Fintech Chain Mail: how to de-risk financial systems through the adoption of central bank digital currencies
For the third edition of Fintech Chain Mail, our MBA team met with Mike Gault and Luukas Ilves, CEO and Head of Strategy at Guardtime respectively. Guardtime specializes in building zero-trust systems which increase the reliability of data and information.
How would you describe Central Bank Digital Currencies (CBDCs) and what is their status today?
CBDCs are the digital equivalent of physical cash as they also represent a claim on Central Banks. Unlike digital wallets such as PayPal, CBDCs offer anonymity benefits and will not rely on private sector-run e-payment systems.
CBDCs are at an experimental stage and we are probably years from a full adoption. Apart from China, which we will discuss later, CBDCs might be initially introduced at two extremes. On one end are economies with low cash usage and wide adoption of digitized payments. Estonia is one strong prospect, especially given its robust digital ID infrastructure which already supports the banking sector with functions like authentication and payment authorization.
On the other end are developing economies, which could potentially leapfrog several generations of technology. Zimbabwe is in this category, especially given its prolonged currency crisis, where cost and trust issues related to managing traditional cash can be mitigated. Countries like France and Germany, with weak digitization and with stronger trust in the existing financial system, may have less consumer pressure to adopt CBDC – though we are happy to be proved wrong! Also, the U.S. might lag Europe due to potential impacts of digital currencies on the U.S. Dollar’s reserve currency status.
What benefits could CBDCs bring to governments and economies?
One potential major benefit to Central Banks of adopting CBDCs is a de-risking of the financial system, as authorities could take the role of monitoring the flow of funds (in this case CBDCs) away from banks. Adopting CBDCs in place of current electronic wallets also reduces risk of reliance on externally managed payment systems. In addition, governments could gain better control over economic outcomes using monetary policies.
For financial inclusion, the existing system is constrained by banks’ unwillingness to bear costs of serving those at the bottom of the economic pyramid. This provided opportunities for other financial players to drive inclusion without the need for traditional banking touch points (e.g. M-Pesa in Kenya). CBDCs can similarly support inclusion in such low-margin segments where banks choose not to play.
In many developing countries, Central Banks are keen on maintaining transparency in order to gain access to global systems. This makes the oversight benefits of CBDCs more appealing, although there may be internal resistance from those who currently benefit from an opaque financial system.
How might CBDCs disrupt financial systems and existing decentralised cryptocurrencies?
One worry that gets brought up is that Central Banks should be cautious in introducing CBDCs, in order to protect the financial sector and broader economy from the potential outflow of deposits from banks. Like cash, CBDCs would be effectively backed by government and are therefore risk-free. Unlike bank deposits, which carry risks linked to banks’ health, CBDCs will be directly domiciled with Central Banks, which could lead to a sharp outflow of deposits from banks.
That said, banks will continue to play a role in credit supply for some time to come, as many alternative credit institutions currently lack scalability and retail expertise. Changing regulations could also redefine what banks are and what activities banking licenses permit. That is not to say all banks will suffer, as many could transition successfully along with CBDCs or ahead of the sector. However, combining regulation with various emerging Fintech Innovations, the sort of monopoly rents that banks enjoy in some countries today are unlikely to remain sustainable.
Since CBDCs are a different kind of asset than decentralised cryptocurrency (e.g. Bitcoin, Ethereum), they should not act as replacement. This means cryptos pose the same threats to CBDCs as they do to cash, as they are also backed by governments. Any concerns around the credibility of governments will similarly affect sentiment towards CBDCs and will continue to make cryptos attractive to those who do not want to rely on governments (and to actors in the shadow economy).
China seems to have an advanced project running similar to a CBDC – is there a global play for the Chinese digital currency?
China is testing its DC/EP (Digital Currency/Electronic Payments) Project in about five cities, which is ahead of Europe and the U.S. China’s approach seems to involve setting up a government-owned alternative to WeChat Pay and Alipay, as the power these private institutions have gathered is considered a potential threat to the Republic. Unlike in Europe, the Chinese state can exert enormous influence on the private sector to drive this.
Currently, the Chinese digital currency only operates domestically, with no finalized framework around its convertibility. But we could imagine a global play, where China either offers to set up domestic CBDCs in other countries – or to run a country’s currency on China’s infrastructure – putting China in a strong global position.
How is Guardtime positioned as a company to benefit from developments in CBDCs?
At Guardtime, we see blockchain as a tool that supports secure processes and applications. We believe security is fundamental to technology design and always integrate strong cryptographic probability into our solutions. This makes our technology ideal for CBDCs, which require transparent and traceable records for every asset and transaction.
No single payment infrastructure supporting traditional cash today can handle the volumes currently flowing through large economies, whereas the technology being considered for CBDCs can. Guardtime specializes in this technology, which could provide retail payment rails that are sufficiently scalable to handle all transactions today and in the future.
Guardtime is used to working with sovereign entities that make digital infrastructure investments for the long term. They must accommodate two decades of Moore’s law and survive cyber-attacks that emerge up to 20 years in the future. CBDC will be that kind of infrastructure, and we are confident we will be a strong player in this space.
Interview conducted by Matteo Conti, Olabisi Ayodeji, Stephanie Hurry, Emon Goswami, Haichen Liu