In response to continued innovation in money and payments, central banks are investigating the creation of central bank digital currencies (CBDCs). This would be a new category of central bank money that would complement existing central bank reserves and currency in circulation.
But how ready are traditional institutions to implement CBDCs, and how will the financial services industry respond to the challenges and consequences of tokenization more broadly? In this post, we explore the technology, discuss the latest thinking from the industry, and share our insights as an innovator and digital finance expert.
In this article:
1. Tokenization has come to traditional banking
2. Programmability is a driving force
3. CBDCs haven’t convinced everyone
4. Interoperability is the elephant in the room
1. Tokenization has come to traditional banking
This year’s Digital Euro Conference represented a milestone on the road to digital cash in Europe. IntellectEU joined over 800 industry participants to discuss recent trends and advances in the world of tokenization, digital assets, and digital money. The event followed the October 2023 decision from the Governing Council of the European Central Bank (ECB) to transition the Digital Euro project from an investigation phase to its two-year preparation phase.
The probable timeframe for practical implementation of a CBDC is by 2027, but the economy will feel the ripples of this project long before that. As industry and regulatory events suggest, institutions are getting serious about tokenization.
Tokenization is the creation of digital representations of assets on a shared or distributed ledger. From a technical perspective, this typically involves blockchain technology.
Bank-maintained digital currencies could bring the same benefits as public cryptocurrencies, but with the advantages of stability, stewardship, and free use for citizens. Their introduction would also align cash with the increasingly digital nature of the economy. Digital integration, therefore, is a significant motivator behind such initiatives. There could also be other advantages, including security, efficiency, and financial inclusion.
That being said, from a regulatory perspective, it is important that CBDCs, and all digital assets, confer the same benefits to bearers as their traditional counterparts. Blockchain is virtually essential if we are to ensure all life-cycle events are modeled appropriately, but it also presents additional questions about what should be held on- and off-chain, which technologies should be used, and how such infrastructure will be managed.
2. Programmability is a driving force
Programmability is a powerful driver for the introduction of tokenized assets and digital money. A programmable CBDC could cover all the cash movements triggered by different securities lifecycle events in an automated way. This could include anything from coupon and dividend payments to asset issuance and redemption processes.
Through programmability features, coupon and dividend payments could become more streamlined, automated, and transparent. Bond issuers could significantly reduce administrative costs and the time involved in managing coupon payments as a result. This efficiency gain would also provide a more seamless experience for investors.
Similarly, programmability could be used to automate processes for asset issuance and redemption, ensuring automatic execution when predefined conditions are met. This would reduce the need for intermediaries, lower transaction costs, and lead potentially to instant settlement. In this way, a programmable CBDC could enhance liquidity and accessibility for investors.
The ECB is already testing three potential options for a wholesale CBDC:
"The trials and experiments will be conducted with three Eurosystem solutions enabling wholesale financial transactions recorded on distributed ledger technology platforms to be settled in central bank money in the T2 real-time gross settlement system operated by the Eurosystem."
In December, the ECB invited financial market stakeholders looking to participate in the planned exploration of these technologies to formally express interest. Moving forward, participants will take part in trials with central bank money settlement and mock settlement in a test environment.
3. CBDCs haven’t convinced everyone
One of the emerging concerns is how CBDCs will interact with each other, as they may be living in different systems, distributed ledger technology or otherwise. Addressing this concern is critical to ensuring these solutions are widely adopted.
Privacy is another critical issue, not only for regulators but also for users of tokenized money. Users want to keep their transactions private, just as they do with cash. The Digital Euro project is even proposing an off-line payment method, potentially using QR-Codes or NFC technology, to ensure that it can be transferred even without internet connection, similarly as cash can be today.
The Digital Euro project still requires more analysis, as there are areas of society that still do not believe it will bring added value compared to the current system. As such, retail banks will play a very important role in its acceptance, particularly as they may see a run on their deposits towards the central bank as a consequence. This possibility is widely understood by the whole community, which is why the ECB has agreed that banks will be able to set limits on their clients' ownership of Digital Euros.
4. Interoperability is the elephant in the room
Money by definition must be freely exchangeable. As such, there is no point in issuing a financial product on a siloed network. Interoperability between the different CBDCs across countries is, therefore, one challenge in need of attention: if digital currencies are not interoperable with each other, they will never bring the benefits they advertise.
In our conversations with industry players, we see financial market infrastructures and financial institutions finally looking closely at interoperability. This is great news, indicating they understand the future is going to be multi-chain. But it is important to acknowledge that that does not simply mean every bank will have its own chain, but rather that even within a single bank there could be several chains in use.
What IntellectEU is looking at with our clients is how we can build all of the necessary bridges to make sure that these various networks can speak to each other, mirroring how traditional banking systems communicate, back-office systems with risk systems, accounting systems, and so on.
Notably, without on-chain cash, we will still need to use traditional payment rails, so it is also essential that these new systems can communicate with them, as well.
In recent months our teams have been exploring these ideas through a delivery-versus-payment use case built using Polygon CDK, a mock wholesale CBDC, and Canton, the protocol that recently demonstrated a comprehensive pilot of tokenized real-world asset settlement.
Our solution makes use of Catalyst Operating System (CatOS), a proprietary suite of software products that simultaneously tackles both the blockchain infrastructure management requirements and the integration needed to connect these different systems. This enables on-chain transfers of assets with real-world cash settlement finality.
We’re excited about the potential of this architecture to enable a range of other new market infrastructures beyond CBDCs, from crypto to tokenized securities, alternative asset classes, and sustainability instruments.
To discuss CatOS or any ideas covered in this article, please get in touch.
