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Analysis
Central banks must adapt to blockchain

Central banks must adapt to blockchain

Distributed ledger technology only in first generation

by Oliver Thew in London

Thu 29 Mar 2018

Last week, OMFIF and the Czech National Bank organised a seminar on private cryptocurrencies, central bank digital currencies, distributed ledger technology and the digital economy. Representatives from the public and private sectors agreed that distributed ledger or blockchain technology is only in its first generation. The proliferation of private cryptocurrencies, as well as the need to create a taxonomy and regulatory standards for these new digital assets, pose challenges for central bank policy-makers and regulators.

It is important to distinguish between concerns surrounding private cryptocurrencies and optimism regarding the underlying blockchain technology. From instant settlements to reducing counterparty risks, private and public sector organisations realise the potential benefits of blockchain. But there are problems with the current generation, which need to be addressed before the technology can be used more widely. Blockchain needs to overcome its scalability problem if it is to replace real-time gross settlements – the Bitcoin blockchain can only process 7 transactions per second, whereas Visa processes 2,000 transactions per second.

Problems like these are not insurmountable and blockchain has evolved beyond the experimental phase into implementation. Central banks must address three key issues before the technology enters its next iteration.

First, central banks should dedicate more resources to understanding which internal operations and systems will benefit from blockchain. One of the most obvious applications is for payments and settlement systems. Several central banks are already undertaking research in this area, including the Bank of Canada, Bank of Japan, Sveriges Riksbank and European Central Bank. The Monetary Authority of Singapore recently reaffirmed its commitment to blockchain technology to facilitate cross-border payments in traditional currencies. Other internal functions may also benefit from blockchain, such as reserves management, auditing, compliance and record management.

Moreover, central banks need to understand there are different design options for blockchain systems that can be tailored to meet specific requirements. A central bank could choose to build a permission-based blockchain system. This would be particularly useful for prudential departments to limit other departments' access to certain information.

Second, central banks must weigh the implications for financial stability and monetary policy of issuing their own digital currencies. There are many advantages, from providing a relatively costless medium of exchange to facilitating rapid and secure settlement of cross-border financial transactions. There are also many disadvantages, such as the risk of facilitating a bank run in times of economic stress and removing the zero lower bound of interest rates. Currently, the disadvantages probably outweigh the advantages. However, the declining use of cash in Nordic countries, increasing role of technology companies in payment processing and other contextual factors mean central banks should continue to evaluate the cost-risk ratio of issuing their own digital currencies as we enter the next generation of blockchain.

Third, central banks play a crucial role as regulators and should mitigate risks while encouraging innovation. This means creating regulations and standards that provide clarity to the market – information for consumers about the potential risks of investing in blockchain-based companies and guidelines for banks and technology companies as they develop applications for the financial services sector. There is a danger for policy-makers to be too prescriptive and not allowing room for innovation.

At this stage, central banks should shape regulation that is technologically neutral, so it does not favour one provider over another and reduce competition in the market. Although the first generation of blockchain companies and start-ups were born out of regulatory arbitrage, the private sector now recognises that regulation is necessary if the next generation of the technology is to achieve its full potential.

Oliver Thew is Business Development Manager at OMFIF.

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