The first block on the Bitcoin blockchain includes the encoded message: “The Times 03/Jan/2009 Chancellor on brink of second bailout for banks” - a direct reference to the failings of the world’s economy to recover from the global financial crisis. With this message embedded forever, the creator of Bitcoin probably didn’t foresee that one day, central banks worldwide would consider using aspects of the very technology designed to disrupt our reliance on financial institutions being the sole processor of all electronic payments.
In September 2021, The Reserve Bank of New Zealand did exactly that. It released an issues paper titled “The Future of Money – Central Bank Digital Currency (CBDC)”. This paper considers the introduction of a New Zealand Dollar-issued digital currency that could be used to innovate and support central bank money. To better understand the ideas introduced in this paper, it’s important to note a CDBC is not a cryptocurrency, but a digital currency that could utilise some of the underpinning technology pioneered at scale by cryptocurrencies like Bitcoin.
One of the catalysts for CDBC technology is the development a crypto-asset class known as Stablecoins which emerged due the lack of government regulation for cryptocurrency, wild market volatility and resistance from the traditional banking system. Cryptocurrency users wanted a solution that could provide the same price stability and the supposed protections of a central bank issued currency.
Stablecoins are essentially cryptoassets backed by reserves to maintain their value. These reserves can be made up of other cryptocurrencies, gold or more commonly cash. The creation of new coins is generally pegged to the value of its reserves. Supply of these coins is controlled by a private organisation that essentially acts as a shadow bank issuing tokens, managing reserves, and governing the overall arrangement with its users.
Stablecoins have matured quickly with an estimated 500% increase of issued Stablecoins over the last 12 months or so. The current market cap of Tether (USDT) - the largest Stablecoin - sits at $74 billion USD putting it just below Westpac NZ and ASB in terms of total assets. Arrangements involving these assets now resemble more traditional banking products. Today they can be used as security to draw loans and deposited to earn interest. However, they still remain a cryptoasset which isn’t regulated or supervised by any single government.
This is where CBDCs differ to Stablecoins. The International monetary fund defines CBDCs as “a form of money, issued digitally by the central bank and intended to serve as legal tender”.
But how can this system be designed to compete with the strengths of an arguably proven decentralised peer to peer technology in a centralised, regulated entity like a reserve bank? This concept is explored in more detail in the issues paper; the key points are outlined below.
Transactional accounts with The Reserve Bank
As legal tender, CBDC holders would have a legal claim on the Reserve Bank. Today the only legal tender issued direct to the public is cash. The traditional accounts model we use in New Zealand means the cash in your bank account is privately issued money, and the legal claim for your bank balance is against your selected retail bank. It is important to clarify this as a CBDC could provide a transactional account directly with the Reserve Bank.
Major disruption for commercial banks and our financial system
Increased use of the CBDC could have an adverse effect on the banking sector. Transactional accounts represent the cheapest form of funding available to commercial banks; a CBDC would disrupt this funding leaving banks to recoup this revenue stream from other areas. This could lead to increased fees and a reliance on offshore wholesale markets. The Reserve Bank notes. “The important issue here is not whether a CBDC (or another form of private money) affects bank services and profitability, but whether it does so in an orderly and non-destabilising way that is welfare enhancing for New Zealand.” This demonstrates that The Reserve Bank remains weary of too much disruption and the far-reaching impact this could have on New Zealand’s financial system as well as commercial banks’ balance sheets. However, some disruption could be positive and remove New Zealanders’ reliance on Australian owned banks.
Design and safeguards
Another important consideration is the overall design and digital infrastructure of a CBDC. Should it be account-based? Or could it be a token-based digital model? What type of verification process will be required for onboarding all CBDC users?
Our current banking system provides us with safeguards – we can cancel or reverse transactions if errors are made, the identity of the payee and payer are known and any risk is managed by our private banks. The system operates on an account-based model with currency being managed by a central authority. In New Zealand this is known as the Exchange Settlement Account System (ESAS) which is used for all individual transactions between financial institutions.
However, Cryptocurrency and Stablecoins operate on a token-based system whereby possession - not identity - proves ownership. By controlling the associated private key of these assets, you can transact to whomever you like, but once a transaction is confirmed on the blockchain, there is no way to reverse it. More often than not, there is no need to personally identify yourself or the person you’re transacting with, reinforcing the uncensored technology that underpins blockchain technology. The upside is there is no reliance on a third party or institution to process your transaction - only trust in the code or protocols that transfer a payment. This transparency means you can see and confirm transactions have occurred without waiting for the bank to clear or settle. The design of a CBDC needs to consider this transactional efficiency that a decentralised token model promotes rather than a business as usual account-based model that the payment current settlement system uses.
Striking a balance between the two is one the biggest challenges of implementation. A hybrid approach where permissioned distributed ledger technology is used to verify the identities of payee and payer as a condition of a transaction is one potential solution. For example, Grant Thornton Spain is the technology partner of a nine-member banking consortium in the late stages of operating a private blockchain to allow the sharing of identity information including biometrics. Should an account holder want to change banks, all they need to do is authorise the transfer and the information is available to their new bank. So it’s not a stretch of the imagination that the counter party risk associated with digital currency transactions could be managed using the same sort of permissioned technology.
Opportunities to eliminate inefficiencies in our current domestic system
So, what advantages does a CBCD have over our current system of consumer protectionism and safeguards? How would a new system benefit everyday consumers and attract mass adoption?
The issues paper lists several pitfalls in current domestic payment system which could be resolved by a well-designed CBDC that enhances distributed ledger technology:
- Lack of competition: Anyone wanting to use the current payment system must go through an established party. And, anyone wanting to set up a new payment service cannot access wholesale central bank money or settlement services.
- Merchant and card fees are expensive: Merchant fees, credit card transactions and payWave surcharges are a significant expense incurred by retailers.
- Cross border transactions are clunky, slow to process and lack transparency: Payments made between international jurisdictions are based on a traditional system whereby each bank has its own opening hours and technical standards. International settlements completed by a letter of credit generally take weeks, SWIFT transfers take days, and processing is often constrained by timezones, weekends and public holidays meaning payments can take days to clear and settle.
A token-based model built on distributed ledger technology could address these inefficiencies. There are no barriers to entry; any user can download software and start running a wallet to accept payments. For example, most Stablecoin transactions are based on the speed at which the payer wants their transaction to be processed and not variable on the total transaction value, only the memory the transaction uses in the next block of the blockchain.
Imagine a world in which your payments are processed around the clock with no reliance on a third party to clear or settle transactions. Take for example the second largest Stablecoin USDC (USD Coin) - a fully backed US dollar reserve supported on the Solana blockchain; it can process and confirm up to 40,000 transactions per second for fractions of a cent per transaction.
Adoption of a similar technology could mean that cross-border transactions would take seconds not days, and domestic transfers would be instant instead of the time it takes to process these within banking business hours. Many New Zealand domestic payments operators are already highly efficient and innovative, and there’s no doubt the industry will jump at the chance to augment their services with this technology.
The future of banking in New Zealand?
The risk of New Zealand falling behind international standards exists if we don’t innovate and adopt a robust CBDC. The central bank of the Bahamas has just launched its Sand Dollar. The use of digital Yuan/Renminbi is in full swing in China, and it’s expected visitors from overseas will be able to access and use it at next year’s winter Olympics.
For now, here in New Zealand, we will have to wait and see what happens when The Reserve Bank releases the summary of responses to its issues paper along with three additional policy papers in April 2022.
For further information, contact:
Manager, Financial Advisory Services
Partner, Financial Advisory Services