This is Part 2 of 2 blogs on what Innovation looks like in the context of Central Banks, specially those in Emerging Markets.
- Innovation & Central Bank Use Cases
- Innovation & Central Bank Policy
Innovation & Central Bank Use Cases
Over the last 10 years we’ve seen the innovation boom in the financial services industry. From Digital Payments, Finance Management to Cross Border Remittance, fintechs have transformed consumer banking. Yet, the Economist notes the average cost of cross border payments is forecasted to increase from the global average of 7% as of 2018.
1. A Distributed Settlement Network
Distributed Ledger Technology (DLT) is being tested to allow financial institutions to engage through a peer to peer network model, compared to the currently siloed systems/processes and the multi layer structure that exists today between those systems. That structure relies on many redundant and outdated activities that complicate the overall process of moving money domestically, let alone cross border.
With this peer to peer model, banks, non banks and the central bank communicate via a common network to effectively manage settlement and liquidity risks. Settlement finality is uniquely achieved with central bank integration. From there, each central bank can decide on wholesale and retail partitions according to their policies.
In addition to the peer to peer networking obtained here, the standardization of the communication will streamline the activities on the network. This makes treasury management, account validations and compliance more trusted, faster and cheaper.
The network model is the foundation to the “Embedded (Trusted) Governance” design mentioned in Part 1 and can bring to life a well integrated payment network for Banks, Corporates, MSMEs and Citizens.
2. Basic Financial Inclusion
Speaking of MSMEs (micro, small, medium enterprises) and citizens, according to a 2019 report from Official Monetary & Financial Institute Forum (OMFIF) and IBM “Retail CBDCs: The Next Payment Frontier”
“…the unbanked are unable to provide the proof of identity required to open a bank account. While an account-based CBDC would probably require unchanged levels of identity control, a token- based version would presumably be easier to access and could thus be a way of facilitating access to payments services.”
The tokenization of the sovereign currencies can make it efficient for Central Banks to support “basic digital wallets” for all unbanked or “un-bankable” citizen.
Those wallets are already built for mobile phones and can be widely accessible in remote areas.
However, given how much cash is still broadly used, let’s refer to “The taxonomies of new forms of currency” from the BIS which shows the overlap between traditional cash and cryptos and CBDCs.
Worth noting is by their nature, cryptocurrencies lack the “guarantee” that sovereign currencies broadly provide. Institutional strength aside, the notion of being a legal tender and is accepted to be a liability to a trusted entity, provides a level of guarantee that’s not found in purely decentralized models. That’s why Libra had to include Central Bank Reserves in their model. I talk about this here.
For risk management, automated restrictions on various wallets that have little-to-no KYC can limit the risk of AML, while providing basic user functions (i.e. no cross border payments, or limit on amount). Those wallets could be attached to National Identification and Biometrics Authentication solutions for individuals to have access to more financial services as they enter the formal economy.
Another way to think of this: although some sovereign currencies might be very illiquid in international markets, but to the farmer in Nigeria or Haiti, the Naira or Haitian Dollar in her mobile account is as good as it gets. She can buy food and pay for services. The only thing better is a USD, Renminbi or Euro, and then maybe a Bitcoin. That’s mostly because of the guarantee provided by a legal tender.
We’re betting the future of payments infrastructure includes cryptos, stable coins and CBDCs. Given their various risk profiles, they’ll play different roles in the overall ecosystem of financial instrument.
Innovation & Central bank Policy alignment
The technical capabilities stated thus far are, however, ineffective if there is no regulatory framework that defines them.
In fact, assuming those benefits are worth achieving, the policy and regulatory frameworks must be well integrated in the technical design process in order to be relevant and aligned. In the quest to not be disrupted by “Big Tech”, Central Banks must consider also adopting technology as a new tool to be an effective regulator of the financial markets. Doing so requires investment, commitment to internal innovation, competitive financial markets and trusted governance.
They must therefore:
- Establish clear governing rules that promote innovation while ensuring a sound financial market.
- Provide tools to support compliance and launch of new fintech solutions (Sandbox)
- Harmonize Policy + Technology + Legal Frameworks.
To be relevant, this work must be done with understanding of the local markets and feed requirements for the design and build phases.