Clifford Chance

Central bank money plays a key role in minimizing settlement risk and avoiding liquidity fragmentation across the globe. When, in the aftermath of the 2008 global financial crisis, IOSCO and the Committee on Payments and Market Infrastructures drew up the Principles of Financial Market Infrastructures (the PFMI) in 2012, they advocated for the use of central bank money to settle financial transactions to avoid credit and liquidity risks, where practical and available.^[1] This principle has since been enshrined in law across many jurisdictions, including Europe and Switzerland.^[2]

Central Bank Money

Recent innovation, particularly the emergence of distributed ledger technology (DLT) and the tokenisation of financial assets (that is, the issuance of digital securities on a distributed, digital ledger), has threatened to disrupt the crucial role that central bank money currently plays in the settlement of financial transactions. This is because, unlike private assets such as stablecoins or certain crypto-assets, central bank money in its current form cannot be settled directly on the digital ledgers on which tokenised securities can be issued, traded and settled.

Central Bank Digital Currencies

A large number of central banks across the globe have therefore been developing central bank digital currencies (CBDC), digital representations of fiat money issued by a central bank, to compliment central bank money and cater for the needs of the digital economy. The desire to explore the potential of CBDC is also driven by other factors, such as the recognition that cross-border payments could be made more efficient, the threat to monetary sovereignty and financial stability posed by private sector actors seeking to develop alternatives to traditional fiat currency, the need to improve cyber resilience and, in the retail CBDC context, the hope of providing greater financial inclusion.

Banque de France Experiment

In March 2020, the Banque de France launched an experimentation programme jointly with other market participants to explore the issuance and use of wholesale CBDC (wCBDC), that is CBDC that can only be used by a limited group of commercial banks and clearing institutions. The aim of the experiments was to show how wCBDC could be used (i) to settle securities in various configurations and for many asset classes and (ii) to complete cross-border and cross-currency transactions.

With regards to the settlement-focused experiments, the Banque de France is not alone in exploring the potential of wCBDC, with recent projects such as Ubin III by the Monetary Authority of Singapore, Jasper III by the Bank of Canada, Helvetia by the Swiss National Bank and Trigger by the Bundesbank rightly receiving a lot of industry recognition. However, the Banque de France’s experiment relating to the settlement of French government bonds (OATs) in CBDC with DLT was unique in its breadth and depth and other experiments have mainly focused on connecting DLT platforms to legacy payment systems such as T2S.

The Banque de France’s OATs experiment, the results of which were published in October 2021, was led by Euroclear and conducted as a proof of concept in a test environment. Both the CBDC and the OATs were natively issued on a distributed, permissioned digital ledger in a multi-cloud environment. Each participant^[3] was given a defined role giving them specific rights and obligations in relation to the transaction, the aim being to allow participants to benefit from the DLT features whilst ensuring market operators (the Central Securities Depositaries (CSDs) and central banks) could continue to run the required controls.
 
The permissioned blockchain environment supported a large range of post-trade functionalities in a stable and flexible way. CBDCs were issued in token-form by the Banque de France directly on the digital ledger, transferred to the participating banks’ digital wallets and then used in the atomic, Delivery versus Payment settlement of the OAT securities tokens. The experiment successfully tested not only primary market distribution, but also secondary market trades between the participants and their clients who didn’t have wallets on the digital platform. Liquidity optimization mechanisms such as auto-collateralization and repo operations, key to increasing settlement efficiency by facilitating settlement when insufficient resources are available in the participants’ wallets, were also tested. Smart contracts were also used to automate coupon payments directly from the issuer’s CBDC wallet to the CBDC wallets of the OAT holders, an improvement from the current market practice of first passing by the issuer paying agent’s cash account in the CSDs.

Conclusion

Central banks will continue to develop CBDC and it is likely that experiments will continue. By virtue of the various experiments that have now been completed, in particular the Banque de France’s OAT experiment, we have proof that CBDC can be used to support the settlement of digital securities on digital ledgers in central bank money. The combination of CBDC, digital securities and DLT looks extremely promising for the capital markets. The OAT experiment in particular allowed participants to benefit from the fullest extent from the possibilities offered by DLT in the management of securities settlement operations: reducing trade to settlement cycles, increasing direct market participation and reducing reconciliation efforts, all in a secure environment which got the balance right between privacy and transparency, included trusted and regulated market participants such as CSDs and central banks, and allowed for interoperability with existing settlement infrastructures.

This article was originally produced for the ICMA Future Leaders, and frst appeared in their Newsletter

References

[1] See Principle 9, PFMI.
[2] For Europe, see Article 40 of the Central Securities Depositary Regulation (Regulation (EU) No. 909/2104) and for Switzerland, see Article 65 of the 2015 Financial Market Infrastructure Act.
[3] The participants included Banque de France, Euroclear, AFT, BNP Paribas, Crédit Agricole CIB, HSBC and Société Générale.