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CENTRAL BANK DIGITAL AND THE THEORY OF

JUNE 2021 DIGITAL CURRENCIES AND THE THEORY OF MONEY

The development of Central Bank Digital Currencies (CBDCs) – a digital representation of issued by a central bank – has been accelerated by COVID-19 and the resulting shift to digital . In this briefing, we consider the different approaches being taken by central banks globally, including the digital , and , what practical adoption of CBDCs may look like, the legal structures that might be employed and the consequences for businesses.

The rise of CBDCs What are CBDCs? The level of interest in central bank digital CBDCs have been defined by the Bank currencies (CBDCs) has grown for International Settlements, as "a digital significantly over the past few years at instrument, denominated in the both a national and international level. national , that is a direct Many major jurisdictions around the world liability of the central bank" in a paper have active research and pilot projects published jointly with several central ongoing, and we are seeing the first banks in October 2020. "CBDCs can launches of live CBDCs – the Bahamas, be based on DLT, but they aren’t for example, launched its CBDC, the necessarily. So, different projects may Sand Dollar, in October 2020. "Different look at an account-based, or jurisdictions have very different token-based, models. The concept that a motivations for pursuing their individual CBDC is a direct liability of a central bank, CBDC projects. Financial inclusion is a is a concept worth considering when we top priority for CBDC development, look at the role that the private sector or particularly across emerging markets and intermediaries might play in a general developing economies – that was a key purpose CBDC," says Douglas. That can motivation for the Bahamas' Sand Dollar," be broken down very broadly into direct says Laura Douglas, a senior associate in models, intermediated or hybrid models. Clifford Chance's Financial Regulation In the direct model the central bank Practice in London. Financial inclusion is would interact directly with end users, generally the motivation for developing a including consumers, although in practice general purpose or retail CBDC where very few if any central banks are pursuing end users include the general public. such a model. Most existing projects are Conversely, financial inclusion is obviously exploring intermediated or hybrid models a less important motivation for wholesale where there are private sector projects where access to a potential intermediaries that would facilitate end CBDC is limited to financial institutions user payments that use CBDCs. and other players that have direct access to central bank accounts and central So, for example, focusing on the UK, the bank money. 's discussion paper on CBDCs, published in March 2020, Wholesale CBDCs are seen as less of a envisages an indirect model where the priority globally, compared with the Bank of England maintains the core general purpose CBDC but, at the same technology platform and ledger, but then time, a number of jurisdictions are looking regulated payment interface providers at wholesale CBDCs motivated by factors act as intermediaries to provide the such as improving efficiency of cross- user-friendly interface between the end border payments, development of user and the Bank of England as distributed ledger technology (DLT) CBDC issuer. enabled capital markets, and enhancement of cyber resilience.

2 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY It is worth noting that the Bank of What the creation of CBDCs does is to England has proposed the use of eliminate all of the technical problems that application programming interfaces (APIs) are created by physical cash," says to make that connection between the London-based Clifford Chance Partner, core ledger and the provision of services Simon Gleeson. to end users similar to what is seen, for example, in the Open Banking space. He adds: "So we suddenly go into a world where you can have as much Intermediated or hybrid models should physical cash as you like taking up no also be distinguished from so-called space at all, which is remotely "synthetic" CBDC. This term has been transferrable and doesn’t require chaps used to describe a scenario where a and guns to look after it. Potentially, that central bank issues a wholesale only could get you to a world where we don’t CBDC and then commercial providers in need commercial banks and commercial turn issue CBDC-backed electronic bank money anymore – everyone can money or stablecoins to retail end users. settle directly in CBDCs. However, the CBDC-backed electronic money or stablecoins do not in fact meet However, this creates a problem. the definition of a CBDC referred to Commercial banks take in deposits, they above, as they are not liabilities of the lend those deposits out as loans, and central bank. Instead, they are liabilities of the difference with the Bank of or claims on the commercial bank that England. But in a world where all money issued them – much like commercial is held in the former Central Bank, the bank money today. question is, where does commerce and industry get its credit from? It has to go Different projects are also looking at to the Central Bank. "If you imagine a different design features and world where everybody does everything functionalities: whether the CBDC will using CBDCs, what you have actually allow functionality for offline payments, done is nationalise the supply of credit to which is obviously important for financial the economy. This has been tried in inclusion; whether peer-to-peer payments various spots around the world; Russia's will be possible; the potential 24/7 Gosbank is the best-known example. It availability of the CBDC; questions around didn’t work terribly well, but the key point privacy and anonymity and determining is that the introduction of CBDCs who gets to see what in terms of actors necessarily changes not only the payment and users of the CBDC and transaction system but also the credit system, and so level data; and how CBDCs function there are some quite big consequences," alongside existing payment methods and says Gleeson. interact with the existing financial market infrastructure, both at a national level and The second issue is how CBDCs are on a cross-border basis. administered. For crypto to be transferred from one person to another What is the impact will require service providers. The of CBDCs? question arises as to what is the legal basis on which that service will be "If you think about how the banking provided? There are two entirely different system actually works today, the reality of ways of providing that service. One is to the situation is that people pay bills with say that it looks like a custody service; money created by commercial banks. The so, the CBDC remains owned throughout commercial banks settle between by the customer, the bank undertakes the themselves in central bank money, so the administration for the customer and only way that the central bank provides charges the customer a fee for so doing. money directly to the end user is when it That is awkward for the customer, creates notes and coins – legal tender. because customers are having to pay for Legal tender is always a very small part of a service that was previously free of the payments world just because it is charge. Alternatively, the bank says to the irritating and difficult to deal with, it has to customer: "We will effectively buy your be stored, it has to be kept secure, it has CBDCs from you, so what you will own to be transferred by physically moving it will not be CBDCs themselves, it will be a around, and it is generally a nuisance.

CLIFFORD CHANCE 3 CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY claim on us for those CBDCs." What that deemed for all purposes to be money, it achieves is basically to reinstate deposit creates as many problems as it solves banking as it exists today. From the because there are then and bank's point of view it accepts the status money laundering requirements. "The quo: it can take those CBDCs, lend them trouble with CBDCs is that they are like out, make money out of the loan, use money, but in a number of respects they that to subsidise the payment service and are not money and an answer 'this is in that respect everything is as it was. money for all purposes' is every bit as However, from the customer's point of unsatisfactory as the answer 'this is not view, the question is 'What is the money for all purposes'. So, part of the difference between owning a claim on a creation of CBDCs will have to be the commercial bank for payment of sterling creation of a new legal architecture that and owning a claim on a commercial deals with all these consequential bank for payment of or questions," Gleeson says. whatever'?" says Gleeson. What's happening in If the structure is a custody structure then the UK? there is a credit problem and customers pay a lot more for the service than they In April 2021, the Bank of England and are currently getting, and if there is a HM Treasury established a new CBDC deposit structure then what was the point Taskforce to ensure a strategic approach in creating the CBDC in the first place? "It is adopted between the UK authorities as is that issue, the question of how these they continue to explore the possibility of services will be provided, which will have developing a CBDC, with the creation of the biggest impact on whether these new engagement and technology for things are created at all and how they are broader stakeholder engagement. actually used in practice," he says. Alongside this, the Bank of England Another question posed by Gleeson is published a discussion paper on new what exactly are these things? "If I give forms of digital money and feedback to you a CBDC, does that discharge a its March 2020 discussion paper, payment obligation? If I go into a shop highlighting five core principles that will and give the shop CBDCs in exchange guide the Bank of England's future for a kettle, have I bought that kettle? It exploration of CBDC. These principles sounds like a stupid question but actually point towards: it has significant consequences because the definition of a sale is the exchange of • Financial inclusion as a prominent goods for a sum of money, called the consideration in the design of price. I only have Sale of Goods Act any CBDC. protection, or Consumer Act protection, if • A competitive CBDC ecosystem with what I did was a sale. So, if the CBDCs the private sector taking a leading role are money, I then have consumer in responding to end users' needs. protection in respect of the kettle; if they aren't, then I don't. How do you take • The need to assess whether non- security over it? Can you not reasonably CBDC payment innovations could claim that you can net a money claim deliver the same benefits. against a different money claim? It's • The need to protect users' privacy equally clear that you can't net a money (whilst complying with important legal claim against an obligation to deliver a compliance requirements such as anti- thing. So, if I owe you £100 and you are money laundering, countering the obliged to deliver to me £100 in CBDCs, financing of terrorism and sanctions). can I net or can I not?" • Consideration of opportunities a CBDC There is a whole array of questions of that might bring for monetary and financial kind, all of which will need to be stability as well as for payments. answered. If, for example, a CBDC is

4 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY What's happening in area will have digital legal tender that can the ? be used in the digital space? What is a digital euro? The report The ECB report identified several key published by the European Central Bank principles: the digital euro should be 1 (ECB) on the digital euro states that the convertible at par; it should be a risk-free digital euro will be, if it comes into force, a asset; it must permit equal access across liability of the ECB and the euro system the Eurozone; and be based on a system offered in digital form for use by citizens and technology that is secure and can and businesses to make payments. The be trusted. intention is that it would complement cash and wholesale central bank money, One of the reasons cited for the issuance but not replace them. "Interestingly, this is of digital euro partly concerns the not synonymous with DLT or block chain, challenges to monetary sovereignty of the and the intention of the report is to remain euro area from private challengers, such technologically neutral even though, when as LIBRA/DIEM2, or potential currency most people speak about central bank displacement when or if the digital , it is frequently in the or digital dollar become a reality and context of block chain," says Jonathan becomes currently used in the digital Lewis, a Clifford Chance Partner in the economy. "In order for the Euro area to Financial Regulatory Group in Paris. preserve its financial and monetary autonomy, it would be necessary to have The Treaty on the Functioning of the something that's more user-friendly than , the Statute of the the current format of euro in the digital European System of Central Banks and space. Clearly, there has been declining the Regulation of 1998, which introduced use of cash and a need within the Euro the euro, provides the legal basis for the area for a modern, robust payment ECB and the euro system issuing notes system which facilitates and encourages and coins which are legal tender in the innovation and the digital economy," Eurozone. The report recognises that, he says. depending on what features and functionality are adopted for the digital What are the challenges euro – and whether it is limited in purpose or is to have the same legal status as a for a digital euro? euro bank note, the legal basis to be There are significant policy issues of how used under TFEU, the Statute and to reconcile a digital euro with financial applicable regulations may differ. "Given stability, specifically how to reconcile a political sensitivities on currency issues, digital euro with the traditional role of the choice of legal basis is quite banks acting as intermediaries, which important because as we saw in the euro transform retail and corporate deposits crisis, there are often groups who take into loans and investments in the real legal actions before the European Court economy both to industry and to of Justice or domestic constitutional consumers. With this in mind the ECB's courts, to challenge evolutions in the role report looked at differences in design, of the ECB, the euro and monetary potential use of direct models, potential policy," says Lewis. use of indirect models where the role of intermediaries is preserved, account or He adds that a parallel issue is, if the tokenised digital euro and issues of digital euro becomes legal tender or its security, secrecy and privacy – today equivalent , what happens in the cash is totally anonymous, but there is a domestic commercial law of EU states as concern that digital euro should not be to how one can validly discharge a ; completely anonymous because of AML in particular, would a person be entitled or concerns on the financing of terrorism permitted to use stable or other and proceeds of crime. digital currencies e.g. DIEM to repay a debt, or will the use of those other digital currencies be restricted because the euro

1 Report on a digital euro October 2020 2 The stable coin sponsored by Facebook.

CLIFFORD CHANCE 5 CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY Within the context of combatting financial otherwise not regulated, and, in particular, exclusion and facilitating full participation Stablecoin. There is also a forthcoming in economic life the use of physical regulation to set up a pilot scheme for devices eg digital wallets or encrypted DLT multilateral trading platforms and mobile phones to facilitate offline use is central depositories. also being explored. Partly with a view to taking steps to preserve the traditional Christine Lagarde stated in the ECB transformational role banks and partly to report that "we need to be ready to explore the role of the digital euro as a introduce the digital euro should the need tool of monetary policy some of the arise." The decision will be taken in the discussions relate to whether there first half of 2021. "It looks as if we are should be limitations on holdings of digital going in the direction of the digital euro euro so they that do not completely being adopted and further work being displace deposits as a source of stable done. With that in mind, the ECB and the investment, and on issues of tiered Commission, in a joint statement in renumeration, so that if you hold digital January 2021, said they were working on euro beyond a certain level, either policy, legal and technical issues to penalties are levied or you do not receive assess feasibility and the way forward," the same renumeration as someone with says Lewis. a smaller holding. The US perspective A public consultation3 resulted in over The US is behind other countries in terms 8,200 people responding (a fairly large of how it sees CBDC development. It is response): 94% were individuals, and only very much in the planning and exploration 6% were professionals; most responses stage, explains Megan Gordon, a partner came from Germany, Italy and France. in the Washington Litigation and Dispute The issues identified were privacy Resolution practice. Last year the Federal concerns, security and trust in the Reserve Chair, Jerome Powell, was system, usability throughout the Eurozone questioned by Congress about CBDCs. and the ability to use offline. However, At the time Powell said that he one encouraging element of the appreciated the importance of making feedback, for those who want to preserve quick progress and generally noted that traditional banking, is the concerns there were unanswered questions. In May expressed to integrate the new system 2021, it was announced that the Federal with existing systems and to potentially Reserve will issue a research paper on regulate intermediaries. Using CBCDs this summer. While the Fed has intermediaries as a gateway was said consistently that it is under no rush something that seemed to be envisaged to introduce a CBDC, it is clear that there by those responding to the survey, who is increasing pressure to do so. did not seem to consider the question of "Congress is worried that the US will fall direct access to the central bank. behind its competitors – in particular China – and there is concern that the US On the wholesale side, there has been Dollar will be replaced as a major some interesting uses of digital euro by international currency by another digital the Banque de France. In March 2020, currency that is easier to move there was an issuance of covered bonds internationally," says Gordon. Part of this using Société General's FORGE system, concern is based on the fact that 5.4% of as well as, in early 2021, an issuance of a Americans still do not have checking or subscription of fund units using block saving accounts. During the pandemic chain and in April 2021 the issuance of this meant that it was very hard to reach an EIB bond using digital euro managed a small, but significant, number of through the Banque de France. This Americans who were entitled to activity needs to be put into the context stimulus payments. of the digital finance initiative; the new Markets in Cryptoassets (MiCA) regulation The published a paper in is intended to provide a context for the February on five broad categories of what regulation of cryptoassets that are are seen as preconditions for CBDCs:

3 Report on the public consultation on digital euro April 2021.

6 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY 1. The first objective is in keeping with the 4. Robust technology and block chain. guiding principle of the Central Bank, What technology is going to be used which is to do no harm, but it also and who is going to design it? How do wants to complement existing forms of we get to a technological environment money and support innovation and that everyone can agree on? Block efficiency. There are currently huge chains are also an issue given the inefficiencies in some money transfers. amount of energy it takes to validate transactions in a block chain. Some 2. Broad stakeholder support. "I think this environmental groups are already is going to be the hardest push for the voicing concern about the energy US, because it includes governmental usage involved, and if very large block bodies. The Fed has said that it will chain systems are used to operate require congressional approval to be CBDCs then that problem will increase. able to issue CBDCs and it's a pretty big issue in the US to get that type 5. Market readiness and the appropriate of consensus," Gordon says. It will timing for the introduction of CBDCs. also require the buy-in of "Are there end users that are willing to financial institutions. adopt it? Is there a demand for it? And is 3. A strong legal framework. There is a there an ecosystem to support it?," asks general question in the US as to Gordon. "In other words, is it seen as whether the issuance of CBDCs would solving a problem? There is a huge be consistent with the Fed's mandate concern that the US will lose its and whether it would require an prominence, and that the US dollar will additional amendment to the Federal lose its prominence if China moves Reserve Act in order to issue them. ahead. I think that is really what's driving "I think that the general thought of the a lot of the US efforts in this regard," she Fed is that it would, although there is says. That said, there is clearly a great some disagreement on that. In the US, deal of caution about moving to a digital legal tender means something different dollar. "I don't see the US as being at all than it does in other countries. Federal the first mover on this, but the Fed has law does not compel private said it will be a big year for CBCDs and businesses to accept a currency or there will be more announcements in the coin even if it is legal tender, and this coming months." could make the rollout of CBDCs both easier and harder. Easier because not China and CBCDs every business has to actually support China is pushing ahead with CBCDs. it technically, but harder because many There are some pilot programmes in businesses could opt out and payment place and many Chinese people are systems, of course, need to have one becoming increasingly aware of the universal way to accept tender," she concept. China's central bank, the says. There is also an issue with anti- People's Bank of China (PBOC), began money laundering and sanctions. The research into digital currencies as early as US has a huge sanctions regime, which 2014, and has renamed the Institute for plays a significant role in foreign policy Printing Technology for Legal Tender as – there are concerns about terrorist the Digital Currency Research Institute. financing, money laundering and "This demonstrates an expectation by privacy. There are also concerns about China's central bank that printed legal cost and liability – the cost of anti- tender will be replaced by digital currency money laundering systems and at some point," says Kimi Liu, a counsel sanctions controls are currently borne in Clifford Chance's Beijing Banking and primarily by the financial institutions, but Finance Group. in a system where the central bank takes that over, who is responsible for In April 2020, China formally announced those costs and for consumer-facing that it would test a digital currency called issues, and who is liable to consumers? Digital Currency Electronic Payment (DC/ EP) in some selected cities. "On the

CLIFFORD CHANCE 7 CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY legislative and technology side, China is What's happening in Hong making progress. Previously, there was a Kong and ? lot of discussion as to whether China's digital currency is for retail purposes only, The Hong Kong Monetary Authority because all the testing is currently in retail (HKMA) has identified the inefficiencies of situations – to buy coffee in Starbucks, cross-border payments, and has applied for example, and to make other small technology to try and resolve those and payments. However, in February 2021, make such payments more efficient, says another initiative was announced focusing Rocky Mui, a partner Clifford Chance's on wholesale," says Liu. Funds Practice, based in Hong Kong. "They haven't created something It is clear that China's central bank will completely new. They are not going to adopt an intermediary model. The PBOC change the law, and it's not going to will issue digital currencies to those create a new digital currency. It's really intermediaries (China's major banks, and just building and upgrading the third-party payment service providers infrastructure with block chain such as TenPay and Alipay, in exchange technology," he says. In conjunction with for the deposit of lawful currency with the the Bank of Thailand, it is developing a central bank. Those intermediaries can pilot prototype of cross-border payments offer digital currency wallets to end users settlement. "The idea is to get rid of the and will undertake daily operations and corresponding bank because it's transactions. "Given China's size, it will inefficient. Simply put, you have the local be difficult for the Central Bank to build payment system in Hong Kong and the infrastructure and a system to deal Thailand, and you then build a bridge with individuals across the country, so it between them using a block chain. You will rely on an intermediary for then can have a live feed in terms of implementation," says Liu. The Chinese quotes, and execution and settlement regulator is quite clear that it will be can be made in real time. That's the aim. technology-neutral, so any technology It is a simple idea, so it's a lot easier to that can satisfy security and reliability get all the stakeholders onboard. There is requirements will be welcome. However, less concern about who has this control, if DLT is used, it is likely to result in who is going to have the legal title and enormous energy consumption which, privacy concerns," he says. Hong Kong's with such a large population, will be approach is to move quickly. The next problematic for the Chinese government. step is to bring in more central banks – the UAE's, and the PBOC in China. In terms of cross-border activity, China's Digital Currency Research Institute has Singapore has been working on Project announced that it will work together with Uban, a digital currency, for the past five the UAE Central Bank, the Hong Kong years. It has tested a lot of elements, Monetary Authority and the Bank of including cross-border settlement Thailand, with support from the Bank for transfers, and has tried to tokenise International Settlements Innovation Hub, bonds, loans and insurance. Now the to develop a proof of concept prototype focus is on using the technology and the to facilitate real time cross-border foreign digital currency concept to make the exchange payments. "I think this is the settlement system more efficient. start of China challenging the digital currency concept on a wholesale and cross-border basis, but it is still at a preliminary stage," Liu says.

8 CLIFFORD CHANCE CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY CONTACTS

Simon Gleeson Laura Douglas Megan Gordon Partner Senior Associate Partner London London Washington DC T: +44 207006 4979 T: +44 207006 1113 T: +1 202 912 5021 E: simon.gleeson@ E: Laura.Douglas@ E: megan.gordon@ cliffordchance.com cliffordchance.com cliffordchance.com

Jonathan Lewis Kimi Liu Rocky Mui Partner Counsel Partner Paris Beijing Hong Kong T: +33 1 4405 5281 T: +86 10 6535 2263 T: +852 2826 3481 E: jonathan.lewis@ E: kimi.liu@ E: rocky.mui@ cliffordchance.com cliffordchance.com cliffordchance.com

CLIFFORD CHANCE 9 CENTRAL BANK DIGITAL CURRENCIES AND THE THEORY OF MONEY This publication does not necessarily deal with every important topic or cover every aspect of the topics with which it deals. It is not designed to provide legal or other advice. www.cliffordchance.com

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