Challenges of 2020 push digital adoption
The Covid-19 pandemic has increased the urgency of adopting safe, efficient, reliable and convenient digital payment services. Amid social distancing, restricted mobility and rising uncertainty, digital and mobile retail payment services have enabled users to send and receive funds electronically.
In developing economies, responses to Covid-19 have led to greater financial and digital inclusion. In OMFIF’s ‘Future of Payments’ report, published at the end of 2020, one Asian central bank reported that 1.6m individuals gained access to their country’s formal banking system during the first half of 2020, while mobile banking transactions rose 192% during the same period.
Payment revenues worldwide have doubled in the decade to 2019 to reach $2tn, according to McKinsey’s latest ‘Global Payments Report’.
Even though payment revenues are estimated to have fallen 22% in the first half of 2020, the decline has been accompanied by growth in online payments.
In the US, online retail spending rose 30% in the first six months of the year relative to the same period in 2019. British credit and debit card transactions in July 2020 fell 16.4% year-on-year, but the share of online transactions increased to 40.7% from 29.8%.
Consumer habits formed over the past year will persist even after the pandemic ends. Amazon reported a 40% year-on-year increase in net sales in the second quarter of 2020, driven by demand for its online grocery shopping service.
Just as the 2003 severe acute respiratory syndrome epidemic prompted a rise in e-commerce and digital payments in China, the Covid-19 pandemic is expected to have a lasting impact on consumer behaviour across the world. We should expect this trend to accelerate in 2021.
Retail CBDC becomes a priority
The vibrancy of retail payments and arrival of private innovations have spurred a wave of research and exploration from governments and central banks. Apart from the roll-out of fast retail payment systems that offer near-instantaneous domestic clearing and settlement, there is potential for profound changes in how central banks can promote better speed, security and access to payments domestically and internationally. Ideas about how to implement central bank digital currency and the notion of digital sovereign fiat currency that can be transferred at low cost and high speed are sparking further changes that could transform monetary transactions.
Use cases and policy objectives are based on the view that cash is a public good, it is declining in use and that it’s up to the public sector to provide another means of payment. Current payment systems could be updated with asset tokenisation or by improving back end systems which are expensive to run. These are the main areas highlighted by most advanced economy central banks.
There is a very different story to be told in Asia. Its digital transformation is being pushed by organic demand for specific digital service platforms, creating an ideal landscape for exploring digital currencies. The region’s progress in developing CBDC reflects people’s desire for technology, convenience and digitalisation of services. A need to boost financial inclusion and facilitate remittances has led Asia to focus on and become a leader in CBDC.
Figure 1 shows that the focus on retail CBDCs has grown. For China, which has arguably the most advanced project, there is a need to provide a public alternative to mobile money that has so far been dominated by the private sector. M0 will be circulated by the private sector on mobile phones. It is fully collateralised and the regulator has access to transaction data to ensure regulatory compliance.
Like Alipay and WeChat Pay, China’s CBDC can be stored and accessed by consumers through digital wallets. However, unlike these private networks, the e-yuan will not require people to have a bank account. Another critical aspect of the e-yuan that would further advance financial inclusion is that transactions will not be subject to any fees, just like cash.
While most central banks are still only researching CBDC or have only recently launched pilots, the Bahamas has already rolled out its digital currency. The sand dollar is designed to increase financial inclusion and improve the resiliency of payments in the natural disaster-prone archipelago.
This CBDC is being released gradually through authorised financial institutions, with retail consumers accessing it through digital wallets. These wallets work on a hybrid wireless network which allows consumers to use their money without an internet connection.
In terms of know-your-customer, anti-money laundering and combating the funding of terrorism regulations, the sand dollar follows a three-tier system. The lowest tier does not entail strict customer screening, but does limit the amount of money held. The two higher tiers take a risk-based approach to KYC, AML and CFT standards.
Sweden, a country with low cash usage, is another frontrunner in CBDC issuance. The Sveriges Riksbank has been running a digital currency pilot since February 2020. In December 2019, the central bank agreed with Accenture to test digital wallets and distributed ledger technology, while ensuring CBDC was interoperable with other bank systems.
Cambodia is likely to follow suit this year with its Bakong system. Cambodia plans to foster greater competition in its payment industry by building a system that operates with incumbent payment service providers, leaving the public to decide which vendor to use. Meanwhile, Singapore and Thailand are experimenting with wholesale CBDC systems, determining business and commercial use cases.
Other countries in varying stages of CBDC development include Ukraine, Canada, France, South Africa and Brazil. As more countries move away from cash, more central banks are expected to explore CBDC issuance.
For instance, Japan, a heavily cash-based economy, has resumed its exploration of CBDC. It plans to launch its digital yen pilot programme in April, following a feasibility study it concluded in January. This proof of concept will be carried out in three phases. The first will test the basic core functions of CBDC as a payment instrument. The second phase starts in spring 2022 and will examine the functional requirements and design of CBDCs (including issuing limits and offline capability). Payment service providers and consumers will participate in the final phase of the programme.
While the Bank of Japan has no plans to issue a CBDC, it considers it important to prepare if such a need arises in the future. Similarly, the Bank of Korea launched a CBDC pilot in April 2020 to study potential use cases. The goal is to future-proof South Korea’s payment system and allow for contingency planning if there is ever a need to issue CBDC. We may see Korea emulate Japan this year. Turkey and Ukraine both plan on beginning their retail CBDC pilot programmes this year. India is in an exploratory phase, which it announced on 25 January. The Reserve Bank of India is investigating if there is an identifiable objective for CBDC and, if so, how could such a system could be put into operation.
Privacy still needs to be solved
Each of these experiments could lead to digital currencies with different designs, prioritising certain aspects over others. Design options includen an account-based, hybrid or token-based approach. All have their own challenges with privacy, KYC and AML regulation compliance and financial disintermediation. Central banks will need to choose how they overcome each of these issues. But authorities do not just need to decide upon the design of their digital cash. As innovations in payment systems advance in tandem with the broader digitalisation of the economy, there will be a need for central banks and financial regulators to update their regulatory mandates. Whether they originate from the private or public sector, upgraded or new retail payment infrastructure must meet financial inclusion and stability objectives, as well as ensure security, interoperability, trustworthiness, resilience, speed and cost-effectiveness.
There is no ‘one size fits all’ design or underlying technology for CBDCs. These aspects will depend on how central banks choose to be involved in the payment environment. OMFIF has gathered the views and opinions from central banks through research and meetings. The main characteristics of money are well understood, being a stable store of value, medium of exchange and unit of account. We would expect any new currency to exhibit these features.
Central banks are unanimous that any new system should be governed by the sovereign authority, which would determine who has access to it, how rules are changed and monetary policy is actioned. It should be secure and resilient. Additionally, interoperability needs to be achieved across platforms in the case of a hybrid model or if users can access a core ledger on the backend as suggested by the Bank of England and Cambodia’s Bakong models.
While this view is relatively commonplace, there is more debate on the level of privacy and anonymity afforded to users. This affects how KYC and AML measures are carried out. It is ultimately a design question for the issuer to answer. While others are still deliberating to what extent privacy and anonymity will be designed into their projects, China swiftly decided on a centralised governance structure. The People’s Bank of China says it will use ‘loosely coupled account links’ to create ‘controllable anonymity’. Under this system, e-yuan will be transferable from one digital wallet to another without using a bank account. This means users can still use other platforms such as Alipay. Only a portion of the money in their account will be in e-yuan. The PBoC will, however, have access to transaction data.
Way forward for wholesale CBDC
Central banks have been exploring methods to adopt distributed ledger technology for wholesale and interbank operations for trade and settlement over the past four years. The technology promises to make infrastructure more efficient, productive and resilient. Prominent DLT initiatives include the Monetary Authority of Singapore’s Project Ubin and the Bank of Canada’s Jasper. More recently, central bank efforts have shifted towards DLT-based retail central bank digital currency as shown in the figure.
The private sector has developed more specific uses for blockchain and DLT. Legacy operations and the need for data reconciliation mean that many financial transaction processes are costly and inefficient.
Banking is where we have seen some of the greatest developments. The most prominent use case for banks is the alleviation of pain points in cross-border payments. This could mark a departure from the high-cost, slow and inefficient correspondent banking relationship models which tie up liquidity and still have counterparty and credit risk.
DLT offers greater resiliency and increased functionality, features that set it apart from traditional real time gross settlement and normal account-based systems. Digital currency could also integrate well with other use cases, such as asset tokenisation or clearing and settlement. Using DLT would allow for continuous payment-versus-payment and delivery-versus-payment settlement globally. Interoperability and fungibility in different DLT systems would also allow a CBDC to be on one side of atomic transactions.
However, this is still in early stages and there are many issues to address. This application of DLT would significantly derisk settlement, although it would create pressures in other places, such as liquidity management. This is one area in which banks expect significant progress over the next five years. The private sector is starting to take a more realistic view of blockchain’s potential and has a better grasp of implementation issues. The public and private sectors have many common goals, with major benefits for both sides if they can overcome certain hurdles.
Leading central banks see wholesale CBDC as a way to make the financial sector more effective and innovative. In December 2020, the Banque de France successfully conducted a CBDC experiment with IZNES as part of its testing programme launched in March 2020. The experiment undertook subscriptions and redemptions of fund units on SETL’s private blockchain platform using digital euro, allowing the simultaneous delivery of funds against payment using digital euro.
We will see a multitude of offerings for specific purposes in the wholesale space. It will be unlikely that a digital currency will live on only one platform and be accessed and used in the same way by all stakeholders in a financial system. The future could well be one with both privately and publicly issued currencies, operating on blockchains connected through application programming interfaces or other technical solutions.
Expectations for the future
Mobile money and digital wallets will grow significantly in the future. As emerging economies expand financial inclusion, innovations that can facilitate basic services will be attractive to regulators. Incumbent banks and payment service providers are developing integrated products that combine older innovations, such as card-based models, with advances from newer players.
Given the rapid pace of innovation in the payment landscape, central banks are pivoting toward greater industry engagement. Policy tools, such as regulatory sandboxes, innovation hubs, waivers and more differentiated payment regulations, are being used to foster more proactive approaches to the evolution of payments. Although not all central banks favour direct partnerships with private payment service providers, the overall regulatory shift to more flexible governance is fostering greater familiarity with new technologies and business models. This will help test and scale beneficial innovations.
There is catching up for some to do. The US has recently become more overt in engaging with retail CBDC developments, while also spurring the private sector towards blockchain-based infrastructure innovation through regulatory changes. The Federal Reserve Bank of Boston stated in an OMFIF meeting that it is identifying policy objectives for a CBDC and actively evaluating different technology platforms that deliver on improvements in the speed, efficiency, security, resiliency and throughput of the system. However, overall progress in the US has been uncoordinated, as interbank and banking operations stride ahead while the benefits to consumers remain unclear.
Despite China’s good progress with its CBDC project, it is highly unlikely we will see a fully operational cross-border Chinese CBDC this year or the next. A successful e-yuan has been set up as a challenger to the dollar’s reserve status. It won’t succeed, however, given the dollar’s strong fundamentals that technology cannot change. The dollar’s status is more of a policy question than a technical one. Debt, retail payments, oil, gold, commodities and asset safety will always be the dollar’s domain.
Consequently, an e-yuan will not challenge the dollar until these fundamentals shift and there becomes an overt preference from the US-backed Society for Worldwide Interbank Financial Telecommunication for a Chinese system. Additionally, until China has highly liquid and open capital markets, the renminbi’s international role will remain limited.
However, we may see an iterative approach to expanding the e-yuan outside of China’s borders. This could be by facilitating payments across the belt and road region, where the renminbi is already the major currency. Renminbi expansion will require global co-operation and compromise on interoperability, international standards and principles, as well as harmonising laws and regulations.
While there are alternative ways forward for cross-border payments, blockchain and DLT are the catalysts pushing the financial industry to upgrade its outdated infrastructure. These technologies are being used for peer-to-peer cross-border payment applications, where they will only grow in importance.
In January, the Bank for International Settlements Innovation Hub listed its priorities and new programmes, which included a platform for testing wholesale CBDCs. This proof-of-concept platform will use different CBDCs ‘to explore the feasibility of faster and cheaper cross-border payments’. Once more technical principles are agreed, central banks will be eager to expand cross-border innovations.
Until major central banks start issuing CBDC in earnest, regulators will remain wary about drastic shifts in payments brought on by DLT and digital currencies. Despite private payment system innovations, such as stablecoin, competing with the traditional dominance of sovereign fiat right now, the future of the payment industry will be based on collaboration.
The potential for interoperability between Diem’s stablecoins and future CBDCs shows how public-private partnerships in payments could leverage central bank trust, while gaining from the private sector’s existing user base. Within this arrangement, central banks will act not only as issuers of sovereign digital fiat, but as standard setters, protecting consumers and enabling innovation.
Bhavin Patel is economist at OMFIF and editor of the DMI Journal. This is an excerpt from the February edition of the DMI journal.