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Highlights
- Central banks around the world are exploring ways to issue a digital legal tender of their currencies in the form of central bank digital currencies (CBDCs).
- In capital markets, CBDCs can bring a host of benefits such as reduced transaction and settlement costs, ease of compliance, and real-time issuance of securities.
- However, CBDC implementation will have to pass through several obstacles related to regulation, acceptance from market participants, and user privacy. These impediments can be overcome through global partnerships and common implementation frameworks among central banks.
In this article
Introduction
Imagine a world without long wait times or hefty intermediary fees for international fund transfers.
Or purchasing treasury bonds within a few seconds instead of trade date plus two days. These scenarios could come true with the advent of central bank digital currencies (CBDCs). They are expected to simplify and disrupt payment and settlement solutions. The currencies will prove especially useful for cross-border and interbank transactions.
Digital currency rollout
Central banks across the globe are witnessing a decrease in the use of paper currency.
At the same time, cybersecurity threats related to digital payments and financial risks posed by unregulated digital currencies such as cryptocurrencies are on the rise. Central banks are striving to shield the global financial system from these risks.
They are now exploring ways to issue a digital legal tender of their currencies in the form of CBDCs. Several pilots have been conducted to evaluate the technical infrastructure, performance, and user feedback of these currencies. Some prominent pilots include those announced by the People’s Bank of China, the US Federal Reserve, and the Bank of England.
Potential use cases
CBDCs can empower investors with access to a wide range of investment assets.
They can decrease transaction and settlement costs and reduce dependency on intermediaries. Issuers can reach a larger pool of potential investors across the globe due to hassle-free, faster, and secure transaction methods.
Further, they have an edge over other modes such as India’s Unified Payments Interface (UPI) and e-wallets in terms of disintermediation and safety features that are backed by central banks. Here are some potential use cases.
- Peer-to-peer lending: CBDCs will facilitate peer-to-peer transactions and reduce the fees paid to intermediaries such as brokers and exchanges. With regulatory measures in place, individuals will be able to lend money to peers anywhere across the globe. This will also boost financial inclusion and ease of instant access to funds.
- Ease of compliance: While managing investments of international customers, capital market firms face several challenges pertaining to know your customer (KYC) and anti-money laundering (AML) laws. They may not have the complete knowledge of the source of customers’ funds, especially after account opening. With CBDCs, every penny of customer funds will be governed by central banks, ensuring KYC ease and low cost of compliance.
- Real-time issuance of securities: Through CBDCs, issuers can simplify the process of issuing and underwriting securities between buyers and sellers. This will involve smart contracts powered by blockchain. Let us assume a company wants to raise capital by issuing a new corporate bond. In a traditional system, the issuance process is time-consuming and costly. It involves several intermediaries, such as underwriters and registrars, who, in turn, spend a lot on human resources and infrastructure. With CBDCs, companies can automate bond issuance with digitized terms and conditions encoded in smart contracts. For example, in a recent wholesale pilot conducted by the Reserve Bank of India, participating banks were able to exchange bonds worth over $2 billion in real-time instead of trade date plus one day.
- Real-time analytics: Central banks will be able to access real-time data on the distribution and usage patterns of CBDCs. This can provide useful insights such as investment preferences and impact on stock prices and currency risks due to geopolitical disruptions, climate change, inflation, rate hikes, and so on. For example, central banks can perform analytics related to end users’ spending patterns and currency trends, such as currency pair differences and changes in price due to geopolitical tensions and energy prices.
Implementation hurdles
Implementing CBDCs will not be easy.
We foresee three key challenges:
- Regulatory challenges: Central banks are yet to formulate a common and globally acceptable regulatory framework for widespread implementation of CBDCs. Countries that are early adopters will face barriers in introducing their CBDC solutions in other jurisdictions.
- Adoption challenges: Now that digital payment solutions such as UPI, e-wallets, and internet banking are popular, CBDCs may face adoption challenges, especially among retail users. Central banks will need to collaborate with authorized private banks and fintech firms for quicker adoption and global implementation.
- Privacy issues: Since all transactions done through CBDCs will be monitored by central banks, several users may raise concerns about losing financial privacy to a central authority. For example, central banks may analyze patterns of users’ spending habits to plan adoption strategies, policy decisions, and macroeconomic interventions. Central banks will need to apprise stakeholders about terms and conditions related to data sharing and draft transparent policies to protect user privacy.
Conclusion
CBDCs have significant potential to disrupt payments and settlement solutions in capital markets.
They can lower costs for all stakeholders and facilitate inflow of more retail investors to markets across the globe. However, the implementation of CBDCs will have to pass through several impediments related to regulatory measures, acceptance from market participants, and user privacy. These issues can be ironed out through global partnerships and common implementation frameworks among central banks. Capital market firms and banks would do well to chart out their CBDC adoption strategy in the near future.
