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The writer is head of macro policy research at State Street Global Advisors
The history of technology in capital markets is largely one-directional. Each innovation has improved market functionality, typically by increasing the speed and/or lowering the cost of transactions.
These technological jumps have been diffused internationally to the benefit of all market participants, leading to ever more efficient and integrated global financial markets.
The latest development, however — central bank digital currencies — could have the opposite effect and invite global financial fragmentation. In addition, de-dollarisation efforts could become more credible. This is not a futuristic abstraction, but highly relevant today. Eleven countries have already launched active CBDCs, and a similar number are at pilot stage.
A CBDC is a novel form of delivery of central bank money, not a neutral technical innovation. Within the closed domestic financial system, such currencies should be market agnostic as each central bank can design their own. But in the global context, cross-border CBDCs could create new hurdles and limitations on capital transactions.
The geopolitics of the 21st century has spurred non-western states to develop alternative payments networks to reduce their reliance on US dollar payment rails and the Belgium-based Swift messaging system for banks. The challenge for new networks such as China’s Cross-Border Interbank Payment System and Russia’s Mir is to overcome Swift’s incumbency advantage in the cross-border market. Their rise was always going to be incremental at best.
CBDCs could change all that. Cross-border connectivity has to be reimagined from scratch, creating the opportunity to establish a new, very different financial architecture. Many sceptics consider CBDCs “a solution looking for a problem” and point to very low uptake of their usage. Yet the mistake is to view CBDC as a standalone digital payment solution, which indeed is superfluous for most countries given advanced digitalisation of finance.
The fact is that the real technological revolution of blockchain lies in the coming tokenisation of wide swaths of financial and real assets, which will require corresponding blockchain-based digital central bank money.
A successful cross-border payment model will have to be the fastest, the most efficient and carry the lowest transaction costs. The critical aspect is the extent to which chosen systems promote alternative payment networks, facilitate cross-border capital flows and lower barriers to access other countries’ financial assets. Our research — to be published shortly — shows that the management of cross-border CBDC has the potential to affect standard measures of countries’ positions in the global political, economic and financial order.
How would cross-border CBDC arrangements work in the real world? We envision three distinct models.
The first would rely on a neutral supranational body to broker cross-border payments — very similar to Swift’s role today. This would be easy to establish — the Bank for International Settlements has been experimenting with its Icebreaker project doing just that — but may have limited functionality, basically just enabling simple currency exchange.
The second model would be new digital infrastructure connecting participating countries’ CBDCs. One could imagine this as the digital equivalent of a rail network, with established lines and interoperable traffic between specific countries. The most advanced example is mBridge, being developed by the Hong Kong Monetary Authority, the People’s Bank of China and other central banks. This could evolve to enable cross-border securities transactions as well.
The third model would be a CBDC shared between countries with shared governance. This would only work for nations with a high degree of political and economic integration.
There are three observations to keep in mind with these emerging models. First, cross-border CBDCs are likely to promote more global financial fragmentation, rather than less. It is very unlikely that a world run on CBDCs would be more seamless than today’s financial architecture. In addition, great power rivalries (such as between the US and China) will help frame countries’ preferences for a model, thus exacerbating fragmentation.
Finally, the most operationally successful cross-border mechanism — as measured by reducing trading costs, raising efficiencies and ensuring transaction security and regulatory compliance — will help drive capital flows. At a minimum, this will have implications for the use of trading currencies, and presumably should reduce global use of US dollar as a trade currency.
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