Introduction

While the rise of cryptocurrencies sparked a new wave of research into alternative currencies and payment systems¹, it was the June 2019 announcement of a stablecoin, namely, Facebook’s Libra currency that injected political urgency into a technical debate previously confined to the research papers of central banks. Since then, the ”new normal” ushered in by Covid-19 has amplified the urgency for research into alternate currency and payment systems because of the possible health risks associated with physical, cash-based money exchange. While leaders in the banking world have already called for a global discussion on the need for government-issued electronic currencies², or a network of central bank digital currencies³, these unusual circumstances call for more in-depth analysis of various digital currency and payment systems as viable alternatives.

This seven part series explores the concepts of stablecoins and central bank digital currencies (CBDCs) as alternatives to cash-based fiat currencies. The purpose of this series is to give readers an understanding of how the contemporary payment system works, and how a stablecoin and CBDC payment system could vary. Part one outlines a brief history of our currency and payment system, what constitutes “money”, and how our modern-day payment infrastructure works. This section establishes context for an analysis of stablecoins and CBDC. Part two introduces the concept of stablecoin cryptocurrency. Part three explores contemporary stablecoin initiatives to identify the technical makeup of various stablecoin systems and their associated payment flows. Part four introduces the concept of CBDC and outlines prospective use cases for CBDC. Part five introduces general criterion for evaluating the efficacy of stablecoins and CBDC within the context of payments and settlements. The criterion used in this report are: financial integrity, financial stability, and monetary policy, all of which are the overarching public policy goals of monetary authorities. In Part five we evaluate stablecoins against these public policy objectives. In Part six we evaluate CBDC against these public policy objectives. Part seven concludes this series by summarizing key points and raising a number of important questions for end-users, private entities and governments, about the future of money.

Part 1 - The Contemporary Currency and Payment System

Before the advent of money, goods were primarily exchanged for the promise to return the favour in the future (i.e., IOUs)⁴. As societies grew larger and economic activity expanded, it became harder to maintain records of increasingly complex IOUs, and default and settlement risks became concerns⁵. Money, and the institutions that issue it, came into existence to address this growing complexity by establishing and maintaining trust in economic relations⁶.

The expansion of economic activity required more convenient forms of money to respond to increasing demand, be used efficiently in trade, and have a stable value. Accordingly, money came to be defined by three primary factors: (1) a unit of account, which refers to money’s ability to lend meaning to profits, losses, liabilities and assets, by allowing things to be compared against each other, (2) a medium of exchange, which reflects whether money can be used to facilitate the sale, purchase, or trade of goods and services between parties, and (3) a store of value, which is an indication of whether money can be predictable saved, retrieved, and exchanged at a later time (i.e., whether the money has a guaranteed value in terms of both its current and future purchasing power)⁷.

Historical experience demonstrates that hundreds of currencies have risen and fallen despite meeting these three factors. In fact, sustainable episodes of one currency are more of a historical exception than a norm⁸. So, what causes currencies to fail? The answer lies in society’s continued ability to trust in the institutional arrangements through which money is supplied⁹.

From ancient times, the stamp of a sovereign certified a coin's value in transactions¹⁰. Later, bills of exchange intermediated by banks developed as a way for merchants to limit the costs and risks of travelling with large quantities of coinage¹¹. Ultimately, the quest for a stable institutional system culminated in the emergence of today’s central banks. 

In the contemporary currency and payment system, money is provided through a joint public-private initiative between central banks and private banks (commercial banks), with the central bank at the systems core.¹² Today, people generally pay each other through electronic bank deposits, whereas banks pay each other through central bank reserves. This institutional arrangement generates trust by establishing independence and accountability for the central bank, away from the profit-seeking relationship between commercial banks and end-users. Accordingly, the end-users of the system trust that their payments will be valid because they trust in the operational rules and regulations that form the basis of this institutional arrangement. Support from the state ensures users that rules and regulations will be upheld. Central banks also fulfill the role of maintaining their currency as a stable unit of account, means of exchange, and store of value. To do this, central banks take an active role in supervising and in some cases providing the payments infrastructure for their currency.

The contemporary domestic payments infrastructure provides the end-user with a relatively trustworthy and efficient means of payment, compared to cross-border payments. The cross-border payment and settlement process can involve multiple parties to execute a transaction, each of whom are required to reconcile technical, operational, and regulatory standards that vary by jurisdiction. This process can be costly, slow, and void of transparency. If an end-user’s financial institution has no presence in a location where that end-user wants to send funds, it will need to rely on another financial institution(s) to complete the transaction. This is known as the “correspondent banking” model, which has been the foundation of cross-border payments and settlements for centuries¹³. Correspondent banks serve as intermediaries in the payment process by passing funds and instructions from the originating bank through over to the beneficiary’s bank. The correspondent banking model is the only ubiquitous cross-border payment solution in modern times¹⁴.

In most countries, three primary stakeholders work together to facilitate cross-border payments: central banks, commercial banks, and the end-user. Central banks often operate at the core of cross-border payments, typically by operating the real-time gross settlement (RTGS) infrastructure and high-value payment schemes within which commercial banks send and receive payments on behalf of end-users¹⁵. Central banks often have oversight that is independent from government, with mandates to establish financial and monetary stability, foster competition, and support innovation within their jurisdiction.

Commercial banks act as the financial intermediaries of the correspondent banking system. Through correspondent banking relationships, commercial banks can access financial services in different jurisdictions and provide cross-border payments to their customers, supporting international trade and financial inclusion¹⁶. Correspondent banking is essential for facilitating cross-border payments, and for the access of banks themselves to foreign financial systems for services and products that may not be available in the banks’ own jurisdictions. If bank A does not hold an account with bank C, they will use the services of bank B as an intermediary – to pass on the payment and instructions to the beneficiary’s bank.

End-users are the individuals or businesses that send or receive funds. The correspondent banking system can pose challenges to end-users when payment routes are structured across a chain of correspondent banks that are less familiar to the originating bank. When a cross-border payment is processed through correspondent banks, the original bank is often only able to guarantee and share information from its own stage of the payment process¹⁷. Once the payment enters the next bank’s payment infrastructure, the originating banks loses sight of the payment. The more correspondent banks in the chain, the less transparency, the more time it takes to process a payment and the higher the transaction cost. Underlying these cross-border transactions is the Society for Worldwide Interbank Financial Telecommunication (SWIFT), a messaging network that financial institutions use to securely transmit information and instructions through a standardized system of codes.¹⁸ SWIFT connections enable access to a variety of applications, including real-time instruction matching for treasury and forex transactions and banking market infrastructure for processing payment instructions between banks¹⁹. While SWIFT clients can take advantage of these applications, membership in the network is costly. The information sharing that SWIFT enables is an essential determinant of trust and efficiency in cross-border payments because standardization creates fluid processing, transparency, and a mechanism for identifying accountability in instances of error.

Inside the Payment Process

The process of facilitating a payment amongst these primary stakeholders is characterized by a series of steps that involve instruction, data input, regulatory screening, and payment. As demonstrated in a joint report called “Cross-Border Interbank Payments and Settlements” by the Bank of Canada, Bank of England, and Monetary Authority of Singapore, the following table breaks down the various activities associated with a typical cross-border payment across the value chain²⁰.

The contemporary payment process also involves important human dynamics that help end-users trust that their transaction is secure. Banks manage relationships with clients, communicate with them throughout the payment process, undergo investigations when any of the forementioned checks are incomplete or unclear, and may be accountable if mistakes are made. These human elements of the process are important to note because they may be difficult to incorporate in alternate currency systems, particularly those that attempt to minimize the role of commercial banks and intermediaries altogether. This is because the underlying design of certain alternative currencies and their payment infrastructures may call for a fundamentally different cross-border payments paradigm, one that replaces commercial banks as the primary facilitators of cross-border payments. The following section introduces the alternate currency and payment systems under review.

^{1 This report refers to “currency and payment systems” as a general term used to describe a system in which issuers of a money enable the money’s distribution.}

^{2 Bruno Le Maire, the French Minister of the Economy and Finance, wants next month’s World Bank and IMF annual meetings to open a global discussion on the need for government-issued electronic currencies, or e-cash. See: Martin Sandbu, “How Facebook’s Libra fuelled push for central bank-run digital currencies”, Financial Times (September 23, 2019), online: https://www.ft.com/content/746808a0-d9f6-11e9-8f9b-77216ebe1f17}

^{3 Mark Carney, Bank of England governor, suggested in a speech in August that a new “synthetic” currency, “perhaps [provided] through a network of central bank digital currencies” rather than a private provider such as a tech company, could gradually replace the dominance of the US dollar in international transactions. Ibid.}

^{4 Bank for International Settlements, “Cryptocurrencies: Looking Beyond the Hype”, BIS Annual Economic Report (June 2018), online: https://www.bis.org/publ/arpdf/ar2018e5.htm [BIS Annual Economic Report 2018].}

^{5 Ibid.}

^{6 Ibid.}

^{7 Murray John, “Central Banks and the Future of Money” (2019) CD Howe Institute, online: https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3369649 at 5-6. [Murray “Central Banks and the Future of Money”]}

^{8 BIS Annual Economic Report 2018, supra note 4.}

^{9 Gianini Curzio, “Money, Trust and Central Banking” (1995) Journal of Economics and Business 47:2, online: https://journals-scholarsportal-info.proxy.bib.uottawa.ca/pdf/01486195/v47i0002/217_mtacb.xml at 219-220.}

^{10 BIS Annual Economic Report 2018 supra note 4.}

^{11 Ibid.}

^{12 Ibid.}

^{13 Committee on Payments and Markets Infrastructures, “Correspondent Banking” (2015) BIS Consultative Report, online: https://www.bis.org/cpmi/publ/d136.pdf at 4. [BIS Consultative Report 2015].}

^{14 Bank of Canada, Bank of England, Monetary Authority of Singapore “Cross-Border Interbank Payments and Settlements: Emerging Opportunities for Digital Transformation” (2018), online; https://www.bankofengland.co.uk/news/2018/november/boe-boc-mas-joint-report-digital-transformation-in-cross-border-payments at 6. [Central Bank Report on Cross-Border Interbank Payments and Settlements]}

^{15 RTGS systems were generally adopted in the 1980s and 1990s as technology developed to support it, but several central banks still face challenges relating to operating legacy infrastructure. One challenge associated with this legacy infrastructure is its need for operational downtime, which restricts the operating hours of the settlement system, allowing delays in payment processing to build up between banks awaiting settlement. As a result, payments can get trapped in a country waiting for the relevant RTGS system to open.}

^{16 BIS Consultative Report 2015 supra note 13 at 1.}

^{17 Central Bank Report on Cross-Border Interbank Payments and Settlements supra note 14 at 13.}

^{18 Shobit Seth, “How the SWIFT System Works”, Investopedia (2019), online: https://www.investopedia.com/articles/personal-finance/050515/how-swift-system-works.asp}

^{19 Ibid.}

^{# Central Bank Report on Cross-Border Interbank Payments and Settlements supra note 14 at 54-55.}