Central banks issue the safest form of money. It enables individuals and institutions to settle any debt at no risk, with confidence and finality. The format of central bank money determines what payments can be made. As the format of assets and other economic goods changes, central bank money needs to change too. Existing central bank money formats may simply no longer be sufficient to accommodate a changing financial ecosystem Central bank money must adjust to stay future-proof.
Tokenisation is a new format to represent economic goods that uses blockchain or similar technologies to record and safekeep transactions. The recent covered bond issued directly on blockchain by French bank Société Générale shows that tokenisation of mainstream assets is coming. The announcements by U.S. bank J.P. Morgan and Facebook to issue digital coins are similar indications of the increasing importance of token-based financial ecosystems.
Tokenisation transforms the rights to an asset into a digital token that sits on a blockchain or decentralised immutable database. The tokens are quasi-bearer instruments and exchanged upon confirmation by private key in a token swap in peer-to-peer transactions. Tokens can be any fraction of the value of an asset. The trading infrastructure consists of a protocol to transfer legal rights to an asset, wallets to store tokens and a trading platform to exchange tokens.
Tokenisation promises to change existing financial relations. It alters the conditions for participating in economic transactions and offer increased efficiency and broadening access to assets. Tokenisation is set to lower the barriers of entry to financial transactions. It is not too different from securitisation but is far cheaper, more flexible and simpler.
Central banks are now considering offering tokenised central bank money. Today, there are two formats of central bank money: 1) Bank notes and coins, or cash, which serve the non-bank public to make retail payments. 2) Reserves held mostly by commercial banks to conduct large value inter-bank transactions. Together they constitute the monetary base and are liabilities of the central bank. In retail payments, tendering a bank note settles all debt instantaneously. In wholesale payments, reserves settle inter-bank transactions by adjusting the reserve balances at the central bank.
Central bank digital currency (CBDC) would constitute simply another liability of the central bank, fully fungible with cash or reserves. The innovation with CBDC does not rest on it being digital money but it being tokenised money. Its issuance would be controlled by the central bank. CBDC constitutes central bank money in token format to service as a settlement medium in token-based financial ecosystems.
Financial market infrastructures should offer settlement in central bank money. The lack of CBDC puts token-based financial market infrastructures at a competitive disadvantage to other payment systems. CBDC would also support and encourage participation in token-based ecosystems.
Several central banks including the Bank of Japan, Bank of Canada, European Central Bank, and Monetary Authority of Singapore conducted projects to test the underlying blockchain technology and most have been successful. Many apprehensions have been addressed regarding privacy, scalability and performance. For many financial and finance-related applications, the technology is not a binding constraint.
The apprehension to offer CBDC is due to concerns regarding the impact on financial stability and conduct of monetary policy. Central banks are concerned that CBDC makes central bank money far more attractive than it is today, driving the non-bank public to hold more of it which would undermine the commercial bank deposit base forcing commercial banks to seek other sources of funding. The assumption that central bank money will crowd out bank money remains speculative. The impact of CBDC on monetary policy will depend on the design of CBDC but is generally considered benign.
Central banks have a historical opportunity to set new standards for digital currencies and be catalysts for token-based financial ecosystems. Technology is reshaping the financial system. It is unlikely central bank money can resist those changes. Central banks therefore need to adopt a proactive stance to ensure they remain in the driver’s seat for shaping the future of money.
To learn more about central bank digital currencies, please see our report: (R)Evolution of Money II