What options are available to the financial industry for payment settlement in an environment where digital transaction technologies are increasingly being used? The latest edition of the Bundesbank’s Monthly Report explores this question. Overall, it is anticipated that the financial industry could generate significant efficiency gains from the interplay of distributed ledger technology (DLT) and the digital representation of assets it makes possible (referred to as tokenisation), as well as digital money. Using DLT allows different companies to use the same database, and through the automated settlement of processes via what are known as smart contracts, reconciliation costs and ultimately back office costs, too, are spared, explains Martin Diehl, payment expert and co-author of the Monthly Report article on digital money. However, in order to fully tap the potential offered by DLT, it must be possible to integrate cash leg settlement into the relevant processes. 

CBDC, stablecoins and tokenised deposits

Central bank digital currency (CBDC), tokenised deposits and stablecoins are therefore being considered as the primary options when it comes to larger-scale financial market transactions. However, Mr Diehl acknowledges, it is questionable whether stablecoins would meet with broad acceptance in the financial sector, owing to their governance structure and the quality of collateral posted for transactions. Some banks are working on tokenised deposits, which take today’s commercial bank money a step further on the basis of DLT. Yet here, too, many legal and practical questions remain unanswered, and a high degree of coordination between banks is required. Furthermore, as with any commercial bank money, there is also a risk of default, according to Mr Diehl. 

Could wholesale CBDC be a solution?

For this reason, many central banks around the world have turned their attention to wholesale CBDC, i.e. digital central bank money used by a restricted user group within the financial sector to settle DLT-based transactions. If new technologies such as DLT become market-ready and achieve market penetration, it must be ensured that central bank money can also be used for these new types of settlement, the authors stress. Whilst innovations and functional advancements in the settlement infrastructure will certainly not come at the expense of the stability and security of central bank money, an erosion in the significance of central bank money resulting from settlement structures no longer being in line with market requirements must, at the same time, be prevented. 

Central bank money should always be the number one choice for settling large-value payments, Mr Diehl states. On financial stability grounds alone, it is important that nothing other than central bank money is used for the settlement of large amounts. For this reason, central banks need to consider new digital settlement options. Although the Monthly Report points out that it would also be possible for third parties to operate a DLT infrastructure for settling payments in digital central bank money, it would be essential to guarantee the continued control over central bank money from a central bank perspective. If we do not operate the DLT network ourselves and it runs on another network, we would require powers of intervention,” according to Mr Diehl. “We cannot outsource the material risk, he adds. On account of this, it looks unlikely that central banks will use public DLT networks. Even if weighing up the arguments made outsourcing central bank money to networks operated by others seem possible, reputational risks would, at any rate, remain for the central bank if problems occurred, the Monthly Report states. 

In view of this, there is a focus on interoperability solutions in the Eurosystem. One example could be tokenised central bank money on its own Eurosystem DLT platform. Alternatively, the Eurosystem could also provide interfaces between external DLT networks and an existing settlement system, such as T2, according to Mr Diehl. The advantage of these interfaces or trigger solutions would be that they can make use of DLT-based settlement options without security and stability having to be compromised. This would avoid negative implications for the implementation of monetary policy or banks’ liquidity management that could arise from the introduction of wholesale CBDC.

Future of DLT and tokenised processing is an unwritten chapter

The authors working with Mr Diehl come to the conclusion in their Monthly Report article that it is virtually impossible to tell how DLT and the tokenised settlement of monetary transactions will develop going forward. Whilst a large proportion of the financial sector is looking into DLT as a settlement technology and also expects an increase in its potential uses, many initiatives have not yet progressed further than the prototype stage. If DLT applications are accepted and proliferate in the market, a growing number of solutions are likely to be developed to settle the cash leg of these applications, the authors write. Close coordination and cooperation among market players, banks and central banks is indispensable for the further development of digital money in order to prevent fragmentation and stand-alone solutions being developed in the future system of digital money. We, too, need to consider how we are going to make the central bank fit for the future, Mr Diehl remarks.