Financial firms confront the threat of central bank digital currencies

Central bank digital currencies have the potential to dramatically change the roles of fintechs and financial institutions, which is why some of those companies are competing to get involved early.

This week Ant Group, the company behind Alipay, became part of testing for China's digital yuan, the central bank digital currency that's closest to launch among large countries. And Swift this week issued a paper with Accenture, which has a bank consulting practice, that argues central bank digital currencies should use existing payment rails such as Swift to support international interoperability.

Swift plans to host a series of trials to gauge potential interactions with CBDCs that operate across borders. Swift, which did not return a request for comment, argues against reinventing the wheel.

"A lot of governments still have to make a decision on CBDCs, but if central banks in Europe or the U.S. were to move forward, there could be significant consequences for the banking system," said Gwenn Bezard, a co-founder of Aite Group. There's a difference between digital currencies designed for consumer use to make payments at retailers and a wholesale CBDC for interbank transactions, he said.

"The roles of banks could be redefined or reduced with a retail CBDC," Bezard said. "That's one reason why the Fed is studying the CBDCs. The Fed is concerned about the impact on the banking system."

Bloomberg

Most working CBDC concepts include at least some combination of retail and wholesale CBDCs. Among existing CBDCs, Sand Dollar, based in the Bahamas, is positioned partly as a way for tourists to make payments. "With a retail CBDC, consumers could theoretically use it to compete with bank deposits," Bezard said.

Most other CBDCs are in the research stage and don't have a formal model. But a growing number of financial institutions and organizations that represent and work on behalf of financial firms are angling to play a facilitating role. One concern is that blockchains will replace the transaction processing steps that generate fee income for banks.

But at the same time, the central banks can't afford a rush from consumers and businesses to draw down bank accounts in favor of digital currencies.

Accenture is a driver behind the Digital Dollar Project, which is working on use cases for CBDCs in an effort to identify bank contributions to the structure of the U.S. central bank digital currency when it is developed.

Like Swift, the Digital Dollar Project plans a series of tests over the next year to consider the impact of a central bank digital currency in different constituencies, including underbanked, banked, small business, large enterprises and international trade. The Digital Dollar Project would not comment for this story, but did share an outline that detailed the pilots.

Among other goals, the DDP will vet how government-affiliated digital wallets will serve as alternatives to, or a gateway into, traditional bank systems in mostly urban and rural areas. For small businesses, DDP's goal is to determine how digital currency can support consumer and supply chain transactions.

The DDP will additionally test use cases for large corporations and international transactions involving countries with and without CBDCs, and how a U.S. digital dollar would comply with existing laws and regulations.

The planned tests will address banks and card networks, while also stressing the digital currencies' goals are to reduce the number of steps involved in financial transactions, shortening time and costs.

The DDP mentions, for example, many small businesses and fintechs do not have access to Fedwire payments, and are depending on financial institutions to execute payments for them. A U.S. digital dollar could cut out this intermediate step.

Distributed ledgers have already proved this concept for international payments, with blockchain firms such as Ripple reducing the need for correspondent banks to manage currency conversions and other steps. This reduction took days out of the traditional process and was initially seen as a threat by banks, but Ripple eventually became a partner to many banks.

The model that DDP is researching for the U.S. would be "distributed through the existing two-tiered banking system and regulated intermediaries," which suggests the project would be a public-private mix that would provide a substantial role for banks, card networks and other financial institutions. DDP also says it should be a monetary policy neutral transaction object, "akin to how cash and accounts-based commercial money" currency function.

In other words, the digital dollar is being positioned as a way to save access to cash at a time when cash-handling is becoming more expensive, providing a way for financial institutions to save costs by streamlining cash disbursement to businesses and consumers in partnership with the government.

Banks could benefit from international transactions and other use cases for CBDCs, Bezard said.

"I don't think central banks have worked out ways to make CBDCs interoperable," and international CBDC processes will need to be made more efficient, similar to traditional currency, he said. "This could benefit banks quite a bit."

Banks and the U.S. card networks are developing CBDC strategies. In addition to its partnership in the Bahamas, Mastercard reports it is engaging with governments globally on CBDC policies and a role for the card brand. Visa is also engaging with central banks and has filed a patent application for technology that allows governments to digitize their currency. And BNY Mellon is pursuing a role in streamlining international DBDC transactions.

"The development of the central bank digital currency platform and currency management is clearly the role of the government," said Tim Sloane, vice president of payments innovation at Mercator Advisory Group. "But driving wide adoption by both merchants and consumers is best achieved by partnering with those companies that already have a relationship with a large customer base of consumers and merchants, like Alipay."