The Future Of Banking: Central Bank Digital Currencies In Asia-Pacific–Pathways Are Plenty, Destination Is Uncertain
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Could central bank digital currencies (CBDCs) revolutionize, modernize, and democratize the future of banking? Maybe, but the road to revolution will be winding. S&P Global Ratings expects most central banks, including those in Asia-Pacific, will start cautiously, should they decide to offer central bank digital payment options. We don’t believe monetary authorities will rush into pathways that drive banks off-road.
In our view, central banks will likely lean toward a model where banks and other financial intermediaries continue to play a strong intermediation role, rather than one managed by the central banks themselves. Depending on the direction that public authorities take, however, and the direction which the technology allows, CBDCs could have a profound effect on banks’ business models. While too early to tell, their evolution may yet change our view of competitive dynamics on the banking landscape or our view of individual banks’ business positions or other rating factors.
China is leading from the front. The country already began pilot trials for its retail CBDC in 2020, and is better-progressed compared with other jurisdictions in Asia-Pacific. Just last month, the People’s Bank of China (PBOC) outlawed all crypto-related activities. In part, we believe this measure to thwart cryptocurrencies is likely to facilitate a smoother pathway for the proposed launch of the digital renminbi in China. We don’t see signs yet that other major central banks in the region will follow this move which, in China’s case, was preceded by a number of public warnings against digital tokens.
In this evolving phase, the future credit impact on Asia-Pacific banks seems to hinge upon the design and end objective that central banks are chasing. Transition to reality for central banks is a work-in-progress. Some tough choices are on the cards for central banks as models evolve.
CBDC Models Face Diverse Driving Forces
The underlying architecture or design of CBDCs will depend mainly on the function that central banks aim to achieve. Outside of Asia-Pacific, for example, Sweden observed a persistent decline in use of banknotes and coins and increases in digital forms of payments. By way of response, the Swedish central bank aims to offer e-krona to the general public since many households and companies have begun to no longer accept cash as a means of payment
In Asia-Pacific developed markets, approaches are diverse and well-progressed. In tech-hub Singapore, the monetary authority recently concluded its five-year digital currency project. Collaborations abound elsewhere including in separate multi-country projects in Japan and Hong Kong, and in Australia, where the central bank is partnering with two major Australian banks and the U.S. developer of the Ethereum blockchain.
In many emerging market banking sectors in Asia-Pacific, cash in circulation continues to be high despite the rise in digital payments. This is due in part to these markets, including China and India, housing a large chunk of the world’s underbanked population. We believe central banks in the region’s emerging markets may tend toward a model that assists in providing inclusive access to the underbanked or unbanked population. The model and technology employed will also need to consider hindrances, however, such as low internet and mobile phone penetration and potential power outages. This could pose challenges for expansion, especially in rural areas.
As CBDCs evolve, we believe access to these digital instruments will most likely be via big banks in the main, both in developed and emerging markets across Asia-Pacific. This is because big banks can best afford development costs, and to various extents may participate and collaborate with public authorities and other parties in the development process.
In jurisdictions where existing payments infrastructure is already at advanced stages, central banks may be more likely to explore models that could seamlessly integrate with, and complement the existing infrastructures. Many banking systems are collaborating regionally and globally to explore models to achieve faster and cheaper cross-border payments.
CBDCs could strengthen public authorities control over fiscal policy, for example by making benefits payments direct to end-users allowing more precise benefit allocations, and by facilitating closer oversight compared with cash. Our current view is that CBDCs would not, for the foreseeable future, be likely to replace cash, but would act as an additional tool for its provision to the public. The extent to which stronger control over fiscal policy may be beneficial to the economy is unclear, noting that commercial banks are the long-established intermediaries between savers and borrowers, and between public authorities and benefit-recipients. Ultimately, weaker banks would likely be unhelpful for the economy.
Banks Will Likely Remain Integral To Financial Services
A widespread adoption of CBDCs has the potential to change the dynamics for the future of banking. The risk of banks being disintermediated in the next one to two years seems unlikely. Because CBDCs are currency, and assuming they will not pay interest, their influence on bank deposits may be limited, under normal circumstances. The impact may be more pronounced on low-cost transactional deposits, and also in the current ultra-low interest rates environment where returns for savers is low.
We believe the choice of design for CBDCs will be heavily influenced by the paramount objective of keeping financial stability. Central banks will ultimately want to avoid significant disruption, and avoid unintended consequences.
While a less-likely possibility at this stage, we believe that an all-out disintermediated CBDC model has the most potential to negatively impact bank ratings. Should material disruption to deposit and funding markets occur, or meaningful changes to competitive dynamics influencing the banking landscape, then this would likely weaken the credit standing of banks and could contribute to negative rating momentum. Banks’ business positions, funding, and earnings could be disrupted, to varying degrees. Banks could lose market share, particularly less-sophisticated banks or payment firms that can’t keep up. And growth in net interest income may be stymied.
Further, we believe that even a hybrid model – or a similar “middle-of-the-road” model solution–where monies are held by central banks rather than banks themselves–could potentially be problematic for banks. The impact from CBDCs on potential government support for systemically important banks across Asia-Pacific is uncertain and too early to predict.
The Payments Industry May Face Structural Shifts
The pandemic has clearly tilted payments dynamics in favor of digital. With the introduction of CBDCs, customers may have one more choice to settle a transaction among the many that are already operational. CBDCs may threaten to squeeze the market share of existing payment service providers, and offer opportunities to those companies that can innovate and seamlessly weave CBDCs into their customer value proposition. If merchants find it cheaper to accept CBDCs as opposed to, for example, having to pay fees on credit card or payment transactions (similar to “pay cash pay less” concept), this would potentially cut fee revenue for associated card providers and processors. In China, the prospects of an “e-CNY” – being a PBOC initiative – could prove challenging for some payment-service providers companies such as Alipay and WePay.
Democratize Or Marginalize?
CBDCs are often associated with the allure of financial inclusion, if the money can reach the grassroots. To bring inclusive access into fruition, prerequisites include smartphones and the availability of high-speed internet in emerging markets, presence of a digital identity, and technological preferences. The design of the underlying CBDC architecture would need to contend with these difficulties.
The development of the underlying technological infrastructure could be costly but may bring some benefits from a public interest standpoint. On the other hand, if the infrastructure is not freely or cheaply available and participating payment service providers have to pay to get in, this could widen the gap between players within the system. Bigger players may be more likely to quickly adopt, integrate, and serve their customers with new CDBC product offerings given their bandwidth to deploy vast resources. Smaller financial intermediaries may be more challenged, or even could find themselves in a game of catch-up.
Cross-Border Payments: Can CBDCs Simplify This Complex Equation?
Cross-border payments have long been a sore point in Asia-Pacific and across the globe–slow, expensive and inefficient. CBDCs come with a promise to potentially unclog this space. However, significant and concerted efforts would be required to fulfill the promise. It is likely that important considerations regarding interoperability, unifying governance, and participation standards will need to be ironed out before tangible progress can be made. Fundamental questions linger; for example, which country’s currency would be used for payments, noting that some countries have a non-convertible currency or make a small contribution to global trade.
Projects in the region and globally are exploring the use of CBDCs in facilitating cross-border payments. For example, the “m-CBDC Bridge” has been jointly initiated by the Bank of Thailand and Hong Kong Monetary Authority (HKMA), and joined by Central Bank of the United Arab Emirates and the Digital Currency Institute of the PBOC. This initiative is exploring the use of distributed ledger technology to facilitate instantaneous cross-border payment. The design allows for on-demand foreign-exchange conversion and settlement in a payment-versus-payment manner. SWIFT, the interbank messages system covering more than 11,000 banking and securities organizations across 200 countries, is also experimenting with leveraging its platform to facilitate cross-border payments using CBDCs.
Another example is Bank of Japan (BOJ)–which has joined a group including the European Central Bank, Bank of England, Bank of Canada, the Sveriges Riksbank (Sweden), and Swiss National Bank to share experiences as they assess the potential cases for CBDC in their home jurisdiction, since 2020. The group will also assess CBDC use cases; economic, functional and technical design choices, including cross-border interoperability.
Wait-And-Watch Stage For Many, While China Gets Real
For many banking systems in the region, CBDCs are still in exploratory stage. Nonetheless, the pace of regulatory developments is evolving and should pick up pace as central bankers collaborate and closely monitor actions of front-runners such as China.
In China, while trials of its proposed digital currency started small, more than 20.87 million personal wallets and over 3.51 million corporate wallets were opened, with transaction value approximating Chinese renminbi (RMB) 34.5 billion (US$5.3 billion) as of June 30, 2021. Additional scenarios are being tested, and further trials are set for the Winter Olympics February 2022. Continued successful outcomes should see the eventual rollout of the e-CNY.
China banned private-sector crypto out of concern they could threaten financial system stability and social stability. A PBOC paper pointed to their lack of intrinsic value and price volatility, as well as their being a means for money laundering. Potential risks for the international payments system, government control of monetary policy, and cross-border capital flow are other issues PBOC cited in private sector crypto currencies.
CBDC successes or failures in countries whose development efforts are further-progressed (such as China) will be instructive for other jurisdictions exploring CBDCs. CBDC development activities can broadly be classified as retail or wholesale, with some countries engaged in both types (see chart 1). Countries are at different stages of development, which can generally be classified as:
- Research: Countries where central banks have announced interest in exploring the feasibility of CBDCs or are at preliminary stages of research.
- Proof of concept: Countries that are at a more advanced stage of development of the potential model or architecture.
- Pilot: Countries at various testing stages including but not limited to simulations in a virtual environment or conducting trials in the real environment.
Asia-Pacific Market Map –Many Jurisdictions Move Forward
The Reserve Bank of Australia (RBA) has partnered with the Commonwealth Bank of Australia, National Australia Bank, ConsenSys (U.S. developer of the Ethereum blockchain) and Perpetual to explore the potential use and implications of a wholesale CBDC using distributed ledger technology. Trials have been concluded, with the potential for a wholesale CBDC to emerge. The central bank is also monitoring the case for a retail CBDC. Recently the RBA also announced a project, in partnership with the BIS Innovation Hub, Bank Negara Malaysia, Monetary Authority of Singapore, and South African Reserve Bank, to develop a shared platform to test the use of CBDC for international settlements.
In October 2020, the National Bank of Cambodia launched Project Bakong, a payment-system infrastructure based on blockchain technology. This could be considered as a quasi-form of CBDC, noting that these aren’t central bank-backed tokens. Cambodia is a highly dollarized economy and one of the objectives for Project Bakong is to promote the use of its local currency.
The PBOC has launched pilots in the cities or special economic zones of Shenzhen, Suzhou, Xiong’an, Chengdu, Shanghai, Changsha, Xi’an, Qingdao, and Dalian, as well as in the southern resort island of Hainan. Further trials are planned, including for the February 2022 Beijing Winter Olympics. As of June 30, 2021, the e-CNY has been applied in over 1.32 million scenarios, with transaction volume totaling 70.75 million and transaction value approximating RMB34.5 billion. The PBOC is also exploring cross-border payment pilot programs with other central banks and monetary authorities.
The HKMA has been working with the Bank for International Settlements (BIS) on the Innovation Hub Hong Kong Centre on Project Aurum, which will focus on the technical aspects of issuing retail CBDCs and the possible architectural designs. The HKMA has already established an internal cross-departmental working group to study the relevant technical, policy, and legal issues, and which target to publish an initial study by June 2022. The study on “e-HKD” aims to understand its use cases, benefits, and related risks to increase technical readiness for Hong Kong to issue e-HKD.
The government formed a ministerial committee in November 2017 which recommended implementation of CBDCs. The Reserve Bank of India (RBI) is now developing a phased rollout plan and looking into use cases that could be deployed with minimal impact. The RBI is investigating the following key areas: (1) the scope of CBDCs – whether they should be used in retail or wholesale payments; (2) the underlying technology – whether it should be a distributed ledger or a centralized ledger, and whether the choice of technology should vary according to use cases; (3) the validation mechanism–whether token-based or account-based; (4) distribution architecture–whether direct issuance by the RBI or through banks; and (5), the degree of anonymity and related matters.
The BOJ, together with the ECB and other major central banks, has established a group to assess the potential use of CBDCs since 2020. The BOJ has begun the first phase of proof of concept to develop a test environment for the CBDC system and conduct experiments on the basic functions that are core to CBDC as a payment instrument such as issuance, distribution, and redemption. This phase will be carried out through March 2022.
The central bank is planning to conduct a proof of concept on wholesale CBDCs as an initial focus. The central bank has announced that it no immediate plans to issue CBDC. It believes that domestic payment systems continue to operate safely and efficiently to support the needs of the economy and allow real-time digital payments.
On Sept. 30, 2021, the Reserve Bank of New Zealand (RBNZ) released an issue paper for public consultation regarding CBDC and its potential to work alongside cash as government-backed money. The paper outlines the advantages and disadvantages, costs and benefits, and risks and opportunities that a CBDC might offer, including six design principles. The RBNZ is seeking feedback on the paper by Dec. 6, 2021. However, the RBNZ believes CBDC development will require long lead times given the inherent complexities, multiple design choices, and policy choices to be made.
The Monetary Authority of Singapore (MAS) concluded its five-year digital currency project, Project Ubin, which explores the experimental usage of distributed ledger technology and CBDC in 2020.This multi-year, multi-phase collaborative project is with top-tier financial institutions in Singapore. A payments network prototype was developed, and this will act as a test network for developing a next-generation cross-border payments infrastructure. Technical specifications for the functionalities and connectivity interfaces of the prototype network have been made publicly available to spur further industry development. Additionally, MAS and Banque de France have successfully concluded a wholesale cross-border payment and settlement experiment using multiple CBDC in July 2021. MAS also teamed up with the IMF, the World Bank and others to launch “Global CBDC Challenge” in mid-2021 to search for innovative retail CBDC solutions globally to enhance payment efficiencies and promote financial inclusion.
The Bank of Korea (BOK) began conducting a simulation test on CBDC from August 2021; it will run to June 2022 over two phases. In the first phase (by end of year) the BOK will establish simulation environments operating in the cloud and test the basic process of CBDC such as issuance and circulation. In the second phase, extended functions such as cross-border remittances, purchasing digital assets and offline payments will be tested.
Since 2018, the Bank of Thailand (BOT) has been continuously engaged in work on CBDC, beginning with the exploration of wholesale CBDC through Project Inthanon via various phases. In the third phase of the project, the BOT partnered with the HKMA to undergo Project Inthanon-LionRock to test the functional benefits of using distributed ledger technology to eliminate correspondent bank intermediaries in cross-border transactions and for settling currencies in a payment-versus-payment manner. The BOT is also exploring the capabilities of ledger technology in a multi-jurisdictional context with two additional central banks, the Central Bank of the United Arab Emirates and the PBOC (m-CBDC bridge project, also called Multiple CBDC). Under Project Inthanon, the BOT created a proof of concept wholesale CBDC prototype using distributed ledger technology in different use cases, ranging from enabling automated regulatory compliance processes to tackling high fees in cross-border payments. Over 2021-2022, it intends to focus its efforts on the research and development of a retail CBDC. Accordingly, the BOT has hired a German technology company to develop a proof of concept for a retail CBDC prototype, and allotted Thai baht 10 billion (US$300 million) for the project.
(Note: the above list of Asia-Pacific banking jurisdictions is selective and covers 11 of the 19 banking jurisdictions in Asia-Pacific where S&P Global has bank ratings. It covers major banking jurisdictions and selected emerging markets).
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