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Where next for public ?

KPMG LLP UK Centre of Excellence

March 2018 CROP MARKS kpmg.com/uk MARGIN CROP MARKS CROP MARGIN

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Executive summary 2 : market 3 overview Major cryptocurrencies 5 Classification of money 7 Recent governmental 9 responses to cryptocurrencies Market developments in 11 banking and payments Key risks associated with 12 cryptocurrencies Strategic considerations for 13 central banks Advantages and risks of 14 issuing CBDCs for central banks Appendices 15 CROP MARKS MARGIN CROP MARKS CROP MARGIN

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• The market proliferation of cryptocurrencies has been fuelled by speculation and tokenisation, namely through the launch of initial coin offerings (ICOs).

• Governmental and regulatory responses to cryptocurrencies vary geographically and are constantly evolving.

• The private sector is also investing heavily in blockchain and cryptocurrencies.

• Cryptocurrencies introduce new risks, including cyber crime; security; systemic risk; and sovereign risk.

• There are a number of advantages and risks associated with the issuance of Central Bank Digital Currencies (CBDCs). The issuance of CBDCs could transform central banks’ current functions. CROP MARKS

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MARGIN MARGIN MARGIN MARGIN MARGIN CROP MARKS MARGIN CROP MARKS CROP Cryptocurrencies: market overview

The previous 12-18 months have seen cryptocurrencies garner significant attention from the media, financial analysts, governments, regulatory institutions and investors.

Bitcoin and other cryptocurrencies are underpinned by blockchain technology. Blockchain functions as a database and/or an accounting system to track the ownership and transfer of tokens from one party to another in the absence of traditional financial intermediaries. Blockchain was the first of many Distributed Technologies (DLTs) to be developed.

Primary market $4bn An increasing number raised of start-ups are through launching ICOs to raise $189bn ICOs significant capital global IPO IPO  ICO proceeds in 2017

More than 1,500 cryptocurrencies (March 2018)

Regulation of ICOs is immature. Reception of ICOs 66 is largely worrisome cryptocurrencies from authorities in 2013 CROP MARKS

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Cryptocurrencies are broadly defined as digital assets in which encryption techniques are used to regulate the generation of units of currency and verify the transfer of funds, operating independently of any central bank.

Secondary market

CAGR growth of approx. Start-ups have 166% launched exchanges to between 2014 enable trading of and 2018 existing coins

Combined market cap for all cryptocurrencies stood at US$800bn (Jan 2018 – )

Bitcoin had a approx. Coinmarketcap.com collates data from 35% over share of the cryptocurrency 182 market in Jan exchanges 2018 CROP MARKS

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Top 10 cryptocurrencies by market capitalisation (as at 16 January 2018):

Bitcoin Ripple (BTC) (ETH) (BCH) (XRP) (LTC) Bitcoin is a digital Officially launched in Bitcoin Cash, Ripple, released in Litecoin was cryptocurrency 2015, Ethereum is a launched in July 2012, is a launched in 2011 and comprised of decentralised 2017, is a of the cryptocurrency that is considered to be processed data computing platform Bitcoin blockchain uses a ‘global the ‘silver’ to blocks. Launched in that features its own ledger, with consensus ledger’. bitcoin’s ‘gold’, due 2009, it was the first Turing-complete upgraded consensus The Ripple protocol is to its more plentiful decentralised peer- programming rules that allow it to used by institutional total supply of 84 to-peer payment language. The grow and scale. actors such as large million LTC. It network that is blockchain records Further, people banks. A function of borrows the main powered by its users scripts or contracts holding Bitcoin when the token XRP is to concepts from with no central that are run and Bitcoin Cash was serve as a bridge Bitcoin but has authority or executed by every created automatically currency between altered some key middlemen. participating node, became owners of national currencies parameters (e.g. the and are activated Bitcoin Cash. that are rarely traded mining algorithm is through payments and to prevent spam based on with the attacks. instead of Bitcoin’s cryptocurrency SHA-265). ‘Ether’.

US$0.06 (2009) US$2.83 (2015) US$413.1 (2017) US$0.005 (2012) US$4.35 (2011) value: Launch Launch

US$12,059.9 US$1,086.2 US$1,929.9 US$1.36 US$200.1 value: Current Current CROP MARKS

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Dash NEM Ethereum IOTA () (XEM) (XMR) Classic (ETS) (MIOTA) DASH, launched in NEM is a peer-to-peer Launched in 2014, , Launched in 2016, 2014, is a cryptocurrency and Monero is a system launched in July IOTA is an open- cryptocurrency blockchain platform that aims to provide 2015, is a source distributed focused on privacy. launched in March anonymous digital continuation of the ledger. It uses a In addition to offering 2015. Its stated cash using ring original Ethereum directed acyclic all the features of objective is a wide signatures, blockchain, featuring graph (DAG) instead Bitcoin, DASH also distribution model. It confidential smart contract of blockchain. It has advanced has introduced new transactions and (scripting) claims to be able to capabilities, including features to blockchain stealth addresses to functionality. It address the instant transactions technology, such as obfuscate the origin, provides a scalability and (InstantSend), private its proof-of- transaction amount decentralised Turing- transaction cost transactions importance (POI) and destination of complete virtual concerns inherent in (PrivateSend), and algorithm, transacted coins. It machine, the other distributed decentralised saw a substantial Ethereum Virtual ledger technologies governance (DGBB). accounts, encrypted increase in market Machine (EVM), that are based on a messaging, and an value in 2016. which can execute blockchain. Eigentrust++ scripts using an reputation system. international network of public nodes.

US$0.214 (2014) US$0.0004 (2015) US$2.47 (2014) US$0.752 (2015) US$0.638 (2016)

US$796.4 US$1.11 US$343.2 US$32.48 US$2.99 CROP MARKS

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Clarification of terms:

Virtual Currency (VC): (DC): a digital representation of a digital asset with monetary value, ordinarily issued and characteristics. DCs are considered controlled by its developers. to fall within the definition of a VC if VCs are not issued by central it is denominated in non-fiat units of banks, credit institutions, or value, or if it is issued in a e-money institutions, decentralised way. It is a meaning they are seldom combination of two elements: an regulated. In some asset and an exchange mechanism. circumstances, VCs can be Commercial bank deposits and e- used to pay for goods and money are types of digital currency. services and can therefore be Digital currency that is issued by a seen as an alternative to central bank is defined as a ‘Central money. Bank Digital Currency’ (CBDC).

Key: Electronic Peer-to-peer (no intermediaries) Liability of the central bank Universally accessible (easy to obtain, easy to use) Liability of the issuer (financial institution, local government, company, or group)

Settlement Cryptocurrency CBDC (private Centralised virtual accounts Reserve (private sector, sector, wholesale) currency accounts wholesale)

Deposited currency CBDC Commercial bank Cryptocurrency accounts (not (public sector, deposits, (privately created) available) retail) E-money

Cash Commodity money Local currency CROP MARKS

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Properties of money versus cryptocurrency

Property of money Cryptocurrency does have the property Cryptocurrency does not have the property

Fungibility: Most digital currencies allow greater divisibility than Some argue that Bitcoin doesn’t satisfy this, as the Individual units must fiat currencies. history of each coin is visible. Some users might refuse be interchangeable to accept ‘dirty money’, or coins whose lineage could reduce anonymity.

Durability: Digital currencies are durable as long as the ledger is It is possible that ‘miners’ or validators of transactions Able to withstand maintained, and ledger storage sizes are widely lose the incentive to maintain the ledger. repeated use manageable. Coins of limited supply could succumb to ‘entropy’, where access to coins is lost forever; coins are forgotten about; or countless transactions leave minute denominations of coin behind (‘dust’).

Portability: Transported via the internet. Arguably crypto-wallets are not user-friendly; user Easily carried and Portable through online wallets, mobile wallets, hard- experience needs to be improved to enable mass transported wallets, and paper wallets. adoption. Some individuals in the UK still rely solely on cash.

Cognisability: Computers are commonplace in the UK and so Non-fiat pegged digital currencies are not ubiquitous Its value must be identification of digital currencies is near-universal. enough to have universally familiar values. easily identified Verification can be automated behind the scenes. ‘Forked’ chains of blockchain-based coins can be Adoption of cryptocurrencies is increasing, which confusing. suggests it has potential to be identified and widely Confusion over many similar digital currencies could understood. result in fraud. Identification is only easy for computers, not humans. Verification of ownership of funds, or of value can only feasibly be done with computers.

Stability of value: Stable cryptocurrencies have been designed. Some Most cryptocurrencies are extremely volatile in value. Its value should not are pegged with a 1:1 relationship with a fiat fluctuate currency, by creating (burning) digital tokens as fiat currency is deposited (withdrawn). Others have in-built code that stabilises the value of the currency using economic theory. 8

Medium of Exchange Function Fiat: Yes Digital currencies: Very few merchants accept them

Unit of Fiat: Yes Account Digital currencies: Merchants usually adjust digital currency prices according to their fluctuating exchange rate relative to fiat currencies

Store of Value

Fiat: Inflation erodes fiat value Digital currencies: extremely volatile price movements relative to fiat currency pairs.

Fixed supply coins are deflationary once mined CROP MARKS

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JAPAN — In April 2017, the Japanese government recognised Bitcoin as legal tender for transaction within the country — The government is developing an accounting framework for both users and businesses dealing with cryptocurrencies — By December 2017, Japan’s Financial Services Agency had licensed 16 companies to operate a crypto-exchange

ESTONIA — Estonia is aspiring to launch its own cryptocurrency, called ‘’, with the help of Ethereum founder Vitalik Buterin. It could be used to pay for public and private services in Estonia — ‘Estcoin’ could be launched through an ICO and the money raised could be managed through a public-private partnership in which parts of the funds could be allocated to developing Estonia as a new digital nation

VENEZUELA — Venezuelan president Nicolas Maduro announced the launch of a national cryptocurrency called . Petro will be backed by Venezuela’s oil, gas, gold, and diamond reserves — Economic crisis and hyperinflation is causing Venezuelans to swap bolivar for in order to buy basic goods — Bitcoin has gained popularity: The website Surbitcoin.com is a platform allows Venezuelans to buy and sell Bitcoins in exchange for bolivars. It had more than 85,000 users in 2016, which had increased from 450 users in 2014

SWITZERLAND — Switzerland considers digital currency to be equivalent to foreign currency — In January 2018, the Economy Minister, Johann Scheider-Ammann, claimed that the country should strive to become the “crypto-nation” — The Swiss Financial Market Supervisory Authority (FINMA) released official ICO guidelines stating that the current financial market law and regulation are not applicable to all ICOs

UNITED — In July 2016, the European Commission published a proposed directive known as MLD5. MLD5 will KINGDOM define ‘’ and will require platforms and wallet providers to implement financial crime preventive measures — In March 2018, it was announced that the Bank of England is undertaking testing on a DLT system for real-time gross settlements

UNITED — In March 2017, US Federal Governor Jerome Powell cautioned that a CBDC could stifle innovation to STATES improve the existing payments system — Several members of the US Congress are drafting legislation to protect cryptocurrency from the interference of the federal government that comply with certain minimum requirements — The Commodity Futures Trading Commission has designated Bitcoin as a commodity — The IRS in the US claims that Bitcoin must be treated as property for tax purposes. That means a capital gain or loss should be recorded as if it were an exchange involving property

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AUSTRALIA — The Australian government introduced a bill in August 2017 to regulate virtual currency exchanges in the country to prevent money laundering and terrorism financing, which recently came into force. The legislation requires cryptocurrency exchanges to register with Australian Transactions and Reporting Analysis Centre (AUSTRAC) and comply with various AML obligations — The Australian Stock Exchange declared that Bitcoin can be used to buy shares in the companies listed on the exchange — In the FY17-18 budget, the government removed double taxation on Bitcoin

CANADA — In September 2017, the British Columbia Securities Commission approved the first registered Bitcoin investment fund manager dedicated to cryptocurrency investments: First Block Capital — Canadian lawmakers appear to be adopting a lighter approach to regulating virtual currencies, with a ‘regulate-and-embrace’ policy, focusing primarily on AML concerns — ICO token sales may fall under the legal classification of securities

RUSSIA — Russian regulators have decided not to implement a regulatory framework and the legalisation of cryptocurrency as a result of Bitcoin’s volatility — Russia's Deputy Finance Minister, Alexei Moiseev, suggested that Bitcoin should not be classified as a property or asset — The Bank for Development and Foreign Economic Affairs has engaged in a partnership with Ethereum on DLT projects — The Moscow Stock Exchange has allowed qualified investors to trade cryptocurrencies against paper currency

INDIA — The government is exploring the issue of its own digital currency called ‘Lakshmi’ — A panel consisting of the Department of Economic Affairs, Reserve Bank of India, and NITI Aayog has submitted a report to the Finance Minister of India detailing how to deal with cryptocurrencies — In November 2017, the Indian Supreme Court issued a notice to the central bank and several agencies asking them to respond to a petition made to the court to regulate Bitcoin — While Bitcoin is not a legal tender in the country, cryptocurrencies are seeing increasing adoption

SOUTH — In May 2017, South Korea became the largest Ethereum exchange market, with US$335 million daily KOREA trading volume and 38% share. It also became the fourth largest Bitcoin exchange market after the US, China and Japan — South Korea is looking to revise the existing Electronic Financial Transactions Act to mandate regulatory approval for cryptocurrency transactions — In September 2017, Coinplug Digital Asset Exchange (CPDAX) launched a trading platform for some cryptocurrencies — Despite rapid adoption of cryptocurrency, the Minister of Justice announced that a bill is being prepared to ban all cryptocurrency trading. However, it was later clarified that a government-wide decision will be made in the future

— China’s central bank has suspended ICO activity CHINA — The regulator said that refunds must be provided from ICOs that have already been issued. It stated that digital tokens cannot be used as currency and banks are forbidden from offering services to ICOs — That said, the Republic of China is considering how it can take ownership of the sector CROP MARKS

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— The central banks of the United Arab Emirates (UAE) and Saudi Arabia are jointly working on a cryptocurrency to enable cross- border transactions between the two countries (December 2017)

— China’s central bank is conducting research to issue the country’s own sovereign digital currency. The reduction of transaction costs; the ability to extend financial services to rural areas and increasing the efficiency of monetary policies have been cited as reasons for such interest in virtual currencies. Similar efforts are ongoing in Russia (November 2017)

— The Bank for International Settlements has stated that policymakers cannot ignore the growth of cryptocurrencies and will probably have to consider whether they should issue their own digital currencies in the future (December 2017)

— UBS have developed a ‘Utility Settlement Coin’, which is an asset- based digital cash instrument underpinned by DLT. This was developed to improve capital efficiency, settlement and systemic risk reduction for central bank backed digital issuance, as a proxy for physical currency assets

— Ripple uses blockchain for financial institutions to process their customers’ payments globally in real-time, in a cost effective and reliable manner. The digital asset XRP can also be utilised by payment providers and banks to further reduce costs and to access new markets

— Microsoft has started accepting Bitcoins as a mode of payment again for its Windows and Xbox Online stores. Microsoft had stopped accepting Bitcoin due to its volatility. The company reversed the decision after ensuring that lower amounts are available for redemption by customers (January 2018)

— Chinese e-commerce giant Alibaba has launched a cryptocurrency mining platform called ‘P2P Nodes’, despite Chinese authorities considering restricting crypto mining (January 2017)

— SWIFT built a Proof of Concept (PoC) on Fabric to improve Nostro processes and are partnering with many banks. Intra-day liquidity standards were met in the PoC tests, as well as governance, security, ID frameworks, and data protection requirements (January 2017)

— Jesse Lund – IBM’s head of blockchain solutions for financial services – stated that the public should ‘definitely’ expect a CBDC to be issued on the Stellar network ‘soon’ and the firm has been working with central banks on digital currency projects (March 2018) CROP MARKS

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Regulatory risk There is uncertainty surrounding the regulatory requirements for entities considering applying DLT and cryptocurrencies, notably due to its distributed nature and because legal classifications are yet to be defined in many jurisdictions. It is unclear how onerous regulatory obligations will be.

Theft and fraud Although cryptographically very secure, wallets storing cryptocurrencies are susceptible for account takeover through the theft of private keys. When private keys are stolen, a malicious attacker can make fraudulent transactions and withdrawals.

Cyber crime Due to pseudonymity, cryptocurrencies are favoured by online criminals and hackers. Cybercriminals use malware to encrypt data on servers, hack computers and mobile devices, and insist that the ransom is paid in cryptocurrencies.

Technological immaturity DLTs are still relatively technologically immature. For example, blockchain has faced significant scalability issues. Although these challenges are increasingly being addressed, the process will take time.

Smart contract security Poorly written or audited smart contracts can be exploited by hackers who execute malicious code to steal funds. The most notable example is the DAO (Decentralised Autonomous Exchange) hack in June 2016 where 3.6m Ether ($70m then, around $2bn today) was stolen. This resulted in an unprecedented ‘editing’ of the Ethereum blockchain to erase the theft from history through a consensus agreement.

Systemic risk Financial contagion may occur if a crypto-based financial system becomes too interconnected. The risk of this could be further heightened if concentrations in geographies or mining systems develop, leading to a domino effect throughout the economy.

Sovereign risk The global, decentralised nature of public largely erodes sovereignty. Around 95% of fiat money creation currently occurs via commercial banks. These are heavily regulated, whereas the jurisdiction of public cryptocurrency issuers and users is unclear. Central banks’ power could be diluted in key functions. Taxation of a pseudo-anonymous asset is difficult to enforce and clearly reduces government power and revenue; unbalancing fiscal policy.

Future proofing Blockchains are difficult to update as changes require consensus. Quantum computing has been considered a threat to cyber security. However, algorithms exist that can ensure the security of blockchains in a ‘post-quantum’ world. CROP MARKS

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Requirements for a central bank digital currency (CBDC) – is DLT ready? — Price stability – most cryptocurrencies are volatile. ‘Stable coins’ have been designed – for example, some are pegged to fiat currency and others have built-in code. — Future-proofing (ability to upgrade without disruption) – Large upgrades require consensus, or ‘forking’ can happen. — Ability to add extra features and innovate

— Fast transaction processing – transaction speed is improving for some DLT coins. — Finality of transactions –blockchain solves the ‘double spending’ problem — Availability 24/7 – decentralising or distributing through DLT ensures network availability. — Scalability – scalability of many coin designs is largely untested. — Security – DLT is cryptographically secure: Computationally impossible to hack. — Confidentiality – blockchains are transparent, but transaction data can be designed to be hidden from parties. — Interoperability – exchange between fiat and other cryptocurrencies is possible. Retail infrastructure and user experience requires investment. CROP MARKS

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Advantages Risks Neutral

Impact on — Reduced risk — Central banks could mismanage central banks to central bank under full greater public lending risk exposure reserve banking — CBDC could erode the functions of the central bank

Impact on — Increased competition — Disintermediation of commercial commercial between commercial banks banks banks — Outsourcing money issuance to commercial banks is preferred by central banks — Less government support for retail banks given CBDC competition

Macroeconomic — Execute fiscal policies in — Potential for quicker bank runs — Full reserve factors real time banking — Central bank competing with possible — Direct monetary policy commercial banks could cause control commercial interest rates to soar or through CBDC real economic capital to dry up — Increased government revenue through public — Liquidity transferred from global deposits trade and locked up in full reserve public deposits — Removal of ‘zero-lower- bound’ constraint on — Potential for reduced economic interest rates through stability digital currency tech — Reduced economic growth due to commercial lending risk-aversion — Risk modelling of CBDC scenarios is difficult

Technological — Greater scope for — DLT is in its infancy factors accelerated innovation and — Alternative money systems could financial applications usurp CBDC if poorly designed — Subjective digital currency design dilemmas — Sharing of data with third parties — Requiring a trusted third party arguably nullifies key features of DLT

Financial — Transparency and — Independence of central banks is stability auditability of transactions seen as important — Improved market — Reduced checks and balances on the confidence central banks — Trusted central parties can — No lender of last resort for central retain central control banks through permissioned — Complexity, customer confusion, blockchains and poor decisions

Efficiencies — Removal of intermediaries — Cost saving digital

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Appendices CROP MARKS

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Issues associated with digital currency adoption faced by SWIFT (Jan ’17)

SWIFT built a Proof of Concept (PoC) on Hyperledger Fabric to improve Nostro processes and are partnering with many banks. Intra- day liquidity standards were met in the PoC tests, as well as governance, security, ID frameworks, and data protection requirements. It is believed that DLT can support financial multi-bank applications: DLT is a ‘strategic priority’ for SWIFT.

Conclusions from SWIFT:

While successfully meeting all the business requirements set out, the PoC evidenced the considerable pre-requisites for industry adoption of such a solution – for instance, all account servicers would first need to migrate from batch to real-time liquidity reporting and processing, and back office applications would need to be upgraded to feed the platform with real-time updates…

…Pre-requisites will have to be met before banks can enjoy the full benefits of switching to a DLT process…

…To facilitate improvements in the Nostro process, SWIFT will continue helping its community migrate towards real-time liquidity reporting and processing through, and establish a roll-out plan for the community-wide adoption…

…The PoC also showed that further progress is needed on the DLT technology itself before it will be ready to support production-grade applications in large-scale, mission-critical global infrastructures. For example, while 528 channels were required in the PoC to ensure Nostro accounts would only be stored on the nodes of their account servicers and owners, to productise the solution, more than 100,000 channels would need to be established and maintained, covering all existing Nostro relationships, presenting significant operational challenges. CROP MARKS

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Removal of intermediaries Reduced Central Bank Counterparty Risk Faster, cheaper, simpler transactions and processes. The risk to the central bank of directly lending to citizens Reduced likelihood of error or fraud. and businesses might be lower than the default risk of advance-lending to highly leveraged retail banks. Transparency Financial Safety Central banks can more easily track the flow of money through an economy with DLT. Central bank retail deposit accounts would limit the need for fractional reserve banking. Triple book-keeping (only possible with DLT) reduces counterparty disputes, and improves auditing and market With cryptocurrencies, a Full Reserve Banking System confidence. could potentially be feasible. There would be complete guarantees of deposits with the central bank, and risk-free Financial inclusion enabling any citizen to avail of liabilities for the central bank. banking facilities using a digital wallet Increased competition in the commercial banking Inclusion for those currently on the outskirts of the financial sector as central banks take market share machinery. Governments can reach, disburse aid to and collect taxes from individuals who are currently unable to This would result in enhanced product innovation and avail of financial services. Money would be protected as a differentiation by commercial banks. public utility under central bank issuance. Branch services, enhanced banking services (beyond central Ability to execute fiscal policy initiatives in real time bank retail services), property valuation, credit checks etc. would still be available through competing commercial With the ability to track individual transactions and monetary banks. flows, governments can execute fiscal policies in real time without the need for manual or administrative delay. Scope for innovation New channel for monetary policy transmission for more If central banks provide a core retail banking service, then direct effects to the economy some services currently restricted to the closed community of commercial banks could be opened up to other internet Direct, real-time control of the money supply would be companies; accelerating innovation for all. possible, versus indirect base-rate changes and quantitative easing. It would be possible to relieve the zero-lower-bound Reduced financial crime constraint of traditional monetary policy, as it is possible to Assigning identities to cryptocurrency accounts would pay negative interest on digital currencies. enable easier monitoring of transactions for criminal activity. Potential for increased government revenue Consensus mechanisms of DLT make fraudulent Commercial banks charge interest on the money they transactions infeasible, unlike ever before. create. If central banks provided retail services, they would Greater market confidence earn interest on the greater share of the money supply that they create, thereby increasing government revenue. A transparent platform for a nation’s financial system would Seigniorage Income would also be preserved. Taxation likely boost consumer confidence. could be automated and complete, through transparency of DLT. First mover advantage, network effects and the erosion of central bank power Cost savings Risk of public or private sector cryptocurrencies eroding the Government bodies are unlikely to take profits (ignoring monetary power of central banks if they don’t explore possible taxes), so there would be minimal account fees CBDC technologies. passed on to customers to cover expenses. Deposit accounts could be near free. Potential infrastructural Permissioned blockchains enable trusted central parties reductions in cost by moving away from a paper-based to retain system control currency system. Subsidies granted to commercial banks Distributed networks enable a high level of operational are costly to governments. If CBDC deposits with the resilience – functioning without service interruption central bank result in a net increase in central bank reserves, then the cost of state borrowing would fall. CBDCs would see massive transaction volume, requiring massive computing capacity. DLT can enable central banks to share the operational requirements with third parties, whilst retaining control CROP MARKS

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Resource limitations versus the private sector Erosion of the functions of a central bank Infeasible for one central bank to assess the Subjective design dilemmas creditworthiness of all citizens. Commercial banks will be CBDC, if launched with DLT, might be difficult to amend or less able to perform essential economic functions (like update in the future, due to the need for consensus monitoring borrowers) if the central bank competes. between parties. A balance between anonymity and Disruption to the status quo traceability. A balance between transparency and central control. Inflationary design of coin issuance, and Commercial banks create over 95% of the UK’s money controllability of money supply. supply. CBDC might have macroeconomic implications that are difficult to predict. Outsourcing digital money issuance to commercial banks is currently preferred by central banks Central bank independence is considered important Outsourcing of liabilities and operational responsibility suits The independence of the central bank improves market central banks. Central banks save costs, take on less direct confidence, as retail banking regulation is less influenced by liability, and retain monetary policy control. central bank agendas. Central banks might be tempted to increase risk Confusion and complexity for consumers exposure to reduce costs associated with money If the introduction of CBDC and central bank retail banking issuance services increases commercial banking competition, then No lender of last resort for central banks the comparability of banking products would be less likely as banks would seek to differentiate. This could result in Central banks might take on greater lending risks, without a confusion and poor financial choices by citizens and safety net. businesses. If CBDC fails after launch, alternative money systems Less government support for retail banks… could usurp central power …from the now-competing central bank. This could reduce Risk modelling of CBDC would be difficult the security of retail bank deposits through increased Reduced economic growth, due to commercial lending default risk. risk-aversion Negative interest rates Commercial deposits would reduce, as the central banks Negative interest rates would be easier to impose on siphons custom. Commercial bank funding would reduce, depositors of digital or crypto currency; an unpopular and increased risk aversion would stifle competitive lending prospect for depositors. risks. Financing of business ventures would become difficult, or central banks might make riskier lending decisions to Potential for quicker Bank Runs… compensate. With dissolved money creation power, …on commercial banks, as people would convert to CBDC commercial banks would need to borrow from central bank for risk-free money. It remains to be seen whether funds in order to pre-fund lending. Central banks could commercial banks would be as popular under CBDC become monopolistic in their power to dictate which economic ventures are worthwhile for all businesses and Disintermediation of commercial banks borrowers. Economic growth could therefore be constrained. Fractional reserve banking is seen as an important part There would be increased pressure on the central banks to of the economy make perfect credit assessments and monetary decisions. There would be reduced checks and balances of a CBDCs could revert the economy back to full reserve competitive monetary system, and place reliance on a single banking, which is controversial. entity’s investment decisions. If the central bank fails, Full reserve banking is economically inefficient alternative money would begin to circulate in the economy and compete with sovereign currency. Opportunity costs of stagnating capital deposits under full reserve banking. Competition could cause commercial interest rates to soar, or real economic capital to dry up DLT is in its infancy – questions over scalability and security Liquidity transferred from global trade and locked up in full reserve public deposits DLT is a young technology that has only been ‘proven’ in open source ecosystems like bitcoin. Basing a sovereign Cash offers greater anonymity than CBDC currency on the tech would need extensive research and For CBDC, the requirement of at least one trusted party development. (the central bank), who retains some control, nullifies CROP MARKS the necessity of key DLT features 18 MARGIN CROP MARKS CROP MARGIN

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Contacts

Anton Ruddenklau Head of Digital & Innovation, Financial Services E: [email protected]

Lauren Taylor UK Blockchain Centre of Excellence E: [email protected]

Michael Connor UK Blockchain Centre of Excellence E: [email protected]

Hannah Wilcock Global Digital Ledger Services E: [email protected]

Anthony Eskander Barrister, Legal Services E: [email protected]

kpmg.com/uk

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