The Evolving Role of Central Bank Money in the Digital Age

Technology is reshaping finance, from how we transfer assets to how we make payments. Yet amidst this transformation, one thing must stay constant - the role of central bank money as the stable anchor upholding the entire monetary system.

As Chairman Thomas Jordan of the Swiss National Bank (SNB) explainsfor:

"It is essential for a central bank to maintain the role of its money as the anchor of the monetary system, irrespective of future technological innovations."

What exactly does it mean for central bank money to serve as the monetary anchor? And how can central banks ensure this pivotal function is preserved as innovation accelerates?

Let's explore these key questions at the forefront of defining the future of money.

The Current Monetary System: Central Bank Money vs Commercial Bank Money
In our present two-tier system, there are two main forms of money in circulation:

1. Central bank money - Consisting of banknotes and sight deposits at the central bank held by financial institutions. This state-issued legal tender holds no credit risk and derives its value from the central bank's credible commitment to price stability through monetary policy.
2. Commercial bank money - The deposits held by the public at commercial banks. Its value is upheld by one-to-one convertibility into central bank money as well as safeguards like deposit insurance and bank regulation.

When paying electronically, businesses and individuals use commercial bank money. However, such payments are ultimately settled through transfers of central bank money between commercial banks.

The "singleness" of money is preserved by ensuring all forms of money can be converted into each other at par value. One dollar is one dollar, whether issued by the central bank or a private bank.

This system upholds trust and functionality in money by leveraging central bank money as the stable foundation while allowing private bank money to facilitate transactions efficiently.

Tokenization & Settlement of Digital Assets

One of the most transformative fintech developments is tokenization - digitally representing real-world assets on a decentralized distributed ledger.

By tokenizing financial instruments like bonds, real estate, commodities, etc. their transfer can be programmed to occur instantly and automatically using blockchain-based smart contracts.

Benefits of tokenization include:

• Increased transparency & liquidity from enabling 24/7 asset trading
• Lower settlement risk and costs from near real-time execution
• Easier cross-border transactions without intermediaries

Switzerland is at the forefront of regulated tokenization. So far in 2024, around 2.5% of all Swiss franc bonds were issued as tokenized assets.

This raised the question for the SNB:

How can central bank money be used to settle transactions involving tokenized assets to realize tokenization's full efficiency benefits?

Introducing the Helvetia III Wholesale CBDC Pilot

The solution being explored is issuing a wholesale central bank digital currency (CBDC) - a tokenized form of central bank reserves that financial institutions can use for instant settlement.

In December 2023, the SNB launched Project Helvetia III to trial Swiss franc wholesale CBDC on a live market. This pioneering pilot made the SNB the first central bank to issue tokenized central bank money on a third-party financial infrastructure for settling transactions.

How does it work?

Selected Swiss banks can use CBDC tokens issued by the SNB to settle purchases and sales of tokenized bonds in real-time on the SIX Digital Exchange (SDX).

Four swiss bond issuances were successfully settled with wholesale CBDC during the pilot's first phase. The SNB is now studying if the system could be expanded to monetary policy operations like repurchase agreements.

Key Preliminary Insights from Helvetia III:

• Tokenized reserves issued on SDX are legally and economically equivalent to conventional central bank deposits
• Wholesale CBDC enables settlement of tokenized assets with central bank money's security while capturing benefits of decentralized finance (DeFi)
• Financial institutions and infrastructure operators can integrate wholesale CBDC into operations
• The SNB retains technical controls and legal safeguards to regulate issuance of its wholesale CBDC

However, Jordan acknowledges important open questions that must be resolved before potentially adopting wholesale CBDC such as:

• Timing - Whether central banks should be proactive in wholesale CBDC to encourage innovation or take a wait-and-see approach as tokenization develops

• Alternative models - Other methods to link tokenized assets and traditional payment rails like settlement accounts on a centralized database

• Design principles - Parameters around access, holding periods, and potential remuneration rates for wholesale CBDC

• Platform governance - Regulatory criteria for third-party infrastructures to host central bank digital money and contractual controls over usage

Enhancing Retail Payments with Instant Settlement

While tokenization and wholesale CBDC impact institutional finance, central banks are also upgrading core infrastructure to enhance retail payment systems.

In November 2023, the Swiss Interbank Clearing (SIC) system was overhauled to introduce real-time gross settlement of electronic retail payments.

Once fully implemented, individuals and businesses in Switzerland will be able to send payments 24/7 between bank accounts that clear instantly rather than the current batch-based nightly settlement. By late summer 2024, the top 50 Swiss banks covering 98% of retail payments will be live on the new system.

Switching to instant, central bank money-backed settlement enhances the monetary anchor for consumer transactions in three key ways:

1. Bolsters security by minimizing credit and liquidity risk between banks as funds move in real-time
2. Enables new innovations and competition as payments essentially become "programmable money" transferable at any time under customized conditions
3. Lays infrastructure for central bank digital cash if there is future demand from the public for a digital alternative to physical banknotes

The Case Against Issuing Retail CBDC
Despite upgrading infrastructure to facilitate digital cash, the Swiss National Bank currently sees no compelling need to issue a retail central bank digital currency (CBDC).

Jordan argues private sector payment solutions like mobile wallets and online/contactless payments give Swiss consumers sufficient access to "digital cash."

His key concern is that a cash-like CBDC available to the public could massively disrupt commercial bank funding models by allowing households to shift deposits directly onto the central bank's balance sheet during crises.

This could spark financial instability, concentrate power at the central bank, and crowd out private innovation given CBDC's sovereign backing.

For now, the risks of issuing a retail CBDC outweigh the potential benefits based on the robust existing payment landscape in Switzerland.

However, Jordan states the SNB continues analyzing the CBDC debate and weighing scenarios where retail CBDC could become advantageous down the road.

Central Bank Money's Enduring Importance
As the financial world pushes into new technological frontiers like tokenization and distributed ledgers, one constant must be preserved - the ability to settle transactions securely in risk-free, central bank-issued money.

By proactively adapting their systems and monetary policy instruments, central banks can leverage innovations like wholesale CBDC and real-time payment rails to modernize settlement while reinforcing their money's vital anchor role.

Looking ahead, the path forward will require balancing innovation with stability and pragmatically assessing trade-offs of different approaches.

Fostering responsible fintech advancement while maintaining the "singleness" of central bank money as the bedrock of the monetary system is the key to harnessing technology's potential without sacrificing trust in money itself.

P.S. What do you see as the biggest risks or opportunities for central banks issuing a digital currency? Share your thoughts in the comments below!

Disclaimer: The views expressed in this blog are not necessarily those of the blog writer and his affiliations and are for informational purposes only.

If you found this blog post insightful, don’t forget to subscribe to our website for more updates on Finance. Your subscription will help us continue to bring you the latest insights into the world of finance. And if you think this post could benefit others, please feel free to share it. Let’s spread the knowledge together!