Wholesale central bank digital currencies could change cross-border payments

SEVEN years ago, central bank digital currencies (CBDCs) were interesting thought experiments without commercial applications. Then in 2016, the Bank of Canada launched Project Jasper, the first collaboration between a central bank and the private sector to examine the use of distributed ledger technology in wholesale payments.

Wholesale payments are not something most people think about. Yet they are the foundation of global trade and crying out for more efficiency – particularly if smaller firms and economies are to be fully included in the global economy. That’s why G20 set out a roadmap in 2020 to make cross-border payments faster, cheaper, and more transparent.

It won’t be simple. As the Bank for International Settlements points out, the challenges in cross-border payments are long-standing and complex.

That’s partly because of the way payments for trade are carried out. While it has evolved, it still requires mountains of paper documentation.

When dealing with a new counter-party or a firm in a jurisdiction with a very different legal framework, exporters may be concerned that they won’t be paid. Banks have thus developed instruments like the letter of credit (LC), which guarantees payment if requirements are met. To issue an LC, there is a network of trade banks and correspondent bank accounts.

Making sure that the money in the global trade system actually flows securely, on time, and to the correct beneficiary, is not a trivial undertaking.

Exploratory projects

Trade banks are very good at what they do. Default rates for export letters of credit in 2021 were 0.02 per cent, on a transaction-weighted basis, according to the International Chamber of Commerce.

But that doesn’t mean things can’t be done better – particularly in the much bigger overall cross-border payments space. Each year, global corporates move around US$23.5 trillion across borders, at a cost of around US$120 billion in transaction fees, according to JP Morgan.

Numbers like that are part of the reason why Project Jasper was much more than a one-off experiment.

By 2018, the Bank of Canada was working with the Monetary Authority of Singapore (MAS), the Bank of England, and HSBC – with contributions from Toronto-Dominion Bank, the Oversea-Chinese Banking Corporation, the United Overseas Bank, KPMG and Payments Canada – on new models for cross-border payments and settlement.

Today, according to the Atlantic Council CBDC tracker, eight jurisdictions are looking at wholesale CBDCs across 12 projects, most of which are multiparty.

The MAS is particularly forward-looking. It is part of Project Dunbar, together with the central banks of Australia, Malaysia and South Africa; of mBridge, with the Bank for International Settlements, and the central banks of China, Hong Kong, Thailand and the UAE; and of UBIN+.

An extension of earlier work, UBIN+ contains several sub-projects. One of those is Project Mariana with the Banque de France, the BIS Innovation Hub, and the Swiss National Bank. This aims to deliver, by mid-2023, a proof of concept on the automatic settling of foreign exchange trades using wholesale CBDCs.

Another is Project Cedar Phase II with the Federal Reserve Bank of New York’s Innovation Centre on the atomic settlement of cross-border cross-currency transactions. It is due to release a report on the findings this year.

Why work hard on wholesale CBDCs?

The rise of big Internet platforms and the use of distributed ledger technology mean that new, private, payment options could be developed. That is one of the reasons why the Bank of England is investigating the use of a retail CBDC. It wants to prevent the potential fragmentation of the monetary system by such private ‘currencies’.

But wholesale payments are likely to be different. In cross-border payment and settlement, fiat backing will be essential.

At an event in April, MAS managing director Ravi Menon noted that this fiat backing is what gives wholesale CBDCs an edge over private cryptocurrencies or stablecoins, acting “as an anchor for that blockchain transaction to work”.

He added: “Most of the impactful use cases are going to be in wholesale CBDCs for cross-border payments, cross-border trade finance and so on.”

Leading trade centres will want digital fiat currencies because trade finance is at two major turning points.

First, it is finally about to digitalise. It will take time for the full shift, but the passage of the UK’s Electronic Trade Document Bill, expected before the summer, will do away with the requirement to ship paper documents.

Around 80 per cent of global trade is governed by English law, under which – currently – only paper documents give title to the goods. The new Bill will allow e-documentation to carry out the same role.

The Electronic Trade Documents Bill is the UK’s version of the United Nations Model Law on Electronic Transfer Records (MLETR). Seven jurisdictions have adopted MLETR, including Singapore. Germany is due to follow this year, as is Japan. China is reportedly looking at implementation by 2024. Once all the major trading nations are on board, there will be no legal barriers to fully digital trade.

Second, ESG (environmental, social, governance) concerns are remodelling global trade patterns. For example, the demand for rare earths will mean new supply chains and new financing requirements. That will change banks’ appetites for country risk and for individual bank risk. Settlement in wholesale CBDCs could soothe some jangled nerves.

So watch this space. One of the biggest shifts in global finance is quietly underway.

The writer is head of trade and transaction banking at the London Institute of Banking & Finance.