Outreach Blog

Friday, February 11, 2022

How Would Cross-Border Payments Change in a Digital Currency World?

World Bank, BIS and SWIFT weigh in on CBDCs


Author: David Schwartz J.D. CPA

 

Widespread adoption of central bank digital currencies (CBDC) could revolutionize cross-border payments by reducing friction and making it possible for T+1 or even T+0 settlement of cross-border trades. The Fed’s Digital Currency discussion paper is the central bank’s first step in a public discussion with stakeholders about a digital dollar, as we described in our January 25 post. But what would such a cross-border payment system look like? Is it enough to mimic the traditional systems of SWIFT, DTCC, and others? Or does the unprecedented interoperability and technology of CBDCs force obsolesce on the current systems? 

With some countries, most notably China, having already adopted digital versions of their national currencies and many more sovereignties in catch-up mode, the Bank for International Settlements (BIS) and the World Bank have started envisioning what cross-border transactions would look like in a CBDC world. They theorize potential CBDC systems for cross-border payments could take several forms. Each of these could reduce many aspects of the friction and inefficiencies inherent in current cross-border payment systems through fewer intermediaries, better integration and technical compatibility, and mitigation of cross-border and cross-currency risks.1

 

What are the Cross-border CBDC Models Being Considered?

 

In a pair of reports2, the World Bank and BIS jointly posit three different models for integrating CBDCs into cross-border payment systems. 

 
  • Compatible CBDC Systems Model - Setting common international standards would permit the interoperability of separate CBDC systems.3 This model resembles traditional cross-border payment arrangements. Common technical standards, such as message formats, cryptographic techniques, data requirements, and user interfaces can reduce the operational burden on financial institutions for participating in multiple systems. 

Source: Report To The G20: Central Bank Digital Currencies For Cross-Border Payments

 

  • Interlinked CBDC Systems Model - A shared technical interface, supported by contractual agreements between the systems, allows participants – either retail or wholesale – in one system to make payments to those in another. A common clearing mechanism takes a different approach by linking systems through designated settlement accounts.

Source: Report To The G20: Central Bank Digital Currencies For Cross-Border Payments

 

  • Single system for multi-central bank digital currency multi-CBDC -  This model posits a single CBDC system across jurisdictions. The concept builds on having a single set of rules, a single technical system, and a single set of participants. It implies cooperation of a higher magnitude among central banks. This deeper integration allows for potentially more operational functionality and efficiency but increases the governance and control hurdles.

Source: Report To The G20: Central Bank Digital Currencies For Cross-Border Payments

 
 
Each of these models has its own strengths and weaknesses. But all of them rely on strong interoperability, which could, in turn, introduce a whole host of security, privacy, and anti-money-laundering challenges. These challenges are not new or insurmountable, just different, according to Thomas Zschach, SWIFT’s Chief Innovation Officer, 
 
“Making payments infrastructure based on CBDCs efficient and interoperable with the broader economy presents some new challenges, but the majority are the same as those faced by existing payment solutions.”4
 
The overarching difficulty, however, lies in adapting existing practices and payment mechanics to digital currency technologies, and vice versa. 
 
 
Who Is Testing these Models? Is there a Proof of Concept?
 
 
Project Helvetia at the Bank for International Settlements
 

The Bank for International Settlements’ (BIS) Innovation Hub has already launched a two-part proof of concept of the use of a wholesale central bank digital currency5 called, “Project Helvetia.”   The experiment was intended to investigate ̈experiment investigates how the provision of central bank money for wholesale settlement might be adapted if distributed ledger technology (DLT) and tokenization are adopted by financial markets." According to BIS: 

 
“Project Helvetia investigates how central bank money can be used for settlement in a world where securities and other financial assets migrate from today’s centralised financial market infrastructures to new so-called decentralised or tokenised platforms for trading and post-trading activities. One proof of concept relies on wholesale central bank digital currency (w-CBDC) whereas another is based on a link to the existing central bank system for wholesale payments.” 

 

  • Phase I built on the test environments of the Swiss real-time gross settlement system – SIX Interbank Clearing (SIC) system6 –  and SIX Digital Exchange (SDX), a platform for the trading and settlement of tokenized assets, assets that exist on a DLT platform, settled with a privately issued digital coin.
     

  • Phase II expanded on the work carried out in Phase I by (i) adding commercial banks to the experiment; and (ii) integrating wholesale central bank digital currency (wCBDC) into the core banking systems of the central bank and commercial banks. It demonstrated that a wholesale central bank digital currency (w-CBDC) can be integrated with existing core banking systems and processes of commercial and central banks. Furthermore, it showed that issuing a wCBDC on a DLT platform operated and owned by a private sector company is feasible under Swiss law.7

Source: https://www.bis.org/publ/othp45.pdf

 

Phase I of Project Helvetia, concluded in December 2020, demonstrated the functional feasibility and legal robustness of settling tokenized assets with a wholesale central bank digital currency and with linking a DLT platform to the existing central bank payment system. Phase II tested the integration of wholesale CBDC settlement with the core banking systems of five commercial banks. Among its findings, Phase II, completed in January 2022, concluded that cross-border transactions employing CBDCs could be made in a few seconds, instead of the three to five days necessary using the current system.8 

 

The speed was achieved by eliminating some of the frictions of the current system, including the mechanics of currency exchange, variations in different technological infrastructure, timezone complications, and coordination problems among intermediaries, including correspondent banks and nonbank financial service providers.

 

Project Jura at Bank of France and Swiss National Bank

 

Project Jura, a joint project of the BIS Innovation Hub, the Bank of France, the Swiss National Bank, and a private sector consortium9, continued the work of Helvetia and explored the settlement of tokenized euro commercial paper and foreign exchange transactions. Tests run and concluded in December 2021 were conducted in a sandboxed, near real-life setting. Jura studied a new approach for central banks to allow access to CBDC’s for Swiss-regulated non-resident financial institutions.10

 

According to BIS, Project Jura was intended to test as-yet unexplored aspects of cross-border CBDC mechanics: 

 

“Issuing wholesale CBDCs on a third-party platform and giving regulated non-resident financial institutions direct access to central bank money raises intricate policy issues. Jura explored a new approach including subnetworks and dual-notary signing, which may give central banks comfort to issue wholesale CBDCs on third-party platforms and to provide regulated non-resident financial institutions with access to wholesale CBDCs.”

 

Other Cross-border Studies


The BIS Innovation Hub is participating in two other trials exploring the use of a wholesale CBDC for cross-border payments, referred to as a multi-CBDC (mCBDC). One is mCBDC Bridge, a project between the central banks of Thailand, Hong Kong, China, and the UAE.  Another is Project Dunbar, in which the Monetary Authority of Singapore is trialing a single DLT solution where banks can use multiple CBDCs for cross-border payments.

 

Conclusion

The frontier of cross-border CBDC transactions lies before us. The results of various projects spearheaded by BIS, central banks, and national monetary authorities demonstrate that a faster, more efficient, and less costly cross-border payment system is possible. As Sopnendu Mohanty of the Monetary Authority of Singapore (MAS) said,

“That’s where the beauty of a wholesale (CBDC) currency plus a DLT based shared ledger could make a big difference, . . . collectively bring[ing] down the 3% cost to a sub dollar cost for transfers and hence encourage financial inclusion.”

 


1 Bank for International Settlements, “Report To The G20: Central Bank Digital Currencies For Cross-Border Payments,” July 2021

2 World Bank Group, "Central Bank Digital Currencies for Cross-border Payments: A Review of Current Experiments and Ideas," Nov. 2021; Bank for International Settlements, “Report To The G20: Central Bank Digital Currencies For Cross-Border Payments,” July 2021,

3 SWIFT’s ISO 20022 is an emerging global open standard for payments messaging that could be adapted to accommodate the eventual widespread adoption of CBDC’s for cross-border payments. https://www.swift.com/standards/iso-20022

4 https://www.swift.com/news-events/news/exploring-central-bank-digital-currencies-swift-and-accenture-publish-joint-paper 

5 Wholesale CBDCs are for use by regulated financial institutions, in contrast to retail CBDCś that would be used by the public. https://www.bis.org/publ/arpdf/ar2021e3.htm 

6 RealTime Gross Settlement (RTGS) is a system where there is the continuous and real-time settlement of fund-transfers, individually on a transaction by transaction basis (without netting). 'Real Time' means the processing of instructions at the time they are received. Because the funds settlement takes place in the books of a nation’s central bank, the payments are final and irrevocable. https://www.bankofengland.co.uk/-/media/boe/files/payments/rtgs-chaps-brief-intro.pdf

7 https://www.bis.org/about/bisih/topics/cbdc/helvetia.htm 

8 https://www.snb.ch/en/mmr/reference/project_helvetia_phase_II_report/source/project_helvetia_phase_II_report.en.pdf

9 Accenture, Credit Suisse, Natixis, R3, SIX Digital Exchange, and UBS

10 https://www.bis.org/press/p211208.htm 

 

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The CSFME’s Regulatory Outreach Programs

Regulatory reform has become a collaborative process. Where once market supervisors promulgated rules without regard for input from practitioners, today’s reform process has evolved into a dialogue of mutual respect for the opinions of all stakeholders in the capital markets. The process of regulatory outreach has become embodied in virtually every developed markets in the world.

The CSFME has adopted a role of facilitating this collaborative dialogue at all stages of the professional contribution process. Starting with students’ contributions to published commentary letters, through panel presentation and webinars, right up to trade association initiatives, the CSFME provides assistance through education, data compilation, analysis and commentary for some of the most pressing issues in contemporary markets.

DLT and Preferred Securities Financing

We believe the widespread use of encrypted third-party ledgers, blockchains, and smart contracts (i.e., DLT) is inevitable in securities finance, and that those technologies will permit lending agents to offer new revenue opportunities to their clients. Among these, we believe that certain agents will use DLT to help their lenders expand their loan books by opening their lendable portfolios on a preferential basis to the hedge funds in which they've already invested, as well as to other trusted counterparties, a concept we have dubbed, “Preferred Securities Financing.”  

CSFME is openly soliciting participation in a research initiative to assess the potential benefits to securities lenders from the use of DLT and data sourced from new regulatory disclosures. Specifically, our research will focus on how DLT, blockchain, and smart contracts can facilitate Preferred Securities Financing.  Learn More about our DLT Securities Finance Initiative

Research and Analysis of the Effects of Financial Regulatory Reforms

Given the sweeping changes in financial market regulation following the financial crisis, CSFME has turned its focus to questions relating to to how these changes are affecting the risks and economics of bank activities. The purpose of the Center’s research in this area is to foster sound policymaking and effective regulation with minimal adverse and unintended consequences. CSFME studies supervision and regulation of global financial institutions, the effects of reregulation on the global financial industry, optimal roles and methods of regulation in securities markets, corporate governance at financial institutions, and the most effective metrics and methods of data collection for understanding and measuring the effects of regulations on the global financial landscape. 

Lately, in response to a call from the FDIC for research on financial sector policy and regulation, the Center submitted a paper modeling the indirect costs to markets of bank regulatory reform.  The paper critiques regulators’ models for assessing these costs, and provides empirically-based suggestions for a more complete dynamic model of the long-term effect of bank capital reform.  Mindful of the Basel Committee's ongoing reviews of modeling tools, i.e., May 2012 and March 2016, the Center's critique is intended as a constructive addition to the holistic conceptual base of the regulatory reforms.

The Center also continues to provide input on regulatory proposals.

In March of 2016, CSFME submitted a comment letter to the Bank for International Settlement's (BIS) December 2015 consultative document regarding step in risk.  While supporting generally the goals of the Basel Committee to minimize the potential systemic implications resulting from situations where banks may choose to provide financial support during periods of financial stress to entities beyond or in the absence of any contractual obligations, the Center expressed some concerns and offered some suggestions regarding the approach taken by the Consultation. Drawing on practical experience, the Center offered an example from the trade finance sector supporting its belief that the nature of step-in risk may be one example of an acceptable, non-diversifiable exposure, given the potential positives for the economy at large.

In February 2015, CSFME submitted a comment letter in response to the Financial Stability Board’s November 2014 consultative document, Standards and Processes for Global Securities Financing Data Collection and Aggregation. In its letter, the Center identified additional metrics that may be necessary to assess properly the risk of collateral fire sales associated with securities lending transactions.  In particular, CSFME asserted that FSB and sovereign regulators must expand the data initiative beyond position aggregates, to include risk mitigation resources as well as termination activity.

Students Learn to Evaluate and Contribute to the Reform Process

As the level of intensity surrounding the reform process continued to build in 2013, the CSFME began to bring a fresh perspective to the reform process. By working with finance students and the US regulatory agencies, CSFME hoped to challenge the settled views of stakeholder by introducing the views of those whose careers would be shaped by the outcome of the reforms.

In the spring of 2013, a select group of Fordham University economics students met in Washington with officials at the U.S. Treasury, Office of Management and Budget, Federal Reserve Board, and the Securities and Exchange Commission. The CSFME helped arrange the meetings and funded the logistics. By all accounts, the experience was very positive for students and regulators alike.

Buidling upon the success of the 2013 pilot program, in 2014, both Fordham and the CSFME decided to expand the outreach program and formalized the Regulatory Outreach for Student Education program as the ROSE program. Honor students in finance and economics were selected by the deans of four schools within the university: the Graduate School of Business Administration, Fordham College at Lincoln Center, the Gabelli School of Business, and Fordham College at Rose Hill. The students were organized into four teams representing their schools. The CSFME selected a contemporary issue of career significance, the Financial Stability Board’s Consultative Document on G-SIFI designation of non-bank, non-insurer financial institutions. Each team was charged with studying the issues in debate, then presenting their opinions in the manner of a formal comment letter to the FSB. Over four months, the students reviewed earlier opinion pieces, met with practitioners and regulators, and then submitted their opinions. Without influencing their opinions, the CSFME arranged access to research materials and opinion leaders, then reviewed their letters and, as appropriate, recommended submission on university letterhead. In April, 2014, the four teams’ letters were published by the FSB on its website. In recent memory, no university had ever had one letter, much less four, published on a regulatory website. To finalize the 2014 ROSE program, the CSFME arranged for all four teams to present their opinions to the key regulators at the Federal Reserve Board and the SEC in Washington, D.C. The day of meetings ended with regulators’ praise at the degree to which the students had understood the issues and presented their opinions clearly.

One student team even offered suggestions that regulators had not previously considered and praised for their creativity. “We always know what the trade groups will say, but you brought a fresh perspective.” That team, Fordham College at Lincoln Center, was awarded the 2014 ROSE Award for Analytic Excellence. In retrospect. each student completed the program with a credit that will not only endure on their resumes but also contribute to the evolution of the financial markets through the Twenty First Century.

In 2015 and 2016, Fordham formalized the ROSE Program as a for-credit course in their curriculum. The focus of the 2016 ROSE Program was the Bank for International Settlement's December 2015 consultative document proposing a preliminary framework for identifying, assessing and addressing step-in risk potentially embedded in banks' relationships with shadow banking entities.  Five teams of graduate and undergraduate students in economics, finance, accounting, management, and law researched and drafted comment letters on the consultation and submitted their letters to a panel of distinguished industry judges.  After reviewing each excellent submission, the judges then one winning letter to be presented at a visit to the Federal Reserve Bank on April 27, 2016. The winning team's letter was submitted in full to the BIS, along with a summary of the key ideas from the letters from each of the other four teams, and the submission was published on the organization's website with those of the consultation's other commenters.   All five teams of Fordham Scholars visited Washington, DC on April 27, 2016 and met with officials at the Fed, Treasury Department, and FINRA.  

Institutional Securities Lenders respond to Academic Criticisms

In 2006 the Center was created, initially for the purpose of testing academic criticisms of the securities lending markets. With funding and data support from the Risk Management Association, CSFME found “no strong evidence to conclude that securities lending programs have been used to any great extent to manipulate proxy votes or exercise undue influence on Corporate Governance issues.” Our study also found that “broker borrowbacks” had contributed to spikes in lending activity around record date – the same phenomenon that the academics had misinterpreted as evidence of hedge fund manipulation – due to the efforts of brokers to meet recall notices from securities lenders. In effect, the brokers were scrambling to acquire votes for their customers, not building positions to swing corporate elections. The academics had fatally misinterpreted their findings!

Ed Blount of CSFME testified at the SEC’s Roundtable on the results of the research in September, 2009. Then, the CSFME white paper, published in 2010, was submitted to the SEC as an attachment in response to a consultative document on the “Proxy Plumbing” process. As a result of the Center’s contribution to the collaborative process, the misguided call for reform of securities lending began to subside. Once again, securities borrowers were fairly recognized to be honest brokers in the corporate governance arena.

Securities Lenders consider new means to retain their Voting Rights

In a follow-up to the Empty Voting project (“Borrowed Proxy Abuse” as it came to be known), the CSFME responded in 2011 to requests by the participating securities lenders, by turning its attention to ways in which those lenders might be able to retain their corporate governance rights, while still benefiting from the income attributable to their securities loans. After all, as many studies have found, securities lending contributes significantly to the efficiency of market operations. Why should lenders be forced to choose between their loan fees and fiduciary duties to vote their shares, especially if they are contributing to market efficiency?? With independent funding, the CSFME retained attorneys from two prestigious Washington D.C. law firms, Stradley Ronon and Sidley Austin, to investigate the legal underpinnings to market practices which force pensions, mutual funds, insurers and other institutional securities lenders to give up their voting rights when they lend portfolio securities. In practice, margin customers of brokers also lend their securities, yet they usually retain voting rights -- and most of them aren’t even long-term beneficial owners. Both groups of beneficial owners retain dividend rights, so why, institutional investors asked, shouldn’t institutions also keep their voting rights? With the benefit of exhaustive legal research, CSFME filed a petition with the Securities & Exchange Commission to initiate a pilot program to test new market procedures by which recently-introduced efficiencies in market operations might permit lender to retain votes.  Learn more about Paradoxical Erosion of Corporate Governance

In 2013, the SEC approved that pilot program, largely in response to the encouraging recommendations of the International Corporate Governance Association, as well as the California State Teachers Retirement System and the Florida State Board of Administration.

That pilot was initiated in 2014. Simultaneously, the CSFME began to apply the results to new initiatives in Canada and Switzerland, where the pressure to meet fiduciary voting obligations was intensifying.  More about Full Entitlement Voting



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