Wholesale changes coming on digital currencies

The evolution of central bank digital currencies (CBDCs) continues as governments and regulators grapple with how to chart the most effective and efficient path on digital assets.

“Many central banks around the world are exploring digital currencies and their likely implications on the financial system for years.”

Last month the Reserve Bank of Australia (RBA) laid out its latest three-year roadmap for digital money which the RBA and Treasury have entitled “Project Acacia”.

Addressing a conference in Melbourne, the RBA’s Assistant Governor on the financial system Brad Jones highlighted how technological innovation often intersects with the changing needs of the economy to radically change the way banking and finance works.

Think the introduction of paper money to replace copper coins in 10^th century China, or the introduction of double-entry ledgers in Renaissance Europe, or using transatlantic cables to transfer financial instructions in the 1850s.

A similar period of technological innovation is happening now as the rapid progression of digital technology reshapes the world of finance and how consumers engage with the banking system.

Think of how much the way you manage your own finances and how you transact in the economy has changed in the last decade or two.

When did you last visit a bank branch to conduct an over-the-counter transaction? Do you carry cash in your wallet anymore? And do you regularly use a banking app to make electronic payments?

Within the financial system, the vast bulk of what we think of as “money” is a dwindling proportion of the overall monetary amounts in circulation through the economy. The latest RBA figures show the split of physical cash compared to digital counterparts is widening.

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The “digital” forms of money – exchange settlement balances and commercial bank deposits – dwarf the amounts of physical cash in the system. When we borrow money, the loan is issued by the lender directly into your account allowing consumers to spend the proceeds.

Like most other developed countries, Australians tend to hold most of their money in bank deposits. And fewer of them are using cash, with the emergence of the digital economy and electronic transfers. The proportion of transactions in Australia using cash has fallen to about 13 per cent in 2022, from about 62 per cent in 2010.

With an increasing emphasis on digital money, including digital currencies and so-called stablecoins being developed by the private sector, how should central banks embrace these changes? How should CBDCs be distributed and which parties should have access?

Many central banks around the world are exploring digital currencies and their likely implications on the financial system for years. The RBA began a program of work back in 2020 to explore the potential use and implications of a wholesale form of CBDCs.

In his recent speech, Jones flagged three key messages to come from the RBA and Treasury’s roadmap.

First, the RBA wants to prioritise work on wholesale digital money and infrastructure – including a wholesale CBDC – rather than focusing any time on a retail CBDC.

“We assess the benefits to the economy as more promising, and the challenges less problematic, for a wholesale CBDC compared to a retail version,” Jones said. Unlike a retail CBDC that would be issued for use among the public, a wholesale CBDC would represent more an evolution than revolution in our monetary arrangements.”

Financial stability

The nub of the RBA’s position to prioritise a wholesale CBDC indicates it sees more immediate benefits from a wholesale CBDC. Central banks have a long history of issuing digital money to financial institutions in support of their monetary and financial stability objectives.

The benefits of a wholesale CBDC include reducing counterparty and operational risks, freeing up collateral, increasing transparency and auditability and reducing costs for institutions and customers.

It also recognises the stabilising role of central bank money in the settlement of wholesale market transactions, particularly in markets deemed systemically important.

Second, the RBA will conduct detailed research on the future of digital money in Australia, including a new project studying wholesale CBDCs and tokenised commercial bank deposits.

It will also focus on how new ledger arrangements and concepts like and ‘atomic settlement’ in tokenised markets could unlock benefits for the Australian financial system.

Atomic settlement does exactly what the name suggests – offers instantaneous swapping of an asset for payment. In theory, this can remove counterparty and operating risks and create efficiencies around reserving capital, legacy system costs and market liquidity.

Lastly the RBA and Treasury have not completely dismissed any chance of a retail CBDC down the track. The RBA plans to reassess the merits of a retail CBDC over time and will produce a follow-up paper on the issue in 2027. The regulatory equivalent of kicking the can a little further down the road.

Potential benefits

Federal Government action would be required if a retail version were to be adopted and it would almost certainly require legislative change, he added. In other words, while a retail CBDC for use by the general public would require significant changes to Australia’s financial and banking system, it may not bring commensurate benefits.

“The potential benefits of a retail CBDC generally appear modest or uncertain at the present time, relative to the challenges it would introduce,” Jones said. “Most of the arguments made internationally in support of a retail CBDCs reflect issues that are either of limited relevance to Australia.”

“We assess the potential benefits as more promising, and the challenges less problematic, for wholesale CBDC compared to the retail variant.”

When it looked at the use cases for a retail CBDC, the RBA didn’t feel any of them warranted urgent action. For example, unlike many developing countries, Australia is already well served by an efficient payments system and Australian households are among the most banked in the world.

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It did suggest a retail CBDC could be of use to aid financial inclusion. However, it determined Australian households already have significant access to banking services and more work was needed to understand how a retail CBDC would help financial inclusion.

With digital money is already the dominant form of transactions with the dwindling use of cash in Australia, why would a retail CBDC be controversial?

Jones concedes there are some deeply held views in the community about the rights of citizens and the role and obligations of the state. This includes issues of safety, privacy, freedom, sovereignty and even geopolitics.

People concerned about CBDCs, for instance, believe a centrally managed currency could be used as a surveillance tool by governments. A retail CDBC would spell the end for financial privacy and give governments undue control over the financial activities of its citizens, critics say.

So the upshot is, there is still a lot of water to go under the bridge but the RBA will focus their energies on wholesale CBDCs alone for the time being.

Later this month the RBA and its research partner, the Digital Finance Cooperative Research Centre, will publish a consultation paper calling for industry submissions, followed by advisory forums next year covering both retail and wholesale CBDC issues.

“Whatever the shape of future innovation in our financial system, it is reasonable to expect central bank money will continue to serve as the ultimate safe settlement asset, particularly in systemically important markets.”

Brett Foley is Managing Editor of bluenotes