The finance industry in Europe is undergoing a transformation due to the progressive digitization. A significant development in this context is the introduction of digital currencies based on Distributed Ledger Technology (DLT). In the early years of this development, private actors like the Bitcoin community or Facebook’s Libra project were in focus, but today, it’s mainly the central banks that are intensively working on the introduction and further development of digital currencies.
It is important to distinguish between two types of digital central bank currencies: the so-called Retail Central Bank Digital Currency (CBDC) and the Wholesale CBDC. While the Retail CBDC would represent a fundamental innovation, the Wholesale CBDC already exists in European payment transactions. (See also our first blog post on Retail CBDC and the possible impacts on the German banking world).
Retail CBDC is often seen as a digital counterpart to banknotes and coins and enables direct transactions between individuals or companies without intermediation by banks or other financial intermediaries. Wholesale CBDC, on the other hand, refers to a digital currency developed by the central bank exclusively for use between financial institutions and large institutional market participants. This form of transaction of digital central bank money is not new and was introduced as early as the late 1990s by the European TARGET services (Trans-European Automated Real-time Gross Settlement Express Transfer System).
The European Central Bank (ECB) is currently investigating how new developments like DLT can interact with the existing TARGET services to make them more efficient. Possible improvements could include accelerated settlement speed, more transparent transactions, financial stability, scalability of cross-system transactions, and improved risk management. However, the exact amount of potential increases depends on the actual use cases in the market and possible consolidation tendencies among the DLT platforms, as Fabio Panetta (ECB) already emphasized in 2022.[1]
Other central banks are also currently evaluating possible efficiency gains through the integration of DLT into existing Wholesale CBDC structures. In a current statement dated June 26, 2023, the President of the Swiss National Bank (SNB), Thomas Jordan, announced the piloting of a digital Wholesale CBDC of the Swiss Franc for the current calendar year to test real transactions with real use cases.[2]
Doing well by doing good – by using Smart Contracts?
A promising use case for this symbiosis lies in the use of smart contracts. These “smart” contracts are characterized by programmable rules that are stored on a blockchain and are automatically executed once certain predefined conditions are met. There is no need for any further control instance to execute or approve the action.
Smart contracts could be used, for example, in the administration of funds from ESG bonds (environmental and social bonds). These bonds, often referred to as “green” or “social” bonds, obligate the issuer to use the funds from investors for specific ESG purposes. By using a blockchain-based Wholesale CBDC, the intended use of the funds could be ensured with predefined rules and tracked on the blockchain until the final payout for the intended and committed purpose. This would reduce the risk of “greenwashing”, improve reporting, and thus support trust and transparency in the labeled ESG bond market.[3]
Another example would be the use of smart contracts in derivatives trading. A derivative could be designed to be paid out automatically when a certain stock index reaches a predefined value. The rules for the payouts would be transparent for all market participants and would be automatically executed upon fulfillment of the condition, without the need for any further financial intermediary to intervene. This would increase the efficiency and speed of financial transactions and reduce the risk of human errors or manipulations.
Overall, the integration of DLT and smart contracts into Wholesale CBDCs promises significant benefits. The automation, increase in transparency, and risk reduction can revolutionize the financial sector sustainably and enable innovative business models. By using these technologies, transaction costs can be reduced, processes accelerated, and new opportunities created for financial intermediaries and market participants.
In conclusion, Wholesale CBDCs and Distributed-Ledger Technology represent a promising development in the financial system and have the potential to further transform the sector.
[1] https://www.ecb.europa.eu/press/key/date/2022/html/ecb.sp220926~5f9b85685a.de.html
[2] https://www.handelsblatt.com/finanzen/geldpolitik/geldpolitik-snb-pilotprojekt-fuer-digitales-zentralbankgeld-noch-dieses-jahr/29226314.html
[3] https://www.esm.europa.eu/system/files/document/2023-03/DP%2022%20FINAL.pdf
