Paper Stresses Fungibility, “Do No Harm” as CBDCs Develop

A new paper seeking to identify the crucial elements required for a successful adoption of wholesale central bank digital currencies (wCBDC) highlights the need for work to proceed cautiously, including the assurance that new currencies are fungible with fiat currencies as part of their development.

The study was commissioned by the Global Financial Markets Association (GFMA) and written by Boston Consulting Group and Clifford Chance, as GFMA says its members will play a critical role in the potential distribution and intermediation of CBDCs. It adds the report is intended to identify those considerations which GFMA regards as critical to the success of potential CBDCs in wholesale markets.

“Banks are recognizing that the adoption of wCBDCs could enhance the efficiency, resilience, and effectiveness of money flows and capital markets, but for a wCBDC to be a valuable instrument, it must be part of a collaborative partnership between public and private sectors,” says Allison Parent, executive director, GFMA. “In this paper, we outline a series of critical design and legal factors that must be taken into account.”

The paper outlines the opportunities, challenges, and questions concerning the design, issuance, and legal status of a wCBDC while also introducing use cases to provide a framework for continuing a constructive conversation.

To a degree the report serves to encourage the continuation of work already underway, for example it recommends that central banks in collaboration with the private sector “continue to explore the role that wCBDCs can play in driving innovation and efficiencies in wholesale markets”. This, of course, as witnessed by the numerous experiment in progress with multiple central banks – often under the auspices of the Bank for International Settlements Innovation Hub – has been ongoing for more than a year now.

The GFMA report observes the adoption of wCBDCs should be “balanced” and the timeline for their introduction should be sufficiently cautious to mitigate any potential transition risk, impacting safety and soundness and financial stability – again these are all part of the various central bank experiments underway. “We recommend the use of sandboxes, proof of concept strategic dialogues with market participants, and pilot programmes based upon defined use cases to test the application of wCBDCs to help identify the impact on capital markets,” the report states. “After sufficient analysis of lessons learned, financial institutions and regulators will require a defined transition period for effective implementation.”

While noting that the adoption of wCBDCs “could” enhance the efficiency, resilience and effectiveness of capital flows, including faster FX settlements on a 24/7 basis, the report also cites what are likely to be policy challenges and trade-offs. These are that wCBDCs may impact bank funding and credit intermediation, especially during periods of stress, and have the potential to crowd out private payment solutions; direct access to central bank issuance of wCBDC needs to entail requisite regulatory protections, including AML/CFT/Sanctions oversight and enforcement; and the form and method of distribution of wCBDCs and the eligibility of market participants involved in such distribution, must be evaluated carefully to ensure that there is adequate capital markets acumen, security, protection of data and privacy controls.

Equally the paper notes the need for interconnection between retail and wholesale markets to be considered in relation to the introduction of wCBDCs such that a wCBDC designed for a particular wholesale market does not overlook potential impact on the related retail market. Furthermore, the technology underlying wCBDCs enables smart contract functionality and programmability, which can present potential benefits, but could also raise significant risks and challenges that the cost benefit must be evaluated.

The introduction of wCBDC design model that differs substantively from legacy fiat central bank deposits may cause market participants and markets to trade wCBDC as a product separate from fiat currency resulting in different legal treatment, the paper observes, adding, this could lead to market fragmentation, basis risk and other market risks currently unidentified. Suboptimal market efficiencies may arise if a) wCBDC operates in isolation and is not freely and more or less instantaneously convertible to other forms of central bank money, or if b) wCBDC trades over separate market infrastructure without any interoperability, or limited interoperability with other wCBDCs, it adds.

A final observation is that a transition period between decision to launch and actual implementation will be needed for central banks and all market participants to adapt to new or evolving processes that will in turn generate new roles and responsibilities to support the financial stability of the financial ecosystem.

“A central conclusion of this paper is that “do no harm” should be the fundamental principle when considering design models for wCDBCs,” it states. “For a wCBDC to be a beneficial and valuable instrument – enhancing the efficiency, resilience and effectiveness of money flows and capital markets – it must be crafted as part of a collaborative partnership between public and private sectors. A series of critical design and legal factors that are outlined within this paper must also be taken into account.”

The key design considerations as far as GFMA is concerned surround access, interoperability, the appropriate legal status, how it will be treated prudentially, how it will be risk managed, and its programmability, as well as ensuring it meets privacy legislation guidelines.

Given how wCBDCs are expected to operate alongside legacy instruments and systems, and not to replace them, the paper stresses the importance of wCBDCs being interoperable with the broader financial market ecosystem.

“wCBDCs are designed to facilitate wholesale market transactions, with direct access to the wCBDCs limited to regulated financial institutions and PSPs,” says Roy Choudhury, managing director and partner, Boston Consulting Group. “We and our partners recommend following the current two-tier structure which places central banks at the foundation of the payment system, while assigning end-user-facing activities to financial institutions and other PSPs.”

Simon Gleeson, partner, Clifford Chance, adds, “The first rule of medicine is ‘do no harm’, and we must follow that principle as we work to transplant wCBDCs into the real world economy. Failure to get the legal status of wCBDCs right could pose a threat to the safety and integrity of markets and to privacy rights. The legal status of wCBDCs would have to be firmly established, guaranteeing wCBDCs as fungible to fiat currencies, before they became widely used.”