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CENTRAL BANK DIGITAL AND – HOW MIGHT THEY WORK IN PRACTICE?

SEPTEMBER 2020 DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRACTICE?

The payments landscape is changing rapidly. Central bank digital currencies (or CBDCs) and stablecoins have received growing attention, particularly around Facebook’s announcement of its proposed global “Libra” in 2019 and the resulting regulatory . Advocates hail them as the future for payments - an unmatched tool for financial inclusion and limiting financial crime, by linking payments to identity - while critics have concerns around regulatory standards and financial stability (in the case of global stablecoins) and whether the improvements are as impressive or distinct as supporters argue.

In this report we consider how adoption of a global stablecoin or a retail CBDC would look in practice, and explore the legal structures that might be employed.

CRYPTO TERMINOLOGY A type of distributed technology (DLT), blockchain is a data storage structure which is maintained and replicated across a decentralised network of “nodes” such that an individual node cannot tamper with the information recorded in the ledger by rewriting the transaction history. This technology was first applied in the design of the , but has the potential to revolutionise how many different types of transactions are conducted and assets are transferred. Cryptocurrency A digital or virtual that uses to control the creation and transfer of new “” or “units” and to secure transactions. In its broadest sense the term could incorporate everything from Bitcoin and Ether, to stablecoins and CBDCs, however, central banks tend to avoid the terminology seeking to distinguish CBDCs from coins and currencies not issued or administered by any central bank or authority. Central bank or CBDC A CBDC is a digital representation of fiat issued by a central bank. CBDC are often associated with underlying blockchain or DLT infrastructure, however, other technology may be utilised to similar effect. CBDCs may either be wholesale (i.e. with access restricted to a limited group of commercial banks and institutions) or retail (which would widen access to central bank money, perhaps to corporates and businesses or generally across the economy to all consumers). A recent survey from the Bank for International Settlements (BIS) reported that around 10% of the 66 central banks surveyed are likely to issue a CBDC for the general public in the short term. Stablecoins A privately issued type of cryptocurrency with a mechanism to minimise fluctuations and ‘stabilise’ its . Their aim is to provide an alternative form of risk-free digital unit which is not limited to commercial banks, but could be used directly by consumers. Most common of the potential stabilisation options is the collateralised stablecoin model, where stability is achieved by linking the currency to a reserve of stable real assets such as fiat currencies or commodities. Alternatives include cryptocollateralised stablecoins (where a reserve is made of other ) or non-collateralised stablecoins (which do not have any reserve but instead use central bank-like to maintain a fixed price by controlling supply with algorithms which respond to conditions).

2 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? Central banks and Private stablecoins are aimed at providing money – a primer an alternative form of risk-free digital unit which is not limited to commercial banks, Central bank notes and coins are the but could be used directly by consumers. paradigm of “money”. However, in most Sufficiently widespread use of stablecoins major economies, notes and coins would eliminate the function performed by comprise a tiny fraction of the payments the commercial banks themselves – if a actually made. In practice, payment is buyer can transfer widely accepted, risk- effected by the exchange of credit claims free stablecoins immediately and directly on commercial banks (and sometimes to a seller, then the necessity for other payment providers). One way of commercial banking as a payment looking at this is to say that “money” is in mechanism disappears. fact provided to the real economy by commercial banks. What would a stablecoin- Commercial banks maintain accounts based system look like? with central banks, and central banks In principle, the concept of a stablecoin- tend to regard the balances on these based payment system is no different accounts as “money”. This gives rise to from a physical -based payment an optical illusion which makes it seem as system. However, physical coins, in order if money is provided by the central bank to be useful, can only span a limited through the commercial banks to the real range of values. This means that there will economy. However, this is not the case - be many transactions for which they are central bank “money” in this sense is no too small (for example, land purchases more than a settlement mechanism and wholesale business transactions), provided by central banks to commercial and others for which they are too large (in banks to enable them to settle net a world where the smallest coin in balances between themselves. circulation is equal in value to a labourer’s daily we can know that purchases Commercial banks settle their balances of food and drink by that labourer cannot through central banks because a credit have been settled in coin). Consequently, balance with a central bank in its own physical coins have historically never currency is a risk-free asset - a £10 been more than a part of a payment balance with the Bank of England is the system which is account based, and this nearest thing there is to a £10 note. If account basis requires what we might call Bank A is owed £100m by Bank B, it has “bank-like entities”, ranging from temples a substantial credit exposure to Bank B. If in ancient times to goldsmiths in Bank B instructs the Bank of England to 17th-century London. transfer £100m in its account to Bank A, then in principle nothing has changed – Cryptocoins or tokens do not suffer from Bank A is still owed £100m, and it is only this problem – a million cryptocoins can the identity of the debtor which has be transferred as easily as one. Thus it changed. However, for Bank A, the would be theoretically possible for such £100m obligation from the Bank of a system to displace account-based England is literally “as good as ”, payment systems completely.1 Also, and its position is therefore since cryptoassets can in principle be significantly improved. held securely, the risk of holding large amounts of value in the form of coins is The reason that this matters is that by also solved – thus the crypto-equivalent eliminating its credit exposure to Bank B of keeping under the mattress through settlement, Bank A is able to becomes a perfectly viable mechanism take on further exposures and do for the storage of value. more business.

1. There is a confusion between the term “account-based” in the sense of meaning based on an underlying receivable and “account-based” in the sense of ownership of the instrument being recorded in a ledger – see for example https://libertystreeteconomics.newyorkfed.org/2020/08/token-or-account-based-a- digital-currency-can-be-both.html#.XzPfGffNVPY.twitter. By account-based here we mean the first.

CLIFFORD CHANCE 3 CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? The problem which the existence of such The first of these stages is the physical stablecoins would create is to do with the safeguarding of the coins. This appears operation of the economy. The financial to have been a service provided by resources of the banking system at any temples in ancient times, and goldsmiths given time consist largely of cash and others in more recent ones. Early law deposits made by customers but not yet had no particular difficulty with this idea – reclaimed – these are lent out to a for safekeeping of fungible borrowers. In a stablecoin system, was well understood for the however, these resources are paid to the warehousing of commodities such as issuer of the stablecoin, who therefore grain and the bailment of money for becomes a single “megabank” to the keeping was easily accommodated within economy as a whole.2 In order for such a that structure. The difficulty arises from system to work, the stablecoins must be the fact that money is not there to be as nearly risk-free as possible. This owned, or to be consumed, but to be means in practice that the issuer of the transferred. The difference between stablecoin must place the deposited warehousing money and warehousing amounts in investments which are as grain was that whereas grain could nearly risk-free as possible. Many reasonably be expected to be returned to stablecoin proposals – such as the depositor, the whole purpose of a Facebook’s Libra – therefore envisage warehousing of money was to facilitate its that funds received in consideration of the transfer to a third party. It rapidly became issue of stablecoins should be invested in clear that since the depositor never government bonds which match the expected to see his money again, the currency concerned, since such bonds obligation of the recipient was more in the give almost the same degree of risk-free nature of an obligation to repay debt than exposure as central bank deposits. an obligation to return goods.

Private stablecoin issuers who adopt this English law rapidly concluded that in model are therefore building almost exact practice there was no such thing as a replicas of the existing central bank “bailment of money”, and that whenever model. The function of a central bank is one person deposited money with to issue money in exchange for value and another, the result was that ownership of lend the value received to the government the money passed to that other and the (or conversely, to take government debt original depositor was left with nothing and monetise it by turning it into money). more than a debt claim against the Central banks looking at such proposals recipient. The reason for this was the may well conclude that if such a model is legal presumption that physical money to developed, it would be better if it were was always fungible, such that unless implemented by existing central banks notes and coins had some special rather than by private sector competitors. identifiable characteristic beyond the usual, any physical transfer of money The legal structure of necessarily transferred ownership with it. money services This is not the case with cryptoassets It would be prudent to base an generally – in theory, every cryptoasset assessment for the appropriate legal has a separate identity which is capable structure for CBDCs and stablecoins on of being traced through any number applicable historical equivalents. For of hands. However, it should be noted much of the history of the second that we are talking here about a legal rule millennium in Europe, payment involved as much as physical reality. In strict the delivery of physical coins issued by theory individual banknotes can be various authorities from one person to physically traced, since each one bears a another. The provision of services unique identification number. However, facilitating payments in such coins is a the legal rule is that voluntary transfer business as old as coins themselves, and destroys ownership, since this is an its development has several fairly inherent characteristic of that which the recognisable stages. law regards as “currency”.

2. There are historical precedents for such a system – the Bank of Amsterdam performed this function in the seventeenth century.

4 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? The key point here is that because the manage such entries directly. physical arrangements in respect of Consequently it seems highly likely that cryptoassets easily permit such the average user of any cryptocoin identification, there are two different ways (whether a stablecoin, CBDC or in which payment services in respect of otherwise) will in practice utilise the such assets could develop. It would be services of some form of “wallet provider” possible to have a traditional banking or to that end. model with a title transfer of each cryptocoin, but it would be equally If we assume that the coin owner is using possible to have a bailment (or “custody”) a wallet service which – to his eyes, at model, where the service provider any rate – closely resembles the payment administers assets at all times owned by services which he currently receives from the customer. his current bank, he is unlikely to perceive any significant distinction in operation This is not unprecedented. In the gold between the two (excluding differences in market, for example, most gold banks look and feel between apps, for example). provide customers with a choice between In particular, he is very likely to envisage allocated gold (custody) and unallocated his stablecoin/CBDC account as gold (deposit) accounts, leaving it to the operating in much the same way as his customer to decide whether the extra cash account - i.e., that it is based on the expense of the allocated account is idea that he has a claim on the bank (or worthwhile in order to eliminate the credit wallet provider) for the redelivery of the risk exposure to the custodian inherent in things recorded as being in the account. an unallocated account. It seems clear This is particularly true since most users that both services could be provided in of bank accounts do not have a clear respect of tokens. idea as to what property rights (if any) they have in “their” money, and indeed The difference between the two would find the question slightly puzzling. arrangements in practice is that a warehouse provider derives no benefit This would suggest that confronted with from his of the assets which two apparently identical offerings from the he holds in the custody model, and is same bank, one charging higher fees therefore obliged to recover all costs plus than the other, most customers will opt from fees charged to customers. for the cheaper option. Deposit -taking, by contrast, permits the deposit-taker to use the amounts The service deposited with it in order to finance its provider’s perspective own business, which in practice means being able to lend them out. In Banks are based on a hybrid product considering how users in the real model in which they offer account economy are likely to employ stablecoins customers two different services. These or CBDCs, this is likely to be the most are value storage and access to payment significant factor. services. In many markets including the UK, customers are generally not charged The customer’s for these services, because the customer depositing money with a bank enables perspective the bank to invest that money and earn a How does the experience differ for return on it, and that return is used to customers between the custody and the reduce or eliminate the cost of provision deposit model? It may be objected that in of the payment services. The existence of principle based a stablecoin creates the possibility of approaches make either service separating these two services. In effect, unnecessary, since the ultimate owners the issuer of the stablecoin offers to can enter themselves on the relevant provide the value storage, leaving to blockchain as the owner without involving others the provision of the payment any intermediary. This is true, but service. The issuer of the stablecoin or overlooks the primary function of money, CBDC will therefore receive the money of which is to be transferred. An owner of customers, but will not pay them for that money who expects to spend it in the deposit. The appeal of a stablecoin over a relatively near future is unlikely to want to bank deposit to its holder is simply that it

CLIFFORD CHANCE 5 CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? is a better credit – indeed, if it is a CBDC, There is another issue here which is likely it is a perfect credit. to be significant. If a customer deposits money with a bank, his deposit will be The problem that arises here is that the covered by the local deposit protection profits on lending deposited money were scheme. Deposit protection schemes traditionally used to subsidise the cost of generally only apply to deposits of money the payment services provided to the – if you deposit government bonds with deposit customer. If a customer uses his your bank, that deposit will not be surplus funds to purchase stablecoins or covered by the scheme. What is the CBDC rather than depositing the money position as regards a deposit of in a bank, the bank will no longer stablecoins or CBDC? Clearly if the generate a return from using that deposit were on a pure “custody” basis, deposited money. This means that if the there would in principle be no protection. bank continues to provide payment However, what would the position be if services to the deposit customer, it the deposit were on the basis that the will have to charge for them. More bank could use the stablecoins or CBDC importantly, if it provides a service of as its own? Given the rules as they “custodying” the stablecoins or CBDC, currently stand, such an arrangement it will have to charge for that service would generally be regarded as “not a as well. deposit”, and therefore outside the scope of the scheme. A customer who It should be noted in passing that purchased stablecoins and deposited charging for payment services could also them with a bank on this basis would create other inefficiencies. For example, therefore have made his own position one of the drivers for the development of substantially worse than it would have the “free banking” model in the UK seems been had he simply deposited the money to have been the fact that if was with the bank. It would be possible to paid to depositors, that income would be extend the scope of deposit protection taxable in the depositors’ hands, whereas schemes to such arrangements as if the depositor received a lower rate of discussed further below. If not and return plus free banking services, the tax customers appreciate that deposits of liability was reduced (an important point in money with banks are protected by the days of the 98% top rate of tax). government whilst deposits of stablecoins Separation of deposit-taking and payment or CBDC are not, then the argument for service provision on a fee-paid basis stablecoins or CBDC over deposits based would revive this problem. on credit quality largely disappears.

There is a way out of this problem, which Taking all of this together, it is clear that takes us back to the goldsmiths. If a the only logical reason for consumers to customer delivers stablecoins or CBDC to use stablecoins or CBDC rather than the bank on the basis that the bank can bank credit would be if the quality of lend them out at a profit, then the existing service which they received was position is restored and the profits on the substantially improved. This is entirely lending will finance the provision of the possible payment services – and in payment services. However, what is particular cross-border payment services happening here the customer pays – are generally regarded even by payment money to a stablecoin provider, buys banks as being susceptible to significant stablecoins, and delivers them to the improvement in terms of the cost, speed bank on a full title transfer basis. The and information available to customers, effect of this transaction is that having and it is clearly the case that in certain bought the stablecoins from the parts of the world customers may be stablecoin seller, the customer promptly prepared to pay a significant premium for sells them to the bank again ending up fast, effective cross-border payment with the same balance that he would services. However, in most developed have had had he simply deposited the markets there are already initiatives from in the first place. the existing payment service providers to The introduction of the stablecoin or upgrade existing payment mechanisms – CBDC into this process is therefore Pay. UK’s New Payments Architecture economically redundant. project is only one example of this. In

6 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? recent years a plethora of cross-border non-bank mechanism emerges that payments firms have also positioned performs the same function as themselves as faster, cheaper and much commercial bank money, we need to be simpler alternatives to banks. It is not aware that a failure of that mechanism (or, therefore certain that the quality of service to be more accurate, a sudden failure of that stablecoins or CBDC will provide will confidence in that mechanism) would of itself be sufficient to drive a wholesale have the same systemic and economic adoption. The role of hype or loyalty by a effect as a bank collapse. large existing customer to a platform operated by a private firm (such as The policy response to the threat of a Facebook’s Libra) will also be relevant, money crisis arising from bank failure is but again is unlikely to drive widespread the creation of deposit protection adoption alone. schemes. The logic of a deposit protection scheme is precisely to try and Financial stability - ensure that even if a commercial bank deposit protection fails, the money which it provides to the economy will continue to be available and and stablecoins to be reliable. It is therefore difficult to see While we have touched on deposit how, if stablecoins were to become protection above from a consumer widely circulated, it would be possible to protection perspective, its primary, and resist the creation of protection schemes. more important role, is as a However, the creation of such schemes macroeconomic financial stability tool. would almost certainly have the effect of The collapse in value of a mechanism in promoting the use of those cryptocoins widespread use across an economy as a covered by the scheme – not least payment mechanism (such as claims on because of the element of regulatory and a commercial bank) would have a government “kitemarking” that such a significant social and economic impact. scheme would create. This is another key The reason is that there is all the reason for central banks to move quickly difference in the world between the and be the driver for adoption of digital collapse in value of a monetary instrument currencies in their jurisdiction. and the collapse in value of an investment (or class of investments). A money collapse undermines the , such that the ability to enter into transactions is itself undermined. If there is a risk that the pound that you have today will not be accepted as a pound tomorrow, the mechanism of exchange itself is undermined.

This is the logical basis for deposit protection. In the real economy, transactions are not effected in central bank money, but in commercial bank money – when a customer of a bank speaks of “his money”, what he means is the credit balance on his bank account. The risk of that bank defaulting has the effect of undermining the value of that money in the same way that the risk of a sovereign defaulting has the effect of undermining the value of its currency. This is, of course, the reason why bank failure is regarded as a different type of problem from the failure of other large corporations. Bank failure does not merely create a loss of wealth, but undermines the mechanism upon which economic activity relies. However, if a

CLIFFORD CHANCE 7 CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? CONCLUSIONS

The following conclusions can be drawn from this: 1. Banks and other payment service 3. Money paid to a central bank or providers have a number of legal stablecoin provider in exchange for options in the way in which they cryptocoins is in practice returned to structure the services which they the relevant government, and is provide to customers in respect of withdrawn from the national economy. CBDCs or stablecoins. These do not Since these balances will not be differ between privately-originated or available to commercial banks to lend central-bank originated coins. out, governments following this model However product providers will wish will have to develop a mechanism for to avoid creating apparently similar returning such balances to the real products with different fee structures. economy, either by direct lending on We therefore expect an industry their own account or by lending to consensus to develop fairly rapidly commercial banks to finance around a particular legal structure. on-lendings. Since a legal structure involving direct 4. An important driver of the ownership of the coin by the development of stablecoins will be customer would be the most their treatment for the purposes of expensive offering for that customer, deposit protection schemes. this seems unlikely to be the preferred Decisions on this matter will require model. However, a structure involving policymakers to make choices about a transfer of ownership of the coins to how they think the deposit-taking and the bank would seem to have no payments aspects of their economies benefits over the existing bank should develop. account offerings. 5. There is currently no clear rationale for 2. There may be advantages for banks in existing end-users of payment employing CBDCs in settlement of services to adopt stablecoins or balances amongst themselves, but it CBDCs except in regions where is difficult to see how this is superior existing payment (and particularly to account settlement on the books of cross-border payment) services are the central bank of the currency exceptionally inefficient. There is concerned. CBDCs could, however, currently a race between stablecoin provide a valuable tool for institutions providers and operators of existing who wish to settle large balances in a payment systems to improve the particular currency but do not have quality of existing payment services, direct access to an account with the and this will continue. relevant central bank concerned.

3. There is nothing unprecedented about central banks acting as commercial lenders – the Bank of England was active in commercial finance until the 1970s (Forrest Capie, The Bank of England CUP 2010 pp. 318-26).

8 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND STABLECOINS – HOW MIGHT THEY WORK IN PRATICE? CONTACTS

Simon Gleeson Caroline Dawson Diego Ballon Ossio Partner Partner Senior Associate London London London T: +44 207006 4979 T: +44 207006 55 T: +44 207006 3425 E: simon.gleeson@ E: caroline.dawson@ E: diego.ballonossio@ cliffordchance.com cliffordchance.com cliffordchance.com

Laura Douglas Laura Nixon Monica Sah Senior Associate Senior Associate Partner Knowledge Lawyer Knowledge Lawyer London London London T: +44 207006 1103 T: +44 207006 1113 T: +44 207006 8385 E: monica.sah@ E: Laura.Douglas@ E: Laura.Nixon@ cliffordchance.com cliffordchance.com cliffordchance.com

Find more of our global fintech team at www.cliffordchance.com/fintech

For more information on Clifford Chance’s global fintech capability and resources, including our global stablecoin regulatory tracker, or to be added to our weekly global fintech regulatory round-up, please email [email protected]

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