMA is responsible for EU-level policy making and legislative initiatives with respect to the financial sector, including Banking Union, Capital Markets Union, sustainable finance, digital finance, anti-money laundering and sanctions. In this context, John represents the European Commission on the Economic and Financial Committee and the Financial Services Committee, which report to EU Finance Ministers. He also represents the Commission on the Financial Stability Board, which reports to G20 Finance Ministers. He attends the European Systemic Risk Board and is a permanent observer on the Single Resolution Board. John has been a Commission official since the mid-1980s and has spent most of that time working on financial-sector issues – first in DG ECFIN (where he contributed to macro-financial analysis in general and more specifically to financialsector aspects of the assistance programmes for Member States) and now in DG FISMA. He worked on preparations for the introduction of the euro in 1999 and was secretary of the so-called Giovannini Group, which produced reports, inter alia, on issues related to euro-denominated debt issues and post-trading in EU securities markets in the early 2000s. In the mid-1990s, he worked for several years with the International Monetary Fund. John has a masters degree in economics from University College Dublin. He is married with two children.

https://doi.org/10.1515/9783111002736-206

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Markus K. Brunnermeier Markus K. Brunnermeier is the Edwards S. Sanford Professor in the economics department at Princeton University and director of Princeton’s Bendheim Center for Finance. His research focuses on international financial markets and the macroeconomy with special emphasis on bubbles, liquidity, financial and monetary price stability, and digital money. In 2020, at the outbreak of Covid, he established a webinar series. Brunnermeier is also nonresident senior fellow at the Peterson Institute, a research associate at the National Bureau of Economic Research, the Centre for Economic Policy Research, CESifo, the Luohan Academy, ABFER, and a member of the Bellagio Group on the International Economy. He is a Sloan Research Fellow, fellow of the Econometric Society, Guggenheim Fellow, and the recipient of the Bernácer Prize granted for outstanding contributions in the fields of macroeconomics and finance. He is a member of several advisory groups, including to the US Congressional Budget Office, the Bank for International Settlements, and the Bundesbank as well as previously to the International Monetary Fund, the Federal Reserve of New York, the European Systemic Risk Board. Brunnermeier was awarded his PhD by the London School of Economics (LSE). He has been awarded several best paper prizes and served on the editorial boards of a number of leading economics and finance journals. He has worked to establish the concepts of: liquidity spirals, Financial Dominance, CoVaR as a measure of systemic risk, the Volatility Paradox, Paradox of Prudence, Resilience, European Safe Bonds (ESBies), the redistributive monetary policy, the Reversal Rate, and Digital Currency Areas. His recent book “The Resilient Society” won the Prize for the 2021 best business book in German and was listed among best economics books by the Financial Times. Agustín Carstens Agustín Carstens became General Manager of the BIS on 1 December 2017. Mr Carstens was Governor of the Bank of Mexico from 2010 to 2017. A member of the BIS Board from 2011 to 2017, he was chair of the Global Economy Meetingand the Economic Consultative Councilfrom 2013 until 2017. He also chaired the International Monetary and Financial Committee, the IMF’s policy advisory committee from 2015 to 2017. Mr Carstens began his career in 1980 at the Bank of Mexico. From 1999 to 2000, he was Executive Director at the IMF. He later served as Mexico’s deputy finance minister (2000–03) and as Deputy Managing Director at the IMF (2003–06). He was Mexico’s finance minister from 2006 to 2009. Mr Carstens has been a member of the Financial Stability Board since 2010 and is a member of the Group of Thirty.

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Mr Carstens holds an MA and a PhD in economics from the University of Chicago. Stephen G. Cecchetti Stephen G. Cecchetti is Rosen Family Chair in International Finance at the Brandeis International Business School, Research Associate at the NBER, Research Fellow at the CEPR, and Vice-Chair of the Advisory Scientific Committee of the European Systemic Risk Board. From 2008 to 2013, Cecchetti served as Economic Adviser and Head of the Monetary and Economic Department at the Bank for International Settlements. From 1997 to 1999 he was Director of Research at the Federal Reserve Bank of New York. In addition, he has served on the faculty of The Ohio State University and the New York University Leonard N. Stern School of Business. Andreas Dombret Dr Andreas Dombret was born in the USA to German parents. He studied business management at the Westfälische Wilhelms University in Münster and was awarded his PhD by the Friedrich-Alexander University in Erlangen-Nuremberg. From 1987 to 1991, he worked at Deutsche Bank’s Head Office in Frankfurt, from 1992 to 2002 at JP Morgan in Frankfurt and London, from 2002 to 2005 as the Co-Head of Rothschild Germany located in Frankfurt and London, before serving Bank of America as Vice Chairman for Europe and Head for Germany, Austria and Switzerland between 2005 and 2009. From May 2010 to May 2018, was a member of the Executive Board of the Deutsche Bundesbank with responsibility for Financial Stability, Statistics, Markets, Banking and Financial Supervision, Economic Education, Risk Controlling and the Bundesbank’s Representative Offices abroad. He was also responsible for the IMF (Deputy of the Bundesbank), Financial Stability Commission (Member), Supervisory Board of the SSM (Member), Basel Committee on Banking Supervision (BCBS) (Member) and has been a member of the Board of Directors at the Bank for International Settlements (BIS), Basel, until the end of 2018. Since 2009, Andreas holds a professorship at the European Business School in Wiesbaden and teaches, as Adjunct Senior Fellow, at Columbia University in New York since May 2018. Christian Edelmann Christian Edelmann is the Managing Partner for of Oliver Wyman Europe. He is based out of their London office. Prior to his current role, Christian co-led EMEA Financial Services, and the global Corporate & Institutional Banking (CIB) practice. He also acted as the Global Head of Oliver Wyman’s Wealth & Asset Manage-

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ment (WAM) practice. Before that Christian was based out of Hong Kong, running Oliver Wyman’s business in Asia-Pacific. He started his career in Switzerland and has worked across Europe, Asia, North America and the Middle East, advising a broad range of sell-and buy-side clients in the areas of strategy and risk management. Christian holds a Master degree in Law (summa cum laude) and a Master degree in Business and Economics (insigni cum laude) from the University of Basel (Switzerland). He has also earned the Chartered Financial Analyst (CFA) and the Financial Risk Manager (FRM) designation. Christian is fluent in English, German and Swiss German. He is the author of many of Oliver Wyman landmark reports; he is also regular speaker at industry events and on TV. Barry Eichengreen Barry Eichengreen is the George C. Pardee and Helen N. Pardee Professor of Economics and Professor of Political Science at the University of California, Berkeley, where he has taught since 1987. He is a Research Associate of the National Bureau of Economic Research (Cambridge, Massachusetts) and Research Fellow of the Centre for Economic Policy Research (London, England). In 1997–98 he was Senior Policy Advisor at the International Monetary Fund. He is a fellow of the American Academy of Arts and Sciences (class of 1997). Michael J. Hsu Michael J. Hsu is the Acting Comptroller of the Currency of the United States. Mr. Hsu became Acting Comptroller of the Currency on May 10, 2021, upon his designation as First Deputy Comptroller by Secretary of the Treasury Janet Yellen pursuant to her authority under 12 USC 4. As Acting Comptroller of the Currency, Mr. Hsu is the administrator of the federal banking system and chief executive officer of the Office of the Comptroller of the Currency (OCC). The OCC ensures that the federal banking system operates in a safe and sound manner, provides fair access to financial services, treats customers fairly, and complies with applicable laws and regulations. It supervises nearly 1,200 national banks, federal savings associations, and federal branches and agencies of foreign banks that serve consumers, businesses, and communities across the United States and conducts approximately 70 percent of banking activity in the country. These banks range from community banks serving local neighborhood needs to the nation’s largest most internationally active banks. The Comptroller also serves as a Director of the Federal Deposit Insurance Corporation and a member of the Financial Stability Oversight Council and the Federal Financial Institutions Examination Council.

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Prior to joining the OCC, Mr. Hsu served as an Associate Director in the Division of Supervision and Regulation at the Federal Reserve Board of Governors. In that role, he chaired the Large Institution Supervision Coordinating Committee Operating Committee, which has responsibility for supervising the global systemically important banking companies operating in the United States. He cochaired the Federal Reserve’s Systemic Risk Integration Forum, served as a member of the Basel Committee Risk and Vulnerabilities Group, and co-sponsored forums promoting interagency coordination with foreign and domestic financial regulatory agencies. His career has included serving as a Financial Sector Expert at the International Monetary Fund, Financial Economist at the U. S. Department of the Treasury helping to establish the Troubled Assets Relief Program, and Financial Economist at the Securities and Exchange Commission overseeing the largest securities firms. Mr. Hsu began his career in 2002 as a staff attorney in the Federal Reserve Board’s Legal Division. He holds of a bachelor of arts from Brown University, a master of science in finance from George Washington University, and a juris doctor degree from New York University School of Law.  

Stefan Ingves Stefan Ingves is Governor of Sveriges Riksbank and Chairman of its Executive Board. Governor Ingves holds the position of Vice Chairman of the Board of Directors of the BIS and is the Chair of the BIS Banking and Risk Management Committee (BRC). Mr. Ingves is also a Member of the General Council of the ECB and First Vice Chair of the European Systemic Risk Board (ESRB). Governor Ingves is also Governor for Sweden in the IMF, Board Member of the Nordic-Baltic Macroprudential Forum (NBMF) and Chairman of the Toronto Centre for Global Leadership in Financial Supervision. Mr. Ingves has previously been Chairman of the Basel Committee on Banking Supervision, Director of the Monetary and Financial Systems Department at the IMF, Deputy Governor of the Riksbank and General Director of the Swedish Bank Support Authority. Prior to that he was Head of the Financial Markets Department at the Swedish Ministry of Finance. Stefan Ingves holds a PhD in economics. Patrick Kenadjian Patrick is currently an Adjunct Professor at the Goethe University in Frankfurt am Main, Germany, where he teaches courses on the financial crisis and financial reform and mergers and acquisitions at the Institute for Law and Finance.

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Since 2012, Patrick has co-chaired a dozen conferences at the University on financial reform, including the need for and design of resolution regimes for banks, insurance companies and CCPs and other potential solutions for “too big to fail”, the proposed European Capital Markets Union, the importance of culture and ethics in financial institutions, the final agreement on Basel III, green banking and green central banking and collective action clauses in sovereign debt issues. Since 2015 he has served on the Advisory Council to the Salzburg Global Forum on Finance in a Changing World where he served as Program Director in 2013 and 2014. Patrick is also Senior Counsel at Davis Polk & Wardwell London LLP. He was a partner of the firm from 1984 to 2010, during which time he opened the firm’s Tokyo and Frankfurt offices in 1987 and 1991, respectively and spent over 25 years in its European and Asian offices. Jean-Pierre Landau Jean-Pierre Landau has worked in the French Government and Central Bank for most of his career. He has served as Executive Director of the International Monetary Fund (IMF) and the World Bank from 1989 to 1993. He was then appointed Undersecretary for External Economic Relations (1993–1996) at the Ministry of Finance in Paris. He was Treasury Representative in London and Executive Director at the EBRD from 2000 to 2006. He served as Deputy Governor of the Banque de France from 2006 to 2011. He is currently at the Economic Department of Sciences Po and Research Fellow at the Harvard Kennedy School. He has been Visiting Lecturer at Princeton University (Woodrow Wilson School) in 2012 and Visiting Professor at SAIS (John Hopkins – Washington DC) in 1992–93. His main fields of interest include monetary policy, financial regulation and international macroeconomics. Bernd Leukert Bernd Leukert became a member of the Deutsche Bank Management Board on January 1, 2020 with responsibility for Technology, Data and Innovation. He joined Deutsche Bank on September 1, 2019. He previously worked at SAP, the global software company. From 2014 to 2019, he was responsible for product development and innovations as well as the Digital Business Services division on the Executive Board. He joined SAP in 1994 and held various management positions. He brings 25 years of experience in product development at the leading Germany-based software firm. Bernd Leukert studied Industrial Engineering and Management at the University of Karlsruhe and at Trinity College Dublin, graduating in 1994 with a Masters Degree in Business Administration

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Andréa M. Maechler Andréa M. Maechler was born in Geneva in 1969. She studied economics at the University of Toronto, and then at the Graduate Institute of International Studies in Geneva, where she obtained her Master’s in International Economics. Following a period of study at the Institute of Advanced Studies in Public Administration in Lausanne, she obtained her PhD in International Economics from the University of California, Santa Cruz in 2000. Andréa M. Maechler’s early career took her to the Organisation for Economic Co-operation and Development (OECD), the United Nations Conference on Trade and Development (UNCTAD) and the World Trade Organization (WTO). From 1999 to 2001, she worked as an economist in the Swiss National Bank’s (SNB) Financial Stability unit in Zurich. She then moved to the International Monetary Fund (IMF), where she occupied a number of senior positions in the Africa, Monetary and Capital Markets, Western Hemisphere and Strategy, Policy and Review departments. From 2012 to 2014, during a sabbatical from the IMF, she worked for the European Systemic Risk Board (ESRB) in Frankfurt. Upon returning to the IMF, she was appointed as Deputy Division Chief in the Global Markets Analysis Division. The functions of this division include monitoring global capital markets, and assessing systemic risks and the macrofinancial impact of capital market developments. With effect from 1 July 2015, the Swiss Federal Council appointed Andréa M. Maechler as Member of the SNB’s Governing Board – the first woman to occupy a Board position. At the same time, she became Head of Department III (Money Market and Foreign Exchange, Asset Management, Banking Operations, Information Technology). Andréa M. Maechler is a member of the Advisory Board of the Department of Banking and Finance at the University of Zurich. Steven Maijoor Steven Maijoor joined the Executive Board of De Nederlandsche Bank (DNB) on 1 April 2021. Steven’s remit includes supervision of banks, horizontal functions and integrity supervision, and legal services. He is also a member of the Supervisory Board of the European Central Bank (ECB). Before joining DNB’s Executive Board, Steven was Chair of the European Securities and Markets Authority (ESMA), from 2011–2021. Between 2004 and 2011 he was a managing director at the Dutch Authority for the Financial Markets (AFM). Prior to that he was Professor (1994–2004) and Dean (2001–2004) at the School of Business and Economics, Maastricht University. Steven graduated from the University of Groningen with a degree in business economics and obtained a PhD in the same subject from Maastricht University in 1991. Steven was born in Hong Kong (1964).

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Wim Mijs Wim Mijs (1964) was appointed Chief Executive Officer of the European Banking Federation in 2014. Between 2007 and 2014 Wim served as CEO of the Dutch banking association NVB. During this tenure he transformed the NVB into a modern industry association, positioning it as the key representative of the banking sector in the wake of the financial crisis. Wim studied law at the University of Leiden in the Netherlands, specialising in European and International law. After his studies he worked at the International Court of Arbitration at the Peace Palace in The Hague. In 1993 he joined ABN AMRO in Amsterdam before moving to Brussels to head up the bank’s EU liaison office. Wim moved back to The Hague in 2002 where he became the Head of Government Affairs for ABN AMRO. Wim is a member of the Advisory Board of the BBVA Center for Financial Education and Capability, the Industry Chair of the European Parliamentary Financial Services Forum and member of the Advisory Board of Leiden Law School. Between 2011 and 2018, Wim held various institutional roles within the international and European financial/banking community: chairman of the International Banking Federation; chairman of the Executive Committee of the EBF; and chairman of the Board of Euribor, now known as the European Money Market Institute. Wim is married and has two children Ted Moynihan Ted Moynihan is Managing Partner and Global Head of Industries at Oliver Wyman. He has led Oliver Wyman’s Financial Services practice globally since 2016 and previously served as the Global Head of the Corporate & Institutional Banking Practice. Ted personally has concentrated on banking strategy, operating structure, financial management and operations. He advises several industry bodies, policy makers and regulatory bodies assisting in the development of strong policy and regulatory rule-making. Ted specialised in control engineering and mathematics for a number of years before joining Oliver Wyman. He is a graduate of University College, Dublin, and holds a degree in Engineering from Cambridge University. Mu Changchun Mr. Mu Changchun is appointed Director-General of Digital Currency Institute, the People’s Bank of China in July, 2019. Mr. Mu joined the People’s Bank of China in 1995 and was appointed as Deputy Director-General of Payment & Settlement Department in 2017. Mr. MU is a member of CPMI, a member of FSB Financial Innovation Network, and also a member of the IMF High-level Advisory Group on Finance and Technology.

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Randal K. Quarles Randal Quarles is Chairman and Founder of The Cynosure Group, an investment firm bringing together several of the United States’ largest family offices to make long-term private investments. From October 2017 through October 2021, Mr. Quarles was Vice Chairman of the Board of Governors of the Federal Reserve System, serving as the Board’s first Vice Chairman for Supervision, charged with ensuring stability of the financial sector. He also served from December 2018 until December 2021 as Chairman of the Financial Stability Board, a global body established after the Great Financial Crisis to coordinate international efforts to enhance financial stability. As FS. Chairman he was a regular delegate to the finance ministers’ meetings of the G-7 and G-20 and to the summit meetings of the G-20. As Fed Vice Chair, he was a permanent voting member of the Federal Open Market Committee, the body that sets monetary policy for the United States. Earlier in his career, Mr. Quarles was a long-time partner at The Carlyle Group, a leading global private equity firm, and before that a partner at the international law firm of Davis Polk & Wardwell, where he was co-head of their financial services practice. Mr. Quarles has been a close adviser to every Republican Treasury Secretary for the last 35 years, including as Under Secretary of the Treasury in the Bush ’43 Administration. He has also been Assistant Secretary of the Treasury for International Affairs, Deputy Assistant Secretary for Financial Institutions Policy, and US Executive Director of the International Monetary Fund. Kermit L. Schoenholtz Kermit L. Schoenholtz is Clinical Professor Emeritus at New York University’s Leonard N. Stern School of Business, where he taught courses on money and banking and on macroeconomics and directed NYU Stern’s Center for Global Economy and Business. He also serves on the Financial Research Advisory Committee of the U. S. Treasury’s Office of Financial Research. Previously, he was Citigroup’s global chief economist 1997 until 2005. Schoenholtz joined Salomon Brothers in 1986, working in their New York, Tokyo, and London offices, eventually becoming chief economist at Salomon and Salomon Smith Barney, prior to the formation of Citigroup.  

Ulrich Bindseil Ulrich Bindseil is Director General Market Infrastructure and Payments at the European Central Bank (ECB), a post he has held since November 2019. Previously, he was Director General Market Operations (from May 2012 to October 2019) and head of the Risk Management Division (between 2005 and 2008). Mr Bindseil first entered central banking in 1994, when he joined the Economics Department of the Deutsche Bundesbank, having studied economics. His publications include,

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among others, Monetary Policy Operations and the Financial System, OUP, 2014, and Central Banking before 1800 – A Rehabilitation, OUP, 2019. Oliver Wuensch Dr Oliver Wuensch is Partner of Oliver Wyman’s Banking and Sovereign Practice, advising banks, governments and central banks on strategy, economic policy and transformation. Before turning to advisory, Oliver held positions at the International Monetary Fund, where he was co-responsible for the financial turnaround of several countries struck by the Euro crisis. During and after the Great Financial Crisis, he was the strategy chief of the Swiss Financial Supervisor FINMA and represented Switzerland to the Financial Stability Board and the Basel Committee on Banking Supervision. Oliver started his career with a global investment bank and also spent several years in academia as researcher and lecturer.

Agustín Carstens

Digital Currencies and the Soul of Money Speech by Agustín Carstens, BIS General Manager Goethe University’s Institute for Law and Finance (ILF) conference on “Data, Digitalization, the New Finance and Central Bank Digital Currencies: The Future of Banking and Money” Frankfurt, 18 January 2022 Dear Andreas, thank you for your kind introduction and for inviting me to speak today. It’s an honor to deliver this speech at Goethe University. Of course, I wish I could be in Frankfurt in person. In a speech four years ago in this house, I addressed the growth and pitfalls of cryptocurrencies like Bitcoin.1 Since then, the debate on the future of money has grown much broader, but it continues to touch on the very foundations of the monetary system. Today, I will take inspiration from the great Johann Wolfgang von Goethe, a true Renaissance man: a poet and a novelist, a playwright, scientist and statesman. Remarkably, his work anticipated some key economic issues of our time, including central bank independence.2 Goethe’s work confronts fundamental questions. In his masterpiece, Faust, he addresses the “Gretchenfrage” – a fundamental question of life. For central bankers, the Gretchenfrage has always been: what is the soul of money? Today, technologists, innovators and futurists are coming up with new answers to this question: – Some say that in the future, money and finance will be provided by just a few big tech corporations.

1 See A Carstens, “Money in the digital age: what role for central banks?”, speech, House of Finance, Goethe University, Frankfurt, 6 February 2018. 2 See J Weidmann, “Money creation and responsibility”, speech, 18 September 2012; H Binswanger, C Binswanger and J Harrison, Money and Magic: a Critique of the Modern Economy in the Light of Goethe’s Faust, Chicago: University Of Chicago Press, 1994. https://doi.org/10.1515/9783111002736-207

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Others dream of a decentralised system in which blockchains and algorithms replace people and institutions. And maybe, all of this will take place in the Metaverse.3

My main message today is simple: the soul of money belongs neither to a big tech nor to an anonymous ledger. The soul of money is trust. And central banks have been and continue to be the institutions best placed to provide trust in the digital age. Let me elaborate, starting with the institutional foundations of money.

The institutional underpinnings of money Money is a societal convention. People accept money today in the expectation that everyone else will accept it tomorrow. At its core, trust in the currency holds the monetary system together. Like the legal system, this trust is a public good.4 Maintaining it is crucial for the effective functioning of societies. Trust requires sound institutions that can stand the test of time. Institutions that ensure the stability of the currency as the economy’s key unit of account, store of value and medium of exchange, and that guarantee the safety and integrity of payments.5 Over history, independent central banks have emerged as the key institution to provide this trust. Alternatives have often ended badly.6 It is for good reason that most countries have established central banks with a clear mandate to serve society.7 In pursuing these mandates, central banks have managed to constantly adapt to technological, economic and societal changes.

3 See P Clark, “The Metaverse Has Already Arrived. Here’s What That Actually Means”, Time, 15 November 2021. The concept of the metaverse is often traced back to N Stephenson, Snow Crash, New York: Bantam Books, 1992. This fictional metaverse was conceived of as a 100-meterwide street around a spherical planet that users could access with virtual reality goggles or from booths, and in which users would be represented as “avatars”. 4 A Carstens, “The future of money and the payment system: what role for central banks?”, lecture at Princeton University, 5 December 2019. 5 BIS, “Central banks and payments in the digital era”, Annual Economic Report, Ch. III, June 2020; C Borio, “On money, debt, trust and central banking”, BIS Working Papers, no 763, January 2019. 6 See J Frost, HS Shin and P Wierts, “An early stablecoin? The Bank of Amsterdam and the governance of money”, BIS Working Papers, no 902, November 2020. 7 C Giannini, The age of central banks, London: Edward Elgar Publishing, 2011.

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This is why central banks are actively engaging with digital innovation, developing public goods such as wholesale financial market infrastructures, retail fast payment systems and central bank digital currencies. Of course, in a market-based system, the private sector remains the main engine of the economy. In today’s two-tier monetary system, deposits are by far the most prevalent form of money held by the public, since cash holdings are relatively small; banks, in turn, place their own deposits with the central bank – as “bank reserves”. In this case, central banks provide an open, neutral, trusted and stable platform. Private companies use their ingenuity and dynamism to develop new payment methods and financial products and services. This combination has been a powerful driver of innovation and welfare. But we must not take this successful symbiosis for granted. Some recent developments may threaten money’s essence as a public good, if taken too far. To illustrate, let me offer three plausible scenarios for the future of money. – In the first, big tech stablecoins compete with national currencies and against each other, fragmenting the monetary system. – The second relates to the elusive promise of crypto and decentralised finance, or “DeFi”, which claims to offer a financial system free from powerful intermediaries but may actually deliver something very different.8 – The third realises the vision of an open and global monetary and financial system that harnesses technology for the benefit of all. You can probably guess which vision I espouse.

Big tech stablecoins Let’s start with stablecoins, issued by big techs. Stablecoins are cryptocurrencies that base their value on safe assets, such as currencies and other regulated financial instruments. They piggyback on, or borrow, the credibility of these safe assets. Big techs have made important contributions to financial services. Their new and innovative products have allowed hundreds of millions of new users to join the formal financial system.9 8 DeFi refers to financial applications built on permissionless distributed ledger technology (DLT). See below. 9 See K Croxson, J Frost, L Gambacorta and T Valletti, “Platform-based business models and financial inclusion”, BIS Working Papers, 10 January 2022.

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In the process, they have also achieved systemic relevance in several major economies. For example, big techs provide 94 % of mobile payments in China.10 This trend could accelerate if one of these firms were to create a dominant, closed ecosystem around its own global stablecoin.11 Once established, a company is likely to erect barriers against new entrants, leading to market dominance, data concentration and less competition. Its stablecoin could disintermediate incumbent banks, posing a risk to financial stability. Moreover, if one big tech stablecoin takes hold, others will seek to imitate it. We may end up with a few dominant walled gardens competing against each other and with national currencies, fragmenting the national and global monetary system. The initial benefits would fade, quickly giving way to the well-known problems of market concentration. In addition, the same economic forces that foster inclusion can also cause discrimination, privacy violations and market concentration. One reason is that data are subject to large externalities. For example, one person’s data can reveal information about others.12 Moreover, it is possible that the data holder ends up knowing more about users’ behavior than the users do themselves.13 Armed with exclusive access to data, big techs can quickly scale up and dominate markets. Let me be clear: it is undesirable to rely solely on private money. Paying with a big tech global stablecoin might be convenient. But in doing so users may be handing the keys to our monetary system over to private entities driven primarily by profit. Such an arrangement could erode trust. A public good like money needs oversight with the public interest in mind.  

10 In India, big techs provide third-party services in the Unified Payment Interface (UPI), accounting for 90 % of transactions on UPI, but the funds remain with banks. See D D’Silva, Z Filkova, F Packer and S Tiwari, “The design of digital financial infrastructure: lessons from India”, BIS Papers, no 106, 15 December 2019. 11 There is an important distinction between big techs offering payment services with other firms’ stablecoins, and issuing their own stablecoins. In the United States and Guatemala, Meta’s subsidiary Novi is currently piloting a wallet product using the Paxos stablecoin. The issuance of the Diem stablecoin is on hold. See Novi, “Pilot Version of Novi Now Available”, press release, 19 October 2021. 12 See D Bergemann, A Bonatti and T Gan, “The Economics of Social Data”, Cowles Foundation Discussion Papers, no 2203R, September 2019. 13 M Brunnermeier, R Lamba and C Segura-Rodriguez, “Inverse Selection”, working paper, 2020.  

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The elusive promise of decentralisation A second plausible scenario for the future of money has attracted a growing number of enthusiasts. This vision replaces institutions with distributed ledger technology (DLT) and in principle allows anyone to be a validator in a shared network. It is embodied in the growth of cryptocurrencies and applications that build on them, such as socalled decentralised finance, or “DeFi”.14 DeFi’s enthusiasts hold out some very appealing promises: DLT will “democratise finance”, cutting out big banks and other middlemen. The internet itself would become decentralised, in what many like to call “Web 3.0”, or “web3”. In this world, data are reclaimed from the big techs, while entrepreneurs and artists keep a greater share of the value they create.15 Decentralisation can be a noble goal. In many applications, governance improves when power is genuinely dispersed, with appropriate checks and balances. But this principle is not what DeFi applications are delivering. There is a large gulf between vision and reality. To date, the DeFi space has been used primarily for speculative activities. Users invest, borrow and trade crypto assets, in a largely unregulated environment. The lack of controls such as know-your-customer (KYC) and anti-money laundering rules might well be one important factor in DeFi’s growth. Indeed, a parallel financial system is emerging, revolving around two elements. The first is automated, self-executing protocols, or “smart contracts”. But these contracts will never be so smart as to cover every possible scenario, and someone must therefore write and update the code, and run the platform. In practice, there is a lot of centralisation in DeFi. BIS economists have discussed this “decentralisation illusion” in recent research.16

14 See S Aramonte, W Huang and A Schrimpf, “DeFi risks and the decentralisation illusion”, BIS Quarterly Review, December 2021; F Schär, “Decentralized Finance: On Blockchain- and Smart Contract-Based Financial Markets”, Federal Reserve Bank of S. Louis Review, vol 103, no 2, 2021; N Carter and L Jeng, “DeFi Protocol Risks: The Paradox of DeFi” in B Coen and D Maurice (eds), Regtech, Suptech and Beyond: Innovation and Technology in Financial Services, Risk Books, 2021. 15 See B Allen, “People are talking about Web3. Is it the Internet of the future or just a buzzword?”, NPR, 21 November 2021. For critical takes, see J Geuter, “The Third Web”, 17 December 2021; M Elgan, “You can safely ignore Web3”, Computer World, 28 December 2021. 16 Aramonte et al (2021).

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The second element is, again, stablecoins. These grease the wheels of DeFi. As they aim to maintain a fixed value to fiat currencies, they allow transfers across platforms, and form a bridge to the traditional financial system. Stablecoins are the settlement instrument in DeFi, alongside governance tokens and other more volatile crypto assets.17 But stablecoins may not be sound as money. One drawback, as I mentioned earlier, is their borrowed credibility. Their issuers have an incentive to invest reserve assets in a risky manner to earn a return. Without appropriate regulation, issuers can diverge from full backing, or become creative on what counts as a safe asset – as experience has repeatedly shown.18 More fundamentally, decentralisation has a cost. Trust in an anonymous system is maintained by self-interested validators who ensure the integrity of the ledger in the absence of a central authority.19 So the system must generate enough fees, or rents, to provide these validators with the right incentive. These rents accumulate mostly to insiders, such as Bitcoin miners, or those who hold more governance tokens.20 These rents are also a reason why DeFi platforms have been so attractive for venture capital investment.21 Many protocols entrench insiders, since those with more coins have more power. Ultimately, this means high costs for users. So, while insiders often make spectacular returns, efficiency gains for average users have so far failed to materialise. And in the absence of regulation, fraud, hacks and so-called rug pulls have become rampant.22

17 Governance tokens are a crypto-asset that grants voting power to its holder for decisions in the shared system 18 D Arner, R Auer and J Frost, “Stablecoins: risks, potential and regulation”, Financial Stability Review, Bank of Spain, no 39, Autumn. There are also decentralised stablecoin designs that eliminate the need to trust an intermediary, but these must generally be highly over-collateralised, limiting their usefulness for mainstream applications. See C Catalini and A de Gortari, “On the Economic Design of Stablecoins”, mimeo, 5 August 2021. 19 R Auer, C Monnet and H S Shin, “Distributed ledgers and the governance of money”, BIS Working Papers, no 924, November 2021. 20 In some automated trading platforms, there is the potential for large validators to front-run other users and “win” the next block in the ledger. This is sometimes referred to as “miner extractable value”. 21 See G Cornelli, S Doerr, L Franco and J Frost, “Funding for fintechs”, BIS Quarterly Review, September 2021. Investment in crypto and DLT firms has boomed in 2021, in line with strong interest in DeFi applications. 22 A “rug pull” refers to the development team of a cryptocurrency or Defi project abandoning their project and absconding with the investors’ funds. According to the firm Chainanalysis, investors around the globe were defrauded to the tune of more than USD 2.8 billion in 2021 alone.

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In addition, this structure makes it hard for fully decentralised systems to scale up. Achieving agreement in a large network takes time and effort and consumes energy. The larger the ledger, the harder it becomes to update it quickly. This is why many DLT systems can only handle a small volume of transactions to date, and often suffer from network congestion. This is the reason why Bitcoin requires so much electricity. Indeed, the necessity of rents to maintain incentives in a blockchain is a feature, not a bug; it is a case of “the more the sorrier” instead of “the more the merrier”. And the proliferation of blockchains means that many are competing to be a single arbiter of truth. Meanwhile, DeFi is subject to the same vulnerabilities present in traditional financial services: high leverage, liquidity mismatches and connections to the formal financial system mean vulnerabilities in DeFi could undermine the stability of the broader financial system.23 As with money market funds, stablecoins could face runs during a shock. With automated protocols, there may also be unpredictable interactions, as liquidity dries up and losses cascade through the system. Thus, there is a risk that this “magic”, once launched, may spin out of control. As in Goethe’s Zauberlehrling (“The Sorcerer’s Apprentice”), DeFi applications could take on a life of their own. When a crash happens and money is lost, users will inevitably turn to a trusted and experienced party – the public authorities – to tame the unleashed spirits and restore order. A better approach is possible. Building on sound money, new applications could stand on a stronger footing. They should not be based on anonymity but on identification and trust. And they should comply with financial regulation designed to keep the system safe. Wherever private stablecoins are issued, they need to be adequately regulated to address risks such as runs, and concentration of economic power.24 We also need effective and consistent international policies.25 Innovators should not fear regulators but work with them, to make their products sounder and more sustainable.

See www.afr.com/companies/financial-services/the-rug-pull-crypto-investors-lose-4b-in-a-newscam-20220111-p59nan. 23 Aramonte et al (2021). 24 See US President’s Working Group on Financial Markets, Federal Deposit Insurance Corporation (FDIC) and Office of the Comptroller of the Currency (OCC), Report on stablecoins, November 2021. 25 In this light, the BIS Committee on Payments and Market Infrastructures (CPMI) and the International Organization of Securities Commissions (IOSCO) have proposed guidance on the application of their Principles for Financial Market Infrastructures to stablecoin arrangements. See CPMI

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An open and global system as a public good In a third scenario, incumbents, big techs and new entrants compete in an open marketplace that guarantees interoperability, building on central bank public goods. End users can seamlessly interact across different providers – both domestically and across borders.26 This would bring about continued innovation, and ever better outcomes for the economy.27 Trust in money remains the bedrock of stability. End users would see low costs and convenient services, with safety, privacy and a broad range of payment choices. This scenario harnesses the benefits of big data and DLT with market structures that foster competition and promote the public good nature of the monetary system. The monetary system is not fragmented into separate walled gardens, nor is it dominated by a few large corporations. High rents for insider validators are no longer needed. At the core of this system are central banks. They do not aim for profits, but to serve society. They have no commercial interest in personal data. They act as operators, overseers and catalysts in payments markets, and regulate and supervise private providers in the public interest. Working together, they can provide central bank digital currencies (CBDCs). Unlike stablecoins, CBDCs do not need to borrow their credibility. As they are directly issued by the central bank, they inherit the trust that the public already places in their currency. They can thus serve as a sound foundation for future innovation. Central banks can provide this foundation domestically, but also on a global scale. Imagine a global network of CBDCs. Different central banks would design and issue a new form of public money, tailored to their economies and social preferences. Importantly, central banks could work with each other, and with the private sector, to ensure that these domestic CBDCs are interoperable across borders. This requires technical compatibility, the ability for systems to “speak each other’s language” and agreement on rights and obligations.28

and IOSCO, “Application of the Principles for Financial Market Infrastructures to stablecoin arrangements”, 6 October 2021. 26 See C Boar, S Claessens, A Kosse, R Leckow and T Rice, “Interoperability between payment systems across borders”, BIS Bulletin, no 49, 10 December 2021. 27 On the ability of (“neck-and-neck”) competition between firms to drive innovation, see P Aghion, N Bloom, R Blundell, R Griffith and P Howitt, “Competition and innovation: An inverted-U relationship”, Quarterly Journal of Economics vol 120, no 2, 2005, pp 701–28. 28 Boar et al (2021).

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To arrive at that point, they could choose whether to build a network of bilateral links, or use a hub-and-spoke model or a single common platform. DLT could connect multiple CBDCs issued by different central banks. This would be useful as no single central bank would be able to straddle all the different currencies in the system. Such a network would be a global version of domestic monetary systems grounded in the trust placed in central banks. It could lower the cost of cross-border payments; increase their speed and transparency; and broaden access to users in different countries. Private providers could interact with clients, conducting know-your-customer and other compliance checks. The private sector could build a host of financial services on top of such a system, from innovative payments to lending, to insurance and investment services. But safeguards could give users control over personal data. This would not require the selling of speculative coins that serve only to enrich insiders. The BIS Innovation Hub is working actively to make this vision a reality, with several experiments involving cooperation between central banks and the private sector. What is notable is that many of these projects are based on DLT, where the central banks play the key role. Based as they are on trust instead of rents, these systems have no problem with scaling up. They also offer greater safety and efficiency. Three important BIS Innovation Hub projects use DLT platforms upon which multiple central banks issue their own wholesale CBDCs to enable faster, cheaper and safer cross-border settlements.29 Overall, these projects show that there is significant potential in new technologies, including DLT, if they are applied in a way that builds on the monetary system’s existing institutional framework. Central banks, as validating nodes, are not there to make money by mining coins. Instead, they perform this role as part of their public service mandate.

29 Banque de France, BIS, Swiss National Bank, “Project Jura: Cross-border settlement using wholesale CBDC”, 8 December 2021; BIS Innovation Hub Hong Kong Centre, Hong Kong Monetary Authority, Bank of Thailand, Digital Currency Institute of the People’s Bank of China and Central Bank of the United Arab Emirates, “Inthanon- LionRock to mBridge: Building a multi CBDC platform for international payments”, 28 September 2021; BIS, “BIS Innovation Hub and central banks of Australia, Malaysia, Singapore and South Africa will test CBDCs for international settlements”, press release, 2 September 2021. The project involves the Reserve Bank of Australia, Bank Negara Malaysia, Monetary Authority of Singapore and South African Reserve Bank.

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Conclusion Let me conclude. The future of money is ours to shape. While central banks share the excitement around digital innovation, we are aware of the potential consequences of some of its incarnations. The design of money has consequences that concern all of society: the integrity and stability of money and payments, market concentration, consumer rights and efficiency. Hence, central bankers must work with other public authorities and private stakeholders, if we are to make the vision I have described a reality. Let’s innovate in a sound, sustainable way, harnessing the benefits of digital technology in a way that is consistent with our shared values. In particular, let’s ensure that our financial system builds on the existing governance of money, serves the public interest, and works cooperatively with the private sector. So, let me go back to where I started, to Goethe. The answer to the Gretchenfrage has not changed: central banks and public authorities are still the glue that holds the monetary and financial system together. Private sector services and innovation are essential and should thrive on this foundation. But trust can never be outsourced or automated. Herzlichen Dank für Ihre Aufmerksamkeit!

I. Digitalization and Data: Can Incumbents Keep Up?

Christian Edelmann

Time for the Heavyweights – How established Financial Institutions can succeed in the Digital Assets Market Digital assets have attracted attention from a variety of players. Many new ventures and investors have benefited hugely from the available opportunities in the largely unregulated crypto market, while others have adapted technologies born in that market for diverse use cases, such as payments and settlement, recordkeeping systems, securitization and trading. Given this rapid expansion, digital assets are now ceasing to be viewed as unconventional, but instead accepted as part of the furniture of financial markets. As a result, more established financial institutions, such as banks, payment companies, insurers and asset managers, are looking to seize the potentially huge and varied opportunities opened up by crypto markets before competitors steal a march on them. Recent key developments have further prepared the ground for greater participation from these traditional players, who now need to act swiftly to take full advantage. But as they step up their activity in these markets, they must at the same time be fully cognizant of the risks involved.

Digital assets in financial services Digital assets are electronic files of data with properties that permit value to be stored, transferred and tokenized. They span a broad variety of digital instruments built on diverse technologies, security and governance models, but generally exist on open permissionless networks, or semi-open, permissioned networks. Open, permissionless networks have fostered the development of crypto assets, such as Bitcoin or Ethereum, which represent one of four main types of digital asset within the financial services environment. Crypto assets have enjoyed a meteoric rise in the recent period, with estimated users trebling in 2021 alone, from 100 million to 300 million. Other digital asset categories in the financial services context are stablecoins, which are pegged to a stable price related to the US Dollar or the price of some other currency / asset; central bank digital currencies, founded on a permissioned model, which are the electronic equivalent of cash as they are a direct liability of the central bank; and tokenized assets, such as a digital representation of the ownership of a security. https://doi.org/10.1515/9783111002736-001

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An auspicious environment While the crypto asset market has mushroomed to a multi-billion-dollar industry, traditional players in the financial services industry have been slow to respond. Their participation in this market has been limited, and they have not exploited the opportunity offered by distributed ledger and blockchain technology to introduce new digital asset propositions or to make existing operations more efficient. More often than not, they have been held back by undeveloped technology stacks, risk governance issues, an inability to demonstrate clear commercial value, or an absence of regulatory clarity. However, four key recent developments in the broader environment suggest that traditional players are set to play a much more active role in the digital assets space. First, institutional investors have started to enter the market more assertively, contributing greatly to the bull market in crypto assets in 2021. Highly publicized investments by major names in the industry have pointed to a new-found commitment by regulated players, driven in particular by client demand for a greater emphasis on an asset class that has generated such high returns over the last decade. Second, the very involvement of institutional investors is itself testament to a maturing market. Liquidity and price-setting venues have acted to bolster confidence in their market governance, compliance and reporting capabilities. The level of market liquidity now supports large block trades involving major acquisitions and disposals. Regulation, although not yet fully developed or consistent, has certainly progressed. In certain jurisdictions, such as Singapore or Switzerland, regulators have embraced the crypto industry and are promoting distributed ledger technology. In the United States, meanwhile, banks have now been permitted to use public blockchains and stablecoins as a settlement infrastructure. Third, the commercial value arising from crypto assets is becoming increasingly obvious. Fintechs have reported a positive consumer response to new crypto asset products. Outside of trading and investment, various payment solutions have also been introduced, based on stablecoins or distributed ledger networks. Finally, the technology infrastructure has moved on considerably, enabling companies to participate in the digital assets market in a more efficient way and on a more mature foundation. For example, developments in Layer-2 solutions, which operate on top of an underlying blockchain protocol, now permit more complex and faster transactions at lower costs. Aside from Bitcoin and Ethereum, new public blockchain protocols and their native currencies are now enjoying more widespread adoption. Another notable development is the introduction of self-custody solutions suitable for businesses, in which keys and the exchange of wallet addresses are both secured.

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Crypto market structure When analyzing the opportunities open to traditional financial institutions, it is first necessary to understand how the crypto market is organized. We therefore divide the market into six layers.

Fig. 1: Crypto asset market and capabilities

The first three layers – crypto liquidity venues, crypto liquidity providers, and global order book and routing – have involved a variety of infrastructure operated by unregulated players, to date largely untroubled by competition from large financial institutions. Liquidity venues are where prices for various crypto assets are discovered; liquidity providers are firms that offer market-making services at liquidity venues. Due to their swift development and their highly developed expertise, incumbent crypto firms enjoy a strong position in these three areas that will prove difficult to challenge. To gain a foothold, therefore, many new entrants will need to find ways to partner with these incumbents. However, the three other layers – asset custody, brokerage licenses, and securitization / structuring – rely on the institutional trust, and the regulatory and legal expertise, for which established financial institutions are known. Custodians, regulated broker dealers, and firms with structuring and securitization capabilities, will all be essential for gaining access to institutional and wealth management markets.

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Custodians and custody solutions serve to allay the considerable risk of fund losses as a result of security breaches or human error; regulated broker-dealer intermediaries facilitate entry into crypto markets in a way that provides investors with legal recourse should disputes arise; lastly, institutional investors and large corporates will demand sophisticated financing products from traditional financial institutions, whose risk management and legal rigor can assuage potential concerns about crypto markets.

Digital asset opportunities for financial institutions Given this market structure, and the clear need for their perceived dependability and know-how, we believe there are six main ways in which financial institutions can usefully and profitably participate in the digital assets market.

Fig. 2: Six models for financial institutions to participate in the crypto market

– Custody and wallets Financial institutions can look to offer licensed and regulated custodial services of digital assets to institutions and retail clients. Any provider of such services will necessarily enjoy a high level of institutional trust, a strong balance sheet, and legal and technical expertise. Indeed, a number of established financial institutions, have moved to capitalize on this opportunity. In order to do so, they have developed the technical and security knowhow to make the transition away from outsourcing digital assets custody to a third

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party, the standard approach for traditional financial assets, towards retaining custody in-house. There will be certainly be customer demand for this direct custody model, principally from other financial institutions that are managing client funds or offering new crypto-linked financial instruments, such as Bitcoin exchange-traded funds (ETFs). However, it is not yet clear that the model will be profitable for the financial institutions themselves. Due to the technical, legal and underwriting complexity involved in the direct custody of digital assets, firms will likely need to take custody of a large volume of assets in order to offset the higher costs involved, as well as charge higher pricing than for traditional assets.

– Trading venues Another avenue for financial institutions is to develop trading venues and settlement platforms and infrastructure for digital assets. However, competition in the retail trading platform market is already intense. In order to differentiate themselves, therefore, new entrants will need to customize propositions for a particular type of customer, or provide more complex features that support auction and bidding structures for a specific market. A certain type of trading venue, however, remains undeveloped, opening up a potential opportunity for financial institutions. There is a demand for trading venues that can offer global execution, deep liquidity, fiat settlement rails, and brokerage services, such as margin financing. Such a trading venue would operate in a regulated environment involving strong know-your-client (KYC) and know-your-transaction (KYPT) compliance frameworks.

– Wealth and fund management A third means of entry for financial institutions is to offer digital asset exposure to institutional and retail clients through wealth management and fund management products. Developing such products would attract substantial capital. However, much depends on regulators who have to date displayed understandable caution. They recognize that discharging their mandate for investor protection will be an uphill task, due to fears of market manipulation and their lack of enforcement powers in relation to foreign market players. However, given the potential size of the market and the ease of obtaining these products through the unregulated market, regulators are likely to permit certain types of crypto financial products for retail usage.

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– Prime brokerage A further opportunity for financial institutions lies in establishing a prime brokerage desk and providing institutional traders with access to crypto markets. The demand for crypto prime brokers is bound to increase as institutional interest in the sector grows. Indeed, certain banks have already made it known that they will install desks to serve hedge funds trading in these markets. A prime broker will need to combine various elements – order routing, execution, crypto and fiat settlement and clearing, and custody – with a strong balance sheet that provides low-cost crypto and fiat financing. To break into this market, aspiring prime brokers will therefore need to attract very substantial crypto deposits, or form partnerships with established players to gain access to low-cost crypto financing.

– Payments and settlement Financial institutions can deploy digital assets to provide more secure and faster payment and settlement systems to banks, institutions and merchants. Firms can use a fungible digital token as an instrument representing a claim against an institution with a strong balance sheet, supported by an open network into which participants can integrate. The current payment and settlement environment is highly complex, and multiple applications and infrastructure already exist. In certain countries, such as China and Singapore, domestic retail payments are already working highly efficiently, and the need for a digital asset-based payment infrastructure is therefore as yet largely unproven. Progress may be more achievable in other markets, however. In the United States, for example, propositions such as, digital stablecoins that are linked to the US dollar, have registered some success as they integrate low-cost public blockchains operating as a payment network with an instrument that can generate yield if deposited with firms that lend USD coins.

– Innovative financial offerings Finally, financial institutions could develop and offer new financial products that combine the technical features made possible by digital assets with innovation in financial engineering.

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One example of such a combination would see tokenization, a process enabled by digital assets, paving the way for new derivative products in which counterparty risks are more visible and manageable, and where fractionalization and bundling can potentially release liquidity. Another potential product offering would involve term deposits that can be redeemed, spent and traded on secondary markets as senior notes. Given its rapid commercial development, and the greater open-mindedness on the part of regulators to permit experimentation with new technologies, financial institutions can ill afford to ignore this area. We believe that they will need to feed off the existing ecosystem to succeed in this market, integrating and building new offerings founded on the core propositions, such as stablecoins, already launched by fintech and crypto companies.

Risks of participation in the digital assets market As financial institutions contemplate various digital asset propositions, they will need at the same time to examine their risk management frameworks. Some of the risks of participation in the digital assets market will have been encountered before, but will nevertheless necessitate new controls. Other risks will demand more fundamental changes in risk taxonomy and management. The risk of money laundering looms large when adopting digital assets, in particular crypto assets built on public networks. Other forms of misconduct, including market manipulation, also present danger. However, solutions are now available for companies to manage and reduce the risks of money laundering and fraud. Most public blockchain wallets are linked to entities. Once pseudonym mapping is deployed, a white-listing process for handling transactions can be introduced relatively easily. The protocol risk resulting from using a public blockchain to store and transfer value is a more difficult one to quantify. Participants have little influence on the future development of networks which are governed and managed as opensource projects. Protocol upgrades have the potential to change the economics of users and node operators in a significant way. Any financial institutions choosing to participate in these networks will therefore need to exert some influence on their direction, and recruit people with the right capabilities to assess the possible impact of upgrades. Financial institutions will also need to manage technology risks to ensure security and stability. Such risks are significant in digital asset applications, which make use of new technologies in an open or semi-open environment. For example, introducing relatively unproven code involves risk, as already demonstrated

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in practice by a number of hacks and trading exploits carried out in the decentralized finance area. Smaller blockchains or private networks are subject to additional threats, such as a 51 % attack (when a person or group takes control of more than half of all the computing power or validation authority of a cryptocurrency network), which are practically impossible to carry out on the more established public blockchains. Regulatory risks stem from the divergence in regulatory approaches applied in different countries, and the unpredictability of potential changes in these frameworks. For example, while China has moved aggressively to stop the development of the crypto currency market, Singapore has actively incentivized crypto companies to create and offer regulated products. Unforeseen policy changes can of course threaten the profitability of ventures. Agility will therefore be the watchword of firms entering any new market as they build their business models and invest in technology. To mitigate the risk of change, financial institutions should consider implementing different operating and partnership models specific to the particular market.  

Conclusion – Merging strength with innovation Major financial institutions enjoy a recognized and trusted brand, vast reach and powerful balance sheets. They now have the opportunity to deploy these established strengths in various roles within the digital assets ecosystem. While they should remain aware of the associated risks, first-movers that manage to offer solutions to various key challenges, perhaps in partnership with fintech and crypto companies, are set to assume a powerful position in this fast-developing market.

Bernd Leukert

Data-driven Innovation in Financial Services – Opportunities and Prerequisites Data has always been the foundation for banks to conduct business and support clients. Whether it is an individual looking to invest, a company looking to raise capital, or a multinational looking to manage the many risks they face every day, it is always about the analysis and processing of data. The dynamics of digitalization and the emergence of future technologies such as big data, artificial intelligence and machine learning have given this topic a relevance that goes far beyond the way banks and their clients have traditionally approached data. During the pandemic we all have experienced an acceleration of digital strategies. Companies across the globe have needed to accelerate salesforce, procurement, and supply chain automation, invest in e-commerce, and enhance their use of big data, in an attempt to maximise their understanding of a rapidly changing landscape. And they have started exploring new business models, and looking to improve or reinvent existing ones, as a result of the opportunities from digitalisation.

Integrating financial services into digital business models of customers For financial services companies it means that they need to quickly adapt and provide the services and support to meet evolving client requirements. They should use the possibilities of modern technology to help their local and global customers reinvent their own business models. The aim is to integrate financial services into the digitized business models of customers. This covers areas such as eCommerce, Internet of Things and platform models. And it involves providing the necessary risk management and hedging strategies to protect our clients against risks such as market and currency volatility. One example from the industrial sector is new financing solutions based on usage. These so-called “Asset-as-a-Service” business models can be applied when companies no longer sell their machines, but bill them as a “service” together with maintenance, wear parts and insurance exclusively on a usage basis. Companies are beginning to see the benefits of such flexibility – during the pandemic, this would have been invaluable as machinery sat idle. Machine manufacturers https://doi.org/10.1515/9783111002736-002

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are adapting and embracing the benefits of regular payments rather than a lump sum up front. In the past, banks would have recommended machine leasing or machine hire purchase. Today, however, there are completely new possibilities for usage-based financing, because machines are networked with each other in the age of the Internet of Things and constant data exchange. A second example is “Embedded Finance”, which means the ingration of financial products and services into the digital applications of non-bank companies via application programming interfaces (APIs). This way banking becomes an invisible but ubiquitous part of every day life, for example when paying in online shops or taking out insurance or loans directly on the platforms of automobile or real estate providers. The novelty here is the idea behind this concept: As a bank, we’re moving closer to our customers’ worlds, enabling them to conduct banking transactions directly in their own environment. A third example is from the area of lending, especially in the context of financing eco-sustainable projects. Data about the customer’s energy consumption and the building details allow banks to lend “green” precisely. Likewise, access to weather data or cadastral information makes it possible to better assess the risk of building financing. These are just some examples. Overall the basic prerequisite for many innovations is the ability to manage, store and process the growing amount of data exchanged on a daily basis. As these examples demonstrated, this increasingly applies not only within companies, but also across company and industry boundaries. If data or insights can be shared with each other in a secure way, there is potential for the development of innovative services or new data-driven business models.

Three main principles to build an open data sharing economy To fully unlock the potential of data for the benefit of the economy, the consumer and the society as a whole, an open data sharing economy needs to be built on three main principles: First, it must place the user at its centre: Data-sharing, as well as competition are not goals in and of themselves. Innovative products should respond to customer needs and provide added value. The data economy should be seen as a way to increase a customer’s control on who they want to share their data with and for what purpose. Providing access to their data should become more simple and convenient for customers to enable their active and secure participation in a data economy.

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Second, it must be holistic: It is essential that data-sharing initiatives bridge existing sector barriers and avoid the creation of new silos to create a broader data economy as the full potential of the data economy can only be raised if you think holistically, across industries. Data is not only borderless in a geographical sense, but data that may be relevant for a financial product, for example for a green loan as mentioned above, can be held outside the financial sector and should therefore be taken into account. We need to understand the complexity of the subject, as well as the fact that some data are more sensitive than others. It makes sense, therefore, to look closely at the protection needs of the individual data areas and to take specific measures if necessary. Third, it must create fair conditions for all participants: The creation of a level playing field is crucial for competition in the interests of the customer. Creating fair conditions means looking at the relevant application and specific data, regardless of who holds the data. This principle should apply for horizontal as well as sector-specific initiatives. Finally, we should ensure we do not create disincentives: Companies often enrich or “add value” to data through complex processes or by combining it with other data. We therefore see the need to distinguish between raw data and processed data in order to protect intellectual property and not to discourage innovation.

The role of technology infrastructure To share data and unlock its potential, you need the right digital infrastructure. Cloud and AI technologies play a key role as they enable the secure storing, processing and analysis of data. The use of cloud service providers offers the opportunity to increase the stability and security of banks’ IT systems on the one hand, while reducing complexity and eliminating the need to operate own physical data centres on the other. Clients will benefit from products and services being developed and brought to market faster. The increasing relevance of technology infrastructure also requires a new understanding of how innovation is being developed. Especially for banks, the idea of partnerships and joint innovation is still somewhat new, but absolutely essential in order to keep up with technological developments. At Deutsche Bank we have established a strategic partnership with Google Cloud to take advantage of this technology and to be plugged into emerging technology trends such as artificial intelligence.

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Not only do we want to use state-of-the-art cloud services, but we also want to drive innovation together with our partner. We are combining our banking expertise with our partner’s technology know-how to jointly develop the next generation of technology-based financial products for our clients. The partnership will enable us to access AI solutions in the cloud directly and use them to develop new applications. The advantage is to be able to use future technologies such as AI as a service whenever we need them. By using artificial intelligence as well as state-of-the-art technologies for data analysis, the bank can react more flexibly and in a more targeted manner to the current trends and needs of its customers.

Regulation as enabler for data-driven innovation One further aspect is the role of regulation. While regulation can create barriers to innovation if too restrictive, regulation can also be an enabler if it creates a reliable and consistent framework that offers legitimation and necessary legal certainty for required investments. The following aspects are of particular importance: Cooperation: To reap the benefits from innovative technologies, the regulatory framework must find the right balance between innovation and risk and enable efficient partnerships between banks and technology providers, regardless of their location. Public and private sector must work together to realise the benefits of innovation and deliver solutions that respond to the needs of economy and society. Harmonisation: In the context of the data economy, we operate in a complex environment of financial, cyber and data protection regulation; often further complemented by national extensions (goldplating) and interpretations that make it difficult to roll out new products across borders. Focus on Data: Policy makers should focus on the aspect of safe and secure data management to enable companies for the of use data to drive better insights and decision-making. This requires a holistic approach – moving away from sectorspecific data silos towards a real data economy – with a clear focus on empowering the user to take control and actively decide who he wants to share data with and for what purpose.

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Conclusion: Banks to play an important role as trusted partners in a data sharing economy We have looked at the dynamics of digital transformation and the emergence of new data-driven business models, as well as what is required in terms of data sharing principles, technology infrastructure and support from a regulatory framework perspective. Banks play an important role in serving their clients and the economy by integrating their financial services into emerging digital busines models and driving innovation. There is also the aspect of trust; something that banks have built up over many decades and will be essential as part of the transition to a data-driven economy. Banks have long been specialists in providing secure custody of cash and personal valuables to their clients. Careful handling of sensitive data has always been part of their work and they are highly regulated, particularly when it comes to sensitive data. They can also assume this function in the digital world – a huge opportunity and obligation at the same time.

Wim Mijs

Banks in the Digital Space When discussing digital finance, banks are often referred to as “incumbents” – with an implied nuance that they have only just entered the digital space. In fact, technology and innovation have always been part of the DNA of banks. Ever since the late 1960s when the first ATMs appeared, banks have been using technology to improve their services, making their operations more efficient and expanding their geographic reach. However, looking at the digital space of the last 15 years, the difference is the unprecedented speed and scale of technological developments, which has shifted the focus of conversation to a more holistic digital transformation of banking. This includes the adoption of new technologies, building new services and new business models, and creating new ways of interacting with customers who are themselves becoming increasingly digital. It is also about dealing with new partners and operating in a financial ecosystem with a growing number of diverse actors, where outsourcing is more and more extensive and on multiple levels. This changing environment raises – sometimes fundamental – implications for banks that need to cope with new challenges and opportunities in order to inhabit the digital space successfully. One factor particular to the situation of banks is that their digital transformation is occurring within the framework of their wider inherent responsibilities. Notably, the responsibility in managing credit risk and in funding the economy, including its sustainable and digital transitions, in protecting consumers and in helping maintain financial stability. Discussing what incumbents need in order to operate in the digital space therefore also means not losing sight of the strategic context and the importance of a robust, well-funded banking sector. This article will examine what incumbents need in their ongoing digital transformation, using as examples an enabling legislative framework and the use of data. It will then look at newcomers to the financial ecosystem and how a shift in the mindset is needed when it comes to regulation on their part and finally, how the broader framework of banks’ responsibilities comes into play.

What do incumbents need in their ongoing digital transformation? As mentioned already, banks are not new to the digital space. Yet as the digital market and the financial services landscape continue to evolve, there are new ophttps://doi.org/10.1515/9783111002736-003

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portunities and challenges that arise which require response strategies to either seize or respond to them. I would like to zoom in on two factors that can affect banks’ digital transformation: a. The legislative and regulatory framework b. Access to and sharing of data

A. A legislative and regulatory framework that enables innovation In a heavily regulated sector such as banking, the regulatory and supervisory perspective is a crucial ingredient of the digital transformation. Banks need to innovate quickly and extensively to continue to satisfy customers with innovative, user-friendly, and secure products and services. In parallel, they need to remain compliant with regulatory requirements every step of the way in their digital journey and they need to compete with all the diverse actors in the financial ecosystem. Therefore, they need a legislative and regulatory environment that assimilates the new reality and adapts, that ensures fair competition, alleviates fragmentation and overlaps, and is proportionate. Fair competition is a particularly important factor, especially considering the entry of large technology companies into financial services. Acting as mixed-activity groups (providing both financial and non-financial services)1, they can trigger risks for fair competition, consumer protection, and financial stability. The size and scale of their services combined with the trends of (i) digitization of financial services, (ii) concentration of the digital ecosystem, facing embedment by large technology companies (BigTech), and (iii) increasing fragmentation of value chains can aggravate such risks. To address the possible risks posed by these new players, regulation needs to recalibrate towards the principle of “same activities, same risks, same rules, same supervision.” Meaning simply that irrespective of the entity providing a service, if that service entails the same risks as the same one provided by a financial institution, then it should be subject to the same rules and the same supervision. This is not something theoretical – there are concrete actions that regulators and policy makers can take to make it a reality. One such step is the extension of the regulatory perimeter.

1 EBA, EIOPA, and ESMA, Joint European Supervisory Authority Response to the European Commission’s call for Advice on digital finance and related issues, January 2022.

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Gaps in regulation and supervision of the activity of large technology platforms in financial services are a major obstacle to a level playing field between these actors and traditional financial institutions. Activities should be covered for all financial and non-financial service providers alike, based on the risk posed by the activity they undertake. Outside of the financial sector, horizontal proposals such as the European Union’s Digital Markets Act2 which address market conditions imposed by gatekeeping online platforms – impacting many sectors – are a major step forward. Alongside ensuring fair competition, alleviating regulatory fragmentation across the EU is also essential to banks being able to leverage new technologies and deliver services across borders, as is avoiding overlaps between horizontal and sectoral regulatory requirements. For example, a proposal has been put forward in the EU for a horizontal AI Regulation (the AI Act)3 which includes creditworthiness assessment among the high-risk use cases. Yet credit assessment in banks is already subject to a strict supervisory regime and banks have many years of experience with regards to granting credit to consumers and managing risks. Furthermore, existing sectoral regulation and supervision ensures consumer protection, risk management and financial stability in all services provided to customers regardless of whether those applications or services involve the use of technologies such as AI. Therefore, existing frameworks need to be taken into account to avoid duplication and potential overlaps for banks in ensuring the continued delivery of secure AI applications. Finally, any new rules should be proportionate, and principle-based, allowing a risk-based approach to innovation. The more prescriptive regulatory requirements are, the more difficult it becomes for banks and the financial sector overall to innovate. Building in flexibility allows to take into account the wide variety and rapidly evolving nature of new technologies, such as AI or cloud computing. The European Union’s Regulation (EU) 2016/679 of the European Parliament and the Council on the protection of natural persons with regard to the processing of personal data and on the free movement of such data, and repealing Directive 95/46/EC (General Data Protection Regulation) is an example of a framework taking a risk- based approach. Legislation is often seen as a barrier to innovation, but we shouldn’t forget that it also establishes the conditions to protect consumers, introduces measures

2 European Commission, proposal for a Regulation of the European Parliament and the Council on contestable and fair markets in the digital sector (Digital Markets Act), 2020. 3 European Commission, proposal for a Regulation of the European Parliament and the Council laying down harmonised rules on artificial intelligence (Artificial intelligence Act) and amendments to certain union legislative acts, 2021.

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to help secure the ecosystem and helps create opportunities for the development of new products and services. The latter is the case with the next “tool” for banks’ digital transformation that I would like to focus on – data.

B. Access to data When we look at what is needed to bring new experiences and services to banks’ customers – data emerges as a key element. But what data are we talking about? For the banking sector, the opportunity lies in combining data from different sectors – such as utility or telecom data or data from online marketplaces – with financial data to deliver new services to customers, both consumers and SMEs. For example, access (with their consent) to consumer and SME data on their energy use and mobility can help banks to facilitate green loans and provide better advice on sustainable investments, offering tailor-made proposals on financial instruments related to the Environmental, Social and Governance (ESG) sector. Here we see not only a potential for new service, but a use case that links to helping the sustainable transition as well. We also see a key point in the data sharing discussion – that the user must be in control. To enable use cases such as this one, a cross-sectoral data sharing framework that puts the user at the centre is needed. At EU level, initiatives have begun to open data in sectors such as for undertakings designated as gatekeepers under the Digital Markets Act4, IoT (Internet of Things) data under the Data Act5, health data under the Regulation on the European Health Data Space6 and possible upcoming legislation on mobility data; yet action in other sectors that would unlock data horizontally across all sectors is still missing. This is particularly worrying for banks considering the Commission’s intention to introduce an Open Finance framework at EU level. Such a framework that is proposed without first introducing concrete data sharing in more sectors will be a setback to banks’ digital transformation. Banks are already sharing payment account data, with the users’ consent, under the revised Payment Services Directive (PSD2)7. With Open Fi-

4 European Commission, Proposal for a Regulation of the European Parliament and the Council on contestable and fair market in the digital sector (Digital Markets Act), 2020. 5 European Commission, Proposal for a Regulation of the European Parliament and of the Council on harmonized rules on fair access to and use of data (Data Act), 2022 6 European Commission, proposal for a Regulation of the European Parliament and Council on the European Health Data Space, 2022 7 DIRECTIVE (EU) 2015/2366 OF THE EUROPEAN PARLIAMENT AND OF THE COUNCIL of 25 November 2015 on payment services in the internal market

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nance, they would have to open even more data – facing a deepening of the existing data sharing asymmetries. The Open Finance debate must therefore take place at the right timing and then it needs to look at how to build a framework that brings benefits to all market participants, including through a fair distribution of value and a level playing field. Without this consideration and without data access opportunities to more types of data in different sectors, banks would be at disadvantage in deploying their potential within a context of data-driven innovation.

Pitfalls for newcomers We have looked at what banks need for their ongoing digital transformation but where do newcomers sit in this picture? The digital transformation of banks is set against the larger backdrop of the digitalisation of the financial sector as a whole, which brings with it new players. They are often seen as more agile in the new digital environment – but to operate long-term in the ecosystem and to continue to deliver to customers, newcomers will need to ensure the same level of protection and security as the incumbents, also for the resilience of the ecosystem itself. This requires a shift in mindset among newcomers. Compliance and ensuring trust in the entire system should not be an afterthought but an essential element in their activities and operations for a secure digital transformation of the financial sector. They are not alone in this ecosystem and as the interconnectedness grows between incumbents, fintechs, new players (including big technology companies providing financial services) and ICT providers, having a common baseline of rules that all actors must adhere to is crucial. An example is security and resilience. With a surge of need for digital services, more newcomers may receive business opportunities. The financial ecosystem is as secure as its weakest link and it also becomes increasingly complex with the participation of different players; it is therefore essential that newcomers ensure as high levels of cybersecurity and digital operational resilience as incumbents and comply with the latest regulatory requirements. It is not only newcomers providing financial services that must undertake this responsibility, but also Third-Party Providers. The Commission’s proposal for a Regulation on the Digital Operational Resilience of the Financial Sector8 which in-

8 European Commission, proposal for a Regulation of the European Parliament and Council on digital operational resilience for the financial sector and amending Regulations (EC) No 1060/ 2009, (EU) No 648/2012, (EU) No 600/2014 and (EU) No 909/2014, 2020

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cludes a chapter on managing the risks arising from these providers is therefore welcome as it acknowledges the growing role they play and, overall, aims to set a common baseline of security for the entire ecosystem.

Digitalisation and incumbents – the big picture Banks continue their digitalisation within the context of a digitally transforming financial sector. Yet, this is not the only sector undergoing a digital evolution. Energy, agriculture, transport, manufacturing, (to name a few) are undergoing their own digital transitions with both large companies and SMEs taking steps to adopt new technologies and devise new ways of working. Alongside the digital transition, there is also the sustainable transition which actions like the European Commission’s Green Deal aim to support. For companies of all sizes to undertake the digital and sustainable transitions, funding is needed. Banks can – and are expected to – play a significant role here. However, to do so, there must be a robust and well-funded banking sector in place. This is of strategic importance and should be factored in discussions on the digital transformation of the financial sector as well when it comes to the regulatory framework. While undergoing their own transitions, banks need to have the conditions to support the twin transition too. If these conditions are missing, this could impact the growth of the digital economy – including funding for new players to enter and for incumbents to continue their own digital journey. Banks have long inhabited the digital space. They are adaptable and ready to continue delivering. To do so, there must be a regulatory framework that supports delivery of new and secure services, powered by new technologies. It must also ensure that all actors in the financial ecosystem, including newcomers, adopt a mindset which is not compliance averse, but instead recognizes the responsibility of all players to foster trust. Finally, regulators and policy makers must factor in the larger role that European banks are expected to play in funding the digital transition of all sectors, together with the sustainable transition, when considering any new sectoral regulation. Getting it right means providing the regulatory and legislative environment where banks can continue to deploy their potential and thrive in the digital space.

II. Technology and Regulation: Are we Focused on the Right Things?

Ashley Alder

Coordinating the regulatory approach to the new technology wave The use of technology in financial services significantly accelerated as COVID-19 spread around the world starting in early 2020. With lockdowns and work-fromhome arrangements, firms were forced to make major adjustments to how they operate and interact with clients. This was accompanied by the increasing popularity of crypto-assets and “meme” stocks among retail investors. From the perspective of financial regulation, these developments raise three major areas of concern. In order of increasing difficulty, they are: operational risks in trading venues and market intermediaries; risks associated with outsourcing, and risks related to decentralised finance, in particular crypto-assets, including stablecoins. The novel, unique nature of these risks calls for a highly coordinated global regulatory response.

Operational resilience The shift to a remote working environment severely tested the operational resilience of financial markets and intermediaries, putting pressure on regulated entities’ business continuity planning, crisis management, cybersecurity measures and supplier arrangements. In January 2022, the International Organization of Securities Commissions (IOSCO)1 published a report on lessons learned during the pandemic2 which concluded that despite unprecedented difficulties, regulated entities largely proved to be operationally resilient and were able to continue to serve their clients and the broader economy. However, their resilience depended as much on their processes and personnel as on the technological solutions they deployed. To promote good practices, the report identified some potential issues and areas for improvement, including the importance of testing business continuity plans across a wide variety of scenarios, even those which are unlikely, as well as the need to establish processes for information security, preventing cyber-attacks,

1 IOSCO is the international body which brings together the world’s securities regulators and is recognised as the global standard setter for the securities sector. IOSCO develops, implements and promotes adherence to internationally-recognised standards for securities regulation. 2 Operational resilience of trading venues and market intermediaries during the COVID-19 pandemic, IOSCO Consultation Report, January 2022. https://doi.org/10.1515/9783111002736-004

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and ensuring that internal surveillance and control functions are properly carried out in the dispersed, work-from-home environment. For regulators, operational risk presents a relatively straightforward challenge. Regulated entities are carrying out the same activities they always have, albeit in different ways. However, new ways of working may persist, to varying degrees. The regulatory response must centre on the appropriateness of expectations around how regulation intersects with the changing work environment.

Outsourcing A related issue, which is more challenging, involves the risks arising when activities traditionally carried on by financial institutions within the regulatory perimeter are outsourced to entities which may not be regulated or which fall outside the regulatory perimeter. This can raise serious concerns about compliance and risk management. In addition, concentration risks may arise if the total number of third-party service providers is small. Substitutability will be limited and firms’ ability to negotiate and monitor the services they outsource may be affected. IOSCO’s Principles on Outsourcing3 outlines ways regulators can deal with these issues. It sets out expectations for due diligence in selecting and monitoring service providers and their performance as well as for confidentiality, concentration risk, termination of outsourcing arrangements and access to data and associated rights of inspection for due diligence purposes. The overarching principle is to adopt a technology-neutral approach and give regulated entities flexibility according to the size, complexity and risks of the activities they outsource. Under this approach, regulated entities are fully responsible and accountable to the regulator, effectively to the same extent as if the services were provided in-house. In Hong Kong, we dealt with an aspect of this involving the degree to which a financial services firm interacts with a cloud service provider, and how we, as the regulator charged with supervision and enforcement, can access information in the cloud. This illustrates a basic problem. Securities regulators operate on a jurisdictional basis and expect regulatory data to be kept in the jurisdiction, so that it is readily available for regulatory purposes such as investigations. However, this could be complicated if the information is kept outside the jurisdiction, and possibly in the cloud, or dispersed across multiple jurisdictions.

3 Principles on Outsourcing, IOSCO Final Report, October 2021.

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Our solution again centred on the responsibilities of the licensed firm. This, however, raises a question: are we straining the system by putting too much emphasis on regulated firms, rather than addressing head-on the issue of whether activities outsourced to technology contractors are in essence financial services which need to be regulated directly? This strain will only be exacerbated as technology continues to evolve over time.

Decentralised finance An even more difficult challenge is decentralised finance, and crypto-assets in general. This is a rapidly evolving sector and it is growing fast. The global crypto market at one point exceeded US$3 trillion and it has quickly evolved to mirror the features of conventional financial markets. In some areas, there are significant touch points with mainstream finance. However, although many activities are closely similar to those provided by traditional financial services, they are delivered in dramatically different ways. This is now a prime area of interest for regulatory authorities around the world. A major challenge is the global, shape-shifting aspect of many crypto businesses, which may be able to reconstitute their structures to move flexibly between regimes and across jurisdictions. With their cross-sector, cross-border nature, they do not sit well within existing regulatory frameworks. Some big firms have tried to pre-empt stricter rules by advancing their own proposals to press for self-regulation. Others have argued for new regulation specifically tailored for them. The question is who adapts to what—should the industry adapt to regulation, or should regulation adapt to the industry? A long list of issues is associated with that. The most prominent is how decentralised finance tries to replace trust in controlling institutions with public trust mechanisms with—ostensibly—no human point of control. This makes it difficult to establish a regulatory nexus as there is no place where regulation can easily attach for the purposes of supervision and accountability. Second is crypto’s propensity to be borderless and rapidly change structures to move between regulatory regimes and across jurisdictions. This means regulators spend a lot of time running to catch up, but never quite do. The combination of cross-border and cross-sectoral issues, and the core problem of decentralisation, will require a new regulatory response. Regulators around the world increasingly recognise that not acting is not an option, and in fact urgent measures are called for. They have adopted a range of approaches, from an outright ban on crypto-assets to light-touch regulation. Both Singapore and Spain have issued rules on crypto advertising.

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It is up to each jurisdiction to determine in its own context whether and to what extent to allow crypto-asset activities in its jurisdiction. But the unique nature of these problems calls for an international, consensus-driven approach which is tailored to them. It would be far from ideal if firms can buy their way into a lighter-touch jurisdiction, without rigorous compliance, to push products globally. This has the potential for extreme levels of regulatory arbitrage.

Stablecoins International regulators are keeping an especially close eye on stablecoins, which are crypto tokens based on a basket of underlying assets. A stablecoin arrangement could involve multiple activities or entities, each performing a different function, such as issuance, redemption, stabilisation or trading. This raises a variety of regulatory issues, from anti-money laundering through to competition, lack of transparency, and the absence of redress mechanisms. Some stablecoin arrangements may have novel features compared to traditional financial market infrastructures. Given the way stablecoins are structured, it may be very challenging for them to comply with the prevailing standards— using the “same business, same risks, same rules” approach—without reforming themselves. An analysis carried out by the Committee on Payments and Market Infrastructures (CPMI) and IOSCO found that we do not need a completely new set of standards to address risks arising from some activities in stablecoin arrangements4. The subsequent CPMI-IOSCO consultation report provides guidance on how the existing Principles for Financial Market Infrastructures (PFMI) could apply to systemically important stablecoin arrangements which perform a transfer function5. We are mindful that there are some things stablecoins do which may not be fully covered by the PMFI and fall outside of the remit of the CPMI-IOSCO. The purpose of our work is to help stablecoin operators structure their schemes in a way that does not lower standards or create new risks to financial stability—and to ensure they compete on a level footing with other payment services providers.

4 Regulation, Supervision and Oversight of “Global Stablecoin” Arrangements, Financial Stability Board Final Report and High-Level Recommendations, 13 October 2020. 5 Application of the Principles for Financial Market Infrastructures to stablecoin arrangements, CPMI-IOSCO Consultative report, October 2021.

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Trading platforms Another area which may present serious, fundamental concerns for regulators is crypto-asset trading platforms. These perform many of the functions associated with securities brokers and exchanges, but with little or no regulatory oversight. Key concerns relate to access to the platform and on-boarding, safekeeping of participant assets, such as custody arrangements, and the identification and management of conflicts of interest. Other concerns include transparency and market integrity, including the rules governing trading on the platform, and how those rules are monitored and enforced, and price discovery mechanisms. In 2020, IOSCO issued a final report setting out key considerations to assist regulatory authorities in evaluating crypto-asset trading platforms within the context of their regulatory frameworks6. It noted that many of the specific regulatory concerns about these platforms are common to traditional securities trading venues, but may be heightened by the business models used in crypto trading. This global perspective is directly relevant to what we are doing in Hong Kong, which is an international financial centre and an open market. The situation we face in Hong Kong is that investors can trade crypto whether or not we regulate it. We chose to regulate crypto-assets and began by focusing on trading platforms, which are by far the most prevalent crypto point of entry for the public in our jurisdiction. The difficulty we face as the market regulator is that we regulate securities and futures, but most crypto-assets do not fall within these definitions. As a starting point, we introduced a licensing framework for centralised crypto trading platforms operating in Hong Kong and trading at least one type of crypto-asset which falls within the definition of “securities” or “futures contracts” under our securities law. As the next step, we are introducing a new regime for centralised crypto exchanges to be licensed under our local anti-money laundering laws. This will enable compliance with the standards laid down by the Financial Action Task Force Recommendation 15, which requires member jurisdictions to impose on crypto service providers the anti-money laundering obligations which now apply to financial institutions. The regulatory requirements under the new regime will, however, go beyond anti-money laundering and be on par with those for securities brokers and automated trading venues. The two regimes will work in parallel: platforms which

6 Issues, Risks and Regulatory Considerations Relating to Crypto-Asset Trading Platforms, IOSCO Final Report, February 2020.

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trade non-security tokens should only apply for a licence under the proposed antimoney laundering regime, whilst platforms which trade security tokens or a mixture of security and non-security tokens would be regulated under the securities law.

Closing the gaps This is just one example of the work regulators are doing to retrofit regulation or match the way the crypto world is evolving. “Same business, same risks, same rules” is clearly the right approach, but it will not be wholly sufficient and the principles already in place will need to be supplemented by further guidance. Close collaboration and coordination amongst regulators is important to cover the potential gaps and address all the risks in a consistent and coherent manner. International standards and guidelines such as the PFMI and the IOSCO report on crypto-asset trading platforms provide individual jurisdictions with internationally agreed baselines to consider when developing their regulatory response to the emerging risks. The risks are clear and we have seen them time and again, at least in the aftermath of the 2022 “crypto winter”. Global efforts are focusing on the right things, but more work is needed to find all the answers.

John Berrigan

Who is afraid of the Blockchain? Towards a new EU Approach to Financial Regulation Financial regulators must be adept at handling the speed, complexity and interconnectedness, which characterize a modern financial system. The principles and rules to ensure the stability and integrity of the system must be designed accordingly. In designing such principles and rules, regulators sometimes anticipate risks and challenges but often they must learn from mistakes. Since the great financial crisis of 2007/2008 – probably the most significant failure in regulation for decades – regulators across the globe have put in place a comprehensive framework for managing financial-system risks. They continue to adjust that framework to respond to new challenges. Nevertheless, this framework reflects a particular understanding of how the financial system functions. The ongoing process of digitalization, which has accelerated during the Covid-19 pandemic, now questions that understanding and raises important questions about how the financial system will function – and must be regulated – in the future. Digitalization means that the financial system is becoming even faster moving, more complex and more interconnected, dramatically changing the context in which regulators must work. Digital finance offers the prospect of great innovation and technical progress. Value chains are being disrupted, giving rise to new business models, products and whole asset classes. This new way of engaging with the financial system holds great potential for businesses and citizens, who stand to benefit from more tailored and intuitive products and services. Digital finance also promises to increase efficiency and drive down costs, as well as giving a boost to financial inclusion. Rarely have we seen so much financial innovation achieved in such a short time. The EU must embrace digital finance and leverage the Single Market to deliver a modern and resilient financial system that is fit for the rest of this century. In grasping these opportunities, however, we must also be mindful of the associated risks and adapt the regulatory framework accordingly. As ever, the key will be to maximize the benefits of digital finance, while mitigating the risks. The EU Digital Finance Strategy, adopted in September 2020, reflects this approach. It sets out to harness innovation in finance – not naively, but in a balanced manner, creating legal certainty that enables progress, while managing the risks. The following are a few examples of the EU approach. First, the Commission has tabled a new regulatory framework for markets in crypto assets, including so-called stablecoins. Fully in line with international consensus, the proposed framework will introduce clear rules for issuers and service providers of crypto assets. In this way, issuers and service providers will enjoy the https://doi.org/10.1515/9783111002736-005

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legal clarity they need to develop and offer new, innovative products, while the risk of abuse, fraud and instability will be addressed. We are pleased that Member States and the European Parliament have found a political agreement on the framework. Given how rapidly crypto markets are evolving, it is essential to have these rules in place as soon as possible to allow these markets to thrive further. Second and closely linked to the first example, the Commission has proposed a pilot project for market infrastructures based on distributed ledger technology. Open to market participants from early 2023, the pilot project will create a safe space for market players to experiment with issuing, trading and settling shares or bonds using blockchain technology. The project is a good example of how the EU is approaching the new world of digital finance: moving early, based on discussions with our partners around the globe, and striving to learn by doing. We look forward to seeing how market players will use this opportunity. Following a thorough assessment and based on experience gained, changes to the EU legislative framework may be needed. We – as regulators – will need to identify where we need to act without choking off innovation. More specifically, we will need to ask ourselves if we have the right approach, the right tools and the right resources. Third, the Commission has proposed the Digital Operational Resilience Act (DORA), a legislative initiative applying to the entire financial sector, which is now also in negotiations between Member States and the European Parliament. Cyber incidents may quickly spread across financial markets and borders. This can threaten financial stability. It is key to strengthen the cyber resilience of firms in the financial sector, so that they can resist cyberattacks and continue to function without disruption. DORA includes rules to boost the overall cyber security and resilience of financial firms, with requirements to identify and mitigate risks, test their capabilities, and report incidents to supervisors. Our regulatory objectives in respect of these three examples are rather standard – to optimize performance of the financial system, while preserving financial stability, safeguarding market integrity and protecting investors. However, the traditional approach of reaching these objectives by means of filling identified regulatory gaps and by focusing on neatly-defined entities, activities, products or sectors seems increasingly ill-suited to the new financial system we see emerging. Crypto-assets reached a combined valuation of around EUR 2.5 tn in November 2021, marking a new all-time high, equivalent to five times the previous high in 2018. With the recent downturn, total market capitalisation has dropped below EUR 1 tn. Yet rapid change in the system continues, as a seemingly endless stream, as a seemingly endless stream of new offerings enters the market and new technologies allow for much greater speed in trading. Moreover, traditional jurisdictional and market-based borders are increasingly blurred. All of this makes it harder for regulators to perform their tasks.

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As digitalization creates a financial system that is ever more complex and less transparent, we also need to deal with fundamental questions related to governance and control. How effective is disclosure-based regulation in an environment where digital assets are created and layered in complex digital structures? How do we achieve transparency and accountability in an environment that is increasingly disintermediated? In addition, for all the talk of decentralized finance, how do we guard against the risk that market power ends up being concentrated in the hands of a few market participants, such as crypto currency infrastructure owners, platform operators or software developers? As regulators, we must ensure that we do not fall behind and leave control over technology to market participants alone. We need to be agile as regulators, rather than being left to catch up. This may mean looking at the way we take decisions. In the EU, regulatory processes ensure that our rules are technically sound, that all interests are heard and that we find balanced solutions. However, these processes can be slow, and they may be too slow for a rapidly changing financial system. We might need to find creative ways of speeding up, while preserving the strengths of the current system. It is not only about being more agile. It is also about taking the initiative. The EU’s work on a potential digital euro is a good example of this. The Commission is working jointly with the European Central Bank to explore the policy, legal and technical issues linked to the possible introduction of a digital central bank currency. We stand ready to table a legislative proposal, which is necessary to achieve political consensus and full legitimacy for a possible digital euro and its key features. Financial stability, market integrity and privacy are just some of the key points we will need to tackle. In addition, we will need to ensure that a digital euro provides added-value and enables citizens to participate fully and safely in the new financial system that is emerging. Another important shift we need to make is towards an approach that is structural, rather than focused on intermediaries or transactions. This will include looking at businesses and developments outside “traditional” financial markets. We have started to do this as technology firms – big and small – have become increasingly active in finance. The Commission has recently received a detailed analysis from the European Supervisory Authorities of how the increasing activity of technology firms affects risk. Based on their recommendations we will need to assess carefully whether legislative steps are necessary. However, this kind of cross-sectoral work has much further to go. Financial regulators and supervisors will increasingly have to look outwards and collaborate with other kinds of regulators, such as data protection authorities or anti-money laundering bodies. We also need a much stronger cooperation at international level, where the EU is already active in working towards synergies when it comes to issues like stablecoins or cybersecurity. International cooperation is something the EU has long

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championed both in multilateral fora and in our bilateral relationships. Here again, on the global stage, financial regulators must stand ready to co-operate closely with other sectoral regulators who often operate in areas where international collaboration is not so well established. To stay on top of developments, regulators and supervisors will also need to be armed with the right technological resources and skills. This is essential if we are to keep up with and understand what is happening in the markets. In addition, it is a key precondition for setting and enforcing rules in a constantly changing environment. We are only starting to build this new capacity at EU and national level. The Commission is pleased to support this effort, for instance, with a new supervisory academy focusing on digital finance that is set to launch later this year. But, much more will need to be done. Old certainties are falling by the wayside as the future of finance emerges, in places beyond recognition. It is an exciting moment for market participants and their customers – and a crucial one for regulators. To make the most of innovation, while staying in control, we must re-learn our trade and re-boot our approach. Digitalization is handing us perhaps our biggest challenge yet. Let us make sure we rise to it.

Michael J. Hsu

Adapting to the Digitalization of Banking and Finance The banking and finance industry, like others, is undergoing a digital transformation. This is affecting business models, introducing new competitive pressures, and raising questions about the future of banking and banking regulation. Banking organizations in the United States operate under a mixture of permissive and restrictive standards. The first of these standards involves a grant of rights and privileges to certain entities, e. g. banks, to engage in the business of banking, often by means of a charter. The second involves limitations on those rights and privileges which restrict the activities that the chartered entities can engage in and subject the entities to oversight and supervision. Taken together these permissive and restrictive standards form what in banking speak we term a “regulatory perimeter” around the banking sector. Entities within the “banking” perimeter operate under these permissive and restrictive standards, while those outside the perimeter, operating in the territory of “commerce,” may be subject to some laws and restrictions but not the same mixture of grants and limitations as those within. This dichotomy creates a natural tension resulting from a mixture of outward and inward pressures on the perimeter as firms outside the perimeter begin to engage in activities traditionally within the perimeter, while banks within the perimeter advocate for parity. This pressure can lead to reforms to the perimeter, but those reforms often arise as a result of crisis or failure.1 Although recent discussions of the regulatory perimeter in the United States would draw a distinction between “entity-” and “activity-based” regulation, it is perhaps more useful to view U. S. financial regulation as “categorical.” Congress often confers regulatory jurisdiction based on a set of categories (e. g., bank, credit union, deposit broker), which may be based on a combination of activity- and entity-based factors. In “A Brief History of the U. S. Regulatory Perimeter,” Tabor et al. sum up the last 150 years of financial regulation according to this rule: “Because you do, you are; and because you are, you do.”2 Today’s regulatory perimeter is “broader, more complex, and arguably more permeable than at any point in its history.”3 In the U. S. alone, there are several  

 

 

 

 

1 Tabor, Nicholas, Katherine Di Lucido, and Jeffrey Zhang “A Brief History of the U. S. Regulatory Perimeter,” (August 2021), 1, retrieved from https://www.federalreserve.gov/econres/feds/abrief-history-of-the-u-s-regulatory-perimeter.htm. 2 Ibid., 1. 3 Ibid., 29.  

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hundred statutory categories into which an entity could fall. Hence, almost any person or entity offering financial services would likely come under some degree of oversight. That being said, a firm that selects its legal form and tailors the scope of its activities with these categories in mind could choose to subject itself to some forms of regulation instead of others. The rapid digitalization of banking has amplified the challenge this type of regulatory arbitrage poses to regulators seeking to manage the risks facing the financial system. History and research warn us that unregulated banking ends badly. Indeed, the origins of the Office of the Comptroller of the Currency, Federal Reserve, and the Federal Deposit Insurance Corporation, as well as of many state banking agencies, can be traced back to financial panics and destabilizing runs resulting from unregulated or poorly regulated banking.4 Building on my comments as a panelist for the ILF conference and my prior speeches on the topics, this article discusses two areas where I believe regulators must continue to focus their efforts—financial technology, or “fintech,” and cryptocurrencies, or “crypto.” Overall, I believe regulators today understand the challenges fintech and crypto pose and are focusing on the right things. However, it is imperative that all regulators remain vigilant and operate from the same shared compass. Only then will regulators be able to avoid jurisdictional biases that would otherwise assert themselves.

Fintech Banking has traditionally consisted of three bundled activities: taking deposits, making loans, and facilitating payments. Banks’ role in providing these services together is what makes banks “special” and thus needing supervision and regulation.5 The bundling of these three activities enables banks to intermediate credit, transform liquidity, and support the economy. It also makes banks highly leveraged, highly confidence-sensitive, and highly interconnected. A run or stress at one bank can cause instability across the financial system. For these reasons,

4 See Conti-Brown, Peter, and Sean H. Vanatta, The Banker’s Thumb: A History of Bank Supervision in America [Cambridge, MA, forthcoming], Introduction and Chapter 1; Menand, Lev, “Why Supervise Banks? The Foundations of the American Monetary Settlement” (October 17, 2019). 74 Vanderbilt Law Review 951; Mitchener, K., & Jaremski, M. (2015). “The Evolution of Bank Supervisory Institutions: Evidence from American States.” The Journal of Economic History, 75(3), 819– 859. 5 See Annual Report of the Federal Reserve Bank of Minneapolis, Annual Report 1982 : Are Banks Special, FRASER, St. Louis Fed (stlouisfed.org).

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banks are subject to prudential regulations, like capital and liquidity requirements, and to supervision, which is unique among private corporations.6 In the early 2010s, fintechs began to unbundle the payments leg, offering goods and services aimed at improving customers’ payments experiences. By and large, such competition has been healthy and beneficial for consumers and businesses. The largest payments fintechs have not stopped there, however. Many have augmented their platforms and expanded into adjacent areas, such as extending various forms of credit and offering interest on cash held.7 Today, a range of fintechs provides seemingly the full suite of banking and investment services—including in cryptocurrencies—with the convenience of technology. These fintechs are reassembling the three legs of banking synthetically, outside of the bank regulatory perimeter. I have referred to this in previous speeches as “synthetic banking.” Given the growth of the fintech industry, I believe we are rapidly approaching the point where we need to define what synthetic banking is. In the words of Tabor, “Because you do, you are.”8 What exactly constitutes “doing”? Where should that line be drawn? By providing that clarity now, we may avoid having to define it after a crisis or failure. To answer these questions, we cannot just focus on bank activities in isolation. We also must consider the nature of fintech-bank “partnerships.” These arrangements enable fintechs to offer banking services to customers—facilitating payments, holding deposits, and offering credit—and often customers are unable to distinguish between providers. Modernizing the bank regulatory perimeter cannot be accomplished by simply defining the activities that constitute “doing banking,” but will also likely require determining what is acceptable in a bank-fintech relationship. Focusing on these bank-fintech relationships poses two major challenges. First, there is a wide range of these arrangements, which prevents regulators from painting with too broad a brush. And second, these relationships are constantly changing. The combination of these challenges makes it very difficult for regulators to come up with taxonomies to address bank-fintech relationships without those taxonomies quickly becoming outdated. So how should we focus on addressing these challenges? Understanding the evolving business models of fintechs and bank-fintech relationships can help us identify the risks and dependencies that underlie bank-fintech relationships, as well as the expected consequences that could result should things go wrong. 6 See Why Are Banks Regulated?, St. Louis Fed (stlouisfed.org). 7 See The Battle For Your Deposits Intensifies And That’s Good News For Savers, Bankrate.com (bankrate.com). 8 Tabor, Di Lucido, and Zhang “A Brief History of the U. S. Regulatory Perimeter,” 1.  

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Understanding the business models begins with understanding who the customer is. “Who is the customer?” is not always an easy question to answer depending on the particular fintech company or service in mind. We have traditionally understood that banks earn their cost of capital based on the services and goods they provide. With technology and fintechs, there can be the approach of capturing user data first and monetizing later. These are two drastically different approaches and have implications for risk taking and the consequences that can result. We must also understand, “Who is providing what to whom?” and “Who is accountable for what?” In some bank-fintech partnerships, the bank could rely on the fintech to provide a particular service or conduct a particular activity, but the bank remains the customer-facing entity. In others, it could be reversed, with the fintech being the customer-facing entity and relying on the bank to perform a particular function. To the customer, it may be difficult to distinguish what company is performing which service, or even that there are two companies at all. Understanding the dependencies that arise in either circumstance is key to understanding what the risks are and ultimately understanding the answer to the question, “Who bears the risk of loss if things go wrong?” And perhaps the most important question we must ask ourselves is, “What are the consequences of a loss of trust?” In the earlier days of our nation’s regulatory history, a loss of trust in the financial system led to crippling and destabilizing bank runs. Could a loss of customer-trust in a bank-fintech partnership lead to a similar panic-induced run? Or would it result in mere inconvenience? Or would it be somewhere in between? Regulators must continue to work through these difficult questions. A regulatory approach focused on understanding the evolving business models of bankfintech relationships can help regulators identify and manage the risks that fintechs pose.

Crypto Related to the topic of fintech are the issues surrounding crypto. In many ways, the two go hand-in-hand. Crypto’s growth, and its rapid mainstream adoption has been nothing short of astounding. In just five years, the total market capitalization of all cryptocurrencies has grown from around $100 billion to over $2 trillion. With the simple click of a button, any internet user can invest in over 12,000 different cryptocurrencies, purchase digital art and collectibles through non-fungible tokens (NFTs), and buy “property” in the metaverse. And they can do so through the hundreds of organizations that have emerged to service this rapidly

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growing market. Credit and debit card issuers are offering Bitcoin rewards programs and facilitating crypto payments.9 Large corporations, like Tesla, PayPal, and Starbucks, are starting to accept cryptocurrency payments.10 Several publicly traded companies now hold Bitcoin in their investment portfolios.11 Crypto has also gone mainstream with consumers. Sixteen percent of U. S. adults say that they have owned, traded, or used some form of cryptocurrency.12 Notably, the underbanked and minorities have been especially interested in crypto. One survey found that 37 percent of the underbanked indicated that they own cryptocurrency, compared to 10 percent of the fully banked.13 A report from The Harris Poll stated that 18 percent of Blacks and 20 percent of Hispanics reportedly own crypto.14 Today, regulators are focusing on the nexus between the crypto space and traditional banking and finance. This is most evident in the attention that regulators are giving to stablecoin, but also arises in the contexts of finder activities and trading. Stablecoins have received the most attention from regulators worldwide15 because they effectively bridge the crypto and fiat worlds. Serving as a blockchain medium of exchange on crypto trading platforms, stablecoins currently play a critical role in supporting and facilitating rapid growth in decentralized finance (DeFi). Stablecoins also provide a good example of why regulators’ longer-term focus should be on identifying the trust vulnerabilities that crypto brings with it. Currently, crypto users trust that the largest stablecoins are stable and equivalent to fiat—that is, the holders of USD-backed stablecoins believe they can redeem their stablecoins for U. S. dollars on demand, at par, with no questions asked.16 This  

 

9 See Upgrade’s Bitcoin Rewards Program; PYMTS, “Mastercard, Voyager Team to Make USDC Stablecoin Spendable and Mainstream”; NerdWallet, “7 Credit Cards With Crypto Rewards.” 10 See Reuters, “Tesla Will ‘Most Likely’ Restart Accepting Bitcoin as Payments, Says Musk”; “7 Companies Where You Can Pay With Crypto” (fool.com); “10 Major Companies That Accept Bitcoin” (yahoo.com). 11 See BeInCrypto.com, “Top 11 Public Companies Investing in Cryptocurrency.” 12 See Pew Research Center, “16 % of Americans Say They Have Ever Invested In, Traded or Used Cryptocurrency.” 13 See Morning Consult, “Banking the Unbanked Requires Raising Trust and Awareness. For the Underbanked, Better Service Means Payments Innovation.” 14 See The Harris Poll, “Speculative Investing,”March 2021. 15 See Basel Committee on Banking Supervision June 2021 Consultative Document; President’s Working Group on Financial Markets, Report on Stablecoins(PWG Stablecoin Report); Financial Stability Board (FSB), “Regulation, Supervision and Oversight of ‘Global Stablecoin’ Arrangements”; European Central Bank speech by Fabio Panetta, “The two sides of the (stable)coin.” 16 See Gary Gorton and Jeffery Zhang, “Taming Wildcat Stablecoins.”  

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trust is similar to the trust depositors have in their ability to withdraw their money from their bank on demand, at par, with no questions asked. Because there is trust, there is no need for stablecoin holders to actually redeem their stablecoins for fiat. They can focus on other things—which is the point. What if, however, that trust were to waver or be lost? Stablecoin holders, knowing that the first to redeem would have the highest chance of getting their money back, would rationally redeem immediately. It would not matter if the stablecoin issuer’s reserve could actually cover the redemptions or not—the attention of stablecoin holders would shift from the issuer to the behavior of other holders and a run would ensue. This dynamic played out in the 2008 financial crisis across banks, securities firms, structured finance vehicles, and money market funds. The vulnerabilities that lead to a run generally do not appear suddenly. They build up over time and are largely ignored, until a small group of participants sense the tail risk, get nervous, and quietly begin to edge away. In the months leading up to Bear Stearns’ demise in early 2008, “smart money” investors—at the time, certain large hedge funds—tried to quietly edge away from Bear by novating their trades to stronger banks. They didn’t want to spark a run, but they did want to cut their exposures before everyone else pulled away. Those moves, of course, raised flags for the market and by mid-March, Bear was enduring a full-blown run. Stablecoins today are at risk of being subject to such dynamics, especially stablecoins with questionable or opaque reserve management practices. As long as there are inflows into crypto, nothing is likely to happen. At some point, however, those flows will slow and then reverse. As Warren Buffet famously quipped, “It is only when the tide goes out do you discover who’s been swimming naked.” In the context of payments, stablecoins also present many of the same risks as traditional payment systems. These payment risks may manifest in novel ways depending, among other things, on the technologies, transaction processes, and governance structures of a particular stablecoin arrangement.17 The President’s Working Group Stablecoin Report states these risks also reveal their own potential trust vulnerabilities because when not managed comprehensively, they “can make payment systems less available and less reliable for users, and they can create financial shocks or operate as a channel through which financial shocks spread.”18 As regulators, we must focus on identifying the trust vulnerabilities crypto presents and understanding the consequences that would result from a loss of

17 President’s Working Group on Financial Markets, Report on Stablecoins(PWG Stablecoin Report), 12–13. 18 Ibid., 12.

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trust. Contrary to what some may say, crypto is not “trustless.” There are many intermediaries in crypto. Successful regulation of crypto will involve identifying those intermediaries and understanding their related dependencies.

A Shared Compass The need for a coordinated and collaborative regulatory approach has never been greater than it is today. As the crypto industry expands and linkages with the real economy and financial system grow, the consequences of a loss of trust—especially for consumers, traditional financial intermediaries, and the broader economy—are of increasing concern to regulators tasked with the responsibilities for ensuring a safe, sound, and fair financial system. The increasing growth and span of activities of large crypto intermediaries make the need for improved collaboration and coordination particularly acute. The largest crypto firms and platform operators today have tens of millions of users and handle hundreds of billions of dollars of transactions every month.19 Yet, in the U. S., none is subject to comprehensive consolidated supervision where a single authority has a line of sight into the entirety of an intermediary’s activities. This means there are gaps in supervision, and risks can build out of the sight and reach of regulators. A typical corporate structure will have a holding company over a number of subsidiaries, some of which may be regulated, others of which will be unregulated. As these companies expand, engage in a wider range of activities and risk-taking, and deepen their interconnectedness with the traditional financial system, the risks from this lack of comprehensive consolidated supervision will increase, as will the need for interagency (and international) collaboration and coordination. The fragmentation of supervision may not be a problem we can solve overnight. However, to the extent various regulators rely on the same shared compass to navigate our way through the important questions that fintechs and crypto pose, we can overcome our jurisdictional biases and arrive together at the same destination, a safer and more secure financial system.  

Acknowledgement: I am grateful to John Carse for his assistance in preparing this text.

19 For example, see Key Business Metrics, 48, Coinbase Global, Inc. Form 10-Q for the quarterly period ended September 30, 2021 (Coinbase – Financials – SEC Filings).

III. Central Bank Digital Currencies: Cui Bono?

Ulrich Bindseil

The Case for and against CBDC – five Years later Abstract: The pros and cons of central bank digital currencies have been debated intensively since 2016. This paper reviews both the recent arguments in favour of CBDC emphasised by central banks preparing to issue CBDC, and the persistent concerns on CBDC, distinguishing a “dismissive” and a “fearful” perspective. Regarding the latter it is argued that the risks associated with CBDC can be mitigated by an adequate design. It is concluded that central banks should eventually react to the digitalisation of payments through CBDC issuance, even if not necessarily in the very near future, and that they should not give up the important role they had for so long in retail payments.

1. Introduction The pros and cons of central bank digital currencies have been debated intensively since 2016. For decades, no other topic in central banking has emerged so quickly to raise so much attention and is expected to stay. Also, no other idea is expected to change central banking as much in the coming decades as CBDC. This paper focuses on the recent debate on the pros and cons of CBDC, i. e. essentially the state of the debate in 2021. It first recalls key arguments in favour of CBDC provided by central banks preparing to issue CBDC. It subsequently reviews in detail the recent formulations of key concerns on CBDC, distinguishing two perspectives, named the “fearful” and the “dismissive” one. The note also recalls that quite some dismissive arguments against CBDC relate to features or objectives of CBDC that central banks never advocated. It is argued that all fears regarding CBDC can be addressed by an adequate design of CBDC. It is concluded that it is hard to imagine that central banks will not react to the digitalisation of payments and continue for ever relying exclusively on 17th century technology1 in their money supply to citizens, such as to lose, at the detriment of society, the important and successful role that they had for so long.  

1 Central bank money on paper (“banknotes”) were invented in the 17th century, although state paper money was invented five centuries earlier in China. Note: Remarks made at a Panel at the 10th ILF (Institute for Law and Finance) conference on the Future of the Financial Sector at Goethe University, Frankfurt am Main, 18th January 2022. The views expressed in this paper are my own, and not necessarily the ones of the European Central Bank. https://doi.org/10.1515/9783111002736-007

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2. The case for CBDC 2.1 Arguments by central banks working on CBDC Central bankers have motivated their work on CBDC mainly with the idea of preserving the advantages of central bank money in a digital age in which people may want to pay less and less with banknotes. Essentially, the availability and use of central bank money has served economies and societies well. Not renewing the form of central bank money available to all and sticking exclusively with 17th century technology, paper notes, despite having also observed for decades now the replacement of all other paper forms of financial instruments, appears at first sight ultra-conservative, but at a second sight revolutionary, as it would imply to largely give up the well-tested two layer monetary system based on a co-existence of central bank and commercial bank money. The advantages of preserving the availability to all of central bank money perceived by users as attractive and convenient include the following: – The continued availability of an ultimate risk-free medium of settlement to novate all claims on parties of lesser credit quality and thereby preventing the build-up of a complex IOU (“I owe you”) network. – Maintaining relevant the convertibility promise defining commercial bank money, which is essentially a promise to convert a claim into central bank money at sight. – Have available for citizens a digital means of payment designed from a public preference perspective, and not only from a profit perspective. Money and payment is a function of universal importance for a society built on the division of labour, or, as argued by Simmel (1900), being even at the core of modern society. – The availability and usability of central bank money adds to competition in an industry with network effects and thus typically a predominance of few players which will unavoidably try to abuse their market power. – Dependence on dominant foreign-owned companies for key functions of society creates vulnerabilities in the context of geostrategic conflicts. A sufficient payment infrastructure under domestic governance addresses this risk in the field of payments. Central bank money in the form of banknotes is sufficiently effective as long as banknotes are heavily used, such as to sustain the network effects underlying any successful means of payment. However, there is a clear trend towards less and less reliance on banknotes in retail payments and it seems easy to predict that in one or two decades, payments in banknotes will be unusual in most countries in

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the world. Progress on the side of mobile devices, electronic identity, and electronic payments will continue and tilt the balance of attractiveness further and further towards electronic payments. Not providing CBDC would then mean accepting to end the role of central bank money in retail payments for the sake of not being ready to move away from 17th century technology in the 21st century. This does not imply that central banks should discontinue the issuance of banknotes, who retain for the foreseeable future some specific advantages in terms of inclusiveness, cyber resilience, and privacy, and accordingly central banks working on CBDC have stressed that they will not stop issuing banknotes.

2.2 Additional arguments by academics and reformists This section recalls very briefly some other arguments brought forward by CBDC supporters, which have however never been endorsed by central banks favouring CBDC work. The respective literature can be found in Bindseil (2020).

A. Sovereign money Some have supported CBDC as it would allow to easily implement “sovereign money”. In a sovereign money framework, banks would no longer be allowed to issue sight deposits, and all giro deposits would take the form of central bank money holdings. Banks would have to finance through longer term deposits and capital market instruments. The authors advocating CBDC from this perspective perceive a number of advantages of sovereign money, such as (i) improved financial stability, (ii) preventing subsidising the banking system through bail outs with taxpayer money (and through an implicit ex ante commitment to do so); (iii) having citizens benefit from increased seigniorage income resulting from an increased monetary base. Central banks have rejected these arguments as they continue to believe in a two-layer monetary system with an important role for commercial bank money and a relatively lean central bank balance sheet.

B. Prevent illicit payment and store of value with central bank money This argument assumes a discontinuation of banknotes, and that CBDC will be designed such as not to allow for anonymous payments. In that combination, the change of the available form of central bank money would make illicit payments more difficult. Central banks reject the idea to discontinue issuing banknotes in the context of introducing CBDC, but plan to continue issuing banknotes in any

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case. The ECB also supports the continuous usability of banknotes in the context of its retail payment strategy.

C. CBDC can make monetary policy more effective This comes in three variants. First, some authors argued that CBDC would facilitate steering aggregate and fighting deflation risks by allowing to drop “helicopter money” on citizens. The relevance of this argument first depends on the perceived merits of helicopter money. Moreover, it seems to be a relatively weak argument as helicopter money if ever decided could also be dropped differently. Central banks have typically distanced themselves from helicopter money and indeed the deflationary scenarios of the last decades were addressed without this tool being ever seriously considered by central banks. Second, varying interest rates of CBDC are considered to provide for a new, non-redundant monetary policy instrument that would allow improving the overall effectiveness of monetary policy. This idea is developed for example by Barrdear and Kumhof (2016, 3) find that “a CBDC regime can contribute to the stabilization of the business cycle, by giving policymakers access to a second policy instrument that controls either the quantity or the price of CBDC in a countercyclical fashion. This second policy instrument becomes especially effective in response to shocks to private money demand and private money creation...” Central banks working on CBDC have not taken up this argument and remunerating CBDC is more seen in the context of avoiding too large inflows of deposits into CBDC in an environment of low interest rates. Third, when one also assumes a discontinuation of the issuance of banknotes (which central banks reject), then CBDC would allow to overcome the zerolower bound (“ZLB”) of monetary policy and therefore allow for an unconstrained negative interest rate policies (“NIRP”) and thereby strong monetary stimulus in a sharp recession and/or financial crisis. This would also allow to avoid the recourse to non-standard monetary policy measures (e. g. quantitative easing) which some consider having more negative side effects than NIRP. Again, central banks have distanced themselves from this argument and prefer to accept that the continued availability of banknotes as store of value constrains them in their possible future NIRP.  

2.3 Lessons from the history of the forms of central bank money Opponents of CBDC still seem to regard paper banknotes as the universal and eternal form of central bank money accessible to all, and the idea to grant dema-

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terialised access to central bank money to citizens as highly innovative and dangerous. However, history tells us the opposite: open access to central bank accounts is not new and preceded banknotes by two and a half centuries (from 1403 to 1661), and actually has been considered the less dangerous form of central bank money from the financial stability perspective for the subsequent three centuries (from 1664 to around 1950) As reviewed in Roberds and Velde (2014), Ugolini (2017), or Bindseil (2019), the first public banks issuing means of payment, i. e. the earliest central banks, did so in the form of deposits, and not in the form of banknotes. Before the Stockholm Banco invented modern banknotes in 1661, there had been at least six major early public central banks that successfully issued giro deposits which were extensively used as means of payment. These public banks granted the possibility to open deposit accounts in principle to anyone, i. e. granted universal access to central bank liabilities (such as banknotes do, and such as CBDC would). However, in the absence of electronic remote access, reach was limited to those who could come to the bank to undertake their transactions physically there (whereby the fede di credito tried to solved this problem and were widespread in particular in Naples). For example, the Taula de Canvi of Barcelona would have had around 1500 depositors in the year 1433 and the Bank of Amsterdam reached close to 3000 in the first decades of the 18th century. Most depositors were domestic and international merchants and other wealthy businessmen and families, including some who specialized in financial intermediation services. Banknotes were first issued by the Riksens Ständers Bank in 1661–64, and then again by the Bank of England (founded in 1694) and the Bank of Scotland (founded in 1695), the latter being the first central bank issuing low-denomination banknotes almost from the beginning, i. e. suitable for normal retail payments. Banknote issuance brought a further break-through in the effectiveness of central banks to provide to a surface economy a universally accessible, efficient means of payment. Still, deposits were never discontinued as they preserved their advantages that they could not get lost, be destroyed or stolen, and that their transfer was documented and thereby auditable (see e. g. Bindseil, Chapter 2). Whether banknotes and central bank deposits are of a fundamentally similar or different nature has been a heated issue of debate during the 18th and 19th centuries, whereby banknotes tended to be associated for a long time with higher risks of tempting (central) banks to over-issue. This view resulted in particular by the spectacular failures of the Stockholm Banco which ended being illiquid in 1664 and the Banque Royale of John Law, which failed in 1720. Both failures had such a lasting impression that the Riksens Ständers Banco (the public successor of Stockholm Banco) dared restarting to issue banknotes only 30 years  

 

 

 

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later, and in France the idea of a note issuing bank had so bad connotation after Law that it took even 150 years before the next attempt to establish a central bank could be undertaken, and this institute could not even be called a bank, but was called the Caisse d’Escompte in 1772. The bad reputation of banknotes from a financial stability perspective relative to central bank deposits went beyond these two countries, and for example Peel’s Act of 1844 constrained the ability of the Bank of England to issue banknotes, but not to issue deposits. Dunbar (1906, 243) is surprised that the act establishing the Reichsbank in 1875 makes such a difference in terms of imposing liquid reserves on banknote-, but not on deposit issuance, and argues that both have “essential similarities”. Still in 1924, the US-designed Dawes plan prescribed that the new Reichsbank statutes would foresee a precious metal reserve ratio for banknotes of one third, without constraining deposit issuance. Only in the 1930s, the concept of the monetary base, which sees banknotes and central bank deposits as equivalent forms of money, conquered monetary economics and central banking. Moreover, the switch to a paper standard after the Bretton Woods era made the problem of over-issuance of central bank money less relevant, at least from the angle of convertibility. Even at the times of the highest popularity of banknotes, some authors insisted that banknotes are neither the initial, nor likely to be the ultimate form of central bank money and that they will be replaced again one day by deposits. In the words of Ulens (1908, 5): No-one is questioning today the advantages of fiduciary money; the advantages of replacing metallic money with it are universally accepted. That fiduciary money takes the form of banknotes… is far from being the last word of progress. Much more perfect will be the mechanism of exchange based on current account deposits. … But we are not yet there. … The love of gold for its own sake has been replaced by the love of the banknote for its own sake.

There are other examples that the revolutionary character of digitalisation in itself might be overestimated in the context of CBDC. In numerous speeches and articles, policy makers and academics have invoked the current radical transformational power of digitalisation and new technology such as DLT and blockchain for the nature of money and payments. But is the current period really outstanding in this respect, and is the nature of money and its associated economic questions really affected? Could one not instead argue that the forms of money have constantly evolved over the centuries across multiple dimensions, but that the basic issues of the nature and interaction between central bank and commercial bank money have not changed (maybe with the exception of the discontinuation of convertibility of central bank money in the 1970s)? For example, Brunner-

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meier and Landau (2022, 19), amongst others, argue that it is digitalisation which allows almost anybody to create “money”, and that this would be a reason for central banks to consider now CBDC. In a digital world, (almost) anybody with some expertise in cryptography and computer science can create money. Not surprisingly, experiments in private money are now flourishing. The issuance of private money has been strongly reinvigorated by technology. … Almost 9,000 cryptocurrencies are currently in use, some of them significant, many other marginal.

This problem that everyone may try to create money is however old and not linked to digitalisation or cryptography. As long as it was not explicitly prohibited, every merchant or money changer could open since the late middle ages a ledger and allow people to acquire deposits and make transfers in the ledger under certain rules. This was done at large scale in several flourishing late medieval city states in southern Europe, such as Venice or Barcelona (see e. g. Kohn, 1999). It sometimes worked with the resulting private deposit banks achieving reputation and sizable giro payment volumes, but also created financial stability problems and interoperability issues, leading to regulation and the creation of early central banks, like the Taula de Canvi in Barcelona and the Banco di Rialto of Venice. In particular the latter was founded with extensive explicit reference to the financial stability concerns related to private money creation, and also 17th century English authors advocating a Bank of England insisted on this point (e. g. Bindseil, 2019, chapter 2). Also 19th century experiments to run a monetary system without a central bank, relying exclusively on competing commercial bank issuers (notably in the US free banking era between 1837 and 1863) failed and eventually led to the establishment of central banks (e. g. the US Fed in 1914). We retail three key conclusions for CBDC from this review. First, CBDC may appear less innovative and dangerous per se than sometimes argued, if one considers that universal access to central bank deposits is not new, nor has past experience with it been perceived as particularly problematic (while banknotes, which were issued only much later, were for centuries seen as the more dangerous form of central bank liabilities). Second, as importantly, it can be argued that the introduction of new and more powerful forms of central bank money has in the past (notably in the case of banknotes) led to spectacular financial stability issues when done imprudently (1661–1664 in Sweden and 1718–1720 in France). This suggests that central banks issuing CBDC must indeed understand all financial stability repercussions and build-in safeguards against uncontrolled and un-intend flows of funds. Getting it wrong in the first attempts could have a lasting negative impact for a long time. Finally, episodes with a purely  

 

 

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private banking system and the absence of a central bank offering universally accessible means of payments have normally witnessed significant financial stability problems leading to the establishment of central banks issuing central bank money.

3. The case against CBDC This section reviews the main points of critique of CBDC as formulated in 2021. We distinguish in the following the “fearful” and the “dismissive” view. The dismissive view states in short that CBDC is not needed and that the arguments in favour of CBDC do not make sense. Section 3.2 does not review the dismissive critique of the arguments in favour of CBDC uniquely supported by academics and reformists (i. e. the ones reviewed in section 2.2).  

3.1 Fearful view According to the fearful view, introducing CBDC will lead to a number of serious problems: (F1): CBDC would cause structural bank disintermediation, uncontrolled capital flows, the ballooning of the central bank balance sheet and an implied centralisation of credit allocation (through central bank choices on asset allocation and the collateral framework), and in case of banking crises the facilitation of bank runs. F1 plays an important role in Cechetti and Schoenholtz (2021), Quarles (2021), and Waller (2021). The authors however do not discuss or try to falsify the proposals to address these issues, such as Kumhof and Noone (2018), Bindseil (2020), and Bindseil and Panetta (2021). The latter had argued that a system of tiered remuneration would be effective to address F1, with CBDC holdings beyond some threshold being discouraged by a sufficiently unattractive remuneration, which could be made even less attractive in the case of an exceptional banking crisis. Some who have discussed tiered remuneration have argued that in a banking crisis it may be impossible to deter large inflows into CBDC through unattractive remuneration of large holdings as depositors would not care in such a moment about financial disincentives. This argument is however speculative and can be countered for example as follows: Safe and easily accessible assets have been available to significant money pools in previous crises, such as highly rated government debt. While very small depositors may have no broker-

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age accounts and may thus be unable to shift deposits into government bonds, all medium and larger pools of funds have this access (average and more wealthy households, corporates, investment and pension funds, etc – certainly all those who do not benefit from deposit insurance). Of course a run into government bonds does not drain liquidity from the banking system on aggregate, but (i) it allows to deplete the deposit funding of many individual banks (and so do interbank transfers of course); (ii) it allows to measure the readiness of medium and large depositors and investors in general to bear negative rates in a state of panic. On the latter aspect, it is striking that during the most acute crises over the last decades, such as the Lehman crisis or the European sovereign debt crisis, yields of safe assets accessible to all, say in Europe for German short term government debt, never reached yields below -1 %. Another critical argument towards tiered remuneration is that in an acute banking crisis the central bank will not dare and will be pressured to not reduce the remuneration of tier two CBDC further. However, again, this argument is speculative, and it could be applied to any potentially unpopular central bank measure, such as setting monetary policy interest rates (e. g. hiking rates when inflation strictly requires so, even if it may cause temporarily stress on aggregate demand, labour markets and corporate profitability; or keeping rates low and negative for a long time, such as done by the ECB, although being perceived by some as “expropriation of the saver”), or providing or not lender of last resort credit to financial firms at the brink of illiquidity, such as Bear Stearns or Lehmann. Brunnermeier and Landau (2022, 42) discuss tiering, perceive some weaknesses, and propose a modification. They express three points of critique towards the tiering proposal of Bindseil and Panetta (2021): – “First, the mere prospects of negative interest rates could reduce the acceptability of CBDC and compromise its primary objective of universal and ubiquitous presence in the economy.” However, the controversial decision of central banks is to introduce negative monetary policy interest rates or not. If it does so for monetary policy reasons, and therefore engineers short term risk free market rates to be negative, then it is only logical and cannot come as a surprise that large holdings of CBDC cannot be unlimited and remunerated at non-negative rates. Moreover, tiering addresses exactly this concern by guaranteeing non-negative remuneration on a relatively significant amount of individual CBDC holdings, but not beyond. – “Second, the central bank would be perceived as deciding upon two interest rates: one is the policy rate applied to its deposit/refinancing facilities, the other would be the (negative) interest rates on excess holdings of CBDC.” However, the central bank anyway decides on numerous rates (in the case of  

 

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the ECB, there are at least three rates relating to monetary policy2, but in addition a number of technical interest rates applied to various types of nonmonetary deposits, such as of foreign central banks and government entities). Anyway, also depositors and investors are used to multiple interest rates in markets. “Third, changing the penalty rate might have an adverse signalling effect and worsen a panic.” This argument would seem to hold for any crises related measure, such as lowering monetary policy interest rates in a crisis, broadening the collateral framework in crisis, or providing lender-of-last resort credit. It must not be solved by no longer taking any crisis-related measures at all, but through well prepared and clear central bank communication.

Brunnermeier and Landau (2022, 43) propose an alternative approach to tiering: To avoid those reactions and problems; it may be preferable to organise the tiering on a different principle. A progressive fee structure could be established, with several thresholds of holdings and increasing levels of penalty. The structure would be fixed, intangible and independent of the economic, monetary and financial situation. It would be a constitutive element of the digital euro. Revisions could only be considered at predetermined periodicity.

This proposal does not seem to aim at the first two concerns of Brunnermeier and Landau (2022, 42). The third point of concern is indeed addressed by this proposal, notably substituting the idea of flexibility and discretion in a crisis with a gradual schedule of more and more penalising rates, which would be deemed to be effective in any case. One may also note that a two-tier system has a specific rationale: the attractive rate is such that it can never be worse than what citizens were used to when holding banknotes: i. e. 0 %. The less attractive rate for large holdings must be in sufficient distance to where the central bank wants the short-term free capital market yield to be (the latter from a monetary policy perspective). Overall, the variant of tiering proposed by Brunnermeier and Landau (2022) is worth being considered with specific pros and cons relative to the initial tiering proposal.  

 

(F2) CBDC would lead to an undue concentration of information on payments of citizens with the central bank, or generally an increase of power of central banks which is not in the interest of a civil democratic society. Generally central banks would be unable to find a good balance between preventing illicit pay-

2 The Marginal lending facility rate, the deposit facility rate, the main refinancing operations rate, and the complex remuneration rate of Targeted Longer-Term Refinancing Operations).

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ments and ensuring compliance on one side and protecting privacy. However, central banks working on CBDC have not signalled that they want to collect individual payment data. At the contrary, central banks will be happy to not collect such data through a correspondingly decentralised CBDC architecture. Moreover, data protection is a general matter of legislation and hence of preferences of society as they can be articulated in a democracy, and obviously central banks will be keen to strictly apply all data protection requirements established by the legislator. Finally, it may be remarked that national security authorities, who are interested in payments data, typically have access to private retail payment data from a technical perspective, and it is again a matter for the legislator and government to not allow their actual access or to define the conditions under which that access takes place. In so far, the introduction of CBDC does not change the fact that electronic payments are normally not anonymous and leave a data trail that might be accessed by security authorities and that preventing misuse is a matter of an effective government defining and monitoring the appropriateness of such data access. (F3) The central bank will struggle to control cyber-risks associated with CBDC because of CBDC’s large surface relative to the electronic central bank money currently accessible to banks. This more technical argument is made for example by Quarles (2021). However, CBDC “only” faces the same cyber risk challenges as any other retail payment instrument. Of course, these challenges are very significant, but they have not been seen to lead to the conclusion to dismiss electronic retail payment instruments altogether. Central banks when designing and operating CBDC must rely on professional expertise and service providers in this field and reap synergies with cyber- and fraud protection of existing private payment instruments. This is crucial for central banks planning to issue CBDC, as it is for the private providers of retail payment instruments.

3.2 Dismissive view According to the dismissive view, CBDC is not needed and/or unlikely to be successful as it does not add value for users of existing private sector payment instruments. Three key arguments can be distinguished. (D1) Private solutions are highly efficient, serve well all relevant use cases and continue improving. Even central banks can contribute to further improvements of retail payments without CBDC. Cechetti and Schoenholtz (2021) emphasise that both the private and public providers contribute to further improvements without CBDC:

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We already see public and private sectors moving to provide cheaper, faster, more reliable, and more accessible retail payments systems that operate both within and across borders. For example, the euro area has the TIPS system, with a processing time of 10 seconds at a cost of €0.002 per transaction.

Cechetti and Schoenholtz (2021) are right to point out the enormous progress in retail payments thanks to digitalisation and the improved services from which customers benefit. However, this is also the reason why the current form of central bank money available to all, banknotes, is at risk to become less and less attractive in relative terms and be marginalised over time, such that the current two layer monetary architecture and the convertibility of commercial bank money into central bank money are significantly weakened. The enormous progress achieved on the side of private electronic payment instruments emphasises what progress central banks would refuse to apply to central bank money available to all, if they would stick exclusively to banknotes, essentially a 17th century technology. The authors’ reference to the Eurosystem instant payment system TIPS highlights central banks’ contribution to the back-end infrastructure of modern retail payments, which is indeed important. However, this is independent from the front-end infrastructure, i. e. from the actual retail payment instruments that are available to citizens and non-banks. TIPS only provides a settlement layer at interbank level. The ECB also encourages the private sector to develop retail payment instruments based on instant payments (such as settled by TIPS). In view of the size of retail payment markets, the ECB does not consider that the co-existence of instant payments-based private sector payment instruments and CBDC is an issue and would lead to an overcrowding of the retail payment market (not even if also card-based payments remain relevant). Quarles (2021) sees particular benefits not only of instant payments, but also of stablecoins, also relative to CBDC:  

Indeed, the combination of imminent improvements in the existing payments system such as various instant payments initiatives combined with the cross-border efficiency of properly structured stablecoins could well make superfluous any effort to develop a CBDC.

Quarles also discusses and dismisses other possible objectives of US-CBDC, such as strengthening the international role or the USD, or supporting inclusion and overall concludes that “the potential benefits of a Federal Reserve CBDC are unclear”. Waller (2021) reviews and rejects arguments that CBDC could lead to improved means of payments relative to private solutions, such as in terms of speed, cost, inclusiveness and geographical scope. His discussion on the impact of CBDC on the price of payment services is particularly relevant as he rightly distinguishes for private payment services provider between marginal costs of production and a mark-up related to market-power:

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In economics, the price of a service is typically composed of two parts: the marginal cost of providing the service and a markup that reflects the market power of the seller. … …it seems unlikely that the Federal Reserve would be able to process CBDC payments at a materially lower marginal cost than existing private-sector payment services. The key question, then, is how a CBDC would affect the markup charged by banks for a variety of payment services. The markup that a firm can charge depends on its market power and thus the degree of competition it faces.

With regards to market power and the mark-up that private firms can impose, Waller (2021) first observes that competition by CBDC would imply deposit outflows (i. e. bank disintermediation) which could incentivise banks to provide better services:  

Introducing a CBDC would create additional competition in the market for payment services, because the general public could use CBDC accounts to make payments directly through the Federal Reserve—that is, a CBDC would allow the general public to bypass the commercial banking system. Deposits would flow from commercial banks into CBDC accounts, which would put pressure on banks to lower their fees, or raise the interest rate paid on deposits, to prevent additional deposit outflows.

Waller (2021) does not distinguish between the market power of banks (which is relatively limited in the area of payments) and the one of the non-bank providers of payment instruments, like Visa, Mastercard and Paypal, which are specialised on payments and are likely to have market power there. It may also be useful to distinguish the means of payment dimension of money from the one of a store of value. As discussed in Bindseil, Panetta and Terol (2021), central banks see merits in the role of CBDC as means of payment, but far less so as extensive store of value, and central banks who work on CBDC are indeed committed to prevent significant flows of deposits from banks into CBDC. For good reasons, central banks do not want to compete with banks in the field of store of value function of money (although CBDC could have great competitive advantages relative to bank deposits in this field), while central banks want to compete with the providers of retail payment instrument for the sake of offering payments in central bank money to citizens in a digital age. In this field, banks have not succeeded to establish sizable market power, at least not in Europe. Waller (2021) also expresses the view that new competition from non-banks and stablecoins will be more effective in reducing mark-ups of banks: It seems to me, however, that private-sector innovations might reduce the markup charged by banks more effectively than a CBDC would. If commercial banks are earning rents from their market power, then there is a profit opportunity for nonbanks to enter the payment business and provide the general public with cheaper payment services. And, indeed, we are currently seeing a surge of nonbanks getting into payments…. one can easily imagine that

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competition from stablecoins could pressure banks to reduce their markup for payment services.

While the entry of BigTechs and stablecoins into payment markets would indeed temporarily add competition, the network effects, increasing economies to scale, and natural monopoly characteristics in the payment market would persist, and, eventually, stablecoins, if really successful, would likely crowd out competitors and establish their own dominant market position, i. e. without improving the competitiveness of the market. The perspective of a stablecoin launched by a global BigTech company with an extremely large client base was not perceived positively from this angle by many authorities. In general, the emergence of new promising retail payments technology and the entrance of BigTech is more likely to increase concentration risks and the potential abuse of market power than to reduce it. Therefore, it is more an argument in favour of, than against CBDC.  

D2: Problems with private payment instruments can be addressed through regulation. CBDC-critical authors have argued that problems arising with the reliance on private electronic payment instruments, such as e. g. financial stability, privacy, security, prevention of illicit payments, or abuse-of-market-power concerns can be addressed through regulation, and that therefore CBDC is not needed nor adequate to cure any of those. Cechetti and Schoenholtz (2021) emphasise the possibility to ban new instruments which would be undesired by public authorities:  

There is a desire to supplant cryptocurrencies like Bitcoin and head off the issuance of private monetary instruments like Libra (now Diem). But governments know from long experience how to handle such private currencies when they become salient – impose either punitive taxes or an outright ban.

Quarles (2021) argues that than ongoing innovations such as the rise of stablecoins will be beneficial and further improve payments in the interest of citizens and firms and that possible issues anticipated with regards to those should and can be addressed through regulation: But these concerns [regarding stablecoins] are eminently addressable—indeed, some stablecoins have already been structured to address them. When our concerns have been addressed, we should be saying yes to these products…

There is no doubt that regulation and oversight of payment systems, instruments, schemes and arrangement is important and has effectively targeted many of the above-mentioned public policy concerns. At the same time, regulation does not in itself address many of the key concerns expressed by central banks regarding the

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scenario in which citizens and non-bank firms would have to rely exclusively on electronic means of payments. The problem of the abuse of market power in an oligopolistic situation can be partially addressed through regulation, but it is even better if a public electronic retail instrument constitutes a further viable alternative for citizens and firms. Even more importantly, the concerns regarding the nature of commercial bank money and its reliance on a convertibility promise when central bank money is no longer used to a significant extent remains unanswered. Last but not least, monetary and strategic sovereignty concerns of jurisdictions in which few global firms dominate electronic retail payments cannot be addressed through regulation. (D3) CBDC will struggle to be competitive because the central banks lack expertise and comparative advantage in this field and also lack the flexibility and strong incentives prevailing in the private sector which are the basis for offering competitive products in a dynamic environment; moreover CBDC will duplicate efforts of the private sector. This point is developed in particular by Bofinger and Haas (2021): There is no obvious justification for digital cash substitutes from the point of view of allocative efficiency. In addition, from a user perspective, the narrow solutions that are discussed by central banks so far do not seem attractive enough to compete successfully with private bank deposits and private retail payment systems like PayPal. The key advantage of CBDC, its absolute safety, is irrelevant for retail payments. … Thus, if central banks stick to their current approach, the risk is high that CBDCs will become a gigantic flop.

However, central banks working on CBDC would consider that the possible abuse of market power by few dominant providers of electronic payment instruments is a matter of “allocative” efficiency that can be addressed by preserving a public offer in this field even when banknotes would be considered outdated by many citizens and firms. With regard to the “narrowness” of the solutions eventually identified by central banks: first, central bankers have acknowledged the importance of the functional scope of CBDC to make it sufficiently attractive (e. g. Bindseil, Panetta, Terol, 2021). Second, while it is indeed important to distinguish the means of payment and the store of value function of CBDC, a positive but limited attractiveness of CBDC with regards to the latter can contribute to the willingness of citizens to on-board CBDC as payment instrument. The absolute safety of CBDC is also unlikely to be totally irrelevant for retail payments, even if it is not a strong sufficient factor for CBDC adoption. Third, the central bank has further selling points, such as potentially unique economies of scale, and credibility as providing an instrument designed for users and not for profit. CBDC could also be supported by a legal tender status, like banknotes. Fourth, central banks like the  

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Eurosystem have demonstrated their ability to develop and run complex market infrastructures such as T2S, or 24/7 instantaneous settlement infrastructures like TIPS. Quarles (2021) emphasises that CBDC would in any case require very large set up and running costs, that would potentially duplicate the efforts of the private sector: That would mean introducing large-scale, resource-intensive central bank infrastructure. We will need to consider whether the potential use cases for a CBDC justify such costs.

Central banks like the Eurosystem have always emphasised that they want to rely on synergies with the regulated private payment services providers when issuing CBDC, to avoid duplicating efforts and to ensure that the instruments are as attractive as what the industry has been able to develop. This also addresses the fear of Bofinger and Haas (2021) that central banks would not be able to replicate solutions developed by the private sector.

4. Conclusions The pros and cons of CBDC have been debated intensively since 2016. The discussion has certainly been evolving and has progressed, although some arguments have been there for a while. This note provides an up to date summary of the discussion, focusing mainly on 2021 and early 2022. The note started by restating the basic argument for CBDC, namely that also in a digital age in which users move more and more towards electronic payments, central banks should continue their core role as issuer of relevant central bank money available to all and not discontinue this role just for the sake of sticking exclusively to banknotes, essentially a 17th century technology. The good reasons for central bank money being available to all have been acknowledged for centuries and have not been invalidated, neither by new insights, nor by new technology. The two-layer monetary system, in which commercial bank money relies on, or is even defined as a promise of conversion at sight into central bank money, has served societies well. Systems relying exclusively on commercial bank moneys have underperformed throughout history relative to two-layer systems in which effective central bank money remained available to all, and an effective convertibility promise was the basis of commercial bank money. Also, other core arguments in favour of CBDC which have been emphasised by central banks (relating to preventing the abuse of market power, and monetary and strategic autonomy) have persisted. Despite these affirmative conclusions on the basic rationale of CBDCs, their actual design raises numerous questions which require in depth analysis. While

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CBDC will allow to preserve the role that central bank money had in the form of cash in a pre- and semi-digital retail payment environment, there is no unique and obvious way of implementing this idea. The digital payment space is not only very different, but is also already populated by a complex ecosystem in which CBDC needs to find its right place and suitable partners, such as to achieve its policy objectives and serve society in the best possible way.

References Barrdear, J. and M. Kumhof (2016), “The macroeconomics of central bank issued digital currencies”, Bank of England, Staff WP No. 605 Bindseil, Ulrich (2019), Central Banking before 1800 – a Rehabilitation, Oxford University press. Bindseil, U. (2020), “Tiered CBDC and the financial system”, ECB WPS No. 2351, January 2020, https://www.ecb.europa.eu/pub/pdf/scpwps/ecb.wp2351~c8c18bbd60.en.pdf Bindseil, U., and F. Panetta (2021), “Central bank digital currency remuneration in a world with low or negative nominal interest rates”, https://voxeu.org/article/cbdc-remunerationworld-low-or-negative-nominal-interest-rates. Bindseil, U., F. Panetta and N. Terol (2021), “Central Bank Digital Currency: functional scope, pricing and controls”, ECB Occasional Paper No. 286. https://www.ecb.europa.eu/pub/ pdf/scpops/ecb.op286~9d472374ea.en.pdf Bofinger, Peter. and Thomas Haas, “Central bank digital currencies risk becoming a gigantic flop”, 01 February 2021, VoxEU, 01 February 2021. https://voxeu.org/article/central-bankdigital-currencies-risk-becoming-gigantic-flop Carstens, Augustin (2022), “Digital currencies and the soul of money”, Speech by Agustín Carstens, General Manager of the BIS, Goethe University’s Institute for Law and Finance (ILF) conference on “Data, Digitalization, the New Finance and Central Bank Digital Currencies: The Future of Banking and Money”, 18 January 2022. https://www.bis.org/speeches/ sp220118.htm Cecchetti, Stephen and Kim Schoenholtz (2021), “Central bank digital currency: The battle for the soul of the financial system”, 08 July 2021, VoxEU. https://voxeu.org/article/central-bankdigital-currency-battle-soul-financial-system Dunbar, C. F. (1906), “Chapters on the theory and history of banking”, Second enlarged edition, edited by O.M.W: Sprague, G.P. Putman’s Sons, New York and London. House of Lords (2021), “Central bank digital currencies: a solution in search of a problem”, Report published 13 January 2022. https://publications.parliament.uk/pa/ld5802/ldselect/ ldeconaf/131/131.pdf Kohn, Meir (1999), “Early deposit banking”, Dartmouth College, Department of Economics Working Paper No. 99-03. https://papers.ssrn.com/sol3/papers.cfm?abstract_id=151848 Kumhof, M. and C. Noone (2018), “Central bank digital currencies – design principles and balance sheet implications”, Bank of England, Staff WP No. 725. Panetta, F. (2021), The present and future of money in the digital age, Lecture by Fabio Panetta, Member of the Executive Board of the ECB, Rome, 10 December 2021. https://www.ecb. europa.eu/press/key/date/2021/html/ecb.sp211210~09b6887f8b.en.html

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Quarles, Randal K. (2021), “Parachute Pants and Central Bank Money”, Speech given on June 28, 2021 at the 113th Annual Utah Bankers Association Convention, Sun Valley, Idaho. https://www.federalreserve.gov/newsevents/speech/quarles20210628a.htm Roberds, William; Velde, François R. (2014), “Early public banks”, Working Paper, No. 2014-03, Federal Reserve Bank of Chicago. https://www.econstor.eu/handle/10419/96660 Simmel, Georg (1900), Philosophie des Geldes, Leipzig, Duncker & Humblot. Ugolini, S. (2017), The evolution of central banking: theory and history, Palgrave studies in economic history, Palgrave Macmillan. Ulens, R. (1908), Les banques d’émission. Études historiques et de legislation compare, Bruxelles, Hayez. Waller, Chris (2021), CBDC: “A Solution in Search of a Problem?”, Speech given on August 05, 2021 at the American Enterprise Institute, Washington, D.C. https://www.federalreserve. gov/newsevents/speech/waller20210805a.htm

Markus Brunnermeier and Jean-Pierre Landau

The Digital Euro: Policy Implications and Perspectives Executive Summary The European Central Bank (ECB) has decided to launch a two-year investigation phase of a possible digital euro. This announcement has raised many expectations and also many questions. What would be the purpose of a digital euro? How would it work? What would be the consequences for European citizens? Would it disrupt the activities of banks? How would it concur with fundamental European Union (EU) values, such as privacy? This study aims at identifying trade-offs and main policy options and possibilities. The digital euro project is a response to a broader change: the digitalisation of money itself. A new type of money is emerging, based on virtual units of value moving on the internet. It can be broadly thought as “digital cash”. It can be stored on a mobile device or a computer. It can be instantly transferred, just like sending an email. It can be used directly to pay from person to person (peer-topeer), irrespective of distances and borders. The digitalisation of money brings several major transformations: First, money is becoming more diverse. Money in digital form is easy to create. It can be tailored to almost any shape or usage. It can be managed through a great variety of ledgers and protocols. Second, money may become more segmented. Digital money often prospers inside large “platforms” which aggregate many activities (e. g. commerce, entertainment, social media) and exploit their synergies. Those platforms tend to be organised as “closed-loop” ecosystems. The money they use and, possibly, create may not be easily transferable into other environments. Finally, money is becoming more competitive. In a digital world, (almost) anybody with some expertise in cryptography and computer science can create money. Experiments in private money (cryptocurrencies) are now flourishing. Currency competition may also develop both inside and across borders, with some countries – or private operators – using their digital networks to circulate their currencies in other jurisdictions, creating so-called global stable coins.  

Note: This report was originally prepared for the European Parliament’s Committee on Economic and Monetary Affairs (ECON). Copyright remains with the European Parliament at all times. https://doi.org/10.1515/9783111002736-008

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Some benefits of digitalisation are certain and visible. Retail payment systems have been pushed to improve and innovate. Major efforts are being made to accelerate cross-border payments and reduce their cost. In Europe, instant payments are being developed and strongly promoted by the authorities. Other consequences will be more challenging. For citizens, the aggregation of money and data will amplify concerns of privacy that are endemic to the digital world. For banks, the emergence of “Big Tech” as major competitors in payments (as well as deposit-taking activities) may increase their funding costs and destabilise their business model. This is not neutral, as banks play a major role in financial intermediation in the euro area and are also essential for the transmission mechanism of monetary policy. The central policy question raised by digitalisation is the role of public money. It is issued by central banks, in the form of cash and reserves held by commercial banks. Public money is the anchor of the monetary system. Because all forms of money are ultimately convertible into public, it ensures that the currency is “uniform”: all monetary instruments with the same nominal value trade at par in all circumstances. They are equivalent. Public money also provides the unit of account, which serves as a standard of value for all transactions and contracts in the economy. Doing so, it also preserves monetary sovereignty, which can be defined as the ability of governments to control the unit of account in their jurisdiction in order to manage the macro economy. To fulfil those functions, public money must be present and freely available in all sectors and parts of the economy. That ubiquity is doubly compromised by digitalisation. First, if cash were to disappear, the general public would not have access to central bank money anymore and would spend their lives in a universe of totally private currencies. Second, platforms and closed-loop systems could develop without any common reference of value, which would greatly compromise the uniformity of money. The main rationale for developing a digital euro is therefore to preserve the role of public money in a digital economy. Should the ECB Governing Council decide to issue the digital euro, its design will involve many policy choices and trade-offs. First on privacy. Privacy is a core value for EU citizens and a central driver of the acceptability and trust in money. Privacy, however, comes into conflict with other, equally valid, policy objectives in which the EU is also a world leader: the fight against money laundering, the financing of terrorism and tax evasion. A second choice is about banks and their role in financial intermediation. It may be that an attractive digital euro would compete with the deposit-taking activity of banks in addition to the pressures already coming from Big Tech.

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A third choice concerns the place that the central bank wants to take in the economy and society. Technology and digitalisation would enable it to directly open accounts to hundreds of millions of euro area citizens. Should it consider that possibility or rather issue the digital euro in the form of a “cash – like” bearer instrument? Finally, on monetary policy. Contrary to cash, the digital euro could be issued with an interest rate. Should that possibility be used, as advocated by many economists? Or should public digital money stay as close as possible to the characteristics of cash? Together, those choices open the possibility of radical changes in the current monetary and financial arrangements in the euro area. They could transform the relationship between citizens and money and put the central bank in a completely different position. There is no indication, however, that this perspective is considered by the Eurosystem or any other EU institution. The study looks instead at a solution of continuity, where the digital euro would be issued as a digital version of cash and conceived to preserve, rather than disrupt, current monetary arrangements. Even so, the precise design will require delicate trade-offs and choices. As public money, the digital euro will have to be universally accepted and widely accessible. It should be present everywhere. On the other hand, the Eurosystem may not want to evict private money issuers (the banks) or private payment providers. It may not want to gain a monopoly or dominant position in retail payments. The digital euro will thus be placed into a strange and paradoxical position. It should to be present everywhere but important nowhere. It should be successful but not too successful. To that effect, the “specialisation” of the digital euro as a pure medium of exchange may be considered. The amounts necessary for transaction balances would be limited and therefore less disruptive. This solution would also be more advantageous from a privacy perspective, as anonymity is more justified for normal payments than for money stored as wealth. To specialise the digital euro, the Eurosystem would have to set an acceptable level of transaction balances. Limits would have to be defined. Those limits can be set either through quantitative (ceiling) or price (tiering) mechanisms. A cap or ceiling on individual holdings is fully transparent, clear, and easily understood. Its quantitative impact can be directly assessed ex ante. Tiering would be based on a different principle. There would be no hard limit, but holdings above a certain threshold would be dissuaded, for instance, through a mechanism of fees. Both solutions are differently attractive and their costs and benefits need to be carefully weighted.

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While the operational case for specialising the digital euro is straightforward, the economics are more uncertain and ambiguous. Money, as a perfectly safe and liquid asset, jointly performs three functions. Separating them by design, however justified, introduces a discontinuity that may have negative side effects. Finally, for the digital euro to produce all its expected benefits, it must develop in an appropriate regulatory environment, sufficiently conducive to the uniformity of the currency. Payments sit at the intersection of many current policies of the EU. They have a close link with money (the topic of this study). Private and regulatory initiatives are all in a state of flux. There is now an opportunity to define and shape the architecture of a unified European payments area

1. Introduction and Overview On 14 July 2021, the European Central Bank (ECB) decided to launch a two-year investigation phase of a possible digital euro. This announcement has raised many expectations and also many questions. What would be the purpose of a digital euro? How would it work? What would be the consequences for European citizens? Would it disrupt the activities of banks? How would it fit with fundamental European Union (EU) values, such as privacy? These are complex issues that, ultimately, will be decided on the basis of social preferences as well as technical imperatives. This study aims at identifying trade- offs and main policy options and possibilities. The digital euro project is a response to a broader change: the digitalisation of money itself. A new type of money is emerging, based on virtual units of value moving on the internet. It can be stored on a mobile phone or a computer. It can instantly be transferred, just like sending an email. It can be used directly to pay from person to person (peer-to-peer), irrespective of distances and borders. It can be broadly thought of as “digital cash” as envisaged by Milton Friedman more than twenty years ago (Friedman, 1999): The internet is going to be one of the major forces for reducing the role of government. The one thing that’s missing but that will soon be developed is a reliable e-cash, a method whereby on the Internet you can transfer funds from A to B without A knowing B or B knowing A, the way in which I can take a $20 bill and hand it over to you and there’s no record of where it came from and you may get that without knowing who I am. That kind of thing will develop on the Internet and that will make it even easier for people to use the internet. Of course, it has a negative side. It means that the gangsters, the people who are engaged in illegal transactions will also have an easier way to carry on their business.

Digital money has surfaced in a variety of contexts. WeChat’s and Alipay’s digital wallets have come to dominate the payments system in China. In Africa, mobile

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providers have launched successful money transfer services, such as Safaricom’s M-Pesa. Facebook has led the development of digital currencies for social media networks, announcing plans – which were later rescinded – to issue its own currency, the Libra, a “stable coin” pegged to a basket of official currencies. Finally, in recent years, thousands of cryptocurrencies maintained on block chains by anonymous record-keepers have been launched. Digitalisation is changing payments. But how far does it change money itself? There have been many phases of monetary innovation in the past. Is this one “special” and will it transform the functioning of monetary systems? Does this new wave of innovation bring a radical rupture with past monetary arrangements? Many proponents of cryptocurrencies certainly think so. The academic and policy communities have been intensively debating this question. Over the last three years, numerous analysts and policymakers, including major central bankers, have given speeches or written books on “the future of money.” This contrasts with the previous three decades, when “as economics has become more and more sophisticated, it has had less and less to say about money.” (King, 2016). It also raises the question in the private-public partnership what the optimal mix between public and private money is. From a public policy perspective, those fundamental questions about the nature of money cannot be escaped. Central banks and monetary authorities have special responsibilities. Confronted with fast and major technological disruptions, they have to determine which innovations they encourage, accommodate, accompany or, on the contrary, dissuade. They must identify which main characteristics of money have to be preserved in a changing technological environment. This study puts emphasis on two key concepts: the uniformity of money and its role as a unit of account. These are the two components of monetary identity and sovereignty. What delimits a monetary zone, what creates monetary sovereignty and what makes and independent monetary policy possible is the simple fact that people count and pay in euros; and that euros are the same everywhere in the area, whatever their form, their location and the identity of their issuer. As the study shows, economic forces unleashed by digitalisation naturally work against the uniformity of currency. Private issuers have strong incentives and the technical capacity to create their own differentiated, special-purpose money. The economic incentives of digital platforms push them to erect technical barriers to the interoperability of their systems. Digitalisation may therefore lead to an excessive fragmentation of the monetary space, ultimately compromising the ability of money to serve its basic functions. Current monetary systems are held together by the public money issued by the central bank in the form of reserves (for banks) and cash (for the general public). Public money defines the unit of account: it can be supplied elastically and

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can be made exchangeable against all private forms of money. It serves as a bridge for converting one private money into another. It guarantees a uniform currency anchored on the unit of account. Those functions will remain central in a digital economy but more difficult to fulfil if cash disappears from day-to-day exchanges and the general public ends up living in a totally private monetary environment. The main rationale for developing a digital euro would be to preserve the role of public money in a digital world. To the extent that money becomes digital, central bank money must be made available in digital form in all parts of the economy and society. All other (private) forms of money must be practically related to it through convertibility and interoperability. This effectively allows all payment instruments to replicate the unit of account properties of public money. While it must be ubiquitous, the digital euro should not aim at domination. Uniformity must not be pushed to the point that it would stifle innovation and efficiency. The delicate balance between competition and cooperation with private providers of payment services must be preserved. Current arrangements based on a complementarity between private and public money have served the public well. Maintaining that equilibrium in a digital economy where scale and network effects are prevalent will involve difficult trade-offs, as well as technical choices, that are discussed in the study. All along, references to European policy objectives and values, first of all privacy, are kept in mind.

2. The Rationale for a digital Euro A decision by the central bank to issue a new form of money, so-called “central bank digital currency” (CBDC), would have significant implications for the financial sector, many parts of the economy and for society. It must rest on an assessment of its costs and policy benefits. Overall, current monetary arrangements have served the public well. Retail payments in the euro area are becoming faster, cheaper and increasingly efficient. From an efficiency perspective, the need for a new form of public money – a digital euro – is not immediately apparent. There is no obvious case for a “public option” in retail payments. Looking into the future, however, money will become increasingly digital. The private sector is clearly embracing and driving the movement. If all private money becomes digital, what should central banks do? Should they consider a future where only private money is available to the general public? Is public money essential or can we dispense with it in a digital world?

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Box 1: Public versus private money, or a mix of both?

Should money be totally public, private, or a mix of both? The question has occupied economists and policymakers for many centuries. The global financial crisis and the digitalisation of money have given new arguments to supporters of either totally public or totally private monetary systems. According to the sovereign money school of thought, money and money creation should be exclusively public. Private banks should not have the power to create money. Private money issuance is the source of moral hazard: it creates unjustified rents. It is the ultimate cause of financial instability as illustrated during the global financial crisis of 2007–2008. Those arguments were recently developed during the Vollgeld referendum in Switzerland in 2018, and supported by 24 % of the population. Digitalisation has given some technical credibility to those ideas, as it is now theoretically possible for a central bank to open and manage millions of individual citizens’ accounts, thus serving as a deposit bank for a whole country. On the other extreme of the debate, followers of Friedrich Hayek (1976) advocate a fully private monetary system with no role for any central bank and public money. This movement is founded on a deep distrust of governments, suspected of a permanent inclination to debase the currency. It counts on competition between private money issuers to instil discipline and monetary stability. This libertarian streak has been significantly boosted by digitalisation and its multiple possibilities of money creation. At its origins and roots, the “crypto” movement is anti-government. A major attraction of Bitcoin for its supporters is its “decentralised” method of consensus and a process of issuance governed by algorithm. Both allow to dispense with a central bank – indeed with any intermediary. A frequent narrative in crypto circles predicts the triumph of cryptos and the collapse of national currencies following the accommodating (non-conventional) policies conducted over the last decade.  

2.1 The digitalisation of money Most of our money, except banknotes, is already electronic. Nevertheless, advancements in digitalisation have led and will lead to transformational changes. Technically, digital money is both an instrument (tokens stored on a mobile device or computer) and an infrastructure (the network that transfers value across space). The internet allows us to copy and transmit information with almost no costs over any distance. This creates enormous possibilities for citizens and businesses. Easy transmission of information is good, from the perspective of money. Easy copying is not. That’s why the new forms of digital money had to wait for recent progress in distributed ledger technology (DLT) and cryptography. Only since recently can such transfer of value over the internet and phone networks be made secure.

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2.1.1 Digital tokens In monetary economics1, a “token” is an instrument representing value that can be exchanged directly, on a peer-to-peer basis, without validation by a third party. Just holding the token means that one legally possesses it. There is no need for identification and certification by any third party. Cash, in the form of banknotes and coins, is a physical token. Technology now allows the creation of purely digital tokens. A digital token is an electronic file that embodies a specific value. It has a name attached to it. By just changing the name, the value has been transferred and a payment is made2. While the principle is simple, its implementation necessitates sophisticated technologies. The possible “tokenisation” of money (and also other financial assets) may be the biggest innovation in the field of payments and finance over the last decades. Digital tokens are easy to create. Today, practically any sophisticated software developer can issue money. Digitalisation seemingly “democratises” the monetary power. Not surprisingly, it has unleashed a wave of new private money initiatives. Today there are almost 9,000 cryptocurrencieswith different characteristics and unequal significance. Digital tokens are fungible, divisible, and transferable. They can be customised to any specific need. They need proper security, and must be supported by a robust legal infrastructure. But they are otherwise fully flexible. In particular, tokens can (or not) keep track of the sequence of payments (the names attached to the file). Payments can be made more or less private or anonymous.

2.1.2 Ledgers and architecture There is, however, one important difference between physical tokens (banknotes) and their digital cousins. Digital tokens have no material existence. It is necessary that they be “registered” somewhere. There must be a designated system to authenticate the signatures. Digital money rests upon a technical infrastructure – a ledger. In public and policy debates, digital money is frequently associated with DLT. A decentralised ledger is securely held in several simultaneous copies by many

1 On the complexity and confusion surrounding the token terminology, see Lee et al. (2020). 2 “The metaphor of a coin, object, or bearer instrument living in a wallet or locally on someone’s machine raises significant questions regarding technological feasibility, safety, and security. Unlike traditional money, tokens in the cryptocurrency space are not stored locally but rather on a block chain. What can be stored locally is a private key that allows for the transfer of the tokens on the block chain. Importantly, what is stored or possessed by the end user has consequences for how we think about bearer instruments in the digital world…” Lee et al. (2020).

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different and unrelated participants. It has to be permanently synchronised between those participants. Most digital tokens function on a block chain, a particular form of DLT where new entries are first bundled into “blocks” and then sequentially linked to each other. The blocks forma chain. Because each block incorporates a coded summary of the entire preceding chain, the block chain cannot be tampered with. It is immutable. It’s only recently that progress in distributed ledger protocols has made it possible to securely transfer tokens peer-to-peer. The ledger structure is extremely important for the governance of digital activities. The DLTs and block chain open new and creative ways to manage complex systems – such as supply chains – where there is a need for precise recording of events and permanent coordination of participants. They offer the possibility of secure, transparent and accessible storage of complex histories, such as medical records or land registers. However, their performance as payment systems is more open to question. Decentralisation is attractive in theory but very challenging to implement in practice. A consensus must be found to validate payments between multiple actors with no time coordination and no mutual trust. As an example, Bitcoin is a monetary system that operates with full decentralisation on a block chain. Bitcoin is very innovative in its “consensus” method, through which all participants to the network have the capacity and right to validate transactions. It is also very secure: all “hackings” of Bitcoin have occurred in peripheral systems. The price to pay, however, is a very slow flow of transactions. Bitcoin is hardly “scalable”. It is also extremely energy-intensive. Decentralisation is an organisational choice, not a technical necessity. Tokens can work perfectly well on more centralised infrastructures. From a monetary perspective, what matters most is not the technical infrastructure but the underlying economic architecture, which determines the tokens’ regime of issuance and the foundations of their value. From a user perspective, all tokens look the same. They can all be spent or transferred through identical processes and applications, such as digital wallets. But, depending on how they are issued, they are in fact very different monetary instruments. They can be denominated, or not, in official currencies (such as the euro or the dollar). They can be attached to an existing deposit in a bank, or totally independent. Tokenisation is compatible with a great diversity of monetary architectures. Currently, three types of models dominate the digital landscape. First, in open banking applications, tokens are just “mirrors” of an existing bank deposit. They are just tools to make payments by moving money from one account to another. They are the digital equivalent of debit cards. Such applications can be developed by bank themselves or independent payment service providers.

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Second, at the opposite extreme, cryptocurrencies are completely new monetary objects. They are not related to a bank account. They are denominated in specific units of account, unrelated to existing currencies. They are private monies with no backing. They are not a claim on any natural or legal entity. There is no historical precedent for this type of digital private money. Most cryptocurrencies are decentralised. They are designed to function efficiently on an open network with no trust between participants. They dispense with any financial intermediary. Third, in between the two extremes, stable coins are a new category of digital currencies that is expanding fast. Coins are deemed “stable” because they are backed by other assets held by the issuer3. Most are backed by non-crypto assets. In effect, they are digital representations of existing fiat currencies. The two largest are Tether (USDT) and US. Coin (USDC), denominated in dollars, and are predominantly used to facilitate trading, lending, and borrowing of other digital assets. More exotic forms exist, where the stable coin is backed by other cryptocurrencies or assets. Stable coins raise many issues of market integrity and financial stability that are beyond the scope of this study. Most of them involve some maturity and liquidity transformation and are therefore exposed to the risk of runs. A specially interesting case of digital coin was the (now abandoned) project of Libra. Libra was a new digital currency developed on the Facebook network (of now Meta), with potentially more than 2 billion users. It was to be denominated in its own unit of account. It was backed by a basket of officialcurrencies. Libra illustrates the potential of private digital currencies to overhaul and disrupt the existing monetary order. Libra was subsequently revamped as stable coin under the new name Diem.

2.1.3 The benefits of digital innovation in money Many benefits of digitalisation of money are certain and visible. For the general public, a digital token stored on a mobile phone closely mimics the characteristics of cash, without any of the physical constraints linked to weight or distance. Digital money can be securely and instantly exchanged on a peer-to-peer basis, including cross-border and at very long distances. Sharing bills and sending money to family members far away, has – or will – become commonplace. Digitalisation is a powerful tool for financial inclusion as, in many

3 Some promoters of stable coins are working on projects where currency issuance would be regulated by a sophisticated algorithm. The objective would be to expand and contract the supply so as to maintain a stable price. While the idea is seductive, the implementation may be difficult. In particular, it is not clear how the protocol could force the contraction of supply in case the stable coins depreciate excessively.

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emerging countries, mobile penetration is significantly higher than bank penetration. The rise of digital money has spurred a wave of innovation in retail and crossborder payments. Under the pressure of competition, retail payment systems have been pushed to improve and innovate. In Europe, instant payments are being developed and strongly promoted by the authorities. Potential benefits may even be greater for corporates and financial intermediaries. In a digital world, “there is a computer in the middle of each transaction” (Varian, 2014). Interactions between machines and algorithms will increasingly shape business activities and relations. Digital money offers the possibility to transfer value between computers in extremely short periods of time, with no settlement risk. Dispensing with a third party may offer huge benefits. Tokens are ideal payment instruments to execute so-called “smart contracts”, which are automated financial operations governed by a predetermined protocol (generally on a block chain). At the moment, such automated transactions are largely confined to the crypto world but will certainly extend, in the future, to a large part of production and trade activities. Digital money obviously finds numerous specific applications in finance. Wholesale digital tokens may be used in the future as settlement assets for real time payments between banks and financial intermediaries. Stable coins have developed as the main medium of exchange for financial transactions that take place inside the crypto sphere. They form the basis for fast growing applications regrouped under the name of “decentralised finance” (DeFi). The term broadly refers to financial activities (lending, arbitraging, derivatives, collateralisation) operated without any intermediaries through automated protocols and smart contracts. Many of these developments raise policy concerns (about financial stability, market integrity and investor and consumer protection) that are beyond the scope of this study4.

2.2 The new and disruptive features of digital monetary systems 2.2.1 The unit of account and a uniform currency People who live in the euro area share one common characteristic in their economic life. They count, pay, contract, and set their prices in euro. The euro is their only standard of value. They do not use any other unit of account. Furthermore,

4 See President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency (2021).

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without any possible doubt, there is only one “euro”. It always has the same value whatever its form, its location and its issuer. The currency is uniform. Together, uniformity and the unit of account form the basic components of a cohesive and functional monetary system. A “uniform currency” is a major objective for central banks. Modern monetary systems rest on a competition between different private exchange media. Most euros are created and issued by private banks; most retail payments are operated by private providers. Their numbers will increase and diversify in a digital world. If the currency is uniform, all monetary instruments with the same nominal value will be exchangeable at par in all circumstances. They are perceived by the public as equivalent. By contrast, in a fragmented monetary system, different types of currency become imperfect substitutes, creating a fundamental uncertainty about the value of money. Each would carry a specific and idiosyncratic risk that would necessarily be reflected in the “exchange rates” that would arise between different types of domestic money. In effect, the monetary system would be transformed and behave more like the broader financial system where the creditworthiness of every single instrument is constantly re-assessed and priced. After more than a century of successful central banking, the uniformity of currency tends to be taken for granted. It should not be. In the past, uniformity was compromised by differences in intrinsic values of monetary objects as well as physical distances. In the “Free Banking Era” in 19th century United States (US), banknotes were not traded at the same value everywhere. In the future, technological barriers will challenge uniformity. It may also be endangered by financial instability. There were periods in the recent history when a “re-denomination risk” materialised between different parts of the euro area, temporarily introducing frictions in money transfers and potentially compromising the equivalence between bank deposits in different countries. The unit of account may be the most important function of money. It serves for quoting prices, for denominating debt and for negotiating contracts. It is a basic convention of society, such as the language and the standards for measurement. In modern economies, the central bank defines and controls the unit of account. Ultimately, a euro is a liability of the Eurosystem with a nominal value of 1 €. If the currency is uniform, all monetary instruments and prices are attached, one way or another, to that standard of value. A uniform currency and the control of the unit of account are jointly necessary to ensure the implementation of monetary policy and preserve monetary sovereignty. Central banks can act on the economy because they set the interest rate attached to their own liabilities. Changes in the policy rate are transmitted across a whole spectrum of financial and credit markets. That process is most efficient  

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when arbitrage is easy and frictionless. It may not be possible if different forms of money have different – or uncertain – nominal values. Monetary sovereignty can be defined as the ability of central banks to control the unit of account in their whole jurisdiction. Monetary sovereignty is lost when citizens start using a foreign (or private) currency in their daily life to quote prices, wages and financial contracts. In that scenario, the economy is “dollarised”. Domestic monetary and financial conditions are determined by an authority (foreign or private) that issues the unit of account. Domestic monetary policy becomes powerless.

2.2.2 Digital monetary systems are less uniform Uniformity and the unit of account have been naturally preserved over the last century of central banking. In the future, digital monetary systems may evolve in ways that would fragilize the existing architecture and monetary arrangements. In a digital world, two economic forces naturally work against the uniformity of currency: the infinite possibilities of differentiating monetary instruments; and the tendency of private money networks to organise into closed ecosystems.

a. Programmable and special-purpose money Digital tokens are very versatile. They can exist in many forms. Creating differentiated tokens is very easy. Issuers can tailor the forms of money to their specific needs. In the current parlance, money can be made “programmable”. There are two possible meanings attached to this formulation. First, programming can be inserted into the use of money. Payments can be managed by smart contracts, i. e., algorithmically triggered by events or conditions. With programmable wallets, it will be possible to make contingent payments that only occur in certain events, and to have fully automated settlements between devices in a world of the internet of things (see Bundesbank, 2020). Automated payments are going to develop. Second, programming can directly affect the nature – and value – of the monetary unit itself. For instance, money may be issued with a date of expiration beyond which it is not valid anymore; like digital coupons used by city authorities of Hangzhou in China. It can be restricted for a particular use, like food stamps. It might be tempting to make exceptional welfare payments in a money with an expiration date, so as to ensure that they are spent, not hoarded, and maximise their stimulus impact. Theoretically, governments with autocratic or moralistic tendencies can limit the use of those welfare payments, prohibiting the purchase of alco 

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hol or leisure goods, making them closer to food stamps. The technical possibilities are almost infinite. But what is the value of a money with an expiration date, or limited use? Will it be traded as a discount? How can it be transferred? It is clear that uniformity of money has been lost. In reality, programmable money is an oxymoron. Strictly speaking, it is not money.

b. Digital platforms as closed monetary systems Digital platforms are multi-sided markets or, in common parlance, “ecosystems” that aggregate a multiplicity of activities within which consumers, merchants, and service providers interact. The economic logic of platforms is to create and develop complementarities and links between those different activities. They have economic incentives to erect technical barriers to the interoperability of their systems, limit their connections with other parts of the economy and operate as closed systems (Brunnermeier and Payne, 2022). Platforms could lead to an excessive fragmentation of the monetary space. Money can play an important role in the business model of platforms. A shared (form of) currency strengthens those links; it keeps the platform growing and profitable. In particular, money gives access to data. Big Tech platforms have an edge in data collection through their ability to combine payment data with other data sources. This induces a self-enforcing mechanism. Platforms that offer their own payment services are able to collect even more data, which improves their recommender systems, which makes more attractive for customers to join them. To further lock-in customers and enlarge their footprint, platforms have the technical capacity to create their own differentiated digital money. This evolution is occurring most spectacularly in China, where fintech companies such as Ant Financial and Tencent have moved aggressively into payment services and emoney. They have developed state-of-the-art mobile payment systems while simultaneously aggregating many diverse activities. This model may also expand to other parts of the world. In sum, platforms may want to become autonomous monetary systems, currency areas of a new kind: digital currency areas (Brunnermeier et al., 2019). They are not defined, as in the traditional literature on optimum currency areas (OCA), by the commonality of macroeconomic shocks and the degree of factor mobility (Mundell, 1961). They are based on digital interconnectedness. Because participants share the same form of money, payments inside the area are easier and trading frictions are lower than with outside. For people who use the same form of money, price transparency is greater, price discovery easier, and so is the netting of payments.

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2.2.3 Digital monetary systems are more competitive Digitalisation creates the possibility of increased currency competition. Whether such competition materialises will depend on regulation and, more generally, the interaction between public policy, private attitudes, and technology. Currency competition could develop across three dimensions:

a. Competition between private mediums of exchange Competition in payments is good for the economy and for citizens. Cryptocurrencies and digital money have already produced significant innovations and improvements, especially in cross-border retail payments, where inefficiencies are still high. They acted as a catalyst for change, like Napster did for the music industry a few decades earlier. Consumers will benefit from faster, cheaper, and more efficient payment services. And those will contribute further to the financial integration in Europe.

b. Competition between private and public unit of accounts Beyond payments instruments competition may extend to the unit of account, thus compromising monetary autonomy and sovereignty. This evolution is more uncertain and speculative but, as the Libra/Diem experiment has shown, it cannot be ruled out in a digital world where money creation has become technically easy. Cryptocurrencies have their own unit of account and the ambition, for some, to displace official currencies. For platforms, having a currency with its own unit of account maximises the lock-in effect. It creates an exchange risk for those who want to exit. It also generates seigniorage.

c. Competition between different national currencies Unless designed otherwise, digital money is naturally cross-border. If not constrained, it naturally penetrates other countries’ territory. Digitalisation has raised concerns of increased currency substitution and competition between countries. The euro seems largely immune to such currency competition. However, the threat to the efficiency of monetary policy could be real if, in the future, global stable coins denominated in a foreign currency expand and develop. Not all countries are equally affected by current technological changes or equally exposed to such competition. Digitalisation may serve as a vehicle for the internationalisation of some currencies. It may help them to quickly gain international acceptance and status. And, symmetrically, other countries may be exposed to new forms of “digital dollarisation,” depending on their monetary re-

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gimes, the openness of their capital account, and their regulation of payments and the internet. Obviously, international currency competition and substitution is nothing new. Digitalisation will, however, give it a new dimension and impetus. It will also create a new dynamic interaction between public authorities and private actors. Some countries may rely on private operators – using their digital networks to circulate their currency in other jurisdictions. The Libra/Diem project launched by Facebook (now Meta) in 2019, and since strongly rebutted by the authorities, has acted as a wakeup call. It demonstrated the technical feasibility of a completely new, cross-border monetary system, based on its own unit of account, with potentially 2 billion participants over the world. Over time, as it transforms domestic monetary systems, digitalisation may reshape international monetary relations and the international monetary system as well. In that world, private money ceases to be a complement to public money and becomes a competitor, to the point of potentially evicting it from the economic space.

2.2.4 Digital monetary systems are more private In a digital world, (almost) anybody with some expertise in cryptography and computer science can create money. Not surprisingly, experiments in private money are now flourishing. The issuance of private money has been strongly reinvigorated by technology. Digitalisation has revived a libertarian school of thought that deeply distrusts governments and central banks. Almost 9,000 cryptocurrencies are currently in use, some of them significant, many other marginal. Innovation goes further with attempts to build up new monetary systems, created by tokens moving around a specialised network of users. A full digitalisation of retail payments would lead to the elimination of cash, which is currently the only public money accessible to all. Should cash disappear, citizens would lose access to public (central bank) money. There would in effect no longer be a functional legal tender, with the operation of the monetary system turned over to private entities. Absent access to public money the general public is effectively locked into private money. The perception that there is no access to safe liquid assets backed by the state could undermine confidence. Money would no longer be a physical manifestation of sovereign authority. Citizens would no longer have any visible symbol linking money to the authorities and to the central bank. Symbols are important for money, as illustrated by the debates around the euro banknotes when the single currency was created. Connecting the central bank to money might also be important for the effectiveness of the central bank’s communication.

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2.3 The digital euro: preserving public money in a digital world There is a paradox of public money. It is hardly visible in everyday life, except for small and decreasing amounts of transactions in cash. It is hardly identifiable either. Citizens perceive money as a whole. They don’t see the distinction between bank deposits – which are private money – and cash, which is issued by the central bank. Yet, the character of public money makes it absolutely central and essential to the stability and functioning of economies. Because it is invisible and not detectable, the benefits attached to public money tend to be taken for granted. But they have to be preserved in a new environment. This is the main rationale for exploring the issuance of a digital euro. Box 2: CBDC initiatives around the world

The past few years have seen an exploding interest in CBDC by central banks all over the world. As the private issuance of a number of cryptocurrencies has raised questions on many aspects of the future of monetary policy, central banks have started exploring CBDC as a concrete option for the years to come. Following this heightened interest, a CBDC Tracker has been established by the Atlantic Council to systematically track CBDC-related initiatives around the globe. A few key statistics (referring to the time of writing) is collected are summarised in Table 1. Nine countries – Nigeria, The Bahamas and the Eastern Caribbean Currency Union (Dominica, Montserrat, Grenada, Saint Vincent and the Grenadines, Saint Lucia, Antigua and Barbuda and Saint Kitts and Nevis) – have completed the launch of a full-fledged digital currency for retail purposes. 14 countries, among which China, South Korea, Singapore, Malaysia, Israel and Sweden, have instead inaugurated pilot projects on CBDC. In particular, the People’s Bank of China has progressed quickly in rolling out digital yuan trials in several provinces across the country. Furthermore, 16 countries and currency areas are developing and testing CBDC technology at an early stage, and among them the euro area with its ECB-sponsored projects and analyses on both retail and wholesale CBDC. 41 countries are instead conducting preliminary research on the details and possible effects of the adoption of a sovereign digital currency. Overall, 87 countries – representing over 90 % of global GDP – are currently involved in CBDC explorative projects, a testament to the growing salience of the issue on central banks’ policy agendas.  

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Table 1: CBDC initiatives around the world

Launched

9

Pilot

14

Development

16

Research

41

Inactive

7

Cancelled

2

Source: See Atlantic Council CBDC tracker [Accessed on 13 January 2022]

2.3.1 Is there a “business case” for the digital euro? The launch of CBDCs is frequently advocated on pure efficiency grounds: to improve the functioning of payment systems. However, central banks have no comparative advantage in managing retail payments and client relationships. This objective may be best achieved through proper regulation and incentives aimed at the private sector. Proponents of such an expansion in central banks’ role mainly refer to three arguments. First, the need to stimulate competition and innovation in payments. Competition in payments is important and difficult, especially in the digital age. It can be best stimulated though specifically designed policies and instruments. As for innovation, recent evidence points to a very dynamic private process. New digital currencies, including cryptocurrencies, in particular stable coins, have revealed latent aspirations for distant, instant, and peer-to-peer payments. To some extent, they are forcing other actors to adapt. Their business model may raise serious issues of competition and integrity. Second, the necessity to foster financial inclusion. More than one billion people in the world (millions in the euro area) do not have a bank account. They mostly come from the poorest of households. Many of those unbanked persons have a mobile phone. Mobile payments work for financial inclusion. Instant and easy identification is possible through phone numbers. In case welfare payments are necessary (as was the case during the COVID-19 crisis), governments can reach those segments of the population that need it most. However, is direct public intervention necessary to create and foster mobile payments? In many cases, including in poor and emerging countries, private initiative has provided an efficient service. M-Pesa, in

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Kenya, has 50 million customers, most of them unbanked. If and when necessary, a proper mix or regulation and incentives applied to private operators could achieve the necessary result. Finally, the need to improve cross-border retail payments. Technically, domestic payment systems are often not interoperable between countries. Delays are longer; compliance risks and costs related to anti-money laundering and countering the financing of terrorism (AML/CFT) are typically higher. Small payments (such as remittances) are most penalised. Some private digital currencies now offer new solutions that “bypass” existing bank-based payment systems. However, sustainable and scalable solutions will require significant investments to be coordinated between countries. This is a case where public intervention might help. The joint creation, by several countries, of interoperable CBDCs could build the necessary infrastructure and offer a backbone, fostering further private developments.

2.3.2 The current complementarity between private and public money In contemporary monetary systems, public and private money do not compete with each other. They are complements. Authorities are generally happy to entrust the private sector (the banks) with running payment systems and allocating credit. They accept that banks manage and create most of the money existing in the economy. Whatever the instrument and infrastructure, ultimately, a non-cash payment is a transfer of a deposit in one bank account into another bank account. But that organisation is only made possible because public money is there, in the background. It performs two essential functions. One is invisible: the central bank issues reserves, which are liabilities held by commercial banks in accounts at the central bank. Reserves are used as a settlement instrument between banks. Because they are claims on the central bank, they are generally considered as a “superior” form of money (in any case superior to any claim on the banks themselves). Because banks can settle between themselves in full confidence and security, the general public is able to transfer money from one bank to another with the same confidence and security. All deposits are considered as equivalent forms of money outside of crisis times. Without public money (the reserves), the situation would be different. Counterparty risks between banks would periodically arise, casting doubts on their mutual solvency, impeding or paralysing interbank settlements. Deposits could not be transferred across different banks, and their equivalence would be broken. The second role performed by the central bank, the issuance of banknotes or “cash”, is more apparent and familiar. While quantitatively of small importance, cash is crucial for the stability and confidence in money. People have the right to exchange their deposits into cash whenever they wish, without restriction or loss

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of value. If the public is confident that this right can be exercised with no condition, the two forms of money – private and public – are perceived as equivalent. Bank deposits are equivalent to cash. Or, in broader terms, private money is equivalent to public money.

2.3.3 The digital euro as an anchor The central policy question raised by digitalisation is the role of public money. The technological evolution leads to a reduction of the role of cash and, ultimately, its disappearance for the general public. That would mark a fundamental shift in existing monetary arrangements. There is no recent historical precedent for a situation where people live their lives in a fully private monetary environment. The main rationale for developing a digital euro would be to prevent this evolution. To the extent that money becomes digital, central bank money must be made available in digital form. Central bank money is of superior quality because it does not depend on the solvency of a private issuer. It is supported by the power of governments to tax and, in most countries, by legal tender. It provides the ultimate settlement asset between banks. It also defines the unit of account. As long as all forms of money are ultimately convertible into public money, it ensures that the currency is uniform: all monetary instruments with the same nominal value trade at par in all circumstances. They are equivalent. To fulfil those functions, public money must be present and freely available in all sectors and parts of the economy. The ubiquity of central bank money is essential to its role as anchor. All households must be given the opportunity to hold and use central bank money. The same is true for corporates and financial institutions. As digitalisation progresses, private payment and settlement networks and mechanisms will develop for good efficiency reasons, with, in some cases, special-purpose tokens acting as “local” media of exchange. To fulfil its functions, central bank money must be able to penetrate all those “cracks” in the productive and financial system. That can only be achieved if it exists in a form adapted to the needs of a digital economy.

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Box 3: Scenario with only private money

In current monetary arrangements, central bank money plays a crucial role, because it is safe. As long it is perceived as safe, it can be elastically supplied, serve as a settlement asset and store of value, and provide the standard of value (unit of account) for the economy. By contrast, left to its own dynamics, private money is unstable. Its nominal value is contingent on the perceived solvency of its issuer and therefore subject to changes in perceptions and multiple equilibria. But what if private money could be made “safe” for the general public through a mix of public regulation and support? There would seemingly be no need to issue a digital public money. Several tools are available to authorities to enhance the safety of existing private money (bank deposits): – In effect, deposit insurance – to the extent that it benefits from public support – already plays that role. – So do the lender of last resort and refinancing activities of the central bank, which preserve the uniformity of money by ensuring that deposits are unconditionally transferable between banks. – Finally, banking regulations aim at ensuring that banks remain solvent in all circumstances, therefore indirectly supporting the value of deposits. Regulators provide for quick and orderly resolution of banks (with insurance of deposits) in case insolvency nevertheless occurs. It also de facto limits banks from issuing too much deposits. It could be argued that the combination of those three tools – tight bank regulation with regulators that can shut down banks, lender of last resort, and deposit insurance – makes it possible to have a system in which 100 % of the money held by the general public is issued by private banks and nevertheless considered as safe. This is certainly an issue worthy of further research. In addition, one could allow new forms of private money in form of stable coins issued by private entities. In addition to the above regulations, interoperability regulations across various platforms and ledgers are necessary to ensure the right convertibility, acceptability, and portability (Brunnermeier and Payne, 2022). However, because there is no precedent in modern history without public money, it would be dangerous to base public policy on that assumption. In such an environment, what would determine perceived safety for the public is unknown. With no public money to turn to, runs on banks may become more frequent. They could occur from one bank to another, or from the euro to foreign currencies. In that case, it is certainly preferable to have a digital euro as a safe haven instead of a foreign currency or a cryptocurrency. Ultimately, recurring episodes of instability may become self-fulfilling and undermine the confidence in the whole monetary system. Finally, there are periods when monetary accommodation is necessary and not spontaneously undertaken by private money issuers. In some exceptional circumstances, monetary authorities need to keep the option of “bypassing” financial intermediaries and directly supply public money to the economy.  

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3. Public Policies and the digital Euro 3.1 The digital euro and privacy 3.1.1 Privacy and payments Privacy is a core value for European citizens. In the EU, privacy is considered not only an individual right, but also a common and social good. Personal data protection is among the prerogatives covered by the EU Charter of Fundamental Rights. The EU has taken a leadership role in the world with the passing, in 2016, of the General Data Protection Regulation (GDPR), specifying a unified set of rules for companies and public authorities. The GDPR has proven an essential policy tool to safeguard individuals’ fundamental rights when interacting with technology in the single digital market. The importance of privacy for citizens is reflected in a survey conducted by the ECB in 2021. Among the requested features of a potential digital euro, privacy ranked highest: for 43 % of respondents, as compared to 18 % mentioning security and 11 % the ability to pay across the euro area (Eurosystem, 2021). There is a fundamental logic to this attachment to privacy in payments. Paying is one of the most frequent acts in everyday life. In autocratic societies, government surveillance of payments is a privileged way to monitor private and social interactions. Apart from governments, people also want to be protected from other people when they transact with them. For individuals, the history of payments reveals an enormous amount of information about their habits, preferences, medical situation and way of life. It is a legitimate aspiration to have this information protected: first, from those with whom one transacts; and, second, from the third party which manages the transaction. In sum, privacy gives money part of its value. It empowers individuals to engage in activities and exchanges that they may not undertake otherwise (Kahn, 2018). Therefore, pursuing privacy as a feature of money is certainly a valid policy objective. Should a digital euro be launched, its privacy features will be a major driver of its acceptability and trust.  

 

 

3.1.2 Privacy and other policy objectives Privacy, however, comes into conflict with other, equally valid, policy objectives. The EU is also a world leader in the fight against money laundering, financing of terrorism and tax evasion. Regulations implementing those objectives (AML/CFT) may limit cash usage: in most countries, regulations mandate that large cash transactions be reported (with significant differences across Member States). “Know your customer” (KYC) regulations, under certain circumstances, allow pro-

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fessionals to reveal the identity of counterparties or account holders with the aim of fighting money laundering. The landscape is changing fast as digital payments introduce additional complexity in the policy trade- off. Digitalisation both threatens and potentially enhances privacy. Depending on social norms and organisation, privacy in digital payments may yield good or bad results. The availability of transaction data can have a positive social value if it allows, for instance, to make better and faster predictions on the economic activity, better recommender systems, or to substitute collateral and make credit more accessible. On the other hand, the business model of platforms rests upon the exploitation of payment data for private scoring and other uses. Payment information can be very valuable to a variety of actors, especially if combined with other data and exploited with artificial intelligence and machine/deep learning algorithms. In autocratic political systems, these same data may be used for social control. In this new digital space, cryptocurrencies derive part of their popularity from the anonymity they confer – be it for legal and illegal reasons. Over the last years, several successive generations of crypto currencies have been designed with the purpose of achieving an ever-increasing degree of anonymity.

3.1.3 Policy challenges for the digital euro For the digital euro, the challenge raised by privacy can be simply described. Cash is private by nature. It guarantees third-party anonymity and it leaves no traces. Regulation is necessary to limit the privacy it confers. For a digital currency, the logic is inverted. Transactions in digital money are recorded on a ledger – they necessarily involve a third party. No public digital currency will automatically and spontaneously ensure the same level of privacy as cash. For a digital euro, privacy has to be decided, organised and embedded into its design. It will result from fundamental political and social choices. Privacy will certainly be a major driver of the attractiveness of a digital euro. Privacy regimes applicable to cash provide a useful benchmark. They will certainly serve as a mental reference for many users. In a digital world, however, additional considerations also matter. Amongst all the providers of payment services, the central bank is the only one which has no interest in exploiting personal data for profit purposes. It can provide citizens with a “privacy safe haven” which mirrors and parallels the monetary safe haven that public money brings. In digital environments that become increasingly intrusive, it would certainly be a useful social function – and give public money a valid comparative advantage. It should be noted that an important difference exists between the concepts of anonymity and privacy. Privacy requires that both the nature and participants to a

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transaction remain unknown. Anonymity is less demanding: while the identity of the parties is protected, the transaction itself can be observed and recorded. That difference may be essential in designing a CBDC. Anonymity may go a long way in meeting citizens’ concerns while preserving other objectives of public policy (such as AML/CFT). Finally, one cannot overemphasise the importance of the governance of privacy. Whatever regime is finally chosen for the digital euro, it will rely upon technical and instructional guarantees5. Those must be fully credible and trusted by the population if the confidence in the currency is to be ensured and maintained. The technology offers many degrees of flexibility in deciding and implementing privacy/anonymity options. Privacy and anonymity can be differentiated according to the operational level. For instance, privacy may be assured for offline transactions below a certain threshold. Anonymity can be guaranteed vis-à-vis public authorities and not private operators – or the reverse. Depending on countries, it is possible that preferences differ, as the population may trust more the government or the private sector to preserve confidentiality of their data. An architecture that gives maximum flexibility while fully compliant with regulations is more apt in ensuring trust.

3.2 The digital euro and financial intermediation The issuance of a digital euro may have important consequences for financial intermediation and financial stability. Concerns have been expressed that, once the general public has easy access to the central bank balance sheet through the digital euro, instability will arise for the deposit-taking activities of banks and destabilise their business model. However, the digital euro is only one of many changes that will impact banks’ business model in the era of digitalisation. Its effects are likely to be small when compared to the magnitude of the disruption that Big Tech will bring in the area of payment apps and digital money. Big Tech and stable coins may entail substantial losses of funding for banks, depending on how those actors manage their liquidity. This being said, banks play a major role in financial intermediation in the euro area. As compared to the US, where capital markets are predominant, bank credit is more important to the financing of productive activities, especially for small and medium-sized enterprises (SMEs). Banks are also essential in the trans-

5 See ECB (2019) for a discussion on the technical aspects of anonymity in CBDCs.

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mission mechanism of monetary policy. In the future, increased competition in payments and deposit activities will produce important benefits for consumers. It will also inevitably alter banks’ business models. Authorities will have to decide how far to go in other changes overhauling the European model of financial intermediation. The introduction of the digital euro should be seen in that broader perspective. Box 4: Firms’ financing in the euro area and US

Firms’ financing operations in euro area and the United States have historically been carried out through different mixes of bank-based and market-based approaches. In Europe, banks have played a predominant role for channelling funds to firms and borrowing to households, while the US has witnessed the prevalence of capital markets as instruments for channelling credit. Figure 1 depicts private non-financial sector borrowing from banks as a fraction of GDP. The blue line depicts the series for the euro area, while the yellow line is the series from the US. The rest of the developed world is also more bank-dependent, as shown by the series for G20 countries in red.

Fig. 1: Bank lending to private non-financial sector as percentage of GDP for the euro area, G20 and US (Source: Bank for International Settlements) SMEs are more bank-dependent than large corporations. Over time, fintech financing will gain an increasingly important role in funding SMEs – a development that will emerge independently of the introduction of the digital euro. To the extent that the introduction of a digital euro could interact with the bank-reliant financing model, a careful monitoring by the relevant supervising authorities is required.

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3.2.1 Digitalisation disrupts banks and financial intermediation Banks bundle together three different functions, essential to the working of a modern economy. They manage deposits and payments; they grant and allocate credit; and, in the process, they create (private) money in the form of bank deposits. Being able to combine all these three functions makes the banking industry a central piece of every modern financial architecture. The general trend of digitalisation of money has the potential to disrupt and challenge the banks’ business model. First, banks will face new and strong competition from Big Tech and platforms. Those actors are mainly interested in one function of money: to make payments. They regroup this function with other activities developed in synergy, such as e-commerce or social messaging. Payments, because they are an essential activity of social life, contribute to keeping all the functions linked together in the ecosystem of the platform. Above all, payments give access to data, which can then be exploited in other lines of business. Payments become unbundled from other aspects of money and banking – such as the store of value – and re-bundled with very different economic functions. Second, increased competition in payments may exert pressure on the deposit-taking and funding activity of banks, ultimately compromising their ability to grant credit or increasing its cost for borrowers. Finally, in the longer run, digitalisation may lead to an inversion in the current industrial organisation of financial intermediation (Brunnermeier et al., 2019; Landau and Genais, 2019). At the moment, banks are the main point of contact with their borrowers and debtors. The pre-eminence of payments may reverse that implicit hierarchy. A new organisation could emerge with payments at its core and all other financial activities organising themselves around that function. Consumers’ point of contact would be the entity that owns the payments platform rather than a bank. Financial services such as credit or asset management and insurance would be subordinated to payments. In this new type of financial hierarchy, banks could be replaced by fintech subsidiaries of payment systems. The two payment giants in China – Ant Financial and Tencent – prefigure that evolution.

3.2.2 Possible effects of a digital euro There is no doubt that a totally safe and liquid monetary asset is an extremely attractive medium of exchange and store of value, especially if offered in unlimited quantities. Depending on its design, significant amounts of deposits and liquid investments could shift to the digital euro. There are two dimensions to this disintermediation risk: (1) a “structural shift” could occur from private deposits to the

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CBDC, fragilizing the funding of banks; and (2) runs on banks may become easier and more frequent.

a. Structural shift away from bank money First, it is possible that the general public will permanently shift part of its transaction balances away from bank deposits and into the CBDC. The potential amplitude of such a shift is unknown. It would have two cumulative effects: banks would lose funding; and they would have to compete more for deposits, increasing the cost of their resources. Depending on the magnitudes, there could be a significant reduction of banks’ profitability, and of their ability to distribute credit. The effects of structural shifts and runs to central bank money can be alleviated or compensated by the central bank itself, through credit and refinancing given to banks, in its function as a lender of last resort. More broadly, Brunnermeier and Niepelt (2019) have shown that it is possible to devise a set of compensating policies that would make the introduction of a CBDC fully neutral on the macroeconomic equilibrium and the allocation of resources (although it would necessitate a great deal of fine tuning). This is discussed in Section 4.3.

b. Increased frequency of runs Bank runs could become more violent and frequent as digitalisation makes it easier to convert one form of money into another. Bank runs would be enabled further by digitalisation, which by design is intended to facilitate electronic transactions. Once central bank money becomes available in digital form, the frictions that are associated to the manipulation of cash would disappear. Any doubt or concerns about a bank could translate into massive movements of funds. It is possible to take a benign view of those risks. Most of the runs occur between banks themselves. They may create localised tensions but do not threaten the financial system as a whole. Banks have always been subject to deposit flights. Digital runs from one bank to another have already occurred in recent times. Runs are the unavoidable counterpart of the convertibility of deposits into public money. They can indeed be characterised as a pathology of convertibility. They cannot be eliminated without restricting convertibility itself. Finally, supposing depositors want to run from banks, in the absence of a digital euro, they would be incited to move to foreign currencies, if those were available in digital form.

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Box 5: Banks, deposit taking and credit

Franchise value as a rationale for bundling: A rationale for bundling lending and deposit taking within the banking sector is to give banks market power in providing transaction services and so extract charter rents from setting deposit interest rates below the policy rate. Although it may seem counterintuitive to view bank rent extraction as desirable, the literature (summarised in Brunnermeier and Payne, 2021) has suggested several potential benefits to giving banks a positive franchise value. 1. Limiting excessive risk-taking. Banking activities are difficult to monitor and bank managers have limited liability for their losses. This has frequently led to excessive risk-taking. One way to discourage risk-taking is to promise banks future rents through their deposit franchise so that banks are more concerned about bankruptcy. 2. Creating an incentive to stay within a regulatory perimeter. Banks within the regulatory perimeter are heavily constrained and so have a permanent desire to shift their activity to the less regulated shadow banking universe. Granting private banks rents for being in the regulated sector counteracts this urge. 3. Overcoming financing frictions. Banks might have superior investment opportunities, but other frictions limit their ability to take advantage of these opportunities without sufficient net worth. Granting a deposit franchise increases bank net worth and allows them to take advantage of the opportunities. These are strong arguments for preserving the franchise value of banks, especially in competition with fintechs. However, they are not absolute. Even if the need for a franchise value is acknowledged, it is not clear that it should be satisfied mainly by limiting competition on payments and deposit-creation activities. Overall, those arguments show the difficulty of finding a proper equilibrium between the objectives of efficient payment and efficient credit distribution when, as in the euro area, banks play a major role in financial intermediation. Digitalisation creates a new competitive environment where non-banks, such as Big Tech firms, enter the market and lead to innovations. Other developments can foster competition among existing banks as they reduce consumers’ switching costs. “Open banking” that will allow customers to transfer their data across banks is one prominent example. What will be the aggregate impact of these developments? To answer these questions, one has to have a clear understanding of the various rationales for bundling financial services and for recognising a special role for commercial banks. Commercial banks are in the business of lending to firms and households. They are also in the business of creating deposit money. The lending activity is reflected on banks’ asset side of the balance sheet, while deposit taking is on their liability side. Deposit taking is closely linked to payments. Synergies as a rationale for bundling: Explicit synergies between lending and deposit creation are a powerful argument for bundling of both activities. Kashyap et al. (2002) argue that economies of scale in liquidity management create synergies between lending and deposit creation. They observe that banks face unpredictable outflows of funds when depositors withdraw their deposits and when borrowers draw down on their credit lines. To manage possible outflows, commercial banks hold liquid assets, but this is costly because liquid assets have a low yield. If deposit demand shocks and credit

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line demand shocks are not perfectly positively correlated, then a bank providing both deposits and credit lines can manage liquidity more cheaply than other financial intermediaries. Central banks have a superior technology for providing a medium of exchange because they do not need to hold liquid assets; they can simply print the money. Hence, in principle they could crowd out commercial banks from the deposit business. As pointed out by Piazzesi and Schneider (2020), unless the central bank also provides credit lines, this will make credit line provisioning more expensive because the commercial banking sector can no longer take advantage of the synergy between deposits and credit lines. The main policy conclusion of the synergy rationale is not necessarily to rule out CBDC but to condition how CBDC should be designed. By paying a lower interest rate or capping holdings, the central bank should be able to balance the benefit of cheaper money creation with the cost of higher credit line creation and improve welfare. A priori, it is not obvious why those activities should be bundled together and offered by the same institution. One could easily envision an arrangement in which banks specialise. Some specialise in lending activity, funding themselves on funding markets, while other focus on payments and deposit/money creation. The latter are often referred to as “narrow banks”; they could also be payment platforms operated by fintech companies.

3.3 The digital euro and monetary policy From a macroeconomic perspective, a digital euro would simply be a new form of central bank money. It would have the same issuer: the central bank. It would be an almost perfect substitute to cash and present the same characteristics of safety and liquidity. It would not, by itself, increase the supply of money in the economy nor change the policy rate determined by the central bank. It would be neutral. Simply changing the form of public money should be a priori neutral and indifferent for monetary policy, as it would result in no discernible macroeconomic impact. However, two nuances should be brought to that statement. First, the digital euro may trigger a shift from bank deposits to central bank money. That would affect banks’ funding and, potentially, their ability to grant credit. It could therefore impact the transmission mechanism of monetary policy. This point is discussed in detail in the previous section. Second, the digital euro could become non-neutral by design, for instance if it were decided that it could carry an interest rate, positive or negative. Then its macroeconomic impact would be very different from cash. This will be a major choice to be made when deciding on the key features of the digital euro.

3.3.1 The technical possibility of negative interest rates Contrary to cash, it would be technically possible to impose an interest rate on a public digital currency. Many economists consider this as a major improvement

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and a reason to introduce the digital euro. They see in a public digital money the possibility of increasing the efficiency of monetary policy. A general effect would be to increase the amount of money in the economy that is sensitive to the interest rate, thus rendering the transmission mechanism more efficient. A more specific advantage would be to allow the imposition of negative interest rates on the currency. At the moment, negative interest rates can be applied only on reserves held by banks via the deposit facility rate (DFR), a measure which is still considered largely unconventional. Some economists would favour negative nominal interest rates on money held by the general public. Their reasoning comes in three parts. First, they note that advanced economies, especially the euro area, may have entered a period of very low equilibrium real interest rates. In this regime, there is a frequent need to bring policy rates at zero or below. Second, imposing negative interest for the general public is currently impossible as there is always the possibility to move to cash, which carries no interest rate. Third, as a consequence, monetary policy is constrained by the zero or effective lower bound on nominal interest rates, which prevents it from reacting appropriately to downward risks to price stability and the possibility of deflationary pressures. A CBDC with a negative interest rate would alleviate this constraint and make other unconventional monetary actions less necessary. However, these potential benefits must be balanced against the very detrimental effects that negative interest rates would have on the acceptability of the digital euro. Moreover, citizens would still have the possibility to hold cash as an alternative, if and when negative interest rates would apply. Even if negative interest rates were applied only sporadically, they may have a dissuasive effect ex ante and fragilize the circulation and trust in the digital currency.

3.4 The central bank in the economy and society 3.4.1 Size of Eurosystem’s balance sheet Following the 2007–2008 financial, European sovereign debt and COVID-19 crises, the balance sheet of the Eurosystem has expanded by more than a factor of 6. Its imprint on financial markets has increased in proportion. Depending on its feature and acceptance, the digital euro could mark a new phase of expansion as well as introduce a larger role of the Eurosystem in financial intermediation. Whether those trends will materialise will partly depend on people’s attitudes. But it will also be result of design and policy choices. By and large, central banks set the conditions for access to their balance sheets. The digitalisation of money will necessitate many such decisions in the period to come.

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The digital euro could become either a complement or a substitute to cash. In the first case, it would add to the aggregate claims held by the general public on the central bank and increase its balance sheet. A larger part of money balances held by citizens and corporates would be in the form of central bank money. Another driver of the expansion of Eurosystem’s balance sheet would be the longer-term refinancing that it would provide to banks that lose deposits. By itself, this policy would expand the central bank balance sheet (as well as requiring the mobilisation of collateral). Supposing there is a permanent shift from deposits to the digital euro, then there would be an equally permanent increase in the Eurosystem’s role as one intermediary between the source and destination of credit. It is impossible to assess precisely whether and to what extent this transformation would influence credit allocation. Bindseil (2020) has identified some consequences. Should the banks rely permanently and significantly on central bank funding, their incentives could change. Large scale refinancing would then transform credit allocation towards a different model, more akin to an originateto-distribute way of functioning.

3.4.2 Access to Eurosystem’s balance sheet Central banks’ balance sheets will also be driven by how the new payment actors – Big Tech and stable coins – will be incited (or forced) to manage their reserves and liquidity. In some models (China, the model advocated by Carney, 2021), all their reserves are deposited at the central bank, which puts it in a privileged position to regulate their activity and exercise oversight of the payment system. Conversely, the central bank may want to avoid giving those intermediaries a privileged backing. That would give the money they issue a quasi-public character, distort competition, consolidate the lock-in effect of their platforms, and, ultimately, delegate to them a form of sovereign monetary power.

3.4.3 Token and account-based money Finally, and above all, the role and place of the central bank will be very different depending on whether the digital euro is token-based or account-based. In the first case, citizens, while holding a direct claim on the central bank, will not have a direct and personal relationship with it. On the contrary, with an account-based system, hundreds of millions of people would become depositors at the central bank. The management and client relationship could be, to some extent, delegated to private intermediaries. But the central bank may have to assume some legal, operational and financial responsibilities. Its role in AML surveillance and its function as a retail payment operator, its accountability to its depositors would

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have to be precisely defined. It is very likely that the central bank would be drawn into activities and territories that are very unfamiliar and fundamentally transform its role and place in the economy and society. Box 6: Token- and account-based money

In monetary economics, the distinction between token- and account-based money has been introduced in Kahn et al. (2009) – although they used a different terminology (instead of token they mention “store of value” payment instruments). The distinction is based on the type of verification required by each system: “Verification of identity is central to accounts systems, just as counterfeit protection is central to store-of-value systems.” Account-based refers naturally to bank money, whereas token/store of value can represent both banknotes and digital money – for which privacy and anonymity can be preserved. While very illuminating, the distinction cannot be used without precautions: – In technological parlance, a token can be many things with no relation to a monetary unit. – Symmetrically, some “tokens” used as application of digital money can be a representation of some account-based (bank deposit) money. A more accurate terminology would be to refer to digital money in the form of “bearer instruments” that can be exchanged peer-to-peer. The technological infrastructure and identity/ privacy characteristics are decided by the issuer and the regulatory authority according, in particular, to the following criteria: (1) whether the instrument is linked or not to a personal identity, and (2) whether it is recorded in the ledger as a separate individual unit or part of a balance held by a specific entity. Both distinctions have immediate implications for the privacy and anonymity regime. An instrument with no link to any identity would be easily accessible through a password, fully private, but not traceable. This raises difficult issues of compliance with KYC and AML regulations. At the opposite end of the spectrum, an instrument recorded as part of a balance held by an identified individual would, from a payment perspective, look very similar to a bank deposit.

3.5 Monetary sovereignty and internalisation 3.5.1 The ability to conduct monetary policy Monetary sovereignty can be defined as the ability to conduct an independent monetary policy. In international economics, it may involve trade-offs and choices on the exchange rate regime and capital account opening. The most fundamental component of monetary sovereignty, however, is domestic. For a central bank to conduct and independent monetary policy, it must control the unit of account that prevails in its jurisdiction. If the unit of account is defined as the central bank liability, it can then fix the overnight interest rate and, by arbitrage, influence the whole set of monetary and financial conditions.

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In sum, monetary sovereignty largely identifies with the integrity of the unit of account and a uniform currency. To the extent it protects and underpins both, the digital euro could appear as an essential component of sovereignty in a digital world.

3.5.2 Strategic autonomy through payment systems In everyday language and politics, the concepts of sovereignty and strategic autonomy are closely related. That is true, as well, for money and payments. The dimension of strategic autonomy is important in payments. Payments depend on critical infrastructures with a clear European dimension. Many efforts are currently deployed to strengthen and improve the efficiency and speed of domestic retail payments in Europe. They include both public and private initiatives. In that context, increased competition in retail payments, coming from large digital operators (“Big Tech”) will bring many benefits, but also additional challenges. Large private digital networks may naturally lead to an increased fragmentation and the build-up of dominant positions. They may not spontaneously internalise the imperatives of continuity, resilience, and cybersecurity. There is a public good aspect to the functioning of payment systems. The ability to pay safely and efficiently everywhere and at any moment in time is a basic necessity for any society and economy. No disruption or interruption is acceptable. Ultimately, the sovereign is responsible and accountable for the accomplishment of those vital functions, that have implications for civil peace and social cohesion. Everywhere, the distribution of banknotes is managed as a public service – while printing itself is often delegated to the private sector. In most countries, and certainly in the euro area, the central bank directly operates the core systems that underpin wholesale payments. It has an oversight responsibility in retail payments. The central bank also assumes responsibility for financial stability and is the lender of last resort to financial intermediaries. The architecture and functioning of payments systems largely determine how efficiently it can perform those tasks. Most wholesale payment systems use central bank money as their settlement instrument. Digitalisation may lead to different configurations where networks do not necessarily rely on existing payment schemes and clearing and settlement arrangements (Panetta, 2020). For example, Libra was an “integrated construct that simultaneously encompasses a new settlement asset, a new payment rail and new end-user solution” (Panetta, 2020). How payment systems will adjust to the new phase of digitalisation is therefore essential for Europe. To the extent that the presence and ubiquity of public

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money is judged as essential, it should inspire the design and adaptation of payment systems. In return, the digital euro may be conceived as part of broader vision on European payments and should be designed in that perspective.

3.5.3 Data: a new dimension of monetary sovereignty On 1 March 2021, leaders of four EU countries reportedly sent a letter to the President of the European Commission, in which they wrote: “data has become a new currency which is mainly collected and stored outside Europe” (Eder, 2021). While technically not fully accurate, this formulation captures a fundamental reality: in the age of digitalisation, money and data are closely linked, and they jointly define the perimeter of sovereignty. Payment systems are one privileged entry point. Every monetary transaction is an opportunity to collect data. Every credit is increasingly based on the exploitation of data. Whoever operates payment systems therefore has a significant impact on the treatment of data in the EU. Today, a large share of retail payments is operated by foreign-based entities. Most data is stored outside the EU, which raises significant privacy issues. To some extent, the tension can be managed as current payments systems – based on banks and credit cards operators – are not built with data exploitation as their primary principle of business and source of profit. Those models are changing, however, with digitalisation and platform-based systems. Those rely mainly upon data collection and treatment as a source of income. From a public policy perspective, technological dependence on payments will translate into less control over data. This may also compromise the pursuit of other core policies, such as the fight against money laundering, terrorist financing and tax evasion. There will be increasing convergence between data and monetary sovereignty. At a global level, those trends may put significant limits on the efforts to build open and cross border payment systems. Future “digital currency areas” (Brunnermeier et al., 2019) may be ultimately delineated by differences in data and privacy laws. For the EU, there is a need to consider jointly the future of data and payment regulations. Sovereignty in those two domains may be hard to dissociate. If, as stated in the leaders’ letter, “now is the time for Europe to be digitally sovereign,” there will be implications for how payments systems are structured. Obviously, the digital euro, if created, would only be part of the solution. It could help and catalyse many essential components of digital sovereignty, such as, for instance, the creation of an EU-wide ecosystem for digital identities.

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3.5.4 Digitalisation and the international monetary system Digitalisation has the potential to reshape the international monetary system. As cross-border payments become easier, currency competition may increase and also develop into new dimensions. It may no longer be based only on the macroeconomic and monetary performance of currencies, but also on pure digital interconnectedness and the bundle of services that platforms, networks and stable coins will offer to users. Specialisation may occur, independent of the characteristics and specificities of each jurisdiction. For instance, some networks could intensely exploit or sell users’ data, whereas others may prioritise absolute privacy. Intercountry links may increasingly depend on whether those digital payment systems will – or not – be made interoperable. In this context, the launch of CBDCs by many countries, first of all China, has often been interpreted as the first act in a new and fierce international currency competition. Whether it will happen or not depends on the forces that drive the international adoption of money. There are, schematically, two ways through which a currency can internationalise: first, by becoming a global store of value, as a reserve instrument; second, by being used for international payments, as a medium of exchange. Historically, the two roles have progressively converged. However, different paths and strategies are conceivable for a currency to gain international status and use in the 21st century. Analysing the current dominant position of the dollar in the international monetary system, some economists (as e. g. Eichengreen 2005) emphasise its function as a reserve asset, based on the size, depth, and liquidity of US financial markets. Others (as e. g. Gopinath et al., 2016) give more importance to its role in the denomination and settlement of international trade and transactions. The distinction becomes relevant and important in a digital environment. Becoming a reserve asset is demanding as it implies, in particular, full and unconditional capital account convertibility. However, if international status can be achieved through trade, a country that is home to large digital networks could find new ways for its currency to gain international acceptance. Digitalisation may thus serve as a powerful vehicle to internationalise some currencies as media of exchange6. It is also likely that the internationalisation of a currency will occur via stable coins, which are subject to the right amount of regulatory scrutiny. The euro, of course, has the capacity to internationalise along both dimensions: as a reserve asset and medium of exchange (as well as a funding and vehi 

 

6 See “International currency competition: the digital dimension” at Markus Academy, Bendheim Center for Finance, Princeton University. https://bcf.princeton.edu/events/jean-pierrelandau-on-international-currency-competition-the-digital-dimension/

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cle currency). It is beyond the scope of this study to discuss whether it should do so. According to the ECB (2020) report on the digital euro, fostering the international role of the euro is not a prime motivation for issuing it. However, should it be created, the design of a digital euro will de facto reveal and imbed preferences regarding its cross-border role. It would also have implications for the international role of the euro. Privacy, degree of interconnection, and interoperability (both with other CBDCs and foreign private systems) are features that will matter. Direct connections between CBDCs could enhance the safety of international payments, including for transfers of remittances. At this stage, therefore, no option should be excluded. If, for instance, international cooperation would develop to the point where several CBDCs become interconnected and interoperable, it would be important to participate actively in the definition and operation of cross-border standards. Also, depending on its design, the digital euro may or may not have an imprint and impact on the currencies of those countries that are economically close to the euro area, whether in Europe or other regions. Two objectives may be taken into consideration, which are not necessarily compatible in all circumstances: first, whether the euro area wants to facilitate cross- border transactions with neighbouring countries; second, whether it will encourage, or not, the “euroisation” of their economies.

4. Trade-offs and Policy Options 4.1 Radical change or continuity? The debate on CBDC has been described as “a battle for the soul of the financial system” (Cecchetti and Schoenholtz, 2021). Sceptics see CBDC as an attempt, by governments and central banks, to fundamentally transform the way financial intermediation works and re-establish public money in a dominant position. Indeed, the digital euro could, in theory, be conceived and designed as an instrument for radical change in current monetary and financial arrangements. However, there is no indication that this perspective is considered by the Eurosystem or any other EU institution.

4.1.1 The possibility of radical change The central bank could theoretically decide to exploit forcefully all the possibilities offered by digitalisation and combine them with its capacity to issue a superior form of money – with no constraint on making a profit. It could then:

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(1) open individual accounts to all citizens, which is today technically feasible (a solution sometimes called “reserves for all”), (2) use that possibility to operate targeted drops of “helicopter” money on selected parts of the population, (3) issue a digital euro that would carry interest, thus reinforcing significantly the transmission mechanism and directly competing with private money as a store of value, (4) in the process, directly intermediate a significant part of credit as it would collect deposits and refinance banks, placing them in a situation of dependence for most of their funding. All those possibilities have been extensively discussed – and frequently advocated – by economists and analysts. Describing that scenario immediately illustrates the numerous challenges it raises. It would change the nature of currency. It would transform the relationship between citizens and money. It would put the central bank in a totally different role and position in the economy and society. While any option deserves to be discussed, it will be assumed, in the remaining parts of this study, that directed and radical change is not the perspective adopted by policymakers. Following their statements and declarations, we will consider a different approach to the digital euro, based on preserving the current equilibrium between public and private money in the economy.

4.1.2 The contours of continuity Describing a scenario of radical change illustrates, by strict symmetry and contrast, the main contours of the solution of continuity: (1) The Eurosystem does not open individual accounts to citizens. Instead, the digital euro is issued in the form of a bearer instrument (a “token”), as close as possible to a digital cash that can be exchanged on a peer-to-peer basis, (2) The digital euro does not carry interest and is not considered as a tool of monetary policy, (3) The Eurosystem does not try to compete systematically with private deposit and payment services. Instead, it tries to create complementarities and synergies between private and public digital monies.

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4.2 The delicate balance between ubiquity and monopoly 4.2.1 A difficult reconciliation As a public money, the digital euro will have to be universally accepted and widely accessible. On the other hand, the Eurosystem may not want to evict private money issuers (the banks) or private payment providers. It may not want to gain a monopoly or dominant position in retail payments. It will thus be placed into a strange and paradoxical position. It wants the digital euro to be present everywhere but important nowhere. It wants it to be successful but not too successful (Bindseil et al., 2021). It certainly helps that the central bank aims at providing a public good and may not feel constrained by profit or cost recovery objectives. Nevertheless, performing that delicate balancing act is made fundamentally difficult by the economics of money. Achieving ubiquity without monopoly is (relatively) easy in a physical environment, with public money in the form of cash. All central banks devote significant resources in ensuring that cash is always present and accessible in their territory, including its most remote parts. The technology of ATMs has proved, over the last five decades, an extremely powerful tool to guarantee the ubiquity of public money. Things may be different in a more digital environment. First, the equivalent of a “digital ATM” would be the applications that citizens install on their mobiles and that merchants accept. Those decisions are decentralised and not controlled by the authorities. Technical choices can therefore lead to the exclusion – or total domination – of public money. Second, a digital economy is driven by network effects and externalities. Money is a network good and digital money even more so. The more people use it, the more attractive and valuable it becomes, the more it brings in new users. As a consequence, acceptance of money and its usage are neither progressive nor linear. They are subject to sudden and ample shifts. To over simply, faced with the introduction of a new form of money, an economy will naturally oscillate between two extremes. Either the new form of currency fails or it dominates. These are precisely the corner situations that a digital euro wants to avoid, staying instead in the middle ground. Finding the right balance will necessitate a very fine design.

4.2.2 The case for “digital legal tender” Legal tender exists for physical cash. There is a good case for extending it to a digital euro. Legal tender performs two fundamental functions. First, it coordinates expectations on the acceptance of money. Second, from the point of view of merchants, it creates incentives to invest in terminals and infrastructures that can

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process public money. Legal tender would ensure ubiquity of the digital euro without necessarily requiring it to dominate existing and future payment systems. Legal tender can also be a powerful weapon to force the interoperability between digital platforms and the uniformity of the currency. If all existing private payment systems, whatever their size, function and destination, are legally obliged to allow and accept the digital euro as an internal settlement asset, it would create a de facto equivalence between any specialised token that may be created and circulate on those networks7.

4.3 The digital euro and bank funding As a group, banks draw part of their funding from refinancing operations conducted by the central bank. To the extent they lose deposits as a consequence of the digital euro, these refinancing operations may grow in volume and relative importance8. Should it lead to specific policy measures and corrections? The answer to this question depends on whether preferential treatment of banks is welfare-enhancing for society. Possible reasons are discussed in Box 4 in Section 3.2.2. On a theoretical level, Brunnermeier and Niepelt (2019) show that it is possible to devise a set of public policies that would fully neutralise the impact of a digital euro on commercial banks. Their neutrality theorem is subject to strict conditions. However, it gives a framework of reference to consider policy options (see Box 7 next page) Box 7: The digital euro, financing short-falls, and bank runs

Sceptics of CBDCs warn that a major drawback associated with the introduction of a digital euro could be the resulting higher funding costs and higher likelihood of runs on private credit institutions such as banks, with obvious repercussions on the stability of the whole financial system. Specifically, they argue that the availability of an easily accessible and potentially safe asset such as the digital euro (as CBDC) might encourage savers to withdraw their bank deposits and move the funds to their digital currency wallets or accounts at the central bank whenever their risk perception – even slightly – deteriorates.

7 See Brunnermeier and Payne (2022) for a more detailed analysis and trade-offs that come with a digital legal tender. 8 These analyses refer to a “normal” situation where banks are, in aggregate, short of reserves. In the current period, with significant excess reserves, there is no aggregate funding problem for banks and the digital euro could be introduced without causing any aggregate disturbance. Paradoxically, as long as the deposit facility yields a negative interest rate, a digital euro today would help banks by reducing the amount of their excess reserves.

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While this line of reasoning may seem appealing, it neglects countermeasures available to the central bank, should it face a run on a private bank towards its digital currency. In fact, as Brunnermeier and Niepelt (2019) show, whether the introduction of the digital euro could undermine financial stability would crucially depend on the strength of the central bank’s commitment to act as lender of last resort. In particular, if such a commitment were strong, a transfer of funds from deposit to the digital euro would translate into an automatic substitution of one type of bank funding (deposits) by another one (central bank funding). This shows, then, that a swap from deposits the digital euro would not reduce bank funding, but rather change its composition. Figure 2 illustrates the working of such a “pass-through” mechanism: Were households to expand their digital euro (“money”) holdings and lower their deposit holdings (see the arrows on the asset side of the household sector’s balance sheet), the central bank’s liabilities would expand correspondingly (see the arrows on the liabilities side of the central bank’s balance sheet), counterbalanced by its acquisition – in exchange for digital euro holdings – of claims vis-à-vis the banking sector (see the arrows on the asset side of its balance sheet). That is, the central bank would automatically provide substitute funding for banks, effectively intermediating between non-banks and banks. A

Gov. & CB

L A

A

Banks B-Debt

Deposits

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L B-Debt

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Fig. 2: Pass-through funding of banks (Source: Brunnermeier and Niepelt, 2019) Importantly, not having a digital euro might make a currency run into a foreign or cryptocurrency more likely.

4.3.1 The refinancing approach One such option could be to create specific refinancing modalities for compensating any deposit loss due to the digital euro. Those modalities could be transitory – to absorb the initial shock of the introduction – or, on the contrary, be made permanent – to compensate for a structural shift in money holdings. Specific features could involve the maturity and, possibly, the interest rate applicable within predefined limits. One big advantage for banks would be the automaticity.

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4.3.2 Drawbacks and limits of the refinancing approach It is not clear, however, that specific changes to the operational framework of central banks will be necessary or justified. Potential shifts in money holdings are difficult to assess ex ante. In most probable scenarios, they can be accommodated by available refinancing facilities. The central bank may want to keep the flexibility of its actions and adapt them to the circumstances if necessary. If, over the longer run, refinancing needs grow significantly as a result of the digital euro, two broader policy issues may emerge. The first is technical but important: the situation may create, for some banks, a shortage of available collateral. The second is more fundamental. High and permanent refinancing needs would change the relationship between commercial banks and the central bank. It would place banks in a situation of dependence and may affect, in unpredictable ways, their incentives and credit behaviour. It would also increase the role and place of central banks in financial intermediation and their (indirect) imprint on credit markets.

4.4 Specialising the digital euro as a medium of exchange A digital euro would be well-placed to serve both as medium of exchange and store of value. However, if it were to become a form of investment, the risk of large shifts away from bank deposits would become significant. To avoid such displacement effects, the specialisation of the digital euro as a pure medium of exchange may be considered.

4.4.1 The case for specialisation Specialisation would present many benefits. In economic terms, the amounts necessary for transaction balances are limited whereas those for store of value are potentially infinite. Limiting the digital euro to its medium of exchange function is quantitatively less disruptive to other financial actors and intermediaries. As a medium of exchange, the digital euro would still potentially compete with banks in payment services. However, this would only add one actor to an already very competitive environment. Banks are, and will increasingly be, submitted to intense competition in digital payments from other service providers, especially Big Tech. The digital euro would not compete with banks on the bulk of their deposit-taking and financial intermediation activity. It would not attack their franchise, which depends on their ability to combine their deposit-taking, money creation and lending activities.

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Specialisation is also advantageous from a privacy perspective. In the current framework for cash applicable in most countries, privacy is recognised for transactions (up to a certain amount). It is implicitly denied for holdings of large quantities – the store of value function. Currently, when important amounts of cash are exchanged, they have to be declared and explained. The specialisation of digital euro as a pure anonymous medium of exchange would explicitly reproduce that distinction. Specialisation would also solve the problem of non-residents and allow to control internationalisation of the digital euro. Transaction balances would be accessible to anyone anonymously up to certain amount. Hoarding of digital euros by non-residents would be impossible (just as for residents). Of course, they would still have access to the euro in its other forms (bank deposits and cash). A digital euro limited to its medium of exchange function may have to be bundled with other functionalities – including programmable uses – developed by private intermediaries to foster common end-user European solutions. It could represent a building block for a European solution for point-of-sale and online payments. The idea fits well with the declared ambition to make the digital euro a catalyst and a support for payment innovation in Europe as well as a tool for greater strategic autonomy. The modalities and conditions of such bundling would have to be carefully designed to ensure both the universality and the neutrality of public money in the digital payment system. Limiting the function of a digital euro would not prevent the public sector from supplying safe stores of value to financial intermediaries and the general public. Safe assets perform an essential role in the economy as collateral, pillars of financial intermediation and definition of risk-free interest rates. Such safe assets, however, are already provided by government bonds and central bank money held by banks in the form of reserves.

4.4.2 The limits of specialisation While the operational case for specialising the digital euro is straightforward, the economics are more uncertain and ambiguous. Money, as a perfectly safe and liquid asset, jointly performs three functions. Separating them by design, however justified, introduces a discontinuity that may have negative side effects. In some circumstances, the distinction between a medium of exchange and a store of value is not clear- cut.People usually hold money in advance for the case that a purchase opportunity arises. They may search and when they accidentally find a suitable product they can immediately make the purchase. The longer the search is expected to last, the lower is the velocity of money, and the higher is the demand for money. Strictly speaking, during the search phase, money stores

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wealth with the intention to use it as a medium of exchange. Both roles complement each other, which blurs the line between the medium of exchange and the store of value roles of money. The key and subtle policy question is the following: how far can the medium of exchange and store of value be artificially dissociated from each other without compromising the unit of account and the anchoring function of public money? In concrete terms, would the existence of small and limited transaction balances in digital euro suffice to incite economic agents to denominate all their operations in euro? Historically, the coincidence between the medium of exchange and the unit of account seems well- established and robust – although not absolute. There are very few historical examples – and almost none in recent times – when people did not count, contract and trade with the same monetary unit. In modern economies, however, financial activities are very developed. When agents enter into debt, derivatives and other contingent contracts for the future, the choice of the unit of account denomination is essential. In some literature (Doepke and Schneider, 2017; Brunnermeier and Sannikov, 2016), considerations of risk sharing and asset liability management determine the choice, by intermediaries, of their preferred unit of account. Network externalities develop and create convergence on a single unit (as natural monopoly), which may not be the official currency (see e. g. Dowd and Greenaway, 1993). This theoretical framework may become increasingly relevant in a digital environment of DeFi and closed networks, where the possibility – and the incentive – to use specific units of accounts will be larger and stronger. The key, here, is that the process is disconnected from any transaction in real goods. Limiting the digital euro to a medium of transaction role might prevent it to penetrate those activities and let them develop outside the reach of the central bank. Finally, specialising the digital euro as a medium of exchange will necessarily involve setting some limits to its holdings. One of the main benefits of public money – its elasticity of supply – could be diminished or compromised. If the limits are strict and rigid, it would introduce frictions in the convertibility of private into public money.  

4.4.3 Capping and tiering To specialise the digital euro, the Eurosystem would have to set an acceptable level of transaction balances. Limits would have to be defined. Below some level, use and holding of the digital euro would be free and anonymity guaranteed. Above, identification would be the norm. In addition, there would be disincentives, or pure prohibition, to holding digital euros above the limit. Limits can be

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set either through quantitative (ceiling) or price (tiering) mechanisms. Both solutions are differently attractive. A cap/ceiling on individual holdings of digital euro could be instituted. It has many advantages. It is fully transparent, clear, and easily understood. Its quantitative impact can be directly assessed ex ante. It gives certainty and permissibility to banks and authorities alike. Forma user perspective, a “waterfall” mechanism can be instituted, whereby any balances in digital euro in excess of the ceiling would be automatically converted in deposit money and transferred to the user’s bank account. Obviously, a cap does not guarantee a fully elastic supply of the digital euro. It may have complex effects on the perceived safety of bank deposits in times of crisis (as it would limit their convertibility). It also carries implicit choices on privacy as digital euro holdings of each individual (or corporates) above the threshold would need to be clearly identified. Tiering would be based on a different principle. There would be no hard limit, but holdings above certain threshold would be dissuaded. For instance, transaction balances below a defined threshold would carry no cost nor benefit. Above and beyond that threshold, a fee would be applied. Conceptually, it would correspond to the safety premium that holders would be asked to pay for storing value in the central bank’s balance sheet. Operationally, it would create a disincentive to excess holdings. The separation between the CBDC’s roles as a medium of exchange and store of value would not be as brutal and discontinuous as with a hard limit. From a theoretical perspective, it would be advantageous for the fee to take the form of a time-varying (negative) interest rate. Its level could be flexibly adjusted in times of stress to price in the increased demand for safety and discourage runs from deposits. Any flight to safety could be accommodated, at least in part, by changes in prices rather than by significant quantitative shift in the holdings of different forms of money. Financial instability created by large asset reallocation might be avoided (absent any signalling effects). Tiering, however, would bring its own challenges. First, the mere prospects of negative interest rates could reduce the acceptability of CBDC and compromise its primary objective of universal and ubiquitous presence in the economy. Second, the central bank would be perceived as deciding upon two interest rates: one is the policy rate applied to its deposit/refinancing facilities, the other would be the (negative) interest rates on excess holdings of CBDC. Third, changing the penalty rate might have an adverse signalling effect and worsen a panic. From a policy perspective, a double-interest rate scheme is rational: one instrument is devoted to monetary policy; the other to financial stability. However, it is likely that a double interest rate structure would create confusion and blur the

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communication on monetary policy. In periods of uncertainty, it may create doubts and reduce trust in the digital euro itself. To avoid those reactions and problems; it may be preferable to organise the tiering on a different principle. A progressive fee structure could be established, with several thresholds of holdings and increasing levels of penalty. The structure would be fixed, intangible and independent of the economic, monetary and financial situation. It would be a constitutive element of the digital euro. Revisions could only be considered at predetermined periodicity.

4.5 Technical choices on infrastructures: preliminary considerations Technical choices are beyond the scope of this study. They are being considered and explored all over the world by central banks engaged in CBDCs, see e. g. Duffie et al. (2021). Most of them, except for China, are still in preliminary or pilot phases. The Eurosystem has started consultations with private participants. However, details of design will unavoidably impact fundamental policy choices. This section presents only some very preliminary considerations. It will be presumed that the digital euro will be issued to the general public as a “cashlike” bearer instrument. That instrument should be usable both online and offline (with proper limitations) i. e. from one mobile phone to another. Even people without a mobile or smart phone should be able to use it. This is a societal and policy choice. A “cash-like” bearer instrument leaves open several possible technical options. For example, the Eurosystem can choose the degree of centralisation or delegation in the ledger structure and operational responsibilities. Two key objectives seem to dominate the current thinking: First, the central bank should be the only entity that is allowed to issue digital euro (CBDC) units and remove them from circulation. This is clearly a matter of fundamental principle. The central bank has the monopoly of issuance and full control of its own liabilities. This applies not just to the overall aggregate amount but also to any single unit of digital euro. Technical arrangement should prevent the issuance of the digital euro by any other actor than the central banks. For instance, banks should not be allowed to offer deposit accounts in digital euro, even if fully backed by reserves held at the central bank. Second, the central bank should want to keep the option to identify the owners of digital euros if and when necessary. This is considered important for compliance with existing AML and KYC regulations. It is equally necessary to implement, if so decided, a specific regime applicable to non-residents. Prima facie, those two objectives would best achieved by the so-called “direct” model of digital euro. In this model, the central bank keeps its own ledger,  

 

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executes retail payments, defines the interconnections with private systems and implements the privacy regime. Interactions with private actors can be managed through application programming interfaces (APIs). They can take place at different levels: either wholesale settlements or retail devices such as digital wallets. An alternative is the “indirect” and tiered system where some functions are entrusted to supervised intermediaries, both banks and non-banks. These intermediaries could be responsible for keeping ledgers and operating payment services, including providing access devices and channels and effecting transactions. In addition to defining standards and supervising the intermediaries, the central bank would keep a record of different aggregate amounts of the digital euro. There are many advantages attached to an indirect operational architecture: (1) It may be more conducive to preserving competition and efficiency in payments. (2) It gives more flexibility in deciding and implementing privacy options (which may vary according to country-specific requirements and preferences). (3) It may facilitate acceptance of the digital euro if, for instance, it can share the retail applications and wallets with existing private digital currencies. (4) Finally, it may make it easier to ensure full interoperability between the digital euro and private forms of money. The whole purpose is to make digital euro as fully substitutable to private money as possible. Technical interoperability will be an important determinant. There are many dimensions and requirements to interoperability, including through regulation. It can be achieved at different levels. It is clear, however, that full and easy exchangeability at the user end will help and mimic closely the current perceptions associated with physical cash.

5. Conclusion and Perspectives The digital euro project is driven by two forces. One is digitalisation and the profound disruptions that it brings to money and payments. The other is the push towards a more unified and autonomous payment system in Europe. Those two forces largely work in opposite directions. Digitalisation naturally tends to segment and organise the economic space around technological borders that have no direct link with the EU/euro area jurisdiction. The digital euro may be essential to overcome this contradiction. It would allow euro area citizens to reap the benefits of digital money while, simultaneously, protecting the uniformity of the currency. It would be the anchor and pillar of single European payment space.

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But it may not be sufficient. Payments sit at the intersection of many initiatives and EU policies. They have a close link with money (the topic of this study). They also involve data and privacy. The technical dimension – interoperability – is central. The future European payments landscape will be defined by the interaction between private and regulatory initiatives. All are in a state of flux. On the private side, the most notable evolution is the European Payments Initiative (EPI), a collaborative project developed by major European banks. As for public policies, both the European Commission and the ECB have adopted retail payment strategies. Both institutions cooperate to complete the Single European Payments Area (SEPA) project. Most of the directives that regulate payments are currently under review (payment services Directive [PSD2] and Directive on settlement finality in payment and securities settlement systems) – or being debated (Markets in Crypto-Assets Regulation [MiCA]). There is now an opportunity to define and shape the architecture of European payments for the digital era. For the digital euro to produce all its expected benefits, it must develop in coherence with its regulatory environment. Major pieces of regulation currently considered or debated will directly impact money and payments. They will define the place and role of private digital money, how it interacts with the digital euro and whether complementarities and synergies will appear in shaping the future payments landscape. As described in this study, digitalisation will create a more diverse and complex architecture, with possible additional layers of financial intermediation. It will also produce a broader spectrum of diverse financial and monetary assets with different degrees of safety and liquidity. Should stable coins, e‑money, cryptocurrencies and other types of digital tokens be equally treated as money or should there be a differentiation? Should regulation incite them to converge with banks through capital requirements? Should they be treated separately, as payment providers? When answering those questions, regulators are primarily concerned with preserving financial stability and market integrity. Most regulatory regimes are based on a classification of actors and activities along several dimensions: the technology (regulation of DLTs is emerging), the type of activity and the risks attached to it, the business model of the intermediary. All those elements contribute to identifying the threats to financial stability. From a monetary angle, however, there is a different – equally central – question: which of those assets will – or should – qualify as money? What matters are the properties of the asset itself – whether it has the features of money, whether it will contribute to the uniformity of the currency. What gives an asset its “moneyness” is the constancy of its nominal value across time and space. That value can-

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not be sensitive (allowed to change) with new information or the state of the economy (Dang et al., 2015). Taking a monetary perspective necessitates a slightly different approach to regulation, centred on the asset itself not on its issuer. A digital financial asset – for instance a stable coin – may be fully backed, its issuer may be perfectly sound and, yet, it may not be proper for use as money. To a large extent, public policy itself will determine what is money: “moneyness” depends on legal status, backing, convertibility and the connection to the central bank (or absence of it). Hence, policymakers do not ask whether assets issued by a specific institution is money. They determine whether they want it to be money and define the regulatory regime accordingly. Technological innovation makes it necessary to have a precise vision of what money should be and base public policy on that perspective. The study considers the preservation of a uniform currency as an overarching priority and the main justification for the creation of a digital euro. Within that framework, however, several options are possible. At the extreme, two opposite visions can be defined: soft and strong uniformity. A system inspired by a “soft” vision of uniformity would accept and encourage the competition between different forms of private money (as long as they are denominated in euros) through different regulatory regimes. This is more or less the current situation. For instance, both e-money (as defined by the Directive) and bank deposits are legal claims on the issuer. But, stable coins (as defined in the draft MiCA Regulation) are not. However, e-money, contrary to bank deposits, does not benefit from deposit insurance. Under a soft vision of uniformity those differences are accepted and result in a gradation between different forms of money from the perspective of safety and liquidity. This approach is most favourable to competition in payments and may be beneficial to innovation. It may also be adapted to digital currencies (stable coins) principally exchanged between financial intermediaries, who are more equipped to trade assets with differentiated characteristics. However, it will be challenging to ensure that specific regulatory regimes will not result in different kinds of money, issued by different entities, with different degrees of safety and liquidity. Soft uniformity will rely on the ability of oversight and supervisory authorities to monitor future evolutions and adjust legal and policy regimes if necessary. By contrast, strong uniformity is based on two principles: a clear and absolute separation between what is money and what is not; and a fully unified policy and regulatory regime between the different forms of private money. Since the private money of reference are bank deposits, strong uniformity would submit all issuers of private money (including stable coins) to a form of banking regulation and supervision – with, inter alia, some capital requirements. This approach is

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currently considered for stable coins by some countries, e. g. the United States9. It brings great clarity and robustness to the policy framework. Conversely, it may limit competition, innovation, and the ability of payment systems to develop flexibly and independently. Furthermore, the reference and equivalence to banking raises two difficult questions: what kind of public guarantee would new forms of private money possibly benefit? What would be their relationship to the central bank and possible convertibility into central bank money? Whatever option is chosen, monetary arrangements in the euro area should continue to be based on the complementarity and cooperation between public and private issuers of money. That complementarity has served the public well over the last decades. It brings a positive combination of private initiative, competition, and innovation, with the stability and uniformity provided by central bank money. The ultimate justification of the digital euro is to maintain that equilibrium in a rapidly changing environment. Its success will be determined by the ability of different actors to preserve the complementarities and synergies between their respective actions.  

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Kahn, Charles M., James McAndrews and William Roberds. (2005). “Money is privacy”, International Economic Review. Kahn, Charles M. and William Roberds. (2009). “Why pay? An introduction to payments economics”, Journal of Financial Intermediation, 18(1): 1–23. https://www.sciencedirect.com/ science/article/pii/S1042957308000533 Kashyap, Anil K., Raghuram Rajan and Jeremy C. Stein. (2002). “Banks as Liquidity Providers: An Explanation for the Coexistence of Lending and Deposit-Taking”, The Journal of Finance 57 (1). https://scholar.harvard.edu/files/stein/files/liqpro-jf-final.pdf Keynes, John M. (1923). “A tract on monetary reform”, London: Macmillan & Co. King, Mervyn. (2016). “The end of alchemy: Money, banking, and the future of the global economy”, New York City: WW Norton & Company. Landau, Jean-Pierre and Alban Genais. (2019). “Digital Currencies: an exploration into technology and money”, French Ministry for the Economy and Finance.https://www.economie.gouv.fr/ files/files/2019/ENG-synthese-ra-crypto-monnaies-180705.pdf Lee, Alexander, Brendan Malone and Paul Wong. (2020). “Tokens and accounts in the context of digital currencies”, FEDS Notes. Board of Governors of the Federal Reserve System. https:// www.federalreserve.gov/econres/notes/feds-notes/tokens-and-accounts-in-the-contextof-digital-currencies-122320.htm Marshall, Alfred. (1923). “Money, credit & commerce”. London: Macmillan & Co. Mundell, Robert A. (1961). “A Theory of Optimum Currency Areas”, The American Economic Review, 51(4): 657–665. Niepelt, Dirk. (2021). “Central bank digital currency: considerations, projects, outlook”, CEPR Press, London. https://voxeu.org/article/central-bank-digital-currency-considerationsprojects-outlook Panetta, Fabio. (2020). “The two sides of the (stable)coin”, Speech by Fabio Panetta, Member of the Executive Board of the ECB, at Il Salone dei Pagamenti 2020.https://www.ecb.europa. eu/press/key/date/2020/html/ecb.sp201104~7908460f0d.en.html Piazzesi, Monika and Martin Schneider. (2020). “Credit Lines, bank deposits or CBDC? Competition and efficiency in modern payment systems”, Working Paper.https://web.stanford.edu/ ~piazzesi/CBDC.pdf Pigou, A.C. (1917). “The value of money”, The Quarterly Journal of Economics (32)1: 38–65. https://www.jstor.org/stable/pdf/1885078.pdf President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency. (2021). “Report on Stable coins”. https://home.treasury.gov/news/press-releases/jy0454. Robertson, Dennis H. (1922). “Money”, London: Nisbet. Varian, Hal. (2014). “Beyond big data”, Business Economics, 49(1): 27–31.

List of Abbreviations AML/CFT API BIS CBDC DeFi

Anti-money laundering and countering the financing of terrorism Application programming interface Bank for International Settlements Central bank digital currency Decentralised finance

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DFR DLT ECB EPI GDPR KYC MiCA OCA SEPA SMEs

Markus Brunnermeier and Jean-Pierre Landau

Deposit facility rate Distributed ledger technology European Central Bank European Payments Initiative General Data Protection Regulation (GDPR) “Know your customer” Markets in Crypto-Assets Regulation Optimum currency area Single European Payments Area Small and medium-sized enterprises

Stephen G. Cecchetti and Kermit L. Schoenholtz

Central Bank Digital Currency: Is it really worth the Risk? Central banks around the world are considering whether to issue retail digital currencies for individual use. According to the Atlantic Council’s tracker, seven small Caribbean nations and Nigeria have taken the plunge, 14 much larger countries are running pilots (including China, South Africa, Saudi Arabia, and Sweden), and nearly 60 others are studying the possibility. At one level this seems odd. For residents of advanced economies, the transition from physical to digital payments instruments is essentially complete. Virtually all their financial transactions use privately run payments networks to transfer the digital liabilities of private commercial banks (see Figure 1). For example, in the United Kingdom, where the total quantity of M3 is 148 % of GDP, demand and time deposits—digital entries on the ledgers of banks—account for 97 % of the total (or 144 % of GDP). For the euro area, 91 % of M3 is digital. And, in China, where broad money exceeds 200 % of GDP, 96 % of it is digital. So, as we look at the evolution of the financial system, we are led to ask the following question: Why would a central bank want to issue retail digital currency? Do the benefits outweigh the costs? Before we get to that, we need to define what we mean by central bank digital currency (CBDC). Our view is that it is a universally accessible system in which individuals can hold unlimited amounts of interest-bearing central bank liabilities. To ensure that the system is not facilitating criminal activity, the system will be account-based in which holders are identifiable to the government.1 Assuring that private bank liabilities used for transactions are convertible into central bank money under virtually all conditions requires an elastic supply of CBDC.2 Finally, since wholesale central bank liabilities (financial intermediaries’ deposits) al 

 

 

 

 

 

1 We agree with Carstens (2021) that the importance of identity verification strongly suggests that CBDC must be account-based rather than token-based. Furthermore, we do not distinguish between accounts that are held directly at the central bank and those held by agents who aggregate accounts into what is in essence a narrow bank. See the discussion in Auer et al. (2021). 2 Some central banks suggest limiting the quantity of CBDC that any individual can hold. However, central banks today supply non-digital currency and digital reserves elastically in part so that the value of one currency unit equals one unit of reserves, which also equals the value of a private bank deposit of the same size. Put differently, the “exchange rate” between bank deposits and central bank money is always fixed at one-to-one. If the supply of central bank currency were capped in a binding way, the market exchange rate between private bank and central bank liabilities would fluctuate, potentially destabilizing the entire financial system. https://doi.org/10.1515/9783111002736-009

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ready are remunerated, it would be politically difficult to avoid paying a comparable interest rate on retail CBDC.

Fig. 1: Fraction of broad money issued by commercial banks and the ratio of broad money to GDP (percent, year-end), 2020 (Sources: Bank of England (M3), People’s Bank of China (Money + Quasi Money), Bank of Canada (M3), Bank of Japan (M3), Swiss National Bank (M3), Eurostat (M3), Bank of Russia (M2), Federal Reserve (M2), and FRED)

To anticipate our conclusion, we agree with the January 2022 report issued by the Economic Affairs Committee of the UK House of Lords: Central bank digital currency is a solution in search of a problem. The potential costs—especially the risk of disintermediation, currency substitution, the creation of a state bank, and loss of individual privacy—are simply not worth the speculative benefits that we can readily achieve by other means.

Potential Benefits of CBDC Many of the costs and benefits of CBDC arise from a combination of externalities, market power, and public goods that cause market failures. For example, network externalities lead the private payment system to be highly concentrated, allowing

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customer exploitation. Similarly, a currency with a stable value is a public good that is difficult for private agents to provide in all states of the world.3 From this perspective, the list of potential CBDC benefits is relatively long. Here we briefly describe eight key benefits: Reduces costs of and improves access to domestic and cross-border payments: In many parts of the world, even the United States, domestic payments remain expensive. For cross-border remittance, the costs are even higher. Allowing individuals to clear payments directly over central bank balance sheets, either within their own country or through an inter-operable multi-country system, could reduce transaction costs and improve access. Broadens access to the financial system more generally: According to the World Bank’s Findex survey, in 2021, more than 1.6 billion adults (16+) in low and lower-middle income countries did not have an account at a financial institution. Even in the United States, the Federal Reserve estimates that, in 2020, 18 percent of households were “unbanked” or “underbanked.”4 By offering no-frills, lowcost accounts at the central bank, it should be possible to reduce the size of the unbanked and underbanked population. Facilitates the distribution of government benefits: In the midst of natural disasters, governments can find it difficult to transfer resources to those in need. Distributing benefits during the pandemic was a particular challenge. If households and businesses were to have accounts at the central bank (either directly or through an authorized agent), such transfers would be faster and more reliable.5 Relaxes the zero lower bound constraint on the policy interest rate: Absent paper currency alternatives with a zero nominal interest rate, the central bank could set deeply negative nominal interest rates. Furthermore, commercial banks would be able to follow suit.6

3 See the discussion in Cecchetti and Schoenholtz (June 2021). 4 See Federal Reserve (2021). 5 Included in this category are money-financed fiscal expansions in which central bank money is transferred directly to individuals—what is known as “helicopter money.” See Prasad (2021) and Cecchetti and Schoenholtz (2016). 6 See Bordo and Levin (2017). Note that, in the absence of paper currency, the chief alternative to using a negative-interest rate currency for transactions is barter, a deeply inefficient technology, or using a foreign currency that introduces exchange rate risk.

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CBDC would substitute for undesirable cryptocurrencies and risky stablecoins: Today, there are thousands of private token-based currencies—commonly known as cryptocurrencies.7 There also are dozens of unregulated stablecoins backed by various combinations of assets. The value of these is large and rising, with many having market capitalization above $1 million.8 Authorities fear that fluctuations in the value of these instruments could be sources of broader financial instability.9 CBDC could displace these, helping to promote financial resilience. Helps counter tax evasion and criminal uses of currency: Identification of the holders of account-based CBDC would improve tracking of financial transactions both domestically and internationally. More effective monitoring could enhance authorities’ ability to ensure tax compliance as well as prevent money laundering and terrorist finance. Prepares for competition from other official suppliers of CBDC: For all but the largest jurisdictions, issuance of CBDC could help limit the further substitution from domestic currency into currencies such as the U. S. dollar, the euro, or the renminbi. By issuing their own attractive and convenient digital currency, smaller countries could guard against the potential loss of monetary sovereignty.  

Reduces the cost of deposit insurance: To the extent that CBDC displaces insured deposits in private banks, it could reduce the need for government-supplied deposit insurance.

Possible Costs of CBDC Balancing these potential benefits are five costs: Risks disintermediation of depositories and the risk of creating a massive state bank: While inertia (combined with interest rate increases and service improvements) might keep funds in the banking system for some time, financial

7 See Carstens (2021) for a description of the difference between token- and account-based digital currencies. 8 https://coinmarketcap.com/accessed on 28 January 2022 lists 9282 cryptocurrencies, of which 79 have market capitalization over $1 million. The total market capitalization for cryptocurrencies now exceeds $2 trillion and that of stablecoins is well over $100 billion. 9 See the discussion in Cecchetti and Schoenholtz (December 2021).

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strains eventually would prompt uninsured (and possibly insured) deposits to flee private banks for the central bank.10 As funds shift, sources of private credit will dry up, driving the central bank to become a commercial lender. Over time, this state bank will be tempted to substitute for the discipline of private lenders and markets, inviting political interference in the allocation of capital and slowing economic growth.11 Risks currency substitution away from less trustworthy jurisdictions: Highly trusted central banks that operate in relatively stable political and financial jurisdictions likely will receive inflows from abroad. Given the current high foreign demand for U. S. paper currency, imagine what would happen if the Fed offered universal, unlimited accounts.12 The consequences could be catastrophic for the financial and monetary systems of emerging market and developing economies.  

Endangers privacy: The flipside of improved tax compliance is a loss of privacy. CBDC is traceable, allowing governments to monitor virtually all transactions. In democratic societies, it will be essential to have credible safeguards to ensure that private information is not used by malevolent official sector actors. Requires costly compliance with Know Your Customer (KYC) and AntiMoney Laundering (AML) rules: Someone will have to ensure that the users of CBDC are law abiding. Such KYC and AML monitoring is costly. As regulated guardians of the private payment networks, commercial banks currently perform these tasks. In a CBDC regime, who will supply these costly services? One approach is to create “intermediated CBDC,” in which regulated brokers (or banks) charge a fee to provide individual account services, guard privacy, monitor compliance, and aggregate balances into accounts at the central bank. Diminishes payments competition and discourages entry of efficient private providers: By supplanting private liabilities, CBDC will reduce the competition in

10 We would also expect to see investors flee nonbank intermediaries that offer uninsured liquid liabilities, such as money market funds and some open-end mutual funds, putting the proceeds into their CBDC account. 11 The central bank could recycle funds to the private sector through enhanced lending operations. But since central banks only lend on a collateralized basis, the haircut and margin structure of their collateral frameworks will provide powerful tools for indirect intervention in credit allocation. 12 Judson (2017) estimated that roughly 60 percent of what was then $1.5 trillion of U. S. currency in circulation was held abroad.  

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payments and issuance of other private liabilities that generally serve as money. The result could be a decline of cost-reducing innovation.

Key Questions to Resolve Before Issuing CBDC Before issuing CBDC, a central bank should carefully weigh these costs and benefits. Critically, policymakers need to ask if there are other, less costly ways to achieve the benefits. We see the following questions: Are there ways to improve the payment system? We already see public and private sectors moving to provide cheaper, faster, more reliable, and more accessible systems that operate both within and across borders. The euro area has the TIPS system, with a processing time of 10 seconds at a cost of €0.002 per transaction. Over the next few years, the ECB will extend this to other currencies. The United Kingdom has Faster Payments, which can take up to 2 hours with a maximum value of £250,000. A group of commercial banks is working to create a pan-Nordic cross-currency real-time system called P27 that will instantly clear both domestic and cross-border payments. Canada is testing Real-Time Rail(RTR) to settle payments in less than a minute. In the United States, the Clearing House has a Real-Time Payments(RTP) system, and the central bank is set to launch its FedNow retail payments service in 2023. None of these requires CBDC. Are there ways to improve access? Here, we find the case of India is instructive. Started in 2014, the Pradhan Mantri Jan Dhan Yojana (PMJDY) provides no-frills bank accounts without charge, using the country’s universal biometric personal identification to lower compliance costs. In just a few years, this project brought 465 million people into the financial system. The lesson we take from the Indian experience is that major improvements in access require government involvement and subsidies.13 How can we improve the efficient distribution of government benefits? Governments already have information on their citizens’ financial accounts both for tax purposes and for the payment of benefits. Why can’t they use it? Are there other means to enhance the effectiveness of monetary policy at the zero lower bound? Over the past decade, central bankers devised a broad ar-

13 See Cecchetti and Schoenholtz (2017) for a more detail on the India program.

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ray of policy tools to allow them to ease policy further when the nominal interest rate hits zero. Would there be sufficient public support for deeply negative interest rates on widely held central bank and private bank liabilities to make the tool usable? Are there additional tools to employ? If not, should fiscal expansion be preferred to deeply negative interest rates? How can we make cryptocurrencies and stablecoins safe? This is a key challenge regardless of whether central banks issue digital currency. As cryptocurrencies and stablecoins become potential sources of financial instability, governments will have to act. Strategies include outright bans, registration requirements, standardized disclosures, bank-like rules for issuers, and regulation of exchanges and broker-dealers, to name just a few.14 What is the best way to counter tax evasion and criminal use of money? Account-based CBDC will make it more difficult for criminals to transact and for people to evade taxes. Absent CBDC, are there efficient ways to identify and prevent these actions under the evolving payments framework? We would start by eliminating all paper bank notes larger than €20 or $20. Beyond that, the problem is tax havens, uncooperative jurisdictions and (potentially) decentralized financial mechanisms that allow the implementation of transactions while concealing identities. It is difficult to see how issuance of CBDC can combat behavior of other sovereign actors or of algorithms that operate without involving a legal entity subject to oversight. In every one of these cases, we see alternatives that limit disintermediation, currency substitution, and the intrusion of governments into privacy of individuals, while preserving incentives for welfare-enhancing financial innovation. So, if central banks eventually move to issue digital currency, they will need to state their objectives clearly and explain why CBDC is the lowest-cost and leastrisky means of achieving those goals. Ultimately, their decisions will shape the financial system of the future.

References Auer, Raphael and Rainer Boehme, “Central bank digital currency: the quest for minimally invasive technology,” BIS Working Paper No 948, June 2021. Bordo, Michael D. and Andrew T. Levin, “Central Bank Digital Currency and the Future of Monetary Policy,” NBER Working Paper No. 23711, August 2017.

14 See Cecchetti and Schoenholtz (December 2021).

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Cartens, Agustín, “Digital currencies and the future of the monetary system,” speech at the Hoover Institution policy seminar, 27 January 2021. Cecchetti, Stephen G. and Kermit L. Schoenholtz, “A Primer on Helicopter Money,” www.moneyandbanking.com, 27 June 2016. Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Banking the Unbanked: The Indian Revolution,” www.moneyandbanking.com, 6 November 2017. Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Central Bank Digital Currency: The Battle for the Soul of the Financial System,” www.moneyandbanking.com, 21 June 2021. Cecchetti, Stephen G. and Kermit L. Schoenholtz, “Stablecoin: The Regulation Debate,” www.moneyandbanking.com, 13 December 2021. Economic Affairs Committee, UK House of Lords. Central bank digital currencies: a solution in search of a problem? HL Papers 31, 13 January 2022. Federal Reserve, Report on the Economic Well-Being of U. S. Households in 2020, May 2021. Judson, Ruth, “The Death of Cash? Not So Fast: Demand for U. S. Currency at Home and Abroad, 1990–2016,” International Cash Conference 2017 – War on Cash: Is there a Future for Cash? 162910, Deutsche Bundesbank. Prasad, Eswar. The Future of Money: How the Digital Revolution is Transforming Currencies and Finance. Cambridge, Mass.: The Belknap Press of Harvard University Press, 2021. White, Lawrence H., “Should the State or the Market Provide Digital Currency?” Cato Journal, Spring/Summer 2021.  

 

Andreas Dombret and Oliver Wünsch

The Case for Central Bank Digital Currencies Abstract: The last five years have seen a seismic shift in the debate on digital currencies. Not only in response to private-sector developments on crypto assets and stablecoins, several central banks around the world have embraced the idea of issuing some kind of central bank digital currency (CBDC). However, many of these initiatives are currently constrained to use cases that involve payment transactions in the retail and wholesale sphere. We argue that for CBDCs to be broadly accepted and not just compete with existing, highly efficient bank-led payment systems, it will require instruments that fulfil all functions of money, i. e. means of payment, unit of account but also store of value, thereby providing an avenue to partially or fully substitute physical cash in a modern world. Further, we acknowledge that a world with potent CBDCs, there might be a new equilibrium between bank deposits and CBDC holdings. This might come with changes to the institutional landscape of the financial system, with financial institutions regrouping around their basic functions of capital, credit and information intermediation and risk management. As such, a CBDC should in the long run be judged against the objective of preserving trust in the financial system and making it more effective and efficient rather than preserving current structures. Finally, we argue that a CBDC that is hampered by disproportionate non-financial considerations, such as compliance or political concerns, might face stiff competition from private digital currencies in particular in countries that do not issue a reserve currency.  

Introduction 20 years ago, we would not have predicted the financial and monetary system that we are witnessing today. We had assumed that the “great moderation” made financial crises and inflation a thing of the past, with policy makers and central banks having identified the necessary toolset to ensure stability. “The end of history” (Francis Fukuyama) celebrated the universal victory of democracy and liberalism. Globalisation provided access to a borderless workforce and markets, ultimately driving convergence of living conditions, growth and development opportunities. And the internet, still in its infancy in the 1990s, was set to democratise access to information and foster competitive markets. Fast-forward 20 years, we live in a different world. We have managed to cope with several financial crises, with the Asian crisis, the Russian debt crisis, the https://doi.org/10.1515/9783111002736-010

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“Great Financial Crisis” of 2008 and the Euro crisis only being the most significant ones. Also as result of the crisis response, central banks in Europe and the United States have expanded their balance sheet massively, without until recently facing the toll of inflation, which remained below benchmarks despite the multiplication of monetary aggregates. While we managed to lift more than one billion humans out of poverty over the last 25 years,1 the idea of spreading democracy and liberalism as mandatory consequence of economic development did not fully succeed – and it seems we are turning back the wheel not only by resurrecting walls against globalisation, but also in terms of security as most recently witnessed with the Russian invasion in Ukraine. The liberal internet is also challenged, both by the emergence of transnational oligopolistic “platforms” but also by politicisation of some of these platforms to shape public opinion and to pursue political objectives. One might wonder why is mentioned in an article that is supposed to discuss digital currencies. Digital currencies have emerged over the last 15 years: It started with Bitcoin, a highly speculative asset with some currency characteristics that is privately issued and not connected to any central-bank or government-issued currency. This was followed by Libra, invented and de-facto controlled by one of the largest BigTechs, which aimed at merging the advantages of being based on existing, official currencies with the advantages offered by technology (“stablecoin”). Nowadays, several central banks are contemplating or already experimenting with issuing a digital currency themselves (“Central Bank Digital Currency”, “CDBC”) that would complement “account-based money” which exists as central bank money (physical cash issued by and reserves with the central banks) and private money (deposits at private credit institutions). Pervasive digitisation has reduced the leverage policy makers have over the choice economic agents make on which currency they use, in particular in countries with less robust institutions and less stable currencies. While the future equilibrium is still unknown, it is quite certain that significant shifts might happen. Policy makers will want to ensure that the official monetary system is the most attractive one.

State of play and the advantages of cash Simply spoken, the fundamentals of monetary instruments have not seen a lot of innovation over the last few decades. Apart from logistical aspects (including the use of ATMs) and developments in banknote security, there has been no tangible

1 World Bank Group (2018), p. 19

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innovation on physical cash. Most of the innovation happened in the accountbased, private money sphere, including the development of fast, cost-effective and risk-minimising clearing and settlement systems for wholesale and retail value transfers, as well as payment “rails” that allow for swift and secure electronic payment transactions such as debit cards, apps and for e-commerce payments. Still, physical cash has features and advantages that deposit money has failed to recreate so far. First, it is the only way non-banks can hold central bank money,2 i. e., the only way non-banks can hold money in a way that does not come with credit counterparty risk. Second, once it is in the hand of its users, cash can be used for payments by just physically handing notes and coins over to the recipient without intermediating infrastructure. This can happen without electricity or internet access. Physical cash is therefore resilient by design. It can also be stored without the need to rely on third parties, provided the holder is able and willing to provide for the storage facilities and adequate security. While physical cash in circulation is increasing in many economies,3 its use for transactional purposes is dwindling.4 This has been accelerated in the Covid crisis when cash was widely perceived as unhygienic and where lockdowns sent e-commerce skyrocketing. While economic agents still seem to appreciate physical cash as “store of value”, daily economic transactions are, regardless of their size, about to become entirely dependent on commercial infrastructure and providers, which might not be desirable from a policy perspective. Hence, CBDCs might be a possible avenue to safeguard the “public good” features of a monetary system brought to the broader economy. Especially in the retail area these experiments are still in their early stages, and more policy and technical work needs to be done, although many central banks have still not determined whether they want to roll out such CBDCs at all. In this paper, we are looking through these experiments and take a long-term view, outlining the target state that might be achieved in a few years from now. We argue why central banks should go bold on CBDCs in the long-term, as such approach is the only one that will allow CDBCs to become viable, in particular as alternative to physical cash and as a co-existing alternative to deposit money.  

2 Generally, only banks can have accounts directly with the central bank. 3 Such as in the Eurozone, the UK and Switzerland 4 SNB (2018)

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Proposition 1: The time of physical cash might be slowly approaching the end The concept of money has emerged several thousand years ago. While academia still has diverging views on whether money had emerged first to record obligations or started as a medium of exchange,5 it is clear it predates the establishment of banking systems or even central banks. Right from the beginning, money provided three basic functions i) unit of account, ii) means of transaction and iii) store of value.6 An important reason for „something“ to be called money or currency was that a particular type of money was accepted by convention, custom or by law as means to account for and settle claims (legal tender). Yet, different kinds of specie were used: coins of precious metal (even though debasement was a repeated feat), paper money (first used in China) or other items such as shells. They all have in common that they are scarce, either by natural constraints (e. g., availability of precious metals), technology (e. g., security features of banknotes) and/or through legal safeguards, such as the monopoly to issue coins and notes protected by criminal law and the enforcement power of a government. Reliance on the laws of physics came with an important inconvenience. Cash had to be physically hauled around and stored. This is logistically expensive. And it comes with security risks, as foes might use the opportunity of a less-guarded transport to steal physical money. It is for this reason that in Europe the first banks emerged in mediaeval times when trans-European trade intensified. Merchants like the Fugger, facing the problem of paying for goods over distance, branched out into banking, where moving around physical money is replaced by moving claims on money around with a stroke of a pen, or today through computers. Using deposit money came with lots of advantages. From a macro-economic perspective, it provided the means of money creation to private-sector banks that did not issue base money in the first place, by way of leveraging up and provide credit. There have been challenges to this principle of „fractional reserve banking“7 and governments and central banks had during crisis times intervene heavily to substitute a banking system that had to deleverage rapidly. But otherwise, the monetary system that relies on central and commercial banks has been quite a success. The issuer of base money, today the central bank, can rely on the wide-spread banking system to contribute to money creation while determining the right amount and the conditions for credit, something that would be difficult  

 

5 For a discussion of the roots of money, see e. g., Graeber (2012). 6 For a discussion of the fundamental functions of money, see e. g., Mishkin (2004), p. 45. 7 See Benes/Kumhof (2012) on the “Chicago Project” or a recent popular initiative on “Sovereign Money” in Switzerland.  

 

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to do centrally.8 For end-users, practicality and convenience counts. Managing the treasury of a modern company, even more so across borders, by physically moving around cash would simply be impossible. For consumers, stocking the right amount of cash at the bank counter or the ATM and paying physically at the baker or the butcher shop is not convenient, which explains economies moving away from cash for daily use as soon as competitive electronic alternatives are pervasively available. Two entities claim important side-benefits: First, providing credit, deposit and payment services is lucrative, albeit less so than it used to be. Second, governments benefit from the universal traceability of non-cash transactions to enforce tax or anti-money laundering (AML) policy or for less universally accepted reasons. While the value of physical cash in circulation is marginal compared to money deposited with commercial and central banks, economic agents could move into physical cash and therefore directly hold central bank money at any time and for any reason if they decided to do so. This option alone is an important anchor of trust of today’s financial system. Now, the advent of cryptography leads to a new equilibrium. The law of physics and rules that used to provide for scarcity and non-duplication are replaced by the laws of mathematics that ensure the same, however without the inconvenience that come with physical goods. At the same time, over recent years digitization became pervasive. Even in less-developed countries people carry connected mobile devices with them all the time. A significant share of our daily activity has a digital angle, might it be checking messages on the smartphone, writing emails or doing e-commerce transactions. In such a world, physical cash becomes anachronistic. Still, physical cash for now stays around for several reasons: First, the world has not yet arrived at broadly accepted alternatives. The digital currency world is too fragmented. Non-sovereign crypto currencies such as Bitcoin and Ether are not universally accepted, exhibit significant volatility in value against official currencies, are technically not fit-for-purpose for large-scale applications, hence come with significant costs and risks for their users and cannot be regarded as efficient. Stablecoin-like instruments backed by official currencies address the issue of volatility, but still suffer from the issue of fragmentation, as attempts to establish a broadly used stablecoins have failed so far for a number of reasons, including the fact that sovereigns are not willing to hand over a key element of sovereignty to private actors.9 CBDCs are still in their infancy, with central banks (rightfully) conducting very limited experiments given the potentially significant implications to the monetary system.

8 Swiss National Bank (2018). 9 Financial Times (2022)

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However, above issues are not insurmountable from an economics and technological perspective, and developments in the theoretical foundations of cryptography as well as practical digitization will not be rolled back. Rather, as practically viable alternatives might emerge in the future, the shift to a new monetary equilibrium might be swift and irreversible. Political and legal roadblocks might indeed slow down or try to prevent such shifts, but this will come with costs to the general trust into the monetary system, as we argue below.

Proposition 2: A central-bank digital currency will need to provide the (mostly) unlimited function of “store of value” Where there are prototypes of CBDCs, these focus on the function of “means of transaction” and do deemphasize the function of „store of value“. In the shortterm, such restrictions are justified: as important policy questions remain to be answered and most CBDC initiatives are also regarded experiments from a technical point of view, it is sensible to not allow or facilitate the aggregation of significant value in something that is not fully developed, especially as the security of digital currencies still needs to be proven. In the medium-term, however, it is questionable whether a CBDC that is significantly limited regarding the „store of value“ function is viable. To be fully accepted as alternative to other currency instruments including cash, a CBDC needs strong use cases. In developed economies with broad financial inclusion and where most individuals and businesses have access to bank accounts, debit/credit cards and other means of non-cash payments, the added value of CBDCs as pure “means of transaction” serves limited purpose. Holders would need to inconveniently „top up“ their CBDC accounts or wallets regularly, when they could just use their existing and future, industry-provided payment products such as cards or mobile apps. The enforcement of a limit of CBDC amounts that an individual or business can hold would require the central bank as issuer or an appointed third-party to monitor the content of CBDC accounts wallets. Alternatively, a limitation could be implemented technically, which would then however require the creation of accounts and wallets being centrally governed.10 This would result in an account-like system that simply does not offer material benefits over today’s bank accounts and payment systems in the eye of the end-users, rendering a CBDC redundant: It would not serve as a replacement for cash, but only compete

10 Otherwise, economic agents could just create several wallets, distribute their CDBC holdings across them and on aggregate exceed the CBDC holding limit.

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with existing and future industry-led solutions. CBDCs could be introduced to serve as fallback option only, but that would require economic agents using it regularly and to a significant extent, otherwise economic agents are not used to it. As a result, a CBDC that is constrained to transactional functions might not have a real use case in today’s economies. Rather, economic agents should be enabled to “store value” in future fullydeveloped CBDCs, if they chose to do so. From a practical perspective, there is no clear case for a limit. While CBDC holders are at risk of fraud and cyber-crime, this can be mitigated through appropriate security measures embedded in the system’s design and through adequate precaution by the holder. Also, there should not be the assumption that the system is completely risk-free, as today’s solutions aren’t either. Even if holdings of CBDCs are not limited, this does not need to apply to actual transactions – again mirroring the situation we have in the physical world today where such limits are imposed by counterparties and policy due to risk and financial integrity considerations.

Proposition 3: Failure to provide a generally accepted, cash-like instrument might undermine important economic policy and political objectives. It is true that physical cash today provides for anonymity and limited traceability, and it is true that these features are by some economic agents exploited for illicit activities. It is for that reason that several jurisdictions push back on the use of cash, in particular in countries where tax evasion and organised crime are pervasive. Examples include Italy that has been the EU‘s front runner in limiting cash transactions in value and encourage the use of cashless payment methods for all economic transactions. In Norway and Sweden it is increasingly impossible to use banknotes and coins, as merchants would simply not accept them. More intrusive initiatives include voiding entire series of bank notes as it happened in India, where economic agents were forced to push their cash stock through the banking system once to establish transparency of cash holdings.11 The perception of physical cash becoming outdated and inconvenient and its reduced use for transactional purposes is the most important facilitator of the “war on cash”. In that sense, it might seem inconsistent to call for a value instrument that replicates those features of physical cash that are perceived by some as disadvantageous. But there are important advantages that remain relevant.

11 Reserve Bank of India (2016) and The Economist (2016)

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First, the availability of a monetary instrument that does not fully rely on private-sector infrastructure is an important public good. Private-sector firms such as firms or credit card companies are commercial enterprises that (rightly) do decide themselves with which counterparties they want to engage with (contractual freedom). They consider mandatory and universally accepted legal constraints (e. g., not aiding or abetting criminal activities), but also their own strategic objectives or world views. These are often shaped in response to societal or political pressure and go beyond democratically legitimised legal rules. Clients have limited or no avenues to challenge such decisions, in particular if they are confronted with oligopolistic structures which develop when network effects are at play, such as with mobile app platforms (e. g., Apple App Store12) or payment providers. These networks nor the described effects stop at jurisdictional borders, and the two global economic points of gravity – USA and China – have substantial leverage over these platforms. Other regions, including Europe, have so far failed to establish competitive alternatives.13 It is likely that for many economies creating a secure alternative to physical cash is now more promising than the development of autonomous digital or payment platforms. Second, not having a monetary instrument that provides for anonymous use creates huge amounts of data that, as experience shows, is not save against data breaches and will exist forever. For example, a person that at home had donated to an non-governmental organisation that supports democratic advocacy in an authoritarian country online with her credit card might leave a data trail that becomes known to that authoritarian country and exposes the woman to personal risks in case she visits that country months or years later. This does not require an illicit data breach. Rather, some company involved in the transaction could be legally obliged to disclose data to jurisdictions that have not been touched in the original transaction. Recent controversies, such as on the EU-US Safe Harbour Framework on data protection, show that such risks cannot be credibly addressed through policies or treaties. Rather, preventing such data from accumulating in the first place might be the only effective solution, especially if the rules-based international system is further challenged. Third and finally, while physical cash requires elaborate and expensive logistics to be available in the entire economy, an actual transaction does not require  

 

12 The market conduct of companies like Apple and Google that leverage their mobile phone business to exert leverage over any economic activity that is performed through their mobile devices is currently under scrutiny by lawmakers in the US, EU and elsewhere and subject to several high-profile court cases (e. g., Epic Games vs Apple). 13 There are several European projects that struggle to gain traction, such as the “European Payment Initiative” or the EU’s cloud computing initiative “GAIA-X”.  

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any technical infrastructure, as bank notes and coins can be used without electricity, internet or digital devices. While we have made significant process in improving the resiliency and availability of core elements of our financial market infrastructure (such as real-time payment systems and communication networks), it is unlikely that we will be able to reach similar standards in the broader economy, which for example would need to include internet access of consumers and merchants. Recent high-profile failures of cloud infrastructures demonstrate these vulnerabilities, which could cause entire economies grinding to halt. Again, it might be more promising to design a payment instrument that is resilient by design than to develop a global, centralized system that is fully resilient. Above examples show that even if physical cash might not have a significant role in a future economy, the specific characteristics remain important. However, at least to our current understanding, the features that make cash resilient to the challenges described above are highly correlated with the characteristics that are targeted by the „war on cash“. Smart choices need to be made to find workable compromises, as the abolishment of a monetary instrument that has the advantageous characteristics of physical cash will likely backfire. Also, a cash alternative must be used widely to be commonly accepted and to prevent it from carrying a stigma. To this end, central banks might be best placed to lead the development of a CDBC as alternative to physical cash. They are the competent monetary authority, enjoy the trust of the broader society, can ensure close coordination with policy makers, and ensure any such initiative is well embedded in the broader financial system, including banks and financial market infrastructure firms. In contrast, we are sceptical of private-sector initiatives such as privately-issued stablecoins except for very limited use cases. Not only will private companies pursue strategic interests that might conflict with the public-good character of the monetary system. As much as fragmentation will hamper the acceptance of any initiative, the emergence of a dominant stablecoin player comes with policy and anti-trust issues. Furthermore, a privately-issued stablecoin cannot be regarded central bank money, even if it is backed by it, as it remains a claim on the issuer of the stablecoin, not directly the central bank.14

14 ECB (2020), p. 50.

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Proposition 4: The risk of disintermediation is real but can be handled. The ability of economic agents to hold central bank money in a more convenient way than physical cash might shift the balance between holdings of central bank money and deposit money with commercial banks. In the end, many of the constraints that deter agents to hold larger amount of cash, do not apply to holdings of CBDC, in particular costly logistics and security measures.15 Commercial banks could be (partially) cut out, leading to “disintermediation”, which by some is seen as a key obstacle to the rollout of the CDBC. To validate this concern, we need to think in scenarios, a „business-as-usual“ scenario, where the financial system is operating as it should, and a „stressed“ one, where there are concerns about the viability of substantial parts of the banking system, such as in a banking crisis. Furthermore, we need to look at interest rate scenarios, one of positive or zero nominal rates, and one where nominal rates are zero (and where there is an incentive to hold cash or cash-like instruments to avoid negative rates). A CBDC that allows for storage of value comes with challenges in two situations. In the stressed scenario, economic agents might choose to withdraw money from their bank accounts, turning their deposits into CBDCs. While they would still be exposed to the risk related to the currency (FX risk, inflation), they could effectively avoid counterparty risk of fragile banks. There is the concern that the availability of CBDCs could facilitate such bank runs and therefore create or amplify financial stability risks. As withdrawals materialise, central banks would need to backstop the banks confronted with withdrawals through Emergency Liquidity Assistance (ELA). But it is to date not clear how much the availability of a CBDC would exacerbate an issue that already exists today: Deposits fall into two broad categories. Larger depositors have in several past crisis episodes demonstrated that they move early and quickly, diversifying cash holdings towards banks that are perceived to be safer either within an economy or outside. Their behaviour does not only stem from the size of risks they are facing. Rather, large depositors have an information advantage as well as accounts with several banks at home and abroad that facilitate the reallocation of funds. Retail investors, on the other hand, have less incentives to move as a large share of their funds are covered by a deposit guarantee. Risks only materialise if the capacity of the safety nets is not

15 There have been episodes of large asset managers holding significant amounts of physical cash in vaults to avoid negative interest rates. These asset managers have claimed the benefit of avoiding negative rates exceeds cost of storage and logistics.

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sufficient and the sovereign is not able to (or chooses not to) backstop the safety net, which could be the case in a systemic crisis. The availability of a CBDCs might have no significant impact on depositor behaviour in stressed scenarios compared to the status quo. Concerned large depositors reallocate funds swiftly already today, leading to substantial deposit outflows from stressed banks. The behaviour of retail depositors largely depends on the confidence they place in existing safety nets. Recent cases in the Eurozone have shown significant flight risk when these safety nets have been perceived as too weak or subject to political bargaining, leading to measures as extreme as the imposition of capital controls within the currency union. However, at least within the EU, significant measures have been taken to enable some mutualisation of contingencies, thereby reducing country-idiosyncratic flight risk. The availability of a CBDC could even contribute to deposit stability, as depositors would be assured of being able to withdraw funds if they decided to. Even in business-as-usual periods might economic agents prefer to hold CBDCs rather than holding deposits at banks that the latter can use to extent loans. Some voices have claimed that this could lead to a credit crunch and/or to a massive expansion of the central bank balance sheet, which might then face public pressure to grant loans directly to companies and individuals. However, it should be expected that depositors make rational choices. In case banks offer higher interest rates than a CBDC, economic agents should have a preference of depositing money with banks. It cannot be ruled out that a CBDC would lead to lower deposit amounts, the gap could be filled by central bank funding. So while a new equilibrium between CBDCs and bank deposits might materialise, central banks can be provided with required mitigation tools.16 This includes existing and adjusted monetary operations tools. Also, a central bank could consider offering interest on CBDCs, thereby getting an additional tool to (dis)incentivise holding deposit money over CBDCs. Political pressure on central banks to provide direct lending to corporates and individuals cannot be ruled out, but would in most countries require fundamental changes to the central bank and monetary legal framework. With development banks as well as lending rules such as the recently enacted EU taxonomy, policy makers already today have significant leverage over lending decisions. The new equilibrium will bring more choice to economic agents, as they can allocate their deposits between CBDCs (without the burden of handling physical cash) and bank deposits. Even with CBDC holdings at the expense of bank deposits, banks are not cut out. Rather, they can be an important part of the CBDC eco-

16 Juks (2020).

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system by playing a role in its operationalisation (similar to how financial market infrastructure is provided in many countries today) and offering services on top (e. g., payments, asset management). Still, as many of such over-the-top services will not include deposit-taking as such (as it is central bank money that is managed or held in custody), the regulatory requirements will be less heavy than those applying to a deposit taker. Banks might therefore face additional competition from non-banks for certain services. Still, a CBDC ecosystem that is run as public good could make it easier to foster a level-playing field and prevent anti-competitive behaviour. Above issues deserve close scrutiny and need to be carefully analysed in theory and practice. Structural changes are to be expected. However, it is unclear whether such changes would be so costly as to be the ultimate roadblock for CDBC deployment.  

Proposition 5: The desire to ensure financial integrity should not constitute a roadblock to innovation. Just recently, the European Parliament (EP) has taken a very fundamental stance on the issue: Legislative proposals in context of the EU’s digital assets (Markets in Crypto Assets; MiCA) and anti-money laundering regulation require all transactions with digital currencies, regardless of issued privately or by a state-entity including the central bank, to be traceable.17 Earlier proposals still foresaw a materiality threshold of EUR 1000 below which such traceability would not have been required. However, EP lawmakers held that the speed of digital currency transactions would facilitate the structuring of larger value transfers into several transactions to such an extent that any materiality threshold would open the possibility of large-scale money-laundering through digital currencies. Effectively this means that any transaction, including the purchase of a cup of coffee, will require the identification of the involved counterparties, although the circle of individuals and institutions that would have access to such information would depend on the actual regulation and technical implementation. The ECB has performed several studies on the end-user acceptance of digital currencies.18 These survey shows that among many potential aspects,19 “privacy” 17 European Parliament (2022). 18 ECB (2021); Kantar (2022). 19 These include: privacy, security, cost, usability in absence of infrastructure (power, internet), usability across EU, ease of use, real-time finality, required devices (smartphone, dedicated device, etc.).

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is regarded the most important one. Most interestingly, the importance of privacy differs across countries: respondents in Germany, Austria, the Netherlands and Ireland place highest emphasis on privacy, whereas it is least important for study participants from Italy. It hence seems that there some degree of conflict between the objectives of policy makers and the characteristics that would drive the acceptance of digital currencies in the general public. These divergences also seem to be driven by culture, which will make it difficult to align on a set of universal rules in the EU, let alone globally. Studies as those prepared by the ECB are to be commended. While AML policies have long been driven by technical committees such as the Financial Action Task Force with limited involvement of the civil society, the emergence of digital currencies and the design of the rules that would apply to them requires such broader discussion. Otherwise, there is the risk of causing unintended collateral damage, as for example the negative consequences strict compliance rules had on financial inclusion and cross-border money transfers, in particular in emerging and developing countries. In the end, it will be necessary to allow for a certain “risk appetite”. The calibration will require careful consideration. Too much risk appetite might make a digital currency vulnerable to abuse. An approach too cautious might hamper the acceptance of a digital currency, as overreaching compliance-related restrictions will negatively impact legitimate use cases. Trade-offs against resilience, the risk of data breaches and centralisation versus more decentralised approaches need to be carefully considered.

Proposition 6: Failure to provide a universally accepted alternative to physical cash might undermine the public’s trust in the financial system. The establishment of trusted monetary systems can be seen as one of the greatest achievements of economic development and is one of the most important pillars of liberal markets. One of the key success factors of currencies is that they are “abstract” and “apolitical”: As long as one stays within the limits of the law – usually a broadly accepted consensus on what is legal and what is not – economic agents can rely on the unimpeded use of monetary instruments in their daily activity. As we have described above, using the privately-driven financial system, e. g. banks or retail payment systems comers with certain drawbacks that economic agents, even if they are conducting perfectly legal activities, might want to avoid at times. As of today, physical cash is a viable alternative, albeit decreasingly so given technological developments. In absence of a viable alternative to physical cash,  

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economic agents are at mercy of private companies and policy makers that might pursue objectives that go well beyond ensuring compliance with fundamental legal rules and that might not enjoy broad and sustainable consensus within the society, within or even across jurisdictions. Both private sector firms and policy makers are increasingly using the financial system to push political objectives that are not related to monetary and financial stability. They are leveraging the fact that funds and payments are front and centre of most economic activities, and that it might be easier to achieve certain non-financial objectives through the financial sector than through directly legislating and ultimately enforcing policy objectives. Safeguarding a certain degree of “abstractness” of the monetary system comes with two important benefits. First, it provides economic agents with an “exit door” safeguarding their funds from interests of private sector firms and policy makers that are not covered by fundamental legal principles. Second, this exit door tames the ability of firms policy makers to „go financial“ when they should rather address the root of policy failures directly. Closing the exit door further might cause economic agents suspecting that the monetary system is not “fair” anymore and open to abuse by powerful private and public stakeholders, thereby undermining the trust in one of the most important pillars of our liberal societies. So, the mere existence of this exit door might be more important than its actual use.

Conclusion With the advent of digital currencies we might stand at a juncture in economic history as significant as the invention of paper money and banking as such. This development comes at a time where the geopolitical, societal and monetary environment is facing significant challenges to the stability we had enjoyed for nearly 30 years. The future design and continued broad acceptance will be an important determinant of our political, societal and economic environment for years to come. Given what is at stake, governments and central banks are right to pursue a cautious approach. A stable monetary system is one of the pillars of stable nations, and changes to this important public good need to be carefully considered. Its ultimate design should be driven primarily by market forces and user requirements to ensure broad acceptance. Regulation and policies should focus on preventing market failures and safeguard stability, while not stifling the move toward an economic equilibrium between different types of money or protecting market structures that are not efficient as technology develops. Otherwise, economic agents might be attracted to alternatives to the formally regulated financial

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system and alternative currencies, with policy makers having limited power to prevent such shifts. Countries with less robust institutions and less stable currencies might be perceived more vulnerable to such developments. However, the recent Covid crisis has demonstrated that even in developed countries the societal fabric and trust in institutions might be more fragile than we would have thought.

References Benes, J., Kumhof, M. (2012): The Chicago Plan Revisited, IMF Working Paper The Economist (2016): The dire consequences of India’s demonetisation initiative, 3 December 2016 European Central Bank (2020): Report on a digital Euro European Parliament (2022): Crypto assets: new rules to stop illicit flows in the EU Financial Times (2022): Facebook Libra: the inside story of how the company’s crypto currency dream died Graeber, D. (2012): Debt – The first 5000 years Juks, R. (2020): Central bank currencies, supply of bank loans and liquidity provision by central banks, in: Sveriges Riksbank Economic Review 2020-2 Kantar (2022): Study on New Digital Payment Methods Mishkin, F. (2004): The Economics of Money, Banking and Financial Markets Reserve Bank of India (2016): Withdrawal of Legal Tender Status for ₹ 500 and ₹ 1000 Notes, Press Release, 8 November 2016 Swiss National Bank (2018): Arguments of the SNB against the Swiss sovereign money initiative (Vollgeldinitiative) Wall Street Journal (2016): India’s Bizarre War on Cash, 22 December 2016. World Bank Group (2018): Piecing together the poverty puzzle

Patrick Kenadjian

On the Coming of Retail CBDCs: Public versus Private Money Abstract: Central banks around the world are considering whether they should issue central bank digital currencies (CBDCs). Many are doing this mainly to become familiar with the problems involved, should other central banks decide to issue them. Some, including the European Central Bank (ECB) and the People’s Bank of China seem more intent on issuing them. Wholesale CBDCs, which would not be available to the general public, pose relatively few problems and could bring identifiable benefits to the international payment system. Retail CBDCs, available to the general public are more controversial. Their advantages to consumers are unclear and the dangers they could bring to financial stability through disintermediation of the commercial banks are obvious. There are solid systemic arguments in favor of CBDCs as a form of public money and as a public interest based counter weight to profit oriented private payment providers, but many of the other advantages touted for CBDCs turn out to be either make weight or contradictory, whereas the danger of disintermediation seems much more real. The central banks believe they can deal with these problems through clever design. But on closer examination, the solution proposed for one problem often comes at the expense of making it more difficult, if not impossible, to achieve one of the other goals. While the central banks have so far devoted a great deal of time and attention to questions of high level policy and technical design, they appear to be just now turning to developing the value proposition for users. The most recent research on public acceptance of CBDCs carried out for the ECB indicates they have quite a long way to go to convince the public and other stakeholders of the advantages of what they are proposing. To the extent they will need legislative action to implement their projects, for example to achieve legal tender status for their CBDCs, a lack of public demand may hinder or at least slow their adoption.

Introduction The smart money is betting that the issuance of central bank digital currencies (CBDCs) is more or less a foregone conclusion. This is, among other things, the conclusion of Eswar S. Prasad’s book on the future of money, except that he omits https://doi.org/10.1515/9783111002736-011

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my qualification of “more or less”.1 Much evidence speaks in favour of this. As of late March 2022 nine CBDCs had already been issued and over 80 central banks accounting for 90 % of world GDP were at various stages of study and development. While none of the major economy central banks professes to have made a firm decision to issue a CBDC, the People’s Bank of China (PBC) and the Swedish Riksbank (Riksbank) are among the most advanced and have conducted pilot projects, in the case of the PBC with up to 200 million participants. The European Central Bank (ECB) is not quite as far advanced, but its President, Christine Lagarde, stated on March 21, 2022 in an interview which was part of the Bank for International Settlements (BIS) annual Innovation Forum, that she expected the ECB to be in a position within two years to commence rolling out of its version of a retail CBDC.2 The US Federal Reserve (the Fed) has been more cautious. It issued its first, rather tentative, paper on the topic only in January 2022,3 whereas the Riksbank had already issued its second comprehensive report two years earlier, in 2020.4 But the Fed received a significant nudge from the President of the United States in the form of an executive order issued on March 9, 2022 urging “the whole of government” to move forward with research and development efforts on the potential design and deployment of a US digital currency, as part of an effort meant to result in legislation authorizing a CBDC within 210 days.5 While I believe many of the central banks who are examining the issue are doing so only so as not to be caught out unprepared if others actually issue the things,6 there is ample evidence that other central banks are more seriously considering issuing them. Mu Changchun, Director General of the Digital Currency Institute of the PBC, concludes his contribution to this volume by stating “the train has left the station”. CBDCs are digital liabilities issued by a central bank and come in two basic varieties, wholesale and retail. The wholesale variety has raised fewer concerns than the retail variety for two reasons. First, it looks much like an extension of the wholesale payments systems central banks already operate and which are used largely by institutions rather than by individual consumers, so nothing revolutionary appears to be involved. Second, because, to the extent it would apply to international payments, which are universally acknowledged to be slow, inefficient and expensive, it would be tackling a recognized market failure of the pri 

1 Prasad, p.356, 2021. 2 Lagarde, March 22, 2022. 3 Federal Reserve, 2022. 4 Riksbank, 2020. 5 Executive Order, 2022. 6 Ravi Menon, General Manager of the Singapore Monetary Authority said as much at the 2022 IMF Spring meetings. See Menon, 2022. See also Andrea Maechler’s contribution to the volume.

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vate sector. In contrast, retail CBDCs, which would be available to and used by individuals as well as institutions and where the argument that they are a response to a market failure is harder to make, have been, to say the least, more controversial. A January 2022 report by the Economic Affairs Committee of UK House of Lords which concluded “[w]e have yet to hear a convincing case” for them, queried whether they are anything more than “a solution in search of a problem” and in fact used that question as the title of their report.7 Retail CBDCs have been variously accused of being part of a plan to eliminate cash and therefore allow central banks to charge negative interest rates, as a danger to privacy, as a threat to the currencies of other countries, as a means to distribute “helicopter money” and as potentially resulting in the disintermediation of the banking sector. Stephen Cecchetti and Kermit Schoenholz in their contribution to this volume provide a useful checklist of the possible costs of retail CBDCs. The House of Lords Committee report summarized the open issues as it saw them as follows: – how can a CBDC be a competitive payments option without causing a level of banking sector disintermediation that would have negative consequences for credit allocation and financial stability; – what additional monetary policy options would a CBDC provide and would they be proportionate to the central bank’s current mandate; – how to reconcile strong privacy safeguards with financial compliance rules and which organizations will be able to access payment data and for what purpose; and – what are the main international and national security risks that arise from a CBDC.8 We will focus on the issues concerning disintermediation, privacy and consistency with central bank mandates and include some thoughts concerning stablecoins, which I view as the key to understanding central bank motivations. We will conclude with some thoughts on timing.

1. The Back Story To start with, a few words on how we got here in are in order. As Randy Quarles said in his opening remarks on the panel on CBDCs at the ILF conference this book is derived from, when he took up his post as Chair of the Financial Stability

7 House of Lords, 2022, p. 2. 8 Ibid.

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Board in November 2018, CBDCs were not on the FSB’s agenda. Now it sometimes seems that, together with inflation, central bankers can speak of little else. What happened? Christine Lagarde, in her March 21 BIS Innovation Hub interview referred to above, pointed to three factors.9 First, the central banks have seen a steady decline over the years in the use of cash for payments and a sharp recent increase in the demand for digital transactions from consumers, the latter coinciding with COVID-19.10 Second, they viewed as a wakeup call the announcement by Facebook (now Meta) in June 2019 of an intention to issue a digital means of payment, initially called Libra, then Diem, before being finally abandoned in Q1 2022. In its initial form it would have been a means of payment backed by a basket of major fiat currencies which would insure its stability, meaning a stable exchange rate to fiat currencies, thus avoiding the wild fluctuations in value of Bitcoin and other cryptoassets not similarly backed. Facebook’s services were used by roughly one third of humanity and the basket of currencies made it look like Libra could become a new global currency in competition with the fiat currencies issued by the central banks. This could have resulted in a global form of the monetary phenomenon known as dollarization, whereby less attractive currencies are replaced by the US dollar or another strong currency in their own jurisdictions, resulting in a loss of control by the central banks over their monetary policy. Libra and Diem were never launched, largely because of the opposition of central banks, financial regulators and supervisors who raised a series of objections to granting the regulatory permissions which would have been required for the project to go forward, until Meta abandoned it in early 2022. But the message had been received and central banks set to work on retail CBDCs. And that turned out to be the third key driver in the development of CBDCs: the fact that other central banks, in particular the PBC, were forging ahead, motivated the others to move as well, to be ready to react with their own program if necessary, rather than be left behind. Stephen Cecchetti, who has also contributed to this volume, likens this to the preparations for mobilization in Europe prior to World War I. The speed at which the central banks advanced appears to have been driven primarily by local conditions. These included the speed of the replacement of cash by digital payments by consumers, for example in Sweden and China, the quasi-monopoly of two privately owned retail payment systems in China and the fact that the large payment systems in the European Union (EU) are operated by

9 Lagarde, March 22, 2022. 10 Stefan Ingves, Governor of the Sveriges Riksbank, notes in his contribution to this volume that at the end of February 2022 there was roughly 60 billion Swedish Kroner worth of bank notes and coins in circulation in Sweden compared to 114 billion fifteen years before. This is probably a rather extreme case, but emblematic of what central bankers have been observing.

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non-EU based companies. The hope that digitalization might enhance the position of their currency as an international reserve currency may also have played a role in the case of China and the EU. In any event, it is clear that the central bank whose currency is the world’s principal reserve currency and whose domestic payment system is neither a quasi-monopoly nor dominated by foreign services providers, the Fed, has been notably more reserved in its movement towards a digital currency. The Fed’s watchword, “it’s more important to get it right than to be first” stated as far back as October 2020 by its Chairman Jerome Powell,11 has not been widely shared. Christine Lagarde, in her BIS interview, explicitly declined to endorse it.12

2. The Central Banks’ Arguments in Favor of Public Money The central banks have advanced a number of reasons for them to look into and eventually issue digital currencies. These include increasing financial inclusion, keeping up with the digital times, increasing the efficiency of payment systems and fulfilling their mandate to provide a widely available safe asset to their citizens. Ulrich Bindseil in his contribution to this volume presents an excellent summary of them, which I will not repeat here. Of these, the most intellectually convincing line of argumentation for me is the one relating to the availability of safe assets, as set forth persuasively by Fabio Panetta, Member of the Executive Board of the ECB, in a speech in Madrid in November 2021.13

2.1 The Importance of Public versus Private Money To put this line of argument in context one must remember that we live in an economy where the money we use is in part public money, issued by the central bank in two forms, bank notes and coins and the reserves maintained by regulated financial institutions with it, on the one hand, and private money issued by these same financial institutions when they, for example, issue loans to their customer on the other hand. The vast majority of the money in circulation is this private, or inside money. Putting aside bank reserves, since they cannot be held by individuals, the proportion of public money is in the low single digits as a percen11 Fed’s Powell: more important for U. S. to get digital currency might than be first, Reuters, October 19, 2020. 12 Lagarde, March 22, 2022. 13 Panetta, November 5, 2021.  

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tage of the money we use. And even these percentages may overstate its importance as a means of payment. Fabio Panetta, in his Madrid speech estimated that only about 20 % of the cash stock in the EU was used as a means of payment, down from 35 % fifteen years before.14 The rest is used as a store of value, some of it held as a precautionary reserve, some outside of the jurisdiction and some for use in illegal activities. So one can ask why we should worry about a further erosion of the share of public money in the mix. The answer is that when one inquires what the source of the value of private money is, one comes to the conclusion that it is founded on the promise of its convertibility at par into public money. Consumers deposit money with private banks based on the implicit or explicit promise of being able to withdraw it and receive public money at par for it. This provides the public confidence in private money both as means of payment and store of value, two of the three attributes of money. The third attribute, being a unit of account, is reserved to public money. Private money not backed by this promise of convertibility would not reliably trade at par with public money, as shown by the long history of attempts to create private money that is not backed by the convertibility promise. See, for example the experience of the US in the so-called “free banking” era and the various works of Gary Gorton of Yale on the subject, nicely summarized in his 2021 article “Taming Wildcat Stablecoins”.15 This promise of convertibility is backed by the ability of central banks to issue the kind of public money people want speedily and in sufficient amounts to meet public demand, consistent with their mandate, for example to provide price and monetary stability. So far this has been provided in the form of banknotes and coins. But what happens if/when the public no longer wants/needs/can use physical money to any great extent, but only digital money, if the central bank cannot issue public money in the form consumers want/need/can use? I am not sufficiently expert in monetary and financial matters to answer this question with any certainty, but I think it is one which those incumbent financial institutions who view CBDCs with concern might want to ask themselves. In objecting to retail CBDCs could they, possibly, be sawing off the branch on which they, and our financial system, are sitting? However, even if that is true, one line of questioning at least remains, which is whether retail CBDCs as the central banks are currently designing them, will be fit for this purpose. As we will discuss in more detail in section 3 below, the central banks are largely thinking of them as a means of payment in competition with payment platforms, while playing down their role as store of value so as not to  

 

14 Panetta, 2021. 15 Gorton, 2021, p. 25 et seq.

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disintermediate incumbent financial institutions. This may be desirable from a financial stability point of view, but may lead to making CBDCs less completely a substitute for cash. The difference between the amount of cash in circulation, which is actually still rising in some jurisdictions, and its use as a means of payment, which is declining, would seem to point to its importance as a store of value. So that dialling back too much on its attractiveness as a store of value could conceivably diminish its acceptance and thus its success. Andreas Dombret and Oliver Wünsch point out in their article in this volume the importance of CBDCs being able to fulfil this store of value function. We will return to this point in section 5.2.3. This is one of the numerous tradeoffs that the project runs into.

2.2 CBDCs can counter the Threat of Network Effects on Payment Systems A second argument I find somewhat persuasive is that the availability of a CBDC would add to competition in an industry with network effects which, in the absence of a not for profit provider, can be expected to result in ever greater concentration. The term ‘network effect’ refers to the phenomenon whereby a product or a service becomes more valuable as more people use it. The individual user derives more value from a network as more users join it, and non-users are motivated to join the network. The phenomenon is familiar to users of social networking services, and can give rise to market tipping, the tendency of one or a small number of service providers to pull away from the others and to dominate the market, stifling competition. It is clear that, as Agustin Carstens pointed out in his keynote address included in this volume, this phenomenon can apply to for profit payment systems providers. One need only look at the Chinese market for retail payments, over 90 % of which is held by two providers, AliPay and WeChatPay. The addition of a not for profit provider, such as a central bank, is not, to my mind, a guarantee that all competition will not disappear. That will depend on whether potential users are convinced of the intrinsic value of the product/service provided by the CBDC, a point we will return to in the concluding section of this article, but it does provide some hope that the ultimate equilibrium point of the payment system will not be a monopoly. Still, this will only succeed if the value proposition of the CBDC for consumers and merchants is a convincing one and, as discussed in section 5 below, I think this is an area in which the central banks have underinvested so far as they have understandably focused first and foremost on technology, financial stability and public policy.  

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2.3 Financial Inclusion is a Concern, but CBDCs may not be the best Way to promote it I find the other arguments put forward by the central banks less convincing, both in themselves and because there are other policies short of CBDCs which the central banks could pursue to reach the same goals. Let us start with financial inclusion. This is clearly a worthwhile goal. The proportion of the unbanked or underbanked population even in advanced economies is large enough that it should be a legitimate concern for central banks. A 2017 survey conducted by the US Federal Deposit Insurance Corporation (FDIC) found that 6.5 % of US households were unbanked and 18.7 % were underbanked, for a total of 25 %.16 An analysis by WSBIESBG in the EU in 2016 came up with a figure of 8.6 %.17 So there is clearly a problem in many places, although not in all,18 but exactly how will CBDCs contribute to solving it? That could perhaps be achieved by offering all members of the public directly the ability to open accounts with the central bank, but this runs quickly into two sets of practical problems. The first is that central banks do not currently have the human and systems infrastructure to offer millions of retail accounts. How, for example, would a central bank, staffed largely by economists, supervisors and regulators, cope with onboarding millions of customers and monitoring compliance with their own rules on Know your Customer (KYC), anti-money laundering (AML) and combating the financing of terrorism (CFT). The second is that, if central banks want to reduce the chances that CBDCs might disintermediate incumbent financial institutions, then, as we will discuss more fully in section 3.1 below, they will tend to adopt a two tier system in which they would issue CBDCs not directly to the public, but to existing financial institutions who would then handle the interface with the public, thus staying in the loop and being able to continue to use their existing onboarding, KYC, AML and CFT monitoring systems. This is the model adopted by both Sweden and China in their pilot projects. If that is the case, however, how will a CBDC issued through incumbent financial institutions increase financial inclusion since the same institutions who are not now providing banking services to the unbanked will be the public facing part of CBDCs?  

 

 

 

16 Federal Deposit Insurance Corporation (FDIC), 2017 FDIC National Survey of Unbanked and Underbanked Households, October, 2018. 17 WSBI-ESBG, Close to 40 million EU citizens outside banking mainstream, www.wsbi-esbg. org/press/latest-news/Pages/Close-to-40-million-EU-citizens-outside-banking-mainstream.aspx, visited April 26, 2022. 18 The House of Lords received evidence that in the UK the number of unbanked was at a record low. House of Lords 2022, p. 17. Andréa Maechler, in her contribution to this volume, notes that in Switzerland access to bank accounts and other financial services is nearly universal.

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One answer might be to require the banks to provide basic CBDC accounts to all members of the public. But if financial inclusion, rather than justifying the issuance of CBDCs is the goal, could not the same requirement be applied to the provision of plain vanilla retail bank accounts, either free of charge or free from most bank charges, without the need to issue a CBDC? This is an argument raised by Gary Gorton in his 2021 article, where he also notes that declines in unbanked rates seem to correlate with improvements in socioeconomic circumstances.19 A counter example is provided by Cecchetti and Schoenholz in their article included in this volume from the experience of a program in India to provide no-frills bank accounts without charge which brought nearly 450 million people in to the financial system. Beyond this, one can question how much the mere availability of a CBDC or other bank account will contribute to financial inclusion without a significant increase in financial literacy. So that if central banks want to increase financial inclusion, promoting measures to increase financial literacy would seem an equally important goal to pursue and one that can be accomplished without a CBDC. Finally, central banks may want to have a look at some of the findings of the Kantar Public Study on New Digital Payment Methods commissioned by the ECB concerning the likelihood that the unbanked and underbanked would adopt a new digital payment method. The study found “an evident level of resistance to the possibility of adopting a new digital payment method…. This emerged from interviews with this segment of the population in all the countries”.20 Part of this resistance appears to be grounded in the fear that “a digital euro would endanger commercial banks and mean the end of the use of cash”.21 While I think the latter reflects a widespread suspicion, I find the concern of the unbanked for the future of the commercial banks who are not serving them more surprising. The study restricts itself to the Eurozone, so it is possible that outside of this area responses might differ, but the separate country studies for the various Eurozone member states show a remarkably similar set of attitudes among the unbanked and underbanked, varying between scepticism and hostility. This definitely seems to be an area where if you build it you should not expect this group to come without much persuasion, a topic we will return to in section 5.2.3 below.

19 Gorton, 2021, p. 44. 20 Kantar Public, 2022, p. 11. 21 Ibid., 20.

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2.4 How much will CBDCs promote Central Bank Participation in Cutting Edge Technology? The argument that CBDCs would allow or require central banks to keep up with and participate in developing cutting edge digital technology also runs into practical problems. The first is that the really cutting edge digital technology is being developed in the area of blockchain-based decentralized finance involving distributed leger technology (DLT). So far, according to Acting Comptroller of the Currency Michael Hsu, no CBDC has been issued “on chain”, nor, in my view, is this likely to be the case in the future. Mr. Hsu flatly stated in an April 2022 speech, that “fiat currencies, like the dollar, cannot be put ‘on chain’”.22 I think this should be understood as referring to retail CBDCs. More cutting edge DLT technology is being experimented with in the context of wholesale CBDCs as explained by Andréa Maechler in her contribution to this volume. The second is that central banks are not likely to develop their own systems and technology to design their retail CBDCs, but rather to rely on existing commercial systems and technology, through outsourcing to the private sector large parts of the design and implementation stages of CBDCs for two reasons. The first is to avoid reinventing the wheel. The second is because they cannot afford to compete financially for the best talent in the digital field. So that while CBDCs will involve central banks in digital matters, their effect on putting the central banks at the cutting edge of the field outside of the wholesale area is open to question.

2.5 Will CBDCs enhance the Efficiency of the Payment Systems? Finally, on the question of increasing the efficiency of the payment systems, I see two issues. The first speaks in favor of the central banks’ arguments. As noted above, the presence of a central bank payment system for retail payments will likely contribute to maintaining competition in retail payments. In the absence of such a public system operated on a not for profit basis (although certain central banks such as the Fed are not supposed to operate at a loss, so their system will likely not be able to operate on a purely concessionary basis), it is likely that the privately operated for profit systems provided by platform operators would, due to the network effects inherent in the operation of platforms, tend to a “winner takes all” development at the end of which only one or two platforms would remain viable. Agustin Carstens, General Manager of the BIS, made these points for-

22 Hsu, 2022.

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cefully in his keynote speech included in this book.23 As noted above, the experience of China where AliPay and WeChatPay represent together over 90 % of the retail payment system is a real life illustration of this phenomenon. On the other hand, the inefficiency of payment systems is most obvious in the international payments field. That is an area in which retail CBDCs are not designed to operate and where wholesale CBDCs might be most useful. But that is an area beyond the scope of this paper. I will only note that a brief look at wholesale CBDC projects indicates to me that they are still largely at the proof of concept stage and that interoperability, both in terms of cross-border and cross-currency operation, is still rather limited and that testimony received by the House of Lords indicates that barriers to interoperability would be “formidable”.24 I would also add, to the attention of the ECB, that if one is concerned about the domination of the EU payment systems by American companies, support of the European Payments Initiative would seem to be a logical place to start. That initiative does not require a CBDC, but its current status is a bit unclear. The ECB had initially welcomed its launch25 but the most recent press reports indicate that 20 of the initial 31 major Eurozone bank participants have pulled out, including all Spanish members as well as Germany’s Commerzbank and DZ Bank, with only 13 shareholders confirming they are still convinced of the strategic value of the project. This has led to comments in the specialized press that “the nascent project is, at worse doomed to failure, and at best will ditch its plans for a pan-European acquirer, in favour of a much less ambitious digital wallet”.26 From the outside, I cannot tell whether this is yet another case of Europeans being unwilling to give up national advantages in favour of a broader European solution, but it does seem like a missed opportunity. The CEO of the European Payments Initiative participated in the conference from which this volume is derived, but unfortunately did not contribute to this volume.  

23 Carstens, 2022. 24 House of Lords, 2022, p. 20. This was taken from the testimony of Barry Eichengreen, who explains the underlying issues in his contribution to this volume. 25 ECB welcomes initiative to launch new European payments solution, ecb.pr.200702N214c 52c766.en.html, visited April 26, 2022. 26 Payments Industry Intelligence, European Payments Initiative has troubles as majority of Banks leave, March 22, 2022, www.paymentscardsandmobile.com, visited April 26, 2022.

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2.6 What about the Effect on Reserve Currency Status? I speculated above that the EU and China might be motivated by the possibility that issuing a CBDC could enhance the position of the Euro and the Yuan, respectively, as reserve currencies. I had always viewed this possibility with scepticism. It seems to me that the Euro’s role as a reserve currency is being held back, as Benoît Coeuŕe pointed out in a 2019 speech when he was still a member of the ECB’s Executive Board, by the relative lack of highly rated “safe assets”, government debt denominated in Euros in which a central bank could invest if it wanted to hold Euro reserves, as well as by the lack of deep and liquid capital markets in which to sell those assets27. The EU itself issues very little debt, so this leaves Germany whose commitment to a balanced budget also results in low issuances in comparison to the US Treasury. In connection with the NextGenerationEU recovery measures enacted to counter the effects of COVID, the EU did agree to issue, on a one time basis, up to around €800 billion through 2026. Alone, that is but a drop in the bucket. If it were to become a model for EU level debt issuance, that might make a difference and there is current discussion of expanding this structure to prepare the EU for future crises. The fragmentation of the EU capital markets is a longstanding problem the EU remains unable to deal with despite repeated attempts at building a European capital markets union dating back to February 2015.28 The attractiveness of the Yuan as a reserve currency is held back by exchange controls, the perceived lack of independence of its central bank and doubts about the rule of law. I do not see how any of these factors is likely to change as a result of the issuance of a CBDC. My priors appear to be confirmed by a recent working paper issued by the International Monetary Fund (IMF) in March 2022 under the aegis of Barry Eichengreen which studied the evolution of reserve currencies since the turn of the century. It concluded that while the share of the international reserves held in dollars had declined, this decline had not been to the benefit of other traditional reserve currencies, including the Euro, but one quarter into the Yuan and three quarters into currencies of smaller countries, such as the Australian dollar, the Canadian dollar, the Korean won, the Singapore dollar and the Swedish Krona. The authors conclude that the traditional view of reserve currency competition as a battle of giants, dollar versus Euro or versus Yuan, is probably no longer valid as direct markets between an increasing number of currency pairs has allowed cen-

27 Coeuré, 2019. 28 See Andreas Dombret and Patrick S. Kenadjian, The European Capital Markets Union, A Viable Concept and a Real Goal? Institute for Law and Finance, Walter de Gruyter (2015).

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tral banks to diversify their holdings into non-traditional currencies which display attractive volatility-adjusted returns compared to the traditional reserve currencies.29

2.7 The Bottom Line In summary, I am most convinced by the argument that our financial system is dependent on the availability of public money in a form consumers want and can use, so that if the form is digital, then it makes sense that public money will have to be, at least in part, digital as well. I am also convinced, by looking at the Chinese experience, that in absence of a not for profit public sector alternative, the inherent dynamics of platform providers of payment systems are likely to lead to a quasi-monopoly situation in which our money will be provided by the platform operators, with all the drawbacks, including the slowing down of innovation and growing barriers to new entrants, which are unlikely to be in the best interest of consumers in the long run. This is the question on Agustin Carstens posed in this keynote speech: who do you want to control your/our money?30 That is not to say that I believe the public sector alone should have the sole privilege of issuing money, because of course it does not, but rather that the existence of platform operated private payment systems has altered the existing equilibrium between public and private money and calls for a new look at it. However, I am not convinced that this settles the issue. The central banks seem to assume that retail CBDCs will have an attractiveness to consumers that I think has yet to be demonstrated and may well be diminished by policy choices made to prevent the disintermediation of the current incumbent financial sector. The central banks are clearly aware that whereas the incumbent financial institutions are not the real target of CBDCs, it is the incumbents who may bear unintended collateral damage from the issuance of CBDCs. So it is to their concerns and the design choices for CBDCs to deal with them that we turn next.

29 Eichengreen, The Stealth Erosion of Dollar Dominance, March 2022, p. 35–36. 30 Carstens, 2022.

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3. The Concerns of the Incumbent Financial Institutions 3.1 Can Disintermediation be avoided by clever Design Choices? Ulrich Bindseil has labelled these concerns in his paper in this volume as “the fearful view”. They can be summed up in one word: “disintermediation”. This is the fear of incumbent financial institutions that if their customers are offered the possibility of an account at an ultra-safe central bank, customers in general and large customers in particular (those whose accounts exceed the amounts insured by the deposit insurance system) will sooner or later abandon their conventional bank accounts in favor of CBDC accounts. Thus the incumbents will lose, first, an important source of financing, the “sticky” deposits, especially the retail ones they rely on to provide the core of their low cost funding, and then direct contact with these customers as a source for the sale of other banking products. The fear of the loss of deposits is less that they would necessarily disappear right away, since retail deposits are notoriously “sticky” and deposit insurance is meant to keep them that way, but more that in a financial crisis the availability of an ultra-safe alternative could accelerate, if not precipitate, bank runs in the direction of the CBDC accounts and that, since the accounts would be electronic, the speed of these runs could be faster than traditional runs, and thus harder to stop. Thus the fact that central banks have not observed significant shifts away from commercial bank deposits in their pilot projects does not strike me as dispositive, as you would not expect to see this in what Dombret and Wünsch call the “business as usual” scenario in their paper included in this volume. But in fact, as analysed in an ECB Occasional Paper dated May 2022, the ECB concedes that there could be a substantial loss of deposits in the Eurozone outside of a panic. The paper analyses a variety of scenarios, the highest of which involves households and non financial companies replacing 50 % of their deposits with digital euros if the supply thereof is unlimited and the users consider it a store of value as well as a means of payments, generating a demand of €7.5 trillion.31 The loss of contact with customers is equally troublesome since bank business models rely on the ability to sell customers multiple products. In fact, commercial banks often measure their success in part in terms of the products per customer they can sell. Anything which reduces customer contact therefore is potentially a problem for their business model. The central banks answer that these fears can be alleviated by a few design features in the retail CBDCs. The first would be, as noted above, to design them on  

31 ECB 2022, p. 11.

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a two-tiered model, where the central banks would issue CBDCs, not directly to the public, but to the financial intermediaries, who would then make them available to retail customers through wallets that the intermediaries would design and maintain. Thus, the existing financial intermediaries would continue to be the point of contact with their customers, could continue to handle onboarding, KYC, AML, CST and other chores for the central bank and would have full freedom (no doubt within certain limits) to design customer facing products and solutions around the CBDC product. Thus direct disintermediation would be avoided. To me this sounds like it could be a sensible answer for both sides, but at the risk of compromising the goal of increasing financial inclusion since, as noted above, the same financial institutions would be facing the public. In fact it’s hard to see how a central bank would be able to cope with KYC, AML and CST requirements for thousands or millions of new CBDC account holders, without significantly staffing up and introducing the appropriate control systems, which would be both time consuming and expensive. So from their point of view this division of labor seems almost inevitable. Beyond that trade-off, the banking community needs to answer whether what sounds like a reasonable solution to an outsider hides additional traps that need to be addressed. In particular, whether and how financial institutions will be compensated for providing these services and, perhaps more importantly, the calculations of deposit losses in the “large demand” scenario need to be examined and the means to counter them considered. To answer the concern over these “large demand” withdrawals, as well as potential bank runs in stressed situations, central banks have considered a cap on the amount of CBDCs which could be held by any individual customer, so that the maximum amount that could be withdrawn in a run would be limited. This has been criticized by parts of the academic community, including Stephen Cecchetti, as going against the idea of CBDCs as a substitute for cash, since an important attribute of cash in a fiat money system is that the central bank can create enough of it so that it is available in large/unlimited amounts everywhere and whenever it is needed. That is clearly a valid theoretical objection and it raises the question of whether such a limitation would in practice be a significant impediment to the central bank’s ability to provide a safe asset in sufficient quantity to support convertibility of privately provided bank accounts into public money and, as discussed below in section 5, to provide a sufficiently attractive alternative to other payment systems. Andreas Dombret and Oliver Wünsch, in their contribution to this volume, detail the practical difficulties which such a limitation would involve. As I stated in section 2.1 above, I see the need to preserve the ability to support convertibility as the strongest argument in favour of a retail CBDCs. I think the central banks are going to have to consider this limitation very carefully in the design of their CBDCs. So far, a direct cap on issuance has been considered by the

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ECB, but indirect caps are inherent in the PBC’s design to preserve the privacy preferences of the public. This involves a tiered system which would limit the availability of their CBDCs to individual holders in proportion to the amount of information the individual account owner is willing to give out about itself, as described in Mu Changchun’s contribution to this volume. This system was designed to overcome privacy issues by placing in the customer’s hands the choice of the amount of information the bank and, through it, the state, could obtain about an individual and their transactions, but it can also operate de facto as a limitation of the amount of CBDCs that can be issued. A further practical question is whether any nationwide or system wide (in the case of the Eurozone) cap, however low it sounds overall (€3,000 was the amount the ECB initially floated, but some of its representatives have since suggested that the formula they used to calculate it would now yield a number closer to €4,000), when broken down on a bank by bank basis might not still have a destabilizing effect on an individual bank, especially in terms of its liquidity. But even on an aggregate level, the “large demand” scenarios considered by the ECB Occasional Paper make clear that the ECB is concerned about the potential for disintermediation that an unconstrained CBDC could bring with it, which is what brings them to seriously consider capping the amounts of CBDCs users may hold. They have even estimated that the effect of raising the cap by €1,000 would result in a decrease of deposits by €340 billion.32 This could have a significant effect on the banks’ liquidity ratios. The Bank of England told the House of Lords Committee they had modelled for 20 % of bank deposits to move to CBDC wallets, an amount roughly equivalent to all uninsured deposits, which would require banks to fund themselves more with long term wholesale debt and result in the loss of revenues from payments.33 These amounts are clearly not negligible, and if the banks become less profitable, their ability to fund themselves long term, especially at a time of rising interest rates, is open to question. An additional question is what proportion of the payments stream a retail CBDC would syphon off from the banks as opposed to the platforms. Revenue from payments has accounted for up to one third of bank revenues,34 and it is unclear to me how much of that they will retain through the two-tier public/private structure the central banks are offering. An additional promise some of the central banks have appeared to be willing to make to reduce direct competition between CBDCs and commercial bank ac 

32 ECB 2022, p. 13. 33 House of Lords, 2022, p. 29. 34 See Statement of Randal Quarles, CFFL and Financial Technology of Cyber-Security Center Stablecoin Webinar, April 27, 2022, “The Impact of Stablecoins on Financial Regulation, Consumers and Politics-Zoom”.

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counts is not to pay interest on their CBDCs, which of course the commercial banks are free to pay, or to pay an uncompetitively low rate of interest. Since cash does not pay interest and CBDCs are meant to be its digital equivalent, not paying interest on them seems logical. In the days of low interest rates this did not sound like much of an advantage, but going forward it might be one. This is clearly both a way to mimic cash and a way to restrict the use of the CBDC to a means of payment, by reducing its appeal as a store of value.35 However, it appears that the ECB at least wold rather retain the ability to pay – or charge – interest on their CBDCs, to retain maximum flexibility in adjusting the attractiveness of the digital euro.

3.2 Would CBDCs result in Bloated Central Bank Balance Sheets and in Central Banks exceeding the Limits of their Mandates? Another concern relates to what happens to the money retail depositors place with the central bank. It has been assumed the central bank would have to use it to make loans and investments in its domestic economy, thus taking on a greater role in the allocation of credit, which risks taking them beyond what is currently thought of as their mandate. In the U. S. we would say they would be “picking winners and losers”. In the EU we would say they would be engaging in fiscal policy, as Gary Gorton points out in his 2021 article.36 However we want to label it, this risks involving them in a role which could endanger their independence as well as reducing the commercial banks’ role in the allocation of credit, where we have long thought they had a competitive advantage in terms of local knowledge of the debtors. The possibility that central bank asset purchases could end up dominating debt markets, affecting asset prices and distorting credit allocation has already been the subject of political and economic debate in the EU during quantitative easing and the question of whether this would cross the line into fiscal policy became the subject of legal challenges the ECB had some trouble refuting.37 How much of a problem this would turn out to be goes beyond my ability to work through the ups and downs of central bank balance sheets and open market and other credit operations. I think the central banks’ answer is that any increase  

35 BIS, WP No. 948, 2021. 36 Gorton, 2021, p. 44–45. 37 Jan Strupczewski, Our way or no way, German ECB ruling rocks EU foundations, Reuters, May 6, 2020, www.reuters.com/article/us.ecb-policy-Germany-eu-analysis-idUSKBN22PZ, visited April 26, 2022.

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in their balance sheets as a result of issuing CBDCs would occur as they were otherwise reducing their balance sheets through exiting investments made during quantitative easing, so that their overall footprint in the economy would not increase. But we should recognize that overstepping the boundary between monetary and fiscal policy is a political hot button central banks ignore at the peril. We will return to it later. I would also add that the ECB escaped being held ultra vires by the German Federal Constitutional Court (FCC) in May 2020 in part because the FCC allowed itself to be convinced that there were pre-set limits to its purchases under the program being challenged. Would that hold in the absence of pre-set limits? Here again, the usefulness of a cap becomes evident. Otherwise the increase in central bank balance sheets is inevitable, assuming users consider CBDCs a store of value.38 And since being a super safe asset is clearly central to the value proposition, it is hard to imagine users not considering CBDCs a store of value, even if some central banks are now backing away from emphasizing that point. These are three of the major concerns incumbent financial institutions have articulated about retail CBDCs. To the extent there are others, now is the time for them to be shared with the central banks, while the design of the systems is still in flux and before a consensus hardens among the central banks on one or the other design feature, as long as the central banks still have an open door and an open ear on design. That seems to be the case now, but I expect that window may narrow as more early adopters start rolling out their pilots.

4. Stablecoin Platforms 4.1 What is the Issue? Since the central banks’ actions are being spurred in part by concerns over stablecoins, I now turn to them. In this paper I will be covering only what the US President’s Working Group (PWG) on Financial Markets in their November 2021 Report referred to as “true” or “payment” stablecoins, that is to say those designed to function as means of payment, rather than as stores of value. These are non-interest bearing financial assets in digital form designed to maintain a stable value against a references fiat currency. For an excellent summary of what they are and how they function, I refer the reader to Jai Massari’s December 14, 2021 Congres-

38 ECB 2022, p. 22.

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sional testimony.39 The most notorious stablecoin, Libra/Diem, never saw the light of day due to the refusal of regulators to grant the permissions necessary for its issuance, but the design of stablecoins is in principle simple. The basic idea is that for each unit of the coin issued the issuer would set aside in a reserve a corresponding unit of fiat currency which would be sold to redeem the stablecoin at any time the stablecoin holder wanted to redeem its holdings. To the extent this collateral maintains its value and has a liquid enough market that it can be sold quickly without affecting its value, it would guarantee convertibility of the stablecoin at par into the fiat currency. So much for the theory. The solidity of the collateral backing has been called into question, as some issuers have claimed full backing where in fact either less than 100 % of face value was secured or the collateral was not as risk-free or as easy to liquidate quickly without incurring a loss as claimed by the issuer.40 The FT’s Lex column cited the case of Tether, where cash and bank deposits as of December 31, 2021 made up only 5 % of its assets, US Treasuries about 44 %, commercial paper and certificates of deposits 30 %, and 6 % was made up of “other investments including other cryptocurrencies.”41 It is clear that this kind of portfolio, including $34 billion of Treasuries and $24 billion of corporate debt, can only be liquidated with difficulty and with repercussions for bond yields and the primary bond market, as Lex noted rightly. There are also so-called “algorithmic” stablecoins which use algorithms to manage issuances and redemptions. For purposes of this discussion, we will leave them to one side because they present the further complication that they are not necessarily actually backed by assets, but rely upon an algorithm and the intervention of unrelated arbitrage traders to maintain the stable value. There is recent evidence that some of these can be accidents waiting to happen42. Stablecoins have also been viewed with some suspicion in that, to date, their main uses have been in connection with crypto asset trading and DeFi applications. In a sense, the attention to them has been out of proportion to the value of coins that have been issued to date. Acting Comptroller Hsu estimates them at roughly $180 billion out of a total crypto asset market of around $2 trillion.43 But they are growing rapidly. The PWG Report estimated they  

 

 

 

 

39 Massari, 2021. 40 Gorton 2021, p. 7–8. 41 Lex, Tether: stable coin sees stable foundation shaken, Financial Times, May 12, 2022, www.ft. com/content/e2bcab47-da70-42ea-b009-831727da3614 42 See “Yellen Renews Call for Stablecoin Regulation After Terra USD Stumble”, www.wsj.com/ articles/yellen-renews-call-for-stablecoin-regulation-after-terrausd-stumble-11662208165, Wall Street Journal May 10, 2022. 43 Hsu, 2022.

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grew nearly 500 % in the twelve months to October 202144 and the central banks’ real concerns have been with the possibility that, properly or improperly regulated, stablecoins might escape from the margins of the banking system and of the real economy and, using blockchain rails, could complement and perhaps supersede existing payment systems such as cash, checks, credit and debit cards and wire transfers. Steven Maijoor, member of the Board of the De Nederlandsche Bank, notes in his contribution to this volume that “[a]s soon as the conditions are right, things could go very fast … we know there is a tipping point beyond which adoption of a new currency increases exponentially.” The PWG Report identified three kinds of risks associated with stablecoins, the kind of run risk we are familiar with from banks and certain kinds of mutual funds from the financial crisis of 2008 and from March 2020, the operational risks associated with all payment systems and systemic risks associated with concentration of power.45 The latter two risks are beyond the scope of this paper, which is not to say they are trivial, but only that the plumbing of payment systems and antitrust law considerations would take us too far afield. So, we will focus on run risk , which is a risk for both individual investors and for the market itself, especially in view of the already high concentration in the US market, where the three largest stablecoin issuers, Tether, USD coin and Binance USD, hold more than 80 % of the market.46  

 

4.2 Can the Issue be solved through Regulation? 4.2.1 What kind of Regulation? There is no doubt that regulation of these instruments at the national level, preferably coordinated at the international level, given that national borders have little meaning for cryptocurrencies, is necessary to deal with run risk. In the United States stablecoin issuers have been regulated at the state level as money forwarders, which resembles the situation of state regulated banks in the United States during “free banking” era. I think it is fair to say that the more forward looking providers welcome appropriate regulation, which they rightly see as enhancing public trust in them. The question is, what kind of regulation would be appropriate. As Acting Comptroller Hsu points out, there are, broadly speaking, two models for mitigating risk run and promoting stability. The first is that applicable to money market mutual funds (MMFs), grounded in disclosure and high-level re-

44 PWG, November, 2021. 45 PWG, November, 2021. 46 Board of Governors of the Federal Reserve System, Financial stability Report, May 2022, p. 42.

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quirements regarding asset holdings. Mr. Hsu points out that this has proven to have notable limits in preventing runs, as evidenced by the need for MMF emergency lending facilities in 2008 and 2020. I think that this paints the situation with too broad a brush. In both cases he cites it is fair to say that funds which invested solely in government paper fared far better than so-called “prime” funds, which invested in corporate assets as well as government securities and thus whose portfolios resembled more Tether’s portfolio outlined above. Nonetheless, the second alternative, based on bank regulation, seems to have found favour with regulators.47 This is perhaps not surprising since the regulators involved, including Mr. Hsu and the other members of the PWG, are banking regulators. Treasury Secretary Yellen is also a former central banker. This alternative is also consistent with the EU’s approach under the markets in Crypto-assets Regulation (MICAR).48 For a more nuanced analysis of the alternatives, I would refer the reader to Stefan Ingves’ contribution to this volume. I am not entirely convinced that an MMF style regulation of the contents of the portfolios backing the coins would not deal with the key criticism of the stablecoins, that they are only as stable as their portfolios. In an MMF style regulation, you could specify the nature, liquidity and maturity of the securities to be held so that they could be liquidated at par with a minimum of disturbance to the market. Paired with periodic reporting on the contents of the portfolio, certified by a responsible US based third party, not an unknown offshore auditing firm, I think this could go a long way to curing the lack of trust which is at the root of many runs. But bank regulation seems to have the wind at its back, so I expect that to be the solution adopted in the US, which is the home of most stablecoins so far. However, I think one needs to think further about what kind of bank regulation.

4.2.1.a Narrow Banks rather than Fractional Reserve Banks The PWG had in mind conventional or fractional reserve banking regulation, where banks must maintain reserves only against a fraction of their assets. I question whether that is the right model. So many of the criticisms about the solidity of stablecoin backing mentioned above seem to point to the benefits of making the stablecoin issuers fully, not fractionally, reserve against their coin issuances and to prescribe collateral rules which ensure that liquidation of collateral could take 47 Hsu, 2022. 48 Under Article I of MICAR issuers of stablecoins above a derisory amount intended to be used as a means of exchange and referencing a single fiat currency that is legal tender would have to be registered as credit institutions.

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place promptly and without loss. Gary Gorton suggests one-for-one backing with US Treasuries or reserves at the central bank.49 In this, stablecoin issuers would resemble the so-called “narrow banks” proposed in 1933 in the United States under which banks would have been required to maintain 100 % of their deposits readily available for withdrawals. The US Congress ultimately rejected this structure in favor of a package consisting of fractional reserving, deposit insurance and prudential regulation.50 If full reserving were adopted for stablecoin issuers, it is not clear to me that these new forms of deposit taking institutions should need either deposit insurance or much of the panoply of prudential regulation, including the capital adequacy and leverage rules which were consequences of Congress’ decision against narrow banking. I do not mean to say that these narrow banks would be exempt from prudential regulation, only that which rules would apply should be carefully considered. Exactly what rules should apply are beyond the scope of this article, but it is likely that applying the Basel leverage ratio to a portfolio made up entirely of government securities would suffice to kill the financial viability of the model. On the other hand, if the entity maintains 100 % reserves, one can question the usefulness of the leverage ratio.  

 

4.2.1.b Central Bank Reserves as Backing for Stablecoins: technically simple, but politically unrealistic Returning to the goal of reducing run risk, to me the goal could be most directly achieved by requiring that the assets held be reserves held at the central bank. These are the safest of safe assets and they can be liquidated without loss, and without affecting the market, by simple book entry at the central bank, thus ensuring convertibility at par of the stablecoin. If the stablecoin issuer is a regulated bank, albeit a special, i. e. narrow, one, then it should be entitled to maintain reserves at the central bank. This is a solution examined by Gary Gorton,51 who sees a problem with it I had hitherto overlooked. If stablecoins were to grow into a dominant form of payment, then the additional reserves they would generate at the central banks would have the same effect in growing the central banks’ balance sheets that an attractive retail CBDC could have, thus raising the question of what central banks would do with all that money without running into the pro 

49 Gorton, 2021, p. 33. 50 Randall D. Guynn and Patrick S. Kenadjian, Structural Solutions: Blinded by Volcker, Vickers, Liikanen, Glass Steagall and Narrow Banking, in Andreas Dombret and Patrick S. Kenadjian (Eds.) Too Big to Fail III: Structural Reform Proposals, de Gruyter (2015). 51 Gorton, 2021, p. 35–36.

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blems I discussed above in section 3.2 with respect to CBDCs.52 He also sees the potential that the growth in stablecoins would occur by syphoning off retail deposits from commercial banks, another problem I discussed above with respect to CBDCs. I am not sure that latter point is quite right. I would expect the flow to come from other payment systems providers, such as credit card issuers, although these are often themselves banks. Of course, since CBDCs are being designed in large part to counter the perceived threat of stablecoins, it would be somewhat naive to believe that the central banks would welcome this kind of solution to the perceived problem they present. In fact, Fabio Panetta, in his Madrid speech seems to recognize that granting stablecoin issuers access to central bank reserves would work, but rejects the notion of allowing this as “outsourcing the provision of central bank money to stablecoin issuers and risking a corresponding reduction in monetary sovereignty”53. Central banks do this with commercial banks, albeit on a smaller scale, since they are only subject to fractional reserving, and without the danger of abetting the creation of a private sector monopoly payment provider. So one could say we are coming back to the question of to whose benefit would we be willing to run those risks, the central banks or the private sector? One way this might play out is that the writing of rules for stablecoin issuers will take sufficiently long that during this time the central banks can make good on lost time and be ready to issue their CBDCs before the stablecoin issuers can obtain approval for their new bank charters and get clarity on the special bank regulations applicable to them. They might either give up like Meta did on Diem or risk being branded as a cheap e-imitation of the real thing, the CBDC.

4.3 The Dangers of Fragmentation and the Lack of Interoperability The appropriate form of regulation might thus solve the major issues of runs and stability, but would not solve all problems associated with stablecoins, in particular those relating to fragmentation and the current lack of interoperability of stablecoin systems. As Acting Comptroller Hsu points out in his April 2022 speech, there are two kinds of interoperability issues with stablecoins, that within a stablecoin across the various blockchain rails, such as Etherum or Solana, which themselves are not interoperable, and that across stablecoins.54 The first lack of

52 Gorton, 2021, p. 45. 53 Panetta, 2021. 54 Hsu, 2022.

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interoperability means that a USDT issued by Tether on the Etherum blockchain cannot be used to pay for something on the Solana blockchain even though the latter also uses USDT issued by Tether. The second lack of interoperability is between various stablecoins, such as Ethereum’s USDT, mentioned above, USD Coin’s USDC or TrueESD’s TUSD, and between them and the US dollar. This is reminiscent of the notes issued by banks under state regulation in the “free banking” era. Could regulation requiring interoperability of stablecoins solve this problem or should we expect the market to solve it? The latter strikes me as unlikely, given the tendency of platforms in general to result in “closed gardens” and the experience in China in particular where AliPay and WeChatPay are not interoperable. Of course, CBDCs so far have also by and large been conceived as closed gardens and not been designed to be interoperable either, and Barry Eichengreen, in his contribution to this volume, explains the complexities he sees in achieving CBDC interoperability. But with the lack of interoperability comes fragmentation which usually leads to reduced market liquidity, which is a particular concern for privately issued instruments. There is also the additional stability related question of whether in case of a liquidity squeeze the central banks, whose liquidity relief comes in the form of making available their own fiat currency, would be as effective if required to intervene in a world populated by private currencies. I think the answer is yes, because ultimately what those private currencies need is access to the fiat currency.

5. So When are Retail CBDCs Coming, especially to Europe? 5.1 Legal Issues: will CBDCs qualify as Legal Tender? To judge by her BIS Interview, Christine Lagarde appears to be looking towards a goal of two years from March 2022 for a go/no go decision by the EBC’s Governing Council.55 The Riksbank and the PBC might well be in a position to move earlier, though all three are careful to emphasize that no firm decision has been taken as yet and, contrary to much speculation, the PBC did not take advantage of the Beijing Olympics to roll out their e-Yuan on a grand scale. The Fed most likely will not be among the first at the starting gate, despite the fire lit under them, the US Treasury and the “whole of government” by the President’s March 9, 2022 executive order. Of course, we should not consider the “go” decision as a starting gun for actual issuance of CBDCs. Currently central bank spokesmen are talking about

55 Lagarde, 2022.

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a three year implementation period once the decision is made. Additionally, I believe these timelines relate principally to the technical side of the CBDC project and not the legal and the politico-social side. On the legal side, the main issue for me is whether central banks are authorized to issue digital assets which would qualify as “legal tender”, i. e. a form of money whose presentation suffices to extinguish public and private debts. Without that feature, the equivalence to cash and the secure status as safe asset would seem to be somewhat compromised. Of course, not all central bank obligations qualify as legal tender but are still considered safe assets. However, if you set out to create a means of payment, it would seem a good attribute to have and most of the central banks which have looked into the issue seem to find it a desirable feature, but not one which they are clearly able to confer without legislative change. Or at least they have concluded that the issue is at best ambiguous and that legislative action should be sought to create certainty. The PBC have already obtained legislative approval. The Fed has stated that it would seek it if it decided to go ahead and the President’s March 9, 2022 executive order contemplates drafting legislation.56 The House of Lords Committee flatly stated they believed a vote in both House of Parliament should be required before a CBDC is introduced in the UK.57  

5.1.1 The ECB’s Treaty Problem The current position of the ECB is unclear to me. There is an ambiguous statement attributed to Fabio Panetta, from November 2021 to the effect that the digital Euro “will have all chances to become legal tender inside the borders of the EU.” Mr. Panetta is an economist and not a lawyer and I do not think his remarks should be understood in a technical sense. I suspect he was thinking of broad acceptance, not legal status. There is also a short two-page (out of a 53 page document) reference to “[l]egal considerations regarding a digital euro” in the ECB’s October 2020 “Report on a digital euro” which notes that “EU primary law does not exclude the possibility of issuing digital euro as legal tender”.58 If that does not sound overly confident, I believe there are ample grounds for them to be cautious. I am not an EU lawyer, but I note that Article 128(1) of the Treaty on the Functioning of the European Union (TFEU) refers only to the ECB having the authority to issue banknotes and coins, so there seems to be at least a preliminary hurdle to be cleared. And here again, as a non-EU law-

56 Executive Order, 2022. 57 House of Lords, 2022, p. 27. 58 ECB, 2020, p. 24.

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yer I am unable to judge whether secondary legislation, which would still require a trip through the European Parliament, could remedy this omission/ambiguity in the TFEU. There appears to be a possibility under Article 133 TFEU of asking the European Parliament and the Council “acting in accordance with the ordinary legislative procedure” to adopt a law which would qualify as a measure “necessary for the use of the euro as the single currency”. And while the “ordinary legislative procedure” of the EU can be long and complex, it would be far preferable to a Treaty change. However, I gather that even this route is not entirely free from doubt and at least one German scholar rejects it.59 Other European scholars argue that no legislation should be needed under Article 128 TFEU and Article 16 of the ECB’s statute based on the view that CBDCs should be viewed as “banknotes” since Article 128(1) does not specify the material or format in which banknotes are to be issued and that neither the wording nor the drafting history of the provision reveals any compelling reason to exclude the issuance of “digital banknotes.”60 Once again, I am not an EU lawyer, but I find this a stretched reading of the Treaty. I understand there is a feeling that the European Court of Justice has tended to be sympathetic to the ECB and its interpretations of its powers, so that in the event of a challenge, it might well side with the ECB. I would still be very careful here and advise in favor of resolving any legal ambiguity before launching as large a project as a CBDC, even at the cost of some delay in the roll out, especially given the oft repeated concerns about a “democratic deficit” in the EU and the issues that have been repeatedly raised about the unaccountable power of central banks which Paul Tucker analysed in his 2018 book61 in general, and specific concerns about CBDCs in particular. In this connection I read with some comfort John Berrigan’s contribution to this volume in which he writes that DG-FISMA stands ready to take a legislative proposal “which is necessary to achieve political consensus and full legitimacy for a possible digital euro and its key features.” In fact, the Commission’s current Targeted Consultation on a Digital Euro which requests comments by June 14, 2022, specifically raises the question of whether the digital euro should be given legal tender status in order for it to meet its objectives.62 In a world where the eagerness of German scholars and populists to chal-

59 Siekmann, 2016, p. 18, states “Article 133 TFEU is, however, not a suitable basis for declaring anything legal tender which is unknown to the primary law.” 60 Grünewald, 2022, p. 5. 61 Paul Tucker, Unelected Power, The Quest for Legitimacy in Central Banking and the Regulatory State, Princeton University Press (2018). 62 Commission, 2022, p. 14.

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lenge ECB actions as ultra vires and the willingness of German courts to give them a sympathetic hearing have been amply demonstrated, I would see seeking legislation as the wiser course if the decision were in my hands. At this point we cross the line from the legal to the political, which is my next issue.

5.2 Political and Social Issues 5.2.1 How important is Privacy? In addition to the legal issues, retail CBDCs will bring with them two sets of “hot button” issues. The first is whether they will result in central banks exceeding their mandates, discussed in section 3.2 above. The second is privacy, which has traditionally been viewed as particularly sensitive in the EU. I think the political process of obtaining any required changes could be quite delicate. While those of us in the trade may consider that an independent central bank is not a part of the government, for many people that is a distinction without a difference and they are concerned about “the government “, in the person of the central bank, having access to increased information about their activities via CBDCs. The answer of designing the CBDC such that only the transactions and not the parties to it can be identified, for example by full tokenization of the CBDC so that possession of the token is the only incidence of ownership and only the token and not the holder can be traced, comes up against objections that central banks should not be in the business of creating structures which facilitate illegal transactions. Even though this is already a feature of cash, the idea of designing a new instrument that would duplicate or even enhance that feature of cash, is a step too far for most central banks, so that the structures being studied and rolled out in pilot projects are mostly account based, within which various levels of anonymity can be built, so that their accounts, but not necessarily their holders, can be easily traced. Still, recent cases in which holders of Bitcoin received in ransomware situations were able to be traced, show that even with a digital system designed to protect anonymity, identification is possible, leading to the presumption that the central bank will likely be able to know who is involved in a particular transaction. The question then becomes who else would have access to how much of this information. Privacy is an issue in China as well, where the PBC has designed a four tier system of CBDC accounts to give participants a choice of how much privacy they want, at the cost of lower amounts of CBDCs and less functionality in their CBDC accounts. Whether the Chinese consumers believe this or not, the care the PBC has lavished on this issue quite clearly shows how careful central banks will have to be with this issue if they expect political and social acceptance for the CBDC project. As Christine Lagarde emphasized in her BIS Innovation Sum-

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mit interview, privacy is at the top of EU citizens’ concerns about CBDCs.63 However, the recent study commissioned by the ECB from Kantar Public discussed above in section 2.3 casts doubt on just how important privacy may be, concluding that “[s]everal participants among the general public, but also among the tech-savvy, indicated that they do not really think about privacy when making payments.”64 While the report includes a treasure trove of granular information on a country by country basis, I would be cautious about reading into its findings that privacy is not important to EU users. Far more enlightening are other parts of the report discussed below in section 5.2.3.

5.2.2 How to win the Political Argument With respect to the second point, I think it would be important for the central banks to work through the points raised by the Economic Affairs Committee of the House of Lords, in their Report quoted in the introduction above. In framing their arguments, I think the central question posed by Agustin Carstens in his keynote speech at the ILF, which I will paraphrase as “who do you want to control your/ our money, the profit-seeking private sector or the public sector following a public interest mandate” could be very effective with EU politicians in general. This may not work quite as well in the UK, where the House of Lords Committee seemed to be looking to be convinced there was a market failure to be remedied before they would be ready to endorse the concept, rather than deciding what was the proper allocation of responsibility between the public and the private sector in the issuance and control of our money. However, concern over control of key infrastructure in the current political atmosphere might also be an increasingly powerful argument. On the other hand, in the current atmosphere of increasing inflation, where the central banks are being accused of having been overtaken by events, spending a lot of time and energy on issues arguably peripheral to their core mandate of financial stability, may make them more vulnerable to political criticism and slow down any legislative action they may need. The editor-in-chief of the Economist, Zanny Minton-Beddoes, recently wrote, in respect of the Fed, that the failure to address current inflationary trends was a result of “an insidious shift among central bankers worldwide. Many are dissatisfied with the staid work of managing the business cycle and wish to take on more glamourous tasks, from fighting climate change to minting digital currencies. Their loss of focus puts their hard-won cred-

63 Lagarde, 2022. 64 Kantar Public, 2022, p. 6.

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itability at risk.”65 While I think the reference to climate change is misplaced, I can see an argument developing on retail CBDCs that central banks should concentrate on licking inflation rather than creating solutions to problems which are not evident to the public. While I am convinced by the convertibility argument discussed in section 2.1 that issuing public money should be viewed as a core attribute of a central bank, I can see room for challenging why it must happen now, and questioning the motivation behind the move. The central banks clearly expect that they themselves will benefit, but have yet to make a convincing case that users will benefit as well. And I think they need to counter more effectively than they have done so far the accusation that, despite all assurances to the contrary, CBDCs are a plot to eliminate cash. This could carry significant weight in countries like Germany, which are still attached to cash, have a growing populist fringe and courts willing to entertain challenges to central banks which take unconventional steps. This leads me to think that the next phase of the development of retail CBDCs, in addition to refining the technical aspects of the instrument, and their infrastructure, will need to include an increased emphasis on selling what I would call their value proposition for consumers and society at large.

5.2.3 The “Acceptance and Adoption Challenge”: how to formulate the Value Proposition I have taken the first half of the caption for this section from the title of a May 4, 2022 speech delivered by Burkhard Balz, member of the Executive Board of the Deutsche Bundesbank responsible for payments and settlement systems and former member of the European Parliament, whose current responsibilities and prior background give him a unique perspective on these questions. He emphasizes that meeting user needs is key to the success of the project.66 As Mr. Balz points out, the ECB has a Market Advisory Group made up of payments professionals. This is a good link to market professionals, but, so far, the views and needs of both consumers and merchants have been less systematically explored. The Kantar Public study is a first step and it has dug up a good deal of scepticism among the public. This is consistent with what Stefan Ingves drily notes in his contribution to this volume: that “[t]he positive aspects of having CBDCs publicly available may not be widely apparent to the public.” The central banks are carefully doing their homework, polling the public on their preferences and concerns and

65 Economist, 2022. 66 Balz, 2022.

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pilot projects will give them more input on what works and what doesn’t, but the Kantar Public study underlines how important it is for them to resist the “build it and they will come” mindset. For example, they should not assume that, because consumers increasingly favor digital payments and are willing to share their personal data with private service providers, from whom they receive tangible benefits in return, they will be ready to do the same with their central bank. As Ravi Menon, General Manager of the Monetary Authority of Singapore astutely remarked on a panel at the IMF Spring Meetings in Washington on April 18, 2022,67 a key attraction of the private payment providers is not that they are digital, as so much of our money is these days, but that they are embedded in platforms where we do a lot of things. We use them not because we are looking for a means of payment, but because we are looking for goods or services and there they are, to facilitate our acquiring those things. This is not a position a CBDC account will naturally find itself in. Will it nonetheless be competitive? More astute observers than I have expressed doubts. On p. 300 of his book on the future of money, Eswar Prasad quotes a 2019 speech by Benoît Coeuré, for whom I have the greatest respect, to the effect that “it is probably easier to connect a new currency to an existing network – the case of Libra – than to build a new network on an existing currency – the case of the euro.”68 Conversely, if the competition is stablecoins which are backed one-to-one by short term government securities or central bank reserves, might stablecoins be an exception to the historical rule that public money always wins out against private money? Could it be that this rule is being replaced by a new one, which is that networks/platforms always win, especially where they can be bundled with other attractive services? I think central banks will have to be clearer on the precise contours of the value proposition they are offering the public and then they have to sell it to all relevant constituencies, including the politicians. On the first point, they will need to deal with the arguments advanced by Professor Bofinger and his colleague Thomas Haas, who have questioned whether CBDCs will be competitive in the marketplace.69 This is primarily because they believe the central banks’ ace in the hole, absolute safety, may not be a decisive argument for anyone who has deposit insurance and because the limits on individual holdings of CBDCs being proposed by the central banks will exclude large depositors who hold in excess of the insured limit, so that they question why people would bother to shift accounts or, indeed, bother to open yet another account for what they see as a dubious advan-

67 Menon, 2022. 68 Coeuré, 2019/2. 69 Bofinger, 2020.

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tage. They thus think, contrary to the fears of the incumbent banks that they will be disintermediated, that CBDCs could be a commercial flop and in that way damage the central banks’ reputations. It is also starting to dawn on some central banks that emphasizing the absolute safety of CBDCs could be counterproductive if a goal is not to disintermediate the commercial banks. But to return to the Professors’ arguments, its strength may well depend on who issues the CBDCs, the ECB or the national bank members of the Eurosystem (I am assuming it will be the former) and, in the absence of a true European Deposit Insurance Scheme (EDIS), who is actually insuring those bank deposits. The degree of comfort to be derived from deposit insurance in the Professors’ native Germany may not be duplicated in all Member States. There is also the question the platforms need to contend with: how to convince merchants to accept their private money. Will CBDCs be exempt from this issue? The Kantar Public Study emphasizes that consumer demand for a payment system is key to its adoption by merchants, together with its financial charges and fees to the merchants.70 The central banks will have control over the latter, but not the former and they are just starting to come to terms with what a senior representative of the ECB recently referred to as “the painful process of convincing merchants” of the value proposition. This is where the findings of the Kantar Public study are particularly interesting. While the findings differ from country to country in often predictable patterns, one set of key findings stands out for me: “[f]ew of the general public and tech-savvy participants had recently adopted a new payment method or had actively been seeking a new one. Almost all felt well served by the range of options they currently use, and they expressed no desire for change. Many, particularly among the tech-savvy, reported actively working to reduce the number of payment options they use. Thus, simply having access to a new payment option would not be a sufficient motive to switch … they feel that to consider a new payment method they would need to have an innovative product that optimises and simplifies, rather than increases their options.”71 Does this sound like anything we have been discussing so far? I don’t think so. When they turn to the news of merchants, the report’s conclusions are no more encouraging: “[t]he overarching key driver for acceptance by merchants of any new payment method, whether digital or non-digital would be customer demand.”72 And we have just seen what looks like a serious lack of that demand. As regards the digital euro, the report

70 Kantar Public, 2022, p. 45. 71 Ibid, p. 8. 72 Ibid, p. 9.

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concludes that “merchants were at best neutral to the idea. They remained sceptical about the introduction of this new means of payment.”73 Some central banks appear to have given more thought to this area than others, as evidenced in Mu Changchun’s contribution to this volume. The first issue he cites under the heading “Challenges of CBDCs” is “the insufficiency of incentives and acceptance of CBDCs”, including the reluctance and costs involved for end-users in switching from their current payment systems to CBDCs and the pecuniary and non-pecuniary costs for merchants of adopting the new technology as well as the need to create an ecosystem around the E-CNY to make retail CBDCs more attractive to merchants as well as end-users. In his conclusion, Mr. Mu welcomes the opportunity to share ideas and experience in CBDCs. It is to be hoped other central banks take him upon on this offer.

Conclusion Central banks should not expect an initiative as far reaching as a new form of public money, which has clear advantages for the central bank (it saves them from being disintermediated) but brings with it the potential danger of disintermediating key consumer-facing parts of the financial system we now have, to be waived through by legislatures and accepted by the public unless the proponents can demonstrate a clear business case for the rest of the society which the central bank serves. So while I am convinced that a number of important central banks want to issue retail CBDCs, they still have a number of hurdles to clear in order to be able to do so. Central banks have not always excelled at convincing the public that what they are doing in the public’s best interest even when that was demonstrably the case. Here the case is less obvious and they will need to be making it at a time when their stewardship of the economy is coming under increasing scrutiny amid accusations that they have let themselves be distracted from their core inflation fighting job to dabble in peripheral matters, like climate or CBDCs. The most recent study of public attitudes commissioned by the ECB shows that there is a long way to go to convince the public. So the time to launch of CBDCs, especially in the EU, may be somewhat longer than predicted. While this process is ongoing there is still time for a fruitful and reasonable dialogue on their design, and I would urge all stakeholders to take advantage of it.

73 Ibid, p. 11

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Seraina Grünewald, Corinne Zellweger-Gutknecht, Benjamin Geva, Digital Euro and ECB Powers, Pre-edited version, accepted for publication in Common Market Law Review, https://ssrn. com/abstract-3807855, visited April 13, 2022 (Grünewald) House of Lords, Economic Affairs Committee, Central bank digital currencies: a solution in search of a problem? 3rd Report of Session 2021–22, 13 January 2022 (House of Lords) Hsu, Michael, Acting Comptroller of the Currency, Remarks Before the Institute of International and Economic Law at Georgetown University Law Center, “Thoughts on the Architecture of Stablecoins,” April 8, 2022 (Hsu) International Monetary Fund Spring Meetings 2022, Money at a Crossroad: Public or Private Digital Money? https://meetings.imf.org.en/2022/Spring/Schedule/2022/04/18/imfmoney-at-a-crossroad, April 18, 2022 (Menon) Kantar Public, Study on New Digital Payment Methods, commissioned by the European Central Bank in September 2021, published March 2022 (Kantar Public) Kiaonarong, Tanai and David Humphrey, Falling Use of Cash and Demand for Retail Central Bank Digital Currency, International Monetary Fund, WP/22/27, February 2022 Massari, Jai, Stablecoins: How Do They Work, How are they Used and What are their Risks? Written Statement, Hearing Before the United States Senate Committee on Banking, Housing and Urban Affairs, December 14, 2021 (Massari) Minton-Beddoes, Zanny, How Inflation humbled America’s central bank, The Economist this week, April 22nd, 2022 (Economist) Panetta, Fabio, Central bank digital currencies: anchor for digital innovation, Speech at the Elcano Royal Institute, Madrid, November 5, 2021 (Panetta) Prasad, Eswar S, The Future of Money, How the Digital Revolution is Transforming Currencies and Finance, The Belknap Press of Harvard (2021) (Prasad) President’s Working Group on Financial Markets, the Federal Deposit Insurance Corporation and the Office of the Comptroller of the Currency, Interagency Report on Stablecoins, November 2021 (PWG) Siekmann, Helmut, Restricting the Use of Cash in the European Monetary Union, Institute for Monetary and Financial Stability, Goethe University Frankfurt am Main, Working Paper Series No. 108 (2016) (Siekmann) Soderberg, Gabriel, Behind the Scenes of the Central Bank Digital Currency, Emerging Trends, Insights and Policy Lessons, International Monetary Fund, Note/202/004, February 2022. Sveriges Riksbank, Economic Review, second special issue on the e-krone, 2020:2, 2020 (Riksbank)

Andréa Michaela Maechler

Wholesale CBDC as a possible Option for providing a Safe and Efficient Settlement Asset for Future Financial Infrastructures Innovations in the area of money and payments are of great interest to the SNB. Our financial system is built on money and money requires trust. A chief concern of central banks is to maintain this trust by safeguarding price stability, supporting financial stability and ensuring the usability of money in a reliable and secure payment system. In recent years, the retail payments landscape has seen numerous innovations, reflecting technical advances, as well as the emergence of new players and evolving consumer requirements. Central banks keep abreast of these developments by studying different development options. One such option is the creation of an entirely new payment infrastructure, based on central bank digital currency for the use by the wider public – known as retail CBDC.1 Another option is to build on the strength of current payment systems by adding new features that accommodate specific user needs and promote innovation. The potential benefits of retail CBDC appear to be rather limited in the case of Switzerland. Proponents of retail CBDC expect it to facilitate access to financial services and cashless payment systems, thus improving financial inclusion. This would be particularly helpful in countries or regions where significant parts of the population have no or only limited access to financial services, or where cash is not widely available. In Switzerland, however, financial inclusion is not a problem. Indeed, in Switzerland, access to bank accounts and other financial services is nearly universal and cash remains an important means of payment.2 Retail CBDC entails risks, which may outweigh potential benefits in Switzerland. Such risks include a possible disintermediation of commercial banks if significant amounts of retail deposits were shifted into CBDC. This would not only increase banks’ refinancing costs, it could also disrupt the well-established banking system. Another potential problem of retail CBDC is a heightened risk of financial

1 A retail CBDC would be made available to the public as cash-like claims on the central bank. 2 Swiss National Bank. 2021. Survey on Payment Methods 2020 – Survey on payment behaviour and the use of cash in Switzerland. https://doi.org/10.1515/9783111002736-012

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instability. Thus, bank depositors fleeing to the safety of retail CBDC could potentially aggravate bank runs. Finally, any retail CBDC will have to balance depositors’ privacy rights with the need to prevent abuse. While different design choices can address these risks, the problem remains that retail CBDC has potentially farreaching implications for the long-term viability of our two-tier banking system.3 Hence, the SNB’s focus is currently not on retail CBDC, but on the development of the current payment system. Switzerland has a highly developed financial system and payment infrastructure. The SNB’s focus is on enhancing the strengths of this infrastructure, by adding features that meet new user requirements and enabling payment innovation in the private sector. In this way, the current payment infrastructure can provide for the same benefits as those expected from retail CBDC, but without the various risks. The SNB is committed to the proven two-tier system, consisting of a strong core infrastructure for wholesale (interbank) transactions and an outer layer for private sector retail transactions. At the core of Switzerland’s payment landscape is the SNB and the cashless payment system Swiss Interbank Clearing (SIC), managed by the SNB. SIC is a state-of-the-art real time gross settlement system (RTGS), which seeks to be interoperable with other payment solutions and technologies. Importantly, unlike most RTGS systems, which settle only large-value wholesale payments, the SIC system processes both wholesale and retail payments. This offers advantages in times of a fast changing retail payment landscape, because it allows SIC to form a secure and reliable foundation for banks and other financial institutions on which to try out innovations and develop payment solutions for their retail clients. To maintain a first-class payment ecosystem in Switzerland, the SIC system is constantly developed further. For example, from August 2024, Swiss banks will be able to offer their clients instant payments around the clock based on the SIC system.4 The goal is to achieve a first-class payment experience by international standards for the economy and the population as well as the creation of a

3 Jordan, Thomas J. 2019. ‘Currencies, money and digital tokens.’ Speech given at the 30th anniversary of the WWZ and VBÖ, University of Basel, September. Available at: www.snb.ch/en/ mmr/speeches/id/ref_20190905_tjn/source/ref_20190905_tjn.en.pdf 4 SIC5 will support the new instant payments use case that Swiss banks will be able to offer their clients starting in August 2024. Instant payments can then be executed 24 hours a day, 7 days a week and 365 days a year, with a transaction’s path from the payer’s to the payee’s account taking only a few seconds.

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basis for new innovative business models. Furthermore, the SNB is further strengthening the cyber defenses of the core payment infrastructures by introducing a new communication network that connects banks among each other and with the RTGS.5 The SNB’s focus on the existing payments system does not mean, however, that it is not involved in CBDC. Indeed, the SNB is studying retail CBDC intensively and closely follows developments in the field, both by participating in relevant working groups at international organisations such as the BIS, and by conducting its own research in the field.6 From the SNB’s perspective, wholesale CBDC7 is currently of greater importance than retail CBDC. While retail CBDC could potentially disrupt the current financial system, wholesale CBDC cannot do that as selected financial institutions already have access to wholesale CBDC in the form of central bank sight deposits, which they use to settle interbank payments. Indeed, wholesale CBDC is primarily about harnessing the potential benefits of technical innovations such as the tokenization of financial assets and distributed ledger technology (DLT). Hence, the main practical issue with wholesale CBDC is whether the tokenization of central bank money and DLT could offer distinct benefits over the existing RTGS setup. Should DLT-based infrastructures become systemically relevant, it will be important to ensure the safe-and-sound settlement of transactions on these infrastructures. The tokenizsation of financial assets and their trading and settlement on DLT infrastructures has the potential to significantly improve and even to transform financial systems. Currently, novel tokenized-asset platforms make

5 The Secure Swiss Finance Network (SSFN) was jointly launched by the SNB and the SIX in November 2021. The SSFN is a communication network that enables secure data exchange between authorized financial market participants and Switzerland’s financial market infrastructures. It protects against major internet risks (e. g. distributed denial-of-service, or DDoS, attacks), thereby strengthening the cybersecurity of the Swiss financial centre. The SSFN is based on the innovative SCION network architecture developed at ETH Zurich. While the SSFN will initially run in parallel with one of SIX’s existing communication services (Finance IPNet), it will replace this service in the medium term. 6 Cf. for example: Chaum, David, Christian Grothoff and Thomas Moser. 2021. ‘How to issue central bank digital currency’. SNB Working Papers 3/2021. Baeriswyl, Romain, Samuel Reynard and Alexandre Swoboda. 2021. ‘Retail CBDC purposes and risk transfers to the central bank’. SNB Working Paper 19/2021. 7 Wholesale CBDC would supplement and further develop the sight deposits that financial institutions already hold at central banks today.  

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use of stablecoins (a form of tokenized commercial bank money) to settle transactions. The dependence on a form of private money could introduce counterparty risks8. As financial market transactions are typically time-critical and often highvalue, any disruption in their settlement can potentially disrupt the entire financial system. Hence, it is essential to ensure the safety and finality of large-value transactions. In the 1980s and 1990s, the settlement of systemic financial flows in central bank money through RTGSs emerged as the most effective solution to mitigating systemic payment-related risks.9 Indeed, it is for precisely this reason that international standards require that systemically important financial market infrastructures settle their obligations in central bank money whenever this is practical and available.10 Wholesale CBDC could potentially serve as a safe and efficient settlement asset that mitigates risks on the new infrastructures. Wholesale CBDC would be complementary to the sight deposits that financial institutions already hold at central banks. Unlike traditional sight deposits, wholesale CBDC could be used to settle transactions conducted on DLT-based financial market infrastructures. Therefore, the SNB, in cooperation with the BIS Innovation Hub Swiss Centre, has been conducting various projects that analyse the feasibility of wholesale CBDC as well as its potential opportunities and the risks. The SNB has conducted experiments with wholesale CBDC. In 2020, the SNB carried out a first proof-of-concept (PoC) experiment with wholesale CBDC. The experiment successfully demonstrated the feasibility, both from a technical and a legal perspective, of issuing wholesale CBDC on a financial market infrastructure based on DLT. This experiment, called ‘Project Helvetia’, was carried out in collaboration with the BIS Innovation Hub Swiss Centre and the Swiss Digital Exchange SDX.11 The findings were further explored in two additional PoC experiments in 2021.

8 Including settlement risk, credit risk and certain operational risks. 9 Maechler, Andréa M. and Andreas Wehrli. 2021. How to provide a secure and efficient settlement asset for the financial infrastructure of tomorrow”. In Central Bank Digital Currency: Considerations, Projects, Outlook. Edited by Dirk Niepelt. Centre for Economic Policy Research, CEPR Press, London 10 Bank for International SettlementS. April 2012. Principles for financial market infrastructures (CPMI) 11 Swiss National Bank. 2020. Accountability Report for 2020, chapter 7, box ‘BIS Innovation Hub and projects at its Swiss Centre’.

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One of these experiments, ‘Project Helvetia – Phase II’, explored methods for integrating wholesale CBDC into the core banking applications of commercial banks and the SNB. This project was carried out by the SNB together with the BIS Innovation Hub Swiss Centre, SDX and five commercial banks – some Swiss, some foreign. The following use cases were successfully tested: (1) the issuance and redemption of wholesale CBDC by the SNB, (2) the execution of wholesale CBDC payments between financial institutions, both in Switzerland and abroad, (3) the settlement of securities transactions with wholesale CBDC. The project examined all issues from operational, legal, and central bank perspectives. Reassuringly, under current Swiss law, the issuance of wholesale CBDC on a third-party platform is feasible as long as the SNB retains the necessary control and monitoring functions. The associated project report was published in January 2022.12 The second PoC experiment, called ‘Project Jura’, explored the cross-border settlement of securities and foreign exchange transactions with wholesale CBDC in two currencies. This project was carried out in conjunction with the Banque de France, the BIS Innovation Hub Swiss Centre and a private sector consortium. The project showed how two central banks could issue wholesale CBDC in their respective currencies on a shared financial market infrastructure while retaining control over the issuance and use of their own CBDC. The solution that was presented enabled the settlement of cross-border transactions directly in central bank money. The final report of Project Jura was published in December 2021.13 The experiments provided significant insights into wholesale CBDC. Both PoC experiments were carried out on a DLT-based test platform of a SIX financial market infrastructure. With the issuance of wholesale CBDC, securities and foreign exchange transactions could be settled directly in central bank money on such a DLT-based infrastructure. This could lead to efficiency gains and contribute to the security of the financial system. The design and execution of these experiments should not be interpreted as an indication that the SNB is considering the issuance of wholesale CBDC. The experiments were exploratory in nature and serve to better understand the 12 Bank for International SettlementS, SIX Group AG and Swiss National Bank. 2022. Project Helvetia Phase II Settling tokenised assets in wholesale CBDC. 13 Bank for International SettlementS, SIX Group AG and Swiss National Bank. 2021. Project Helvetia Settling tokenised assets in central bank money.

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implications of new technologies. It is essential for central banks to remain up to date with technological progress that could enhance financial market infrastructures, but that could also affect their monetary policy and financial stability mandates. In the retail payments space, future-proofing the existing core infrastructure and ensuring appropriate framework conditions for innovation in cashless payments is likely to provide substantial benefits, with lower risks than CBDC. In the wholesale space, a CBDC for financial intermediaries could be an option for providing a safe and efficient settlement asset for future DLT-based financial infrastructures. However, further operational, legal and central bank-specific questions currently remain unanswered.

Changchun Mu

Theories and Practice of exploring China’s e-CNY Introduction Technological change is permeating the financial system. Starting from a cryptographic experiment, Bitcoin and crypto-assets have gone too far, stealing the positive value of FinTech innovation while stablecoins entail promise and perils that we have to remain vigilant to and establish an appropriate supervision framework for accordingly. Sound money is a perpetual pursuit of central banks that always commit to providing public goods in the public interest. Meanwhile, the ongoing digitalization of our economy is leading to far-reaching changes in the mandates of central banks. Money and payment are no exception, and a digital form of central bank money for individuals and businesses to use in retail payments, the central bank digital currency (CBDC) is around the corner. There have never been more central banks who feel that: (i) unsupervised private networks could become a Wild West of financial fraud; and (ii) possible future payment solutions based on digitalization would most likely be CBDCs.

Motivations of CBDCs CBDC as a new form of money and payment method could potentially facilitate enhancing resilience of the retail payment system, contribute to a better financial system, improving efficiency of the central bank payment system, and promoting financial inclusion of the society. The first motivation is to improve the efficiency of the central bank payment system. Big Tech and fintech firms move into payment markets and digital payments via mobile phone provided by the private sector have gained ground. Concentrated yet fragmented market power may reduce the integration of different payment tools. As a trend in recent years, many central banks are improving their payment systems by building up fast payment systems, which widen the access to the payment system and incorporate more participants from different sectors. CBDC has a non-profit nature (Soderberg, 2022). By facilitating the integration among the payment markets, as well as adopting the latest technologies, CBDC with a low-fee structure could offer a digital form of payment that is cheaper to operate than legacy tools (Chen, 2022).

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To demonstrate, e-CNY is one of the People’s Bank of China’s (PBC’s) latest efforts to improve the efficiency of the central bank payment system. E-CNY provides around the clock (24 x 7 x 365) services to the general public, which delivers the maximum level of accessibility to users. In addition, e-CNY realizes higher efficiency with the feature of settlement upon payment. Furthermore, e-CNY features in its high capability of 10,000 transactions per second, which enhance the concurrency performance of the central bank payment system. What’s more, the PBC joins hands with participants from different sectors including not only commercial banks and financial market institutions, but also payment service providers (PSPs), fintech companies, telecommunication operators. This could fully tap the comparative advantages of different stakeholders in payment product design, system development, use cases exploration, marketing, business processing as well as operation and maintenance, and build a market-driven e-CNY eco-system in a more efficient way. The second motivation is to provide a backup or redundancy for the retail payment system. Ensuring the ability to pay under severe circumstances is vital for all jurisdictions. For some countries frequently hit by natural disasters, resilience is considered a key policy goal. In addition, countries with a highly digitalized payment sector may be concerned with disruption to digital services and concentration risks where there are only a few large operators. The failure of any of these could have serious consequences to the payments system. Similarly, in some advanced economies, central banks advocate the continued existence of cash, and their CBDCs could potentially serve as additional backup to existing forms of digital payments Therefore, CBDC could function as a backup to the existing digital payment solutions. (Bank of Canada, 2020; BIS, 2020; Carstens, 2022). China has witnessed a leapfrogging of mobile payment development in which the private sector has played a conspicuous role in digitalizing financial plumbing and providing retail mobile payment services to the public. Yet, any financial or technical malfunction of the payment system could bring dread consequences to financial stability. Central banks are born to facilitate the mandate to continuously provide public products and services in payment and settlement especially retail payment that directly serves the broad public, so this is the duty of the PBC. E-CNY as a new form of legal tender could build upon the latest innovations and technologies in the payment sector. Moreover, with a dual-offline payment function, it has sufficient motivation and capacity to better serve the public interest even in extreme scenarios during unexpectedly adverse times. The third motivation is to improve financial inclusion. Financial inclusion entails access to useful and affordable financial services that meet individual and business needs in a responsible and sustainable way, which is essential to the

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common goal of poverty reduction worldwide. While digitalization has resulted in material progress in financial inclusion globally, 1.7 billion people remain outside the formal financial system (Auer at el., 2022). In addition, with network effects, a few payment service providers may obtain a substantial market share and build “walled gardens” with exclusive user data in the payment sector (Gowrisankaran, Stavins, 2004). This may lead to elevated cost of services and to long-tail users like the disabled, the elderly, as well as the non-residents, who might encounter difficulties accessing local payment tools. Therefore, it is the obligation and responsibility for the central bank to cover those long-tail users. By developing new services with greater added value, facilitating fiscal policy implementation, CBDC could make digital payments more accessible and widen the access to financial services for countries that demand improving access to financial service. The PBC has, for nearly two decades, sought to promote digital payments and to promote financial inclusion in all aspects, and e-CNY is such an effort. Firstly, e-CNY enhances the accessibility of payment services. E-CNY is loosely coupled with bank accounts, so a digital wallet could be delivered to an end user without opening a traditional bank account as a prerequisite. E-CNY also features hardware wallets and wearable products such as e-ink displayed cards and smart watches. The elderly, foreign visitors and non-residents can thus easily access the formal financial services in China, which could extend financial services. Moreover, the dual-offline payment function of e-CNY could be a new problem solver for the remote domiciled as well as for situations with poor telecom network coverage. Furthermore, the PBC collaborates with authorized operators on barrier-free designs to meet the needs of the people with disabilities. People with visual impairment can access the e-CNY wallet with user-friendly interface and tailor-made functions. Secondly, e-CNY lifts unnecessary costs of payment services and helps improve their affordability. The PBC does not charge authorized operators for exchange and circulation services, the operators do not charge individual users for the e-CNY related services either, which reduces the burden of the retail payment and improves the business environment as a whole. Thirdly, e-CNY improves the retail payment efficiency. [With loosely-coupled account linkage and value-based feature.] The e-CNY system achieves “Settlement upon payment”, which improves capital turnover efficiency for merchants and helps relieve liquidity constraints imposed on small and medium-sized companies. Lastly, e-CNY could bolster market innovation and level the playing field which is vital to market structure and social welfare (Lovegrove, 2022). E-CNY is programmable in the sense that smart contracts can be loaded for complex payment functions such as conditional payments. Its programmability feature to-

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gether with wallet matrix design, which will be explained below, can support innovations towards inclusive, green and sustainable finance. At the same time, with legal tender status, e-CNY is not constrained by the choice of service provider or payment tools, which could break institutional or tool-based barriers and harmonize fragmented payment markets.

Progress of e-CNY With the visions and motivations above in mind, the PBC has promoted the development of e-CNY since 2014. For now, the PBC has partially realized three goals and motivations of e-CNY. From 2014 to 2016, the PBC established the digital fiat currency research group, and kicked off research in this field. In 2016, the concept prototype of China’s first-generation digital fiat currency had been built. The PBC established the Digital Currency Institute, and proposed the top-level designs and fundamental features of e-CNY. At the end of 2017, the PBC started the e-CNY R&D project. The PBC has been piloting the e-CNY in Shenzhen, Suzhou, Xiong’an, Chengdu and 2022 Beijing Winter Olympics venues at the end of 2019. In November 2020, pilot areas were expanded to 6 more cities, including Shanghai, Hainan, Changsha, Xi’an, Qingdao and Dalian. More cities and areas have joined e-CNY pilot since 2022, now in total e-CNY pilot has covered 23 cities and areas in China. In particular, e-CNY has reached several milestones since 2021. In July 2021, the PBC had released a white paper, namely Progress of Research & Development of e-CNY in China. In Jan 2022, the e-CNY App was launched for the public to download and for resident to sign up in for 11 pilot areas. From Feb to Mar 2022, e-CNY was piloted in the Beijing Winter Olympics venues. The non-residents used e-CNY App, e-ink card, or bracelets which imbed e-CNY hardware wallets to make quick payments at the Beijing Winter Olympic venues. Now e-CNY has been piloted in 23 cities, including Shenzhen, Suzhou, Xiong’an, Chengdu, Shanghai, Hainan, Changsha, Xi’an, Qingdao, Dalian, Beijing & Zhangjiakou, Tianjin, Chongqing, Guangzhou, Fuzhou, Xiamen and the 6 Asian Games host cities in Zhejiang Province. As of December 31, 2021, transaction volume of e-CNY had totaled 230 million and transaction value approximating RMB 88 billion. E-CNY had been accepted by over 3.6 million merchants, covering utility payment, catering service, transportation, shopping, and government services.

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Multi-dimensions of e-CNY Beyond those achievements, the multi-dimensional characteristic design is the foundation for the e-CNY system. Based on a holistic consideration of monetary functions, market demand, supply model, technological support, and the costbenefit analysis, the PBC introduced the e-CNY system. Among them, there are four major dimensions. The first dimension is the operation architecture of e-CNY. In line with the central bank’s mandates, there are two options to operate a digital fiat currency. One is a single-tier system under which the central bank directly provides issuance, circulation, and maintenance services. The other is two-tier operation under which central bank issues digital fiat currency to authorized operators and then these operators take charge of exchange and circulation. Before the pilots of e-CNY, the PBC had feared that the former could lead to a digital stampede of bank assets to the central bank and financial disintermediation and now this view is becoming industry consensus that a one-tier system is not minimally invasive (Working Group on E-CNY R&D of the PBC, 2021; Auer& Boehme, 2021; Board of federal reserve system, 2022). E-CNY adopts a two-tier design whereby the PBC is responsible for issuance and redemption, interoperability and wallet ecosystem management. Additionally, it prudently selects commercial banks which meet criteria of capital and technology as authorized operators. The authorized operators are responsible for taking the lead in providing e-CNY exchange services, opening different types of digital wallets for customers based on the strength of KYC. Other commercial banks and institutions emancipate their capacities of creation, and collectively provide services for e-CNY circulation and retail payment, including payment product design, system development, use cases exploration, marketing, business processing as well as operation and maintenance. With the adoption of the two-tier operational system, the e-CNY system can minimize its impact on the financial system while keeping a level playing field. It would not change the current currency circulation system and not disrupt the proven two-tier architecture of the monetary system, thus be neutral to competition in the savings market. In other words, a two-tier CBDC would not increase banks’ reliance on interbank borrowing or affect their lending capacities, thus disintermediation could be avoided. Neither would it change the current creditor-debtor relationships in currency circulation. The commercial banks would need to reduce their reserves with the central bank to exchange for the equivalent amount of CBDC issued, thus the e-CNY issued to the public would remain as the central bank’s direct liability. Since it would not affect the monetary policy transmission

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mechanism, it would not strengthen macroeconomic procyclicality. Accordingly, e-CNY would not impact economy negatively. The second dimension is that e-CNY could be a compound of a value-based, quasi-account-based, and account-based payment system, which takes the initiative worldwide. With a loosely-coupled account linkage design, the general public could apply for digital wallets without opening bank accounts in advance. The least privileged e-CNY wallet could be opened with any users’ unique ID such as a phone number, thus users’ real identity is not required. Moreover, this dimension of e-CNY helps foster financial inclusion and achieve managed anonymity, which will be demonstrated as the fourth dimension below. The third dimension is the wallet matrix design of e-CNY. E-CNY wallets could be classified by KYC level, by the type of holder, by the carrier type, or by the management authority. More elements shall be added to the wallet matrix in the future. By KYC level, e-CNY wallets can be classified in four categories with different balances and transaction caps. Users can open the least privileged category wallet with a mobile phone number only. Under the Personal Information Protection Law in effect, telecommunication operators are prohibited from providing any identity information to authorized operators or the PBC, thus the wallet is anonymous to banks, merchants and the PBC. Users can upgrade wallets by providing more information like ID and banking account information if they wish to make large amount payment or keep higher balances. By the type of holder, e-CNY can be classified as individual wallets and corporate wallets. Individuals and self-employed business owners can open individual wallets. Corporates, whether legal persons or non-legal persons, could open corporate wallets. The functions of wallets can be customized to suit the diversified needs of users. By the carrier type, e-CNY can be classified as software wallets and hardware wallets. Software wallets could provide payments services via apps or software development kits. Hardware wallets are supported by IC card, mobile phones chips, wearable objects such as badges, bracelets, smart watches, gloves, and Internet of Things devices with payment functions. By management authority, e-CNY can be classified as main wallets and subwallets. Users could set major wallets as the main wallets and open several subwallets under the umbrella of the main wallets. E-CNY pushes sub-wallets to online merchants including e-commerce platforms, O2O (online-to-offline) platforms, using encryption and tokenization, which could insulate personal information against tech companies and protects user privacy. The fourth dimension is that e-CNY supports managed anonymity. E-CNY system follows the rule of “anonymous for small-value and traceable for high-value

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transaction”, and adopts a way to strike a balance between combating criminal activities and privacy protection. In terms of combating illegal and criminal activities, such as tele-fraud, Internet gambling, money laundering etc., authorized operators are responsible for applying AML/CFT regulations to the transactions, and required to report large-value and suspicious transactions to the Financial Intelligence Units. If any suspicious or illicit transaction is identified, FIUs or law enforcement agencies can present authority to execute or authority of law[?] to the telecommunication operators and retrieve the real identity information, which keeps the capacity to combat the illicit activities. In terms of privacy protection, the PBC aims to be the vanguard in protecting people’s privacy and personal information in the digital era. Firstly, users could open the least privileged e-CNY wallets without revealing their real identities, which could facilitate user privacy protection. Secondly, users could make payments under the protection of the encrypted and tokenized e-CNY sub-wallet, or choose to pay with no-real-identity-attached hardware wallets, which provide users varied options of securing personal information. Thirdly, based on the Personal Information Protection Law, the e-CNY system does not provide information to third parties or other government agencies. Commercial banks are usually required to collect and process nine categories of personal data from individuals during the onboarding process, or before engaging in certain business transactions with the traditional banking sector. Compared to traditional electronic payment method or instruments, e-CNY has a higher degree of privacy and personal information protection. To begin with, telecommunication operators can’t release or provide user identity information to any third party, including PBC and authorized operators. What’s more, the e-CNY App gives a notice to the user to get a permission for personal information collection. E-CNY still provides basic services to the user without user permission for information collection, which took the lead on the App market[?] Furthermore, e-CNY provides services to a user under age 14 with parental or guardian consent. Provisions similar to GDPR such as the right to forget, to make correction, and to delete, the protection of transfer of personal data, are also adopted in the e-CNY App. Fourthly, the PBC sets up a firewall for e-CNY-related information, and strictly implements information security and privacy protocols, such as designating special personnel to manage information, separating e-CNY from other businesses, applying a tiered authorization system, putting in place checks and balances, and conducting internal audits. Any arbitrary information requests or use are prohibited.

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Together, the four dimensions of e-CNY follow the principles of safe and inclusive, innovative and user-friendly, and time-evolving, which facilitate delivering an open, inclusive, sound, and reliable e-CNY system that best realizes its three motivations and serves the retail payment market in China.

Challenges of CBDCs With the progress of e-CNY, CBDC explorations in other jurisdictions have also reached their milestones and manifested much progress in achieving the common visions, whether retail or wholesale. However, there still remain some common challenges, where e-CNY also pioneers the way to solutions. The first challenge lies in the insufficiency of incentives and acceptance of CBDCs. For end-users getting used to retail payment provided by the private sector, switching cost may prevent consumers from using new instruments like CBDCs. For the adoption environment, merchants might be concerned with the pecuniary and non-pecuniary costs of accepting CBDC payments, which includes up-front cost, on-going update and maintenance costs, as well as learning costs. Given that it is a two-sided market, if there was no collaboration with market participants to build up the adoption system for all merchants, user experience would be below market expectation and switching cost would be daunting. To tackle these challenges, the e-CNY system has been continually evolving its design and building its ecosystem. E-CNY preserves the dynamism of the market by enhancing the efficiency of market mechanisms and restoring fair competition in the market. The two-tier system adoption of e-CNY fully taps authorized operators’ advantage in resources, talent, and technology to build a market-driven ecosystem that promotes innovation and fair competition. In terms of user adoption, the two-tier system of e-CNY respects customer behavioral inertia in accessing formal financial services and products via commercial banks and their distribution networks, and leverages the partnership with commercial banks to boost mass adoption of e-CNY. In terms of user experience, the PBC seeks to provide diversified choices of smart and tailor-made functions, as well as a wide variety of use cases. In particular, e-CNY is ready-to-hand and easy to master for the elderly, the disabled and foreign visitors, which serves the long-tail users and fills the gaps among other payment tools. To decrease adoption environment frictions, e-CNY system is exploring how to integrate with the existing payment instruments, which could ease the burden of the merchants. The second challenge arises from cyberattacks. The CBDC system, as an important payment system, could become the center of cyberattacks. So concerns over on security and data protection of CBDC are also paramount for ensuring

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trust (ECB, 2021). Therefore, ensuring cyber security is the common challenge for CBDC projects. The PBC, in this case, collaborates with the national security team and is carrying out security training and tests. In addition, the e-CNY system improves its security management throughout the entire lifecycle, covering encryption algorithms, financial information security, data security and business continuity, thus defending cyberattacks from multiple dimensions. The third challenge lies in CBDCs for cross-border payments. There are three main challenges in cross-border payments: high cost, low speed, and low transparency. Cross-border payments suffer from long transaction chains in which regulatory cost is the major cost. In addition, cross-border payments suffer from low traceability and lack of transparency, causing frictions regarding AML/CFT checks. Rules and regulations including capital flow management measures, data and privacy treatment differ among jurisdictions, which exacerbates the burden on compliance. In addition, central banks have to balance universality and autonomy with appropriate governance arrangements (BIS, 2021). The PBC follows the initiatives of the Committee on Payments and Infrastructures (CPMI) and the Financial Stability Board (FSB) to explore the potential of CBDC arrangements in enhancing cross border payment. Under this area, the PBC introduced the principles of “no disruption, compliance, and interoperability” in cross border cooperation, which shall be observed before conducting any CBDC cross-border experiments. First is no disruption. CBDCs supplied by one central bank should continue to support the healthy evolution of the international monetary system, and should not disrupt other central banks’ currency sovereignty and their ability to fulfill their mandate for monetary and financial stability. Second is compliance. Cross-border payment arrangements with CBDCs should comply with the regulations and laws of the jurisdictions concerned, such as capital management and foreign exchange mechanisms and also the regulatory requirements for anti-money laundering and countering terrorist financing. Third is interoperability. The development of CBDCs should fully tap the role of the existing infrastructures and leverage Fintech so as to enable interoperability between CBDC systems of different jurisdictions as well as between CBDC systems and incumbent payment systems. Currency conversion will be processed on the virtual border between wallets. In that way, there is no financial risk such as currency substitution, since domestic CBDCs should be converted to other currencies as payments cross borders to avoid potential adverse macroeconomic implications. Under these principles and approaches, the PBC has raised the Lego Bricks approach in the Multiple CBDC Bridge (mBridge) project. The Lego Bricks approach allows for disparate modules, including payment, foreign exchange, capi-

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tal management, AML/CFT, etc. Modules can be assembled as needed as building Lego bricks to accommodate evolving needs from different jurisdictions and parties. In addition, technical tools such as smart contracts can help accommodate the enormous clauses and make them machine readable. Compared to a “Silo Architecture”, where information is sequestered in different parts, the Lego bricks approach is better as it allows further interaction and synergy among modules, which could significantly reduce compliance and regulatory cost. On the mBridge platform, transaction costs are halved and transaction time has been reduced from a few days to few seconds. While tackling these challenges, the development of e-CNY will still base on previous pilot tests, further improving user experience, functions such as programmability, security and robustness of systems, efficiency of business model, and exploring more functions and scenarios in the future.

Conclusion “The train has left the station”. Central banks should be pioneers in exploring the endless frontier of financial technology to better capture the zeitgeist of the age of digital transformation. In concert with the initiative of CPMI and FSB, the PBC welcomes broad forums of relevant stakeholders to share ideas and experience in CBDCs, and encourage open discussion and cooperation of CBDCs worldwide. The PBC believes that CBDCs will be the answer for the digital era, and there is no doubt that central banks shall offer the real economy a better future with continuous efforts on unleashing the potential of CBDCs.

References Auer, Raphael., & Boehme, Rainer (2021, June), Central bank digital currency: the quest for minimally invasive technology, BIS Working Papers, 948 Auer, Raphael et al. (2022, Apr), Central bank digital currencies: a new tool in the financial inclusion toolkit? FS. Insights, 41 BIS (2020, June), “Central banks and payments in the digital era”, Annual Economic Report, Chapter III, Retrieved from https://www.bis.org/publ/arpdf/ar2020e3.pdf Board of federal reserve system (2022, Jan), money and payment: the US dollar in the Age of digital transformation Central bank digital currencies for cross-border payments Report to the G20. (2021). Bank for International Settlements. https://www.bis.org/publ/othp38.pdf Carstens, Agustín (2022, Jan). Goethe University’s Institute for Law and Finance conference on “Data, Digitalization, the New Finance and Central Bank Digital Currencies: The Future of Banking and Money”

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Chen, Sally et al. (2022). BIS, Retrieved from https://www.bis.org/publ/bppdf/bispap123_a_rh. pdf Contingency Planning for a Central Bank Digital Currency. (2020, February 25). Bankofcanada.ca. https://www.bankofcanada.ca/2020/02/contingency-planning-central-bank-digitalcurrency/ European Central Bank. (2021, April). Eurosystem report on the public consultation on a digital euro. Retrieved from https://www.ecb.europa.eu/pub/pdf/other/Eurosystem_report_on_ the_public_consultation_on_a_digital_euro~539fa8cd8d.en.pdf Gowrisankaran, G., & Stavins, J. (2004). Network Externalities and Technology Adoption: Lessons from Electronic Payments. The RAND Journal of Economics, 35(2), 260. doi: 10.2307/1593691 Lovegrove, Simon (2022, Mar). FinTech and Market Structure in the COVID-19 Pandemic: Implications for financial stability, Financial Stability Board Soderberg, Gabriel et al. (Feb, 2022). Behind the Scenes of Central Bank Digital Currency Emerging Trends, Insights, and Policy Lessons, IMF, FinTech Notes, 2022 (004)

Randal Quarles

Does Basel Dream of Electric Sheep? Prospects for the Development of Central Bank Digital Currencies According to the Atlantic Council, which maintains a website devoted to tracking the progress of central banks around the world in developing digital alternatives to paper currencies (“central bank digital currencies” or “CBDCs”), 92 of the world’s central banks are actively researching, developing, piloting, or even adopting CBDCs as of June 2022.1 This is especially astonishing when one considers that only a little over three years ago, there was essentially zero interest in creating a CBDC anywhere except at the Swedish Riksbank. Given the usual stately evolution of central bank workstreams, this is an unprecedentedly scorching pace. What on earth happened? It turns out, we can trace the eruption of activity in pursuit of CBDCs to two concrete events in the summer of 2019. First, in June 2019, Facebook (now Meta) announced that it was developing a new stablecoin called Libra (later renamed Diem). A month later, the People’s Bank of China announced that it would rapidly develop and implement a CBDC. These two revelations created a prodigious degree of agitation in finance ministries and central banks around the world. Many feared that a broadly available, privately issued stablecoin like Libra would undermine the sovereignty of nation states. More than one finance minister announced passionately that “Only the state may issue money”.2 Others worried that a Chinese CBDC would be a powerful tool in China’s projection of soft power, accelerating the acceptance of the renminbi as one of the world’s dominant currencies to the disadvantage of others. In the US, there was even concern that a Chinese CBDC would be able to supplant the dollar as the global reserve currency. These two catalysts spurred a torrent of activity among central banks who wanted, on the one hand, to develop a state-sponsored offering that could reduce the attractiveness of a private stablecoin like Libra, and, on the other hand, to maintain pace with the Chinese to preserve the global competitiveness and relevance of their own currencies. Not to put too fine a point on it, these are terrible reasons for the world’s central banks to jump headlong into the highly complex world of CBDC’s, with its im-

1 https://www.atlanticcouncil.org/cbdctracker/ 2 https://blockchain.news/news/bruno-le-maire-insists-he-cannot-support-facebooks-libra https://doi.org/10.1515/9783111002736-014

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mense technological and conceptual challenges. To begin with, the notion that the issuance of money by a private company is a threat to national sovereignty is puzzling to the point of incoherence. Almost all retail money in the world’s advanced economies is already issued by private companies, namely by banks in the form of bank deposits. The issuance of private money through stablecoins is a new technology, but it is hardly a new concept. Indeed, the world’s financial systems are fundamentally grounded in private money, and have been since the development of modern banking in the 17th century. Governments of the world do have an interest in ensuring the stability of the structures through which such new private monies are issued, just as they have an interest in ensuring the stability of the institutions that issue bank deposits, and governments have an interest in protecting consumers from sharp practice in the trading of new forms of money just as they have always had in regulating the trading of traditional forms of money. But such regulation is perfectly possible to craft, and when properly regulated, stablecoins such as Libra / Diem would pose little to no threat to national sovereignty or monetary policy. Second, fears of China overtaking the United States as the provider of the principal global reserve currency simply because China has adopted a CBDC are endearingly simple-minded. The strength of the U. S. dollar rests on many factors, including the strength and size of the U. S. economy, vast trade linkages throughout the world, deep financial markets, stability and strong law and property rights, the ease of exchange and conversion, and the presence of a credible monetary policy. None of these factors is going to be threatened any time soon by a foreign currency, and certainly not because that foreign currency is a CBDC. In any case, it is doubtful that many investors would come to prefer a currency that is monitored by the Chinese government, and subject to their absolute control. As the world economy continues to grow and develop, it is inevitable that the hegemony of the dollar will continue its mild and gradual erosion, but there is no reason to fear it being materially supplanted, and the formation of a foreign CBDC does little to accelerate that. If the initial reasons for the creation of a CBDC were underwhelming, perhaps in the intervening years CBDC proponents have developed a superior rationale. Unfortunately, a review of the latest arguments in favor of a CBDC suggests that, if they have developed such a rationale, they have yet to articulate it. For example, one argument often proffered by advocates for a CBDC is that it would promote financial inclusion. Financial inclusion is certainly a worthy goal. Exactly how a CBDC promotes financial inclusion, however, has never been clear. All of the major central banks studying or developing CBDCs have emphasized that they will structure the CBDC so as not to disintermediate the existing banking system (in part because of the risk to financial stability that such a sudden disintermedia 

 

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tion would create). In practice, this means that the holder of a CBDC will not have a direct account with the central bank, but will need to hold that CBDC in a private wallet or deposit account of some sort. But if every holder of CBDC must hold that CBDC in a wallet or account intermediated by a private company, which must somehow be compensated for the service, how has the creation of a CBDC materially advanced financial inclusion? The holder still needs a bank account, or its equivalent, but now he also needs a cell phone, an internet subscription, and constant connectivity. The need for technology may even hinder financial inclusion as businesses move away from cash, making it difficult for those unlikely to move toward a CBDC, such as the elderly, to conduct simple transactions. It would seem financial inclusion could be much better achieved through existing models for improving access to cheap, basic bank accounts, such as “Bank On” accounts in the United States. Other benefits proposed by CBDC evangelists are no more persuasive. Some have argued, for example, that creating a CBDC would stimulate innovation in the payments sector. But there doesn’t seem to be any shortage of private sector innovation in this area; rather, one of the principal reasons for the current CBDC ferment is precisely that the private sector has been innovating at a rate that central banks have struggled to keep up with. In general, competition and innovation are best achieved when the government sets the rules, then acts as a referee, not when it gets involved as a player itself. Indeed, a CBDC could even stifle innovation from the private sector by “occupying the field.” The private sector would have materially less incentive to continue experimenting with novel payment systems if they will be competing with a government backed and subsidized system. Others have suggested a CBDC could help to facilitate a more efficient and effective cross-border and small-denomination payments system. Work on improving the payments system is already underway, however. Systems like FedNow and the continued innovation of stablecoins and other forms of digital payment in the private sector are just as likely to accomplish it without the risks and government investment required by a CBDC. So far, the arguments for a central bank to adopt a CBDC do not appear especially strong. The arguments against adoption, by contrast, are compelling. First, and most obviously, a CBDC would pose a massive cybersecurity risk. Any CBDC, but especially the CBDC of a major economy, would become a prime target for hackers, foreign and independent, representing a significant weak point within the economy and payments system. In order to maintain security, significant resources would need to be devoted to the infrastructure, personnel, and supervision of a CBDC system. On top of the risk from hackers actively seeking to breach cybersecurity, a CBDC would face operational risks. If a CBDC was dependent on the internet, weather events and other natural could limit access. Similarly, wher-

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ever the main database and hub for processing and storing CBDC transactions was stored would always pose the risk of failure for digital or real-world reasons. Beyond cybersecurity risk, a CBDC would need to walk the fine line between privacy and security. The vast amounts of personal information and transactional data that would be generated using a CBDC would need to be guarded, and limited in use. In addition, this privacy must be balanced with the need for security and the prevention of illicit activity. A fully anonymous and untraceable digital currency would be the ultimate tool for money laundering and other illicit financial activity. Successfully maintaining a CBDC with adequate privacy, while alleviating security concerns is a mammoth task. It would require significant additions to the know-your-customer and anti-money laundering monitoring frameworks, and an expansion of supervision and regulation of individual consumers. Most significantly from my point of view, CBDCs would inevitably lead to significant pressure for the political allocation of credit. Today, private commercial banks are critical for the provision and underwriting of credit. The creation of a CBDC, however, will inevitably reduce at least some of the funds currently in the private banking sector. This is obviously true if the CBDC is structured to allow direct retail accounts at the central bank for all CBDC holders. The funds in those accounts would otherwise have been in the banking system. But even without direct accounts, the creation of a CBDC is likely to result in at least some drainage of deposits from the private banking system. Because a CBDC will be more easily used than cash for a number of transactions – especially online transactions – many people are likely to hold at least some funds in the form of CBDC in an internet wallet that otherwise would have been in the form of bank deposits. The European Central Bank, for example, has estimated that this drainage May be between 12 % and 20 % of banking system deposits. Even with only a mild deposit drain, the credit market would be constrained by a drop in the availability of funds, unless those funds are re-intermediated into the system somehow: either (1) the central bank itself must make those loans directly – and the politicians will certain want a large say in where those loans are made – or (2) the central bank must find a way to return those funds to the private banks, and no political system known to man would allow those funds to go back without strings. Even the best efforts to limit deposit drains and maintain funding for the credit system will result in this problem to some degree. The creation of a CBDC would also mean the creation of a new risk-free, highly liquid asset and a CBDC would likely be viewed as the safest possible asset to hold, in times of stress and uncertainty. This however, this poses significant financial stability risks. On top of the initial disintermediation, banks would now face competition from a new, safe, liquid, and easily obtainable asset during the  

 

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periodic stampedes that the banking flesh is heir to. This will increase the number of banks that fail during such stresses, and at the very least will mean that banks must maintain higher — inefficiently higher — levels of liquidity, even in times of calm, to forestall such contingencies. Given all these concerns, I believe it is fortunate that, at least in the United States, the Federal Reserve almost certainly cannot issue a CBDC without Congressional authorization. And I believe that when the Congress is finally forced to direct its attention to the matter, they will see that (a) the initial reasons central banks began rushing to develop CBDCs were bad reasons, (b) no one has come up with any better reasons, and (c) there are plenty of good reasons for central banks – and especially, in my view, the Fed – to avoid this unnecessary, complex, and risky endeavor.

IV. Decentralized Finance, Blockchain, Payment Systems, Tokens and Stablecoins, the Changing Rails of Banking and Commerce: In What do we Trust?

Barry Eichengreen

A Douse of Digital Cold Water The current period is one of frenzied activity in the realm of finance and payments, as entrepreneurs, investors, regulators and central banks all turn their attention to digital tokens of various sorts. The question, which sometimes gets lost in the shuffle, is whether all this activity will ultimately amount to more than a digital hill of beans. The consensus view would appear to be that cryptocurrencies, stablecoins and central bank digital currencies will radically reduce the cost of payments and enable decentralized finance. They will disintermediate the financial gatekeepers. They will bank the unbanked. They will dramatically cut the cost of cross-border payments. This is the consensus view in discussions of new financial technologies and instruments because, I submit, such discussions are dominated by enthusiasts. So it might be appropriate to throw just a little bit of cold water on all this enthusiasm. I will attempt to do so while, at the same time, trying not to come off as a Luddite. A first observation is that progress in these areas is ongoing, quite independent of cryptocurrencies, stablecoins, CBDCs and all things Blockchain. Recall Paul Volcker’s remark about how the most important financial innovation of his lifetime was the automatic teller machine. Seriously, payments and financial transactions of all kinds continue to fall in cost and rise in speed quite independent of Blockchain. I can set up an automatic electronic payment to my electricity provider using my bank account. The transfer is free, and I need keep only a minimal amount of money in that account. I can send money to a friend or relative more cheaply than ever using PayPal or Venmo. I can transfer funds between countries at a fraction of traditional bank fees using a variety of online platforms. Policy should continue to encourage innovations that promise to reduce transactions costs and increase consumer surplus. Heavy-handed regulation that stifles innovation is in no one’s interest – no one other than the incumbent intermediaries, that is. At the same time, one should not lose sight of the need for adequate regulation. The fundamental rationales for financial regulation, recall, are consumer protection, market integrity and financial stability. All of these apply in the realm of digital finance and payments. Consumers are imperfectly informed about new crypto-coins, crypto-exchanges, and smart crypto-contracts, whose promotors promise cheap and seamless payments and unrivaled financial returns. Nearly every day brings stories of crypto investments that go to zero or crypto entreprehttps://doi.org/10.1515/9783111002736-015

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neurs who abscond with assets. Commercial banks and conventional investment funds are not permitted to get away with such behavior, or so we like to believe. It should therefore be no surprise that the U. S. Securities and Exchange Commission is turning its attention to the crypto sphere. The need to ensure the integrity of the market – to ensure fair competition on a level playing field – directs our attention to the involvement of very large platform companies in digital finance and payments. Because these companies can harvest, and are not inclined to share, data about their customers’ other activities, they may be able to leverage those data so as to dominate payments and lending. BigTechs can use their platforms to generate large amounts of customer data, employ it in training their AI algorithms, and identify high quality loans more efficiently than competitors lacking the same information. Customers may be able to move their financial data to a bank or FinTech, but what about their nonfinancial data? What about the algorithm that has been trained up using one’s data and that of other customers? Without this, digital banks and FinTechs won’t be able to price and target their services as efficiently as BigTechs. Problems of lock-in and market dominance won’t be overcome. Rather, overcoming them may require mandating that BigTechs create impermeable firewalls between their financial and nonfinancial businesses (the Chinese approach) or breaking up BigTechs into smaller firms (currently under active, if inconclusive, discussion in the United States). Then there are issues of systemic stability. Will issuance of a CBDC disintermediate the banking system by making it possible for retail depositors to hold their funds at the central bank? Will it heighten bank-run risk by making it easier for depositors to shift their funds out of commercial banks at the first sign of trouble? Are CBDC systems secure, or could a denial-of-service attack cause the network to go down, effectively freezing all monetary transactions in the economy? Recall how the Eastern Caribbean Central Bank digital currency, DCash, went offline in early 2022 owing to what was described as a “technical issue.” Similarly, will the growth of stablecoins pose risks for the stability of treasury bill markets, insofar as large-scale redemptions force stablecoin issuers to liquidate their treasury collateral? Will stablecoins therefore have to be regulated in the same manner as money-market mutual funds, where in some countries such regulation entails redemption fees and even gates (quantitative limits and prohibitions) – whose application would challenge the rationale for stablecoins as a reliable means of payment? Will stablecoins de facto dollarize monetary and financial systems in developing countries, eroding the effectiveness of national monetary policies? Finally, will the volatility of cryptocurrencies such as Bitcoin heighten the volatility of other financial assets with which they are correlated, whether through  

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extrapolative expectations or because crypto investors buy tokens on margin, forcing them to engage in fire sales of other assets when prices turn against them? For all these reasons, the benefits of digital innovation, in the form of cheaper and more convenient payments, should be balanced against the risks. Here it is worth emphasizing that the immediate benefits are relatively slight. I can already make an electronic payment to a vendor using my credit card at a cost of approximately one percent of the value of the payment. The difference between one percent and zero is, recall, just one percent. The case for payments innovation is most perhaps most compelling when we consider financial inclusion. Making available a private label stablecoin or CBDC through a digital wallet that could be downloaded by anyone with a smartphone would be a quick and easy way of banking the unbanked, or so it is said. In the U. S., some 5 percent of households are unbanked, and numbers are higher in developing countries. But in the U. S. the majority of the unbanked lack bank accounts because they are undocumented, homeless, or flying under the radar for reasons related to the nature of their economic activities. The availability of a private-label stablecoin issued by an entity required to follow know your customer (KYC) rules wouldn’t change this. Nor would a CBDC issued by a central bank whose promise to respect the confidentiality of private payments data was unproven. Indeed, one oft-heard argument in favor of CBDCs is that they would provide central banks with real-time data on payments that would be useful for informing the conduct of monetary policy – reminding us that the proof will be in the pudding. It is true that being unbanked is economically disadvantageous. For example, the unbanked pay more for certain goods and services. They are offered less consumer-friendly plans by power, telecom and broadband companies. They find it more difficult to obtain credit. But the argument that giving the unbanked the CBDC equivalent of a bank account would allow them to obtain services and credit on the more favorable terms available to the banked is specious. Power, telecom and broadband companies provide more favorable terms to the banked because they can be expected to be paid more promptly and regularly through inter alia direct debit. An account with a bank is a signal of financial stability and reliability; it is not surprising that it is associated with superior access to credit. A CBDC or stablecoin that was available to everyone unconditionally would not signal anything. Isn’t the case more compelling in developing countries where significantly higher proportions of the population are unbanked? In principle yes, but it is important to bear in mind that unbanked is not the same thing as denied all access to financial services. Even where bank branches and ATMs are lacking, rural residents are increasingly able to access make and receive payments services through  

 

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cellphone and satellite-enabled services such as M-Pesa. To be sure, M-Pesa charges handsome fees, presumably because it can; as an arm of a dominant telecom company, it faces only limited competition. But this is less an argument for a CBDC or stablecoin competitor than it is for regulation by the relevant competition authorities. In addition, there is the fact that services like M-Pesa also engage in microlending; they use information on payments to inform and price their lending activities. A CBDC that disintermediated M-Pesa would thus increase financial exclusion, not financial inclusion, since we have every reason to expect that the central bank would not engage in micro-lending. On many tellings, the killer app for CBDCs is cross-border payments. International wire transfers generally incur fees of $50 or more. International ACH (automated clearinghouse) transfers have lower costs but can take three or more days to clear. For a cash transfer from storefront to storefront, the preferred vehicle of the unbanked, Western Union charges 7 percent for $100. A central bank digital currency that was used globally could effect cross-border transactions more conveniently (no need to visit the Western Union store), more quickly, and at lower cost. A digital dollar that also circulated outside the United States, for example, or a Chinese CBDC that also circulated outside China would have this merit. If American importers as well as Chinese producers could open digital renminbi wallets, payment for orders could be seamlessly transferred from purchaser to supplier without mediation by correspondent banks or a clearinghouse. Note, however, that fees for international payments are much lower, as a share of the funds transferred, for larger-value transactions. And other entities are already experimenting with digital technologies with the potential to reduce costs and accelerate transactions. Global banks such as Santander are using Ripple’s open-source, semi-permissioned system to transfer funds between branches in different countries. SWIFT (the Society for Worldwide Interbank Financial Communication), through which virtually all international interbank transfers are effected, is experimenting with distributed ledger technology. It has launched “Swift gpi,” a set of high-speed electronic rails to increase the speed and predictability of high-value payments, and “SWIFT Go” for small payments. These systems allow participating banks (currently limited in number) to pre-validate information about the beneficiary and to correct costly and time-consuming mistakes, using an Application Programming Interface, or API, that allows the sending bank to automatically tap into information on the account of the receiving bank. Similarly, countries with instant payment systems that do not use distributedledger technology but allow retail customers to transfer funds instantly between participating banks are exploring linking these across countries. Singapore and

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Thailand linked their PayNow and PrmoptPay real-time retail payments systems in April 2021, allowing customers to transfer funds simply by entering the recipient’s phone number. Credit-card companies such as Visa and Mastercard, which operate in multiple countries, are developing the capability to settle transactions using stablecoins. In mid-2021 Mastercard announced a partnership with Circle, the principal issuer of US. Coin, which will enable it to accept US. Coin from card issuers and then either pay it out or the exchange it for fiat currency when settling with the merchant. All this suggests that a variety of private entities are starting to do in the cross-border sphere the same things to which potential CBDC issuers aspire. Then there is the question of whether central banks will permit nonresidents to maintain digital wallets. In the PBOC’s pilot projects to date, such permission has been promised only to foreigners traveling temporarily in China. Even if permission is granted, one wonders whether residents of other countries would feel safe using the Chinese CBDC, given privacy concerns. In mid-2021, the PBOC described “anonymous” wallets tagged only with a phone number (presumably a Chinese number), with balances limited to 10,000 yuan (US$1,560), but also wallets permitting larger balances and payments but requiring “valid ID” and bank account information. How comprehensively such transactions will be tracked by the authorities – how much information they will demand or simply harvest – is unclear. The PBOC states that it will follow the principle of “anonymity for small value and traceable for high value.” It insists that its CBDC “collects less transaction information than traditional electronic payment” and that the information so collected will not be shared with other central bank or government departments. We shall see. Alternatively, cross-border payments would be facilitated if different national CBDCs were interoperable. A growing number of central banks are investigating this possibility. For example, the Bank of Thailand and Hong Kong Monetary Authority are exploring building their own separate CBDC platforms (“Inthanon” and “LionRock” respectively) but allowing them to “talk to” one another. ((In a second project, the central banks of Hong Kong, Thailand, China and the United Arab Emirates, each with separate CBDC infrastructures, are exploring the possibility of making them interoperable.) Thus a Hong Kong importer of silk would be pay the Thai exporter in HK$, assuming that nonresidents are permitted to download a Hong Kong wallet. But that Thai exporter presumably has no appetite or use for HK$. An alternative would be for the Hong Kong importer to ask his bank for a HK$ depository receipt, at which point a corresponding amount of HK$ in the payer’s account would be extinguished. That depository receipt would then be transferred into a dedicated international “corridor” where it would be exchanged for a Thai-denominated depository receipt at the best rate offered by dealers li-

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censed to operate in the corridor. Finally the Thai payee’s account would credited with the corresponding number of digital baht, extinguishing the depository receipt. The transaction would be completed in real time at a fraction of the current cost of cross-border payments. Notice the formidable preconditions for making this work. The two central banks would have to agree on an architecture for their corridor. They will have to jointly govern its operation. They will have to license and regulate dealers holding inventories of currencies and depository receipts to ensure that the exchange rate inside the corridor doesn’t diverge significantly from that outside. They will have to agree on who provides emergency liquidity, against what collateral, in the event of a serious order imbalance. In a world of 200 currencies, moreover, arrangements of this type would require scores of bilateral agreements. And corridors of more than two countries would require rules and governance arrangements considerably more elaborate than those of the World Trade Organization or the IMF. Finally, it is worth asking again: by how much would such arrangements reduce costs and increase speed relative to, say, SWIFT Go or blockchain-free linked instant payments systems a la Singapore and Thailand? With linked CBDC platforms, it would still be necessary to pre-validate or ex-post verify the identity of the customer account at the recipient bank. It would still be necessary to engage the services of an authorized dealer to complete the foreign exchange (depository receipt for depository receipt) transaction. One can imagine using automated market-making (AMM) and automated liquidity management (ALM) technology for the foreign exchange transaction, but these have yet to be stress tested. (Automated liquidity management systems are programmed to provide rewards – additional digital tokens – for agents that lend the token in question when demand rises. But as in old-fashioned systems of liquidity provision, one can imagine circumstances when there is no rate of return – no number of additional tokens – that compensate providers adequately for supplying such liquidity. Perhaps the central bank as liquidity provider of last resort can be programmed into such a system. Who knows?) And it is not obvious why, if and when AMM and ALM technology is proven, it can’t be adopted equally by SWIFT and other non-distributedledger-based payments services. The alternative to linking separate national blockchains would be for multiple central banks to share a single blockchain. The Monetary Authority of Singapore and Banque de France have run experiments using Ethereum’s permissioned enterprise blockchain. In the summer of 2021, the BIS announced that the MAS, Reserve Bank of Australia, Bank Negara Malaysia and South African Reserve Bank would engage in cross-border settlement trials using “a variety of different blockchain technologies and governance structures.” “A variety of different govern-

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ance structures” leaves important questions up in the air. Indeed, the type of governance structure that would be needed for a single unified blockchain running the currencies of 200 countries rather boggles the mind. This is enough cold water, I hope, to at least modestly reduce the temperature of the discussion.

Stefan Ingves

Crypto Assets, CBDCs and Trust Within the realms of new, digital finance, there are many “new” assets with different functions and features. Terms like crypto assets, stablecoins, tokens, central bank digital currencies (CBDCs) and decentralised finance (DeFi) are now common. Two relevant questions to pose are: whether these assets can be trusted; and whether, and how, these new assets and functions should be regulated. Going back to basics, these assets all build on the relatively new technology of blockchain. Blockchain has a wide range of possible applications and could become a very important technological innovation, or a marginal one. It is not yet possible to say. However, there is no denying that blockchain may well play an important part in the future transformation of the financial system. In general, the assets of the new digital finance area can be divided into four different types. First, we have assets that use blockchain technology but for all practical purposes are equivalent to the traditional assets that we are used to dealing with. Using blockchain technology within different financial activities and financial assets does not necessarily have to be seen as something entirely new but can instead be viewed as a choice of technology or technical platform. For example, there are firms that issue bonds using blockchain technology. If these assets are identical to other bonds, have the same issuer, confer exactly the same legal rights and have the same risk characteristics such as credit risk, liquidity risk and operational risks, they should probably be treated as traditional assets. However, in practice many blockchain-issued assets give rise to additional risks that have to be considered. Secondly, we have stablecoins, i. e. assets that have an issuer and a value that is tied to some underlying asset. Furthermore, we have free-floating crypto assets, for example Bitcoin and Ethereum. These crypto assets have no issuer and their value is not built upon anything other than pure speculation. It is difficult to see any economic value in these. Finally, we have CBDCs, which I will expand further on later in this text. Stablecoins can take on several different forms. As previously mentioned, they are distinguishable from other crypto assets in that they have a value usually tied to the value of a fiat currency and have a set of underlying or reserve assets. These assets could be bank deposits in different fiat currencies, financial instruments, or even other crypto assets. The main purpose of the reserve asset is to provide trust in the upholding of the stability of the value of the stablecoin. So, are stablecoins to be trusted? I would say, probably not. I will explain my reasoning by providing three examples.  

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Some stablecoins are similar to mutual funds, in that their reserve assets largely consist of short term assets such as commercial paper. There is, however, one distinct difference – in almost all countries, mutual funds are regulated with a focus on consumer protection. The market turmoil following the Covid-19 pandemic has also highlighted the systemic nature of some mutual funds, motivating a discussion on the need for the possible prudential or macroprudential regulation of mutual funds. In contrast, stablecoin issuers are able to use technology to circumvent the existing funds regulations. Without any regulation of these stablecoin mutual fund set-ups, the trust in the stability of the coins could easily disappear. As a second example, some stablecoins resemble currency boards. Currency boards are set up by pegging a currency’s exchange rate to another currency. To uphold the peg, the domestic central bank has to hold at least the same amount of the foreign currency as the outstanding value of its domestic currency. Currency boards are not regulated, instead the trust lies in whether a public authority – normally the central bank – can sustain the currency board, or not. In other words, whether the central bank sufficiently can control the domestic money supply. Historically there are only a few examples of successful long-term currency boards, but it is not impossible. An important feature of currency boards is that the volatility of the exchange rate is very low until the trust dissipates. When the trust begins to disappear, volatility suddenly skyrockets. Similarly, many stablecoins are likely to have a comparatively low asset volatility in normal times. However, in turbulent times holders are likely to lose confidence. This holds especially true if there are indications that the stablecoin reserve assets are not sufficient for all holders to redeem their coins. This generates a non-linear relationship between the underlying asset and the stablecoin. Consequently, historical estimates of asset volatility are likely to be underestimated in normal times when investors have confidence but will look very different in stressed times when that confidence evaporates. In the end, stablecoins are not likely to be stable in stressed times. My third example is that some stablecoins try to resemble money, or at least a medium of exchange. Throughout history, there have been countless experiments with private money. These have in most cases ended in disaster. Sweden is no exception. In the mid-17th century, a Dutchman by name Johan Palmstruch ran the Stockholm Banco and issued bank notes. However, Palmstruch did not have enough collateral, in the form of metal, for the bank notes issued. When the bank’s customers wanted to redeem their banknotes, the metal quickly ran out. This eventually led to the bank’s liquidation and the creation of Sveriges Riksbank, the central bank of Sweden, with a public mandate. While more sophisticated, stablecoins could be seen as another experiment with private money. In order to ensure that we do not end up in another crisis –

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this time spurred by stablecoins – such assets have to be properly regulated to address the risks they pose. In any discussion of appropriate regulation of stablecoins, an important distinction is between stablecoins that promise a fixed redemption value and those that do not. If it is clear that investors only have a claim on the underlying assets, and will only be repaid depending on the value of the underlying assets, the stablecoin is very similar to a mutual fund. Logically in this case, their regulatory treatment needs to follow that of mutual funds. This implies a consumer protection motive in the regulations. Given the experience of mutual funds in March 2020, such funds may also need some form of prudential and/or macroprudential regulation, but that is still unclear. If on the other hand the investor has an – either implicit or explicit – claim on the issuer, and not only the underlying reserve assets, the “asset” becomes similar to a deposit. It implies that the issuer puts their own assets at risk, beyond the value of the reserve assets. This would require more extensive regulation. If the issuer is a prudentially regulated bank, the regulation of such stablecoins will probably need to inherit many features of banking regulations, including the fact that those stablecoins need to be included in the prudential metrics. However, it also raises several other issues. One issue is how stablecoins should be treated in relation to the deposit insurance system, which aims to reduce the risk of bank runs. Another issue is what rights stablecoin holders should have in resolution and bankruptcy, i. e. whether there should be a depositor preference. Today most stablecoins are covered neither by any prudential regulations nor by deposit insurance and there are no special provisions in resolution or bankruptcy. All of these things need to be addressed. If the issuer is a non-bank, additional considerations come into play. Then the issuer would need to fall under some form of prudential regulation, similar to banking regulations and a corresponding supervision. Deposit insurance is also needed. The issuer may also need to be subject to macroprudential regulations. Moreover, the treatment under resolution and bankruptcy needs be addressed. In addition, it is important that central banks have the legal mandate to grant emergency liquidity assistance to such entities. Thus, a central question is if stablecoin holders always have the right to redeem their coins at par value. In any case, stablecoins would require more extensive regulations. Many countries are currently drafting such regulations. One example is the Markets in Crypto Assets (MiCA) regulation in the European Union. All in all, in order for us to be able to trust stablecoins, there is first a need for regulatory clarity. This clarity regarding the legal status and regulatory environment of the stablecoin is important for those who issue stablecoins, for those who invest in them or use them in other ways and for authorities. This also implies that the issuer’s risks must be efficiently managed, adequately regulated and suffi 

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ciently supervised. Second, the stablecoin has to be bankruptcy-remote from the issuer. Thus, under the relevant legal jurisdiction, it has to be perfectly clear that the value of the stablecoin will remain intact even if the issuer defaults. Third, unless the stablecoin takes the form of a pure mutual fund, there needs to be sufficient regulatory requirement on the underlying assets to ensure that each stablecoin is backed with sufficiently liquid assets so that it can always be redeemed at par value. This will be crucial to avoid stablecoin runs, similar to bank runs. Such runs would negatively affect the holders and users of stablecoins and may even spread to the rest of the financial system. Moreover, on the other side of the coin, as soon as banks and insurance companies start to build up any exposures to these assets, there is a need for prudential requirements that cover the exposures that these entities may have towards stablecoins. Regulation will be very important to deal with the risks stablecoins pose from a consumer and system-wide perspective. At the same time, central banks also have to adapt to the new needs and preferences of the public while also maintaining safe and efficient payment systems. I will therefore expand a bit on CBDCs. Central banks are unique in that they can provide unlimited amounts of riskfree money, central bank money. Today, central bank money is only available to the public in the form of cash. Sweden is facing a challenging, albeit not unique, situation where cash usage has been decreasing rapidly in recent years. At the end of February this year, there was roughly 60 billion Swedish kronor worth of banknotes and coins in circulation.1 Around fifteen years ago, that number was approximately 114 billion Swedish kronor. Given the decline in cash usage, the Riksbank launched a project a few years ago to investigate the need for a digital form of central bank money available to the public – a CBDC, the e-krona. The positive aspects of having CBDCs publicly available may not be widely apparent for the public. However, it is in my view important for the public sector to provide some form of central bank money. While there is yet no formal decision to issue a CBDC in Sweden, there are many aspects to analyse before an e-krona can be offered to the public. An obvious one is what technical platform the e-krona should use. The Riksbank is investigating different technical solutions for the e-krona. One working model is that the Riksbank provides the underlying core infrastructure and creates e-kronor. Private sector intermediaries such as banks and payment service providers would then distribute the e-krona to end-users. One important aspect is

1 See “Statistics on banknotes and coins”, Sveriges Riksbank, 2022. Last updated 11 March 2022. Retrieved 11 March 2022, https://www.riksbank.se/en-gb/statistics/statistics-on-payments-banknotes-and-coins/notes-and-coins/.

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that the end-solution should be energy-efficient, which stands in stark contrast to crypto assets like Bitcoin that require large amounts of energy. Another central aspect is the legal terms of the e-krona and whether it will need to maintain the same legal aspects as cash, but in a digital form. The legal aspects of cash – that it is legal tender and neither is subject to interest nor constitutes a direct claim on the Riksbank – are not tied to its physical form. Rather, cash is simply a concept that we have in our heads to quantify economic value. It could just as easy be something else than banknotes and coins, seashells or chunks of precious metals, for example, as long as we all agree on the form. One way to look at it is to say that for the CBDC to be a digital version of cash, it needs to have the same properties as cash. This argument implies, for example, that it needs to be legal tender, that it has a zero interest rate and that it does not imply a direct claim on the central bank, but rather represents an economic value for everyone. It also has to be user-friendly, i. e. that it can be used in practically the same manner as cash. An alternative to a cash-like CBDC is to let the CBDC be a different form of money compared to cash. Perhaps it could be allowed to be an interest-bearing instrument. That would have several other legal implications, though. A third central aspect is the issue of confidentiality and integrity. Both Bitcoin and cash are practically anonymous. This may be an attractive feature for some but creates certain problems related to, among other things, money laundering. A CBDC is in contrast likely to have a higher degree of traceability. However, a similar argument could also be levelled at privately issued stablecoins, where a profit-seeking private entity would be able to gather considerable amounts of data on its users. In this context, it is worth noting that central banks have no commercial interest in selling or misusing the users’ data whereas a private entity may gain from doing so, again undermining the trust in a stablecoin. A fourth central issue relates to the offline functionality of CBDCs. It seems vital that a CBDC should be available for use in offline transactions just like cash is. A crucial aspect is that there are controls in place to avoid what is typically called double spending. Double spending means that someone is able to use the same CBDC more than once to make a payment or a transfer. As a comparison, once you have handed over a bill worth 100 Swedish kronor as a payment, you cannot use it again. The concern is therefore how the central bank can ensure the same functionality in an offline environment for CBDCs. There are also a number of other outstanding questions, such as how CBDCs in general can be used for cross-border purposes and regarding anti-money laundering and countering the financing of terrorism (AML/CFT) measures. The Swedish government has started an official investigation about the role the state should play in the payment market. The investigation is considering,  

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among other things, the need for the Riksbank to issue an e-krona and whether it should be legal tender, as cash is. It is commendable that the Swedish state has been so quick off the mark and is looking into these topics, which raise many difficult, but interesting, issues. It is also important to keep pace with the rapid international developments in the field, both in the private and in the public sector. A CBDC could be a safe and robust alternate to private sector initiatives, without excluding them. It could be similar to how the current financial system works, with banks offering private money and central bank money acting as an anchor in the background. The central bank money anchor, coupled with strong regulations for banks and other players, provides households and firms with the trust necessary for the system to work. The state has incentives to maintain the value of the currency and the economic value of money in order to maintain public confidence. To achieve this, it is vital to ensure that the value of the money remains more or less stable over time. The private sector, while being innovative and able to provide new services that are quick and easy to use, lacks these incentives, since the aim of private enterprises is to maximise profit rather than maximise the public good. As long as stablecoins are properly regulated and CBDCs become a reality, they can complement each other. In such a scenario, CBDCs can work as safe havens if the trust in private monies is lost.

Steven Maijoor

Changing Landscape, Changing Supervision: Preserving Financial Stability in Times of Tech Revolution Introduction Ongoing digitalisation, new technologies and the entry of BigTechs have farreaching implications for the financial sector and require financial supervisors to reconsider the way in which financial supervision is structured. Throughout history, financial innovation has often been a driver of economic growth and prosperity. That’s why in a market economy, the challenge for financial supervisors has always been to adapt to innovation. So that we can benefit from the good, while keeping in check the bad. Nothing new, you might say. But still, amid all the excitement, there is some nervousness of financial supervisors about fintech. Because right behind all the benefits of new tech solutions, all kinds of new risks and uncertainties are looming, many of which go to the very heart of our mandate, which is to safeguard the stability of the financial system. For example: Will the well-known market power of BigTechs increase concentration risks in finance? As the value chain gets sliced between various parties, is it still clear who bears the ultimate financial risk? And how can we be certain it’s still managed and priced adequately? What if a major incident relating to data privacy triggers a loss of trust in a BigTech? These are just a few of the many important questions financial supervisors need to ask themselves. But perhaps the most fundamental question is how are we going to ensure that the financial system remains robust and consumers stay safe in a system where so many new, previously non-financial, players are becoming instrumental in offering financial services?

Platformisation One of the new trends we have seen arising in the financial sector recently is what I would call “platformisation”. Platformisation is a trend where we see banking and insurance increasingly being offered as a service on a platform that offers all kinds of other products and services. Platforms are often active across various sectors, and here financial supervisors are not the only, nor even the primary regulahttps://doi.org/10.1515/9783111002736-017

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tor. This makes it more complicated for supervisors to have the full picture of the activities and risks of the entire platform. It also raises questions about the extent to which financial regulators should look at a platform’s non-financial activities. Next to the issue of having the full risk picture, financial supervisors will have to act more and more on the basis of horizontal rules and regulations. Rules that are not specifically designed for the financial sector, but have a much broader application. For example, on data privacy and Artificial Intelligence. It is important that financial policymakers and supervisors have a seat at the table when these rules are set. Blockchain-based platforms pose even more profound challenges. These are often much more decentralized than traditional financial intermediaries, which makes it harder to determine the supervised entity. Furthermore, these decentralized platforms are often “borderless” in their design, thus requiring regulators to work closely together with their international colleagues.

Stablecoins Next to the rise of platforms, another important development is the emergence of stablecoins. The use of private stablecoins is still limited, partly because of their risks to users. But stablecoins also have features that could make them attractive, for example in countries with weaker institutions and unstable national currencies, and for cross-border payments. As soon as the conditions are right, things could go very fast. Based on the experience with dollarization in developing countries, we know there is a tipping point beyond which adoption of a new currency increases exponentially. Without regulation, such a steep rise in the use of private stablecoins could pose a threat to financial stability. Potentially, private stablecoins can, in the future, contribute to faster, cheaper and more inclusive global payments. However, currently stablecoins pose too many risks, and lack trust of the public. One of the reasons stablecoins lack trust is because the issuers, and in particular their reserve management, are not yet subject to financial supervision. Supervision on the reserve management of a stablecoin, might help the public to trust claims being made about the value of a stablecoin, making stablecoins more suitable for payment transactions. Given the nature of this new wave of innovation, the guardians of the financial system will have to be innovative themselves in redesigning regulation and reorganizing supervision and cooperation is key here. Since stablecoins, just like platforms and many other innovations, cross both geographical and sectoral borders, regulators and supervisors from various jurisdictions, remits and sectors will have to join forces.

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Central bank digital currency Digitalization and changing consumer preferences are causing a rapid increase of cashless transactions. This trend urges regulators and lawmakers around the world to ask themselves how they can maintain or restore the proper balance between public and private interests. In Europe, a digital Euro as central bank digital currency (CBDC), could be a form of sovereign (public) money provided by the ECB in electronic format. Different designs of the digital Euro must be investigated thoroughly to be able to see what the effects of these design options are on, for instance financial stability and monetary transmission. When designing a CBDC, it is essential that public authorities work closely with private operators, consumers, firms, merchants and of course most importantly, financial intermediaries. In my opinion, public and private sectors will play complementary roles in the future payments landscape, and we as supervisors should make sure that we strike the right balance between public and private interests.

Way forward Platforms and new technologies do not emerge exclusively in the financial sector, but do play an increasingly important role there. I think we should therefore recognize that horizontal regulation is often the best way to regulate them. For instance, the European Services Act and Digital Markets Act are important tools for regulating platforms. More horizontal cooperation needs to be mirrored by more cross-border cooperation. For example, the rise of platforms poses a higher risk of regulatory arbitrage compared to traditional finance. International consistency is needed in how platforms are regulated, for instance in the regulatory approaches to BigTechs. Another key example is stablecoins, where we have seen different jurisdictions moving towards regulation, and where consistency is especially needed. This will only become more important as decentralized finance grows. At global level, the FSB has a key role in ensuring an overall consistent approach, and for bringing all the necessary expertise together. Next to regulation, the sector’s changing structure also calls for us to rethink supervision. First, I believe we should look more towards the EU-level, and where necessary transfer financial supervisory tasks related to fintech to the European Supervisory Authorities (ESAs). A good example hereof is the supervision of significant stablecoins under the proposed Markets in Crypto-Assets Regulation (MiCAR). Moreover, the remit of financial supervisors may have to be expanded so they can continue overseeing key parties in the financial value chain. The Digital

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Operational Resilience Act (DORA) makes this possible by introducing financial oversight of so-called non-financial Critical Third-Party Providers. To make oversight as powerful and efficient as possible, it should therefore be properly resourced and as much as possible centralized with one of the ESAs. In addition, as the lines between financial and other sectors blur, we need cooperation arrangements with other types of supervisors. These can take different shapes depending on the issues at hand. In the Netherlands, for example, supervision of payment service providers under PSD2 is conducted by the two financial supervisors jointly and with the data protection and competition authorities. In the future, we may even have to move towards joint, centralized supervision in newly formed entities. And by centralized, I mean not only across financial subsectors, but also across the financial and non-financial sectors. That may be the case for supervision of cloud providers. In order to prevent fragmentation and duplication in cloud supervision, we should consider a new European horizontal cloud supervisor that would have a mandate regarding the resilience of cloud providers and their compliance with privacy rules. The board of this horizontal cloud supervisor could consist of representatives of the ESAs, the European Data Protection Board, the European Union Agency for Cybersecurity and possibly other relevant supervisors. We will need to accept that these changes will not happen overnight. Over the next few years we have to make cloud supervision under DORA as effective as possible. But centralizing supervision is something to keep in mind when we will review the DORA framework in a couple of years. As the financial sector transforms, the stakes – and gains – from cooperation are high. As financial supervisors, we have a responsibility to make sure that we can continue to deliver on our mandate to safeguard financial stability. We should prevent holes in the global financial safety net, even though technological innovation will stretch and reshape that same safety net. Therefore we should live up to our responsibility and take the first steps now, so that as finance proceeds further into the digital age, we continue to have a stable and efficient financial system that works for all.