Digital Currencies, Blockchain and the Future of Money

“Blockchain”, “cryptocurrencies”, “tokenisation”, and now “central bank digital currencies” have made it into the technology hype cycle vocabulary, but what’s the difference between all these terms and what do they mean for the future of money? Why are regulators around the world so concerned about Libra, and why is China accelerating their blockchain initiatives and so eager to launch a digital renminbi? Below, we’ll differentiate the terminologies relating to digital currencies and set out the global ambitions by governments and regulators, which may enable full transparency (as well as subject individuals to privacy risks) of transaction level over the coming years.

Blockchain

Blockchain is a term broadly used for distributed ledger technology (DLT) – a database that is consensually shared and synchronised across multiple participants, using cryptography to enable all participants to agree on what transactions go on to the ledger (to reach a “consensus”), and making them unable to be changed (to achieve “immutability”). DLT does not necessarily involve a mechanism of using a chain of blocks of digital information like the original bitcoin blockchain, but the marketing hype has led to these terms being used interchangeably. There are public blockchains (like bitcoin’s blockchain), where the distributed ledger is “decentralised” so anyone can access and become a connection point in the network (a “node”), or there can be private (or “permissioned”) blockchains where only certain parties can be the nodes and/or have access. An example of a permissioned blockchain is Hyperledger Fabric. The Ethereum blockchain offers both public and private options.

Cryptocurrencies

Cryptocurrencies are digital assets which use DLTs to regulate the generation of units of currency and verify the transfer of funds, operating independently of a central bank. Bitcoin and Ether (powered by the Ethereum blockchain) are popular public cryptocurrencies. These cryptocurrencies have experienced significant volatility, and given that these cryptocurrencies are not fiat money (legal tender by government decree), the fluctuations in their value on conversion to fiat money or into other cryptocurrencies are deemed to give rise to a taxation event. In Australia, the tax consequences of these transaction can be estimated with the KPMG Crypto Tax Estimator via cryptocurrency exchanges. Cryptocurrencies can be either collatoralised or non-collatoralised, with the latter which created a plethora of initial coin offerings (ICOs) since 2017, many crashing dramatically by mid-2018 when the market became overrun by scammers and over-hyped projects lacking substance.  “Stablecoins” are a relatively new class of collatoralised cryptocurrencies that attempts to offer price stability. Stablecoins can be pegged to traditional fiat currencies (such as Tether’s USDT), physical assets (such as gold) or other assets (including other cryptocurrencies). Use cases for stablecoins include efficient cross-border remittance in addition to functionalities relating to its programmable nature with smart contracts. Our view is that there are current opportunities for fully collatoralised corporate stablecoins, where corporates carry the liability, to thrive such as loyalty tokens which can be programmable for use at certain vendors and transferrable to other users. The troubled Libra, introduced by Facebook and its coalition of founding members as part of the Libra Association, is proposed to be a stablecoin and designed to be backed by a basket of fiat currencies and short-term government securities. The announcement of Libra has prompted regulators globally to closely consider the potential risks and benefits of cryptocurrencies, with a particular focus on stablecoins with the potential to operate on a global scale. In October 2019, the G7 released a report on global stablecoins in which it recognised that they have the potential to be more efficient and inclusive than existing payment methods, particularly for cross-border payments. However, the G7 also noted that such proposals raise “significant legal and regulatory risks, including to consumer/investor protection, data privacy, monetary policy, and financial stability”. Accordingly, it cautioned that private sector global stablecoin initiatives should not be permitted to launch until all risks and regulatory requirements have been addressed. In December 2019, in a submission to the Senate Committee, the Reserve Bank of Australia (RBA) indicated that it is supportive of the G7’s view on the risks of corporate stablecoins, stating that “a key consideration for regulators is to ensure that private sector stablecoin initiatives operate under a comparable regulatory regime to existing payment systems, and in particular, that they do not all fall outside the existing regulatory framework”. Further, the RBA indicated that “in Australia, it is unclear that there will be strong demand for stablecoins even if they do meet all regulatory requirements, particularly for domestic payments. Australia is already well served by a range of low-cost and efficient real-time payment methods, such as the New Payments Platform (NPP), that utilise funds held in accounts at prudentially supervised financial institutions. Moreover, while Australians may not have been well served by banks providing cross-border payment services in the past, a number of new non-bank digital players have entered the market in recent years offering significantly cheaper and faster money transfer services”.

Central Bank Digital Currencies

Central bank digital currencies (CBDCs) are different from cryptocurrencies in that they are issued by the state and have legal tender status declared by the government.  As such, CBDCs could compete with commercial bank deposits and challenge the status quo of the current fractional reserve banking system. It could be implemented as a wholesale CBDC (issued by central banks to commercial banks and potentially other financial institutions for use in interbank payments and securities transactions) or a retail CBDC (the first digitised form of central bank money and liability the general public could own). It could be held by domestic or cross-border users and financial institutions. A CBDC could also use DLT or a hybrid approach for implementation. There is also a distinction between token-based vs account-based money as set out in the report on CDBCs by the Bank for International Settlements (BIS), as illustrated below: The ability for central banks to trace payments using a CDBC or existing mechanisms in advanced financial systems such as Australia enables greater controls on anti-money laundering and counter terrorism financing (AML/CFT). As such, it also makes tax avoidance and tax evasion much more difficult, as it mitigates methods such as offshore banking and unreported employment to hide financial activity from the central bank or government. There is the potential to tackle the black economy, enable faster and more efficient remittances, and improve exchanges of ownership such as for property transfers. However, it may also shift the liability from existing intermediaries such as retail banks, to the central banks in cases of default.   Global developments on CBDCs In January 2020, the World Economic Forum gathered insights from central bank researchers, global policy‑makers, international organisations and experts from over 40 institutions to create the CBDC Policy‑Maker Toolkit. It set outs key opportunities and key challenges or alternative solutions identified for governments and regulators in the implementation of a CBDC. The Bank of Canada, the Bank of England, the Bank of Japan, the European Central Bank, the Sveriges Riksbank and the Swiss National Bank, together with the Bank for International Settlements (BIS), have recently created a group to share experiences as they assess the potential cases of CBDCs in their home jurisdictions. The group will assess CBDC use cases; economic, functional and technical design choices, including cross-border interoperability; and the sharing of knowledge on emerging technologies. It will closely coordinate with the relevant institutions and forums - in particular, the Financial Stability Board and the Committee on Payments and Market Infrastructures (CPMI).  However, the working group did not include the People’s Bank of China, which is well known as being in the process of preparing a retail CBDC, the Bank of Thailand for its Project Inthanon, the US Federal Reserve, or the RBA. China’s Digital Currency / Electronic Payments (DC/EP), potentially to launch this year proposes to use distributed ledger technology for its two-tier currency, where the first part involves the commercial banks converting some of their central bank deposits into CBDC, and the banks then distribute this CBDC to consumers. The process is intended to mirror the way physical cash is distributed. China has been working on a CDBC since 2014, to complement the Belt & Road initiative which aims to bolster trade between China and foreign countries by providing large loans. China’s CBDC could be a way of challenging the dominance of the USD. Swift’s report in June 2019 found that Africa’s payments using China’s currency increased by 123% over 3 years, compared to the 28% increase in all currencies. The accelerated developments from China were also influenced by the announcement of Libra, and this has in turn accelerated the US Federal Reserve’s assessment of the CBDC, with former US Commodity Futures Trading Commission Chairman Chris Giancarlo aka "Crypto Dad" joining the Chamber of Digital Commerce the American Financial Exchange and calling for a US CDBC. Current state of CBDC in Australia In the December 2019 submission to the Senate Committee, the RBA indicated that its assessment, like those of most other central banks, is that the case for issuing a CBDC for use by households has not been established. Nevertheless, the RBA identified a number of potential benefits that could arise, such as:

•       Speed, cost and robustness of payments. A CBDC fully integrated into a blockchain platform could enable payments to be made between participants in real-time and 24/7 without relying on external payment systems.
•       Atomic transactions. A CBDC integrated within a blockchain platform could more easily allow for ‘atomic’ transactions. An atomic transaction is ‘all or nothing’, meaning that either all parts of the transaction are executed or none at all. When applied to delivery-versus-payment, this can reduce settlement risk as a payment and corresponding asset can be exchanged simultaneously.
•       Programmable money. A CBDC in combination with smart contracts on a blockchain may enable new kinds of ‘programmable money’. This refers to the ability to attach conditions to how money can be spent or transferred, which could be automatically executed, without the need for a trusted third party.

The Bank is not currently considering a CBDC for retail use, but notes the availability of a wholesale settlement token based on DLT could allow payment and settlement processes to become more integrated with other business processes. It is not yet clear if there would be demand for a CBDC for wholesale settlement. The RBA indicated that its Innovation Lab developed “a proof-of-concept of a wholesale settlement system running on a permissioned Ethereum network. The proof-of-concept simulated the issuance of central bank-backed tokens to commercial banks in exchange for exchange settlement account balances, the exchange of these tokens among the commercial banks, and their eventual redemption with the central bank”. The RBA “intends to extend this research over the coming year, potentially through collaboration with one or more external partners”. There is also the potential for “future enhancements to the NPP to “facilitate delivery of documents with payments and support payment messages with data elements specifically tailored to e-invoicing, SuperStream payments, reporting to tax and statistical authorities, etc. These capabilities should all be feasible over the next few years, and the industry is working on some of these innovations already. The shift towards more data-rich payments will create opportunities for fintechs and others to develop innovative services that utilise these data to improve convenience, efficiency and reduce risk in the payment system”. There is an open question on whether the recent accelerated advancements by central banks around the world, including our significant trade partners China and the US, will create a need for an Australian CBDC, potentially directed by cross-border interoperability with other CBDCs, as seen by the working group of the BIS and six other central banks.

Tokenisation and the Future of Money

Tokenisation is the process of converting physical (and non-physical) assets into digital tokens using DLT, creating a “digital twin”. This could include anything from real estate, artwork, stocks, diamonds and other goods and services. There is an opportunity to tokenise goods included in the existing system of the Global Trade Item Number (GTIN), found on the barcode of products and standardised by GS1. This is the current approach from provenance platforms such as KPMG Origins - a blockchain-based track & trace platform to enable global trade participants to share information, trade faster and be more protected against fraud and misconduct. It allows producers to trace each product along the supply chain ensuring its authenticity, as well as transport and storage conditions which may affect quality. For industries such as rice and wine, it enables organisations to tell the story of their products, including ingredients, origins and certifications. Certifications are recorded and independently verified by relevant certification bodies. When a tokenised asset is exchanged with programmable money (potentially via a CBDC), automatic settlement can be executed with smart contracts. Smart money was trialed by CSIRO Data61 and the Commonwealth Bank of Australia using the National Disability Insurance Scheme (NDIS) as a case study. However, this pales in comparison to the blockchain initiatives in trade finance and supply chain in China. China Construction Bank has a platform that has already processed more than US$50 billion in transactions. One of the international networks, Voltron, recently piloted a cross border transaction in Renminbi involving HSBC. Using a CBDC for on-chain transaction settlement is potentially an optimal scenario for all players. Closing thoughts If a CBDC was implemented along with our global trade partners, it would enable the automation of transaction processing (including payment, exchange and settlement), streamlining, automating and improving the coverage of all financial services. It could shed light on digital transactions that currently fall outside the financial intermediaries reporting requirements. For example, foreign students and tourists may use WeChat Pay by scanning a QR code by a vendor in Australia, avoiding Australian financial intermediaries in the process. However, in a world of pervasive smart money converging with artificial intelligence and ubiquitous IoT sensors, all our activities may become not only subject to the algorithms of corporates, but also governments alike, creating a big brother scenario if these privacy risks are not addressed.