Central bank digital currencies

The prospect of a widely used privately issued global stablecoin has engendered an important policy debate on the desirability of CBDC.[1] The introduction of a CBDC as a third category of base money, complementing cash and reserves, would allow households and businesses to hold claims in digital form against the central bank directly, providing an additional and widely available instrument for retail payments. A CBDC may be either account-based or token-based. An account-based CBDC could be easily introduced and would largely resemble the current system of deposits at commercial banks, except that accounts would be held directly with the central bank. By contrast, a token-based CBDC as a fiat cryptocurrency could replicate some of the features of a cash payment. The tokens representing claims on the central bank could be transferred cash-like peer-to-peer with some degree of anonymity depending on the wallet software. This could be achieved on the basis of a permissioned DLT network maintained by the central bank. However, whether CBDC may be implemented as a fiat cryptocurrency remains to be seen. Systems based on centralised settlement technology may prove to be more efficient.

Legal challenges

The operation of tokenised and off-chain collateralised stablecoin systems depends on an entire ecosystem of entities with specialised functions, some of which may fall within various regulatory perimeters. The issuer may need to obtain licences as payment services provider and/or electronic money provider; a banking licence may be necessary where the issuer or custodians accept deposits. If the stablecoin set-up is interpreted as a collective investment fund it may require a licence as such. Custodians may require licences for the custody and safekeeping of reserve assets. Depending on the regulatory classification of the respective coin - money, security, commodity and/or derivative -, market-makers and exchanges may need a licence as investment firms; and management of the pool of reserve assets may require an asset manager licence.125 These regulatory regimes ensure a minimum of user protection and address to some extent operational, market, credit and liquidity risks. Outside these various regulatory perimeters, the protection of users depends entirely on the generally applicable law and contractual documentation.

In the absence of a robust statutory underpinning, the relationships between the various participants need to be firmly specified by contractual arrangements. For example, the

Cryptocurrencies 337 legal entitlement of a user vis-à-vis the issuer may be a personal claim for an amount in the reference currency, or it may be, or secured by, a proprietary interest in a segregated pool of assets.[2] Segregation of reserve assets or holding them through a bankruptcy remote special purpose vehicle will have to be clearly set out in the agreement between the issuer and any custodians, if not mandated by applicable regulation. Users will be interested in whether any profits will be distributed to the issuer and validating nodes only, or whether the users themselves will participate. The system’s governance arrangements have to set out the allocation of decision-making power between the issuer and other holders of key functions. At the user interface, there is the general issue of the applicability of consumer and investor protection laws. Without a clear specification of the nature and allocation of legal entitlements across the participating entities, the failure of any key function may not only bring down the whole system, but any attempt at disentangling the various positions may be difficult and chaotic.

On-chain collateralised stablecoins and algorithmic stablecoins may engender legal challenges of an entirely novel kind. Where issue, redemption and margining are entirely controlled by a DAO the question as to the legal nature of this set-up immediately arises with significant consequences for users, initiators and validating nodes. For lack of registration a DAO is unlikely to be a corporate type entity. Depending on the allocation of rights and obligations, a DAO may constitute a commercial partnership, at least in certain jurisdictions, with initiators and/or validating nodes and/or users as partners. This raises the issue of liability, not just for initiators, but potentially also for validating nodes and even users. Overall, the delineation of the legal responsibilities of all constituencies involved requires careful consideration.

The allocation and use of stablecoins that run on globally distributed ledger systems will rarely be confined to a single jurisdiction. Effective cross-border regulation and supervision will require enhanced international cooperation. The otherwise ensuing fragmentation of the regulatory landscape may incentivise arbitrage attempts and result in inefficiencies in cross-border settings. Regulatory concerns arc amplified for stablecoins with a potentially global reach. Facebook’s 2.5 billion active users provide a massive incentive for online and offline retailers to accept Libra (now Diem') as a means of payment. The network effects that would normally hamper the adoption of alternative currencies actually work in Libra’s (Diem’s) favour. A global stablecoin, issued by Facebook or other Tech giants, may or may not be systemically important from day one; it certainly has the potential of getting there sooner rather than later. Trust in a stablecoin depends on users’ confidence that each coin is continuously backed by an adequate amount of reserve assets, which can only be achieved through robust measures addressing market, credit and liquidity risks. At the same time, stablecoin providers face a constant conflict of interest between maintaining redeemability

338 MA Schilling

at par and profit maximisation through deviations from full collateralisation.[3] The users’ realisation of this conflict of interest - perhaps triggered by weak mechanisms to redeem value, ambiguous legal obligations of the issuer, inadequate legal remedies, and poor governance arrangements - may result in a loss of confidence in the stablecoin, which may also be caused by reputational damage resulting from the issuer’s other lines of business (data breaches, political scandals). The resulting run of users to redeem their coins at par may be akin to conventional bank runs, however without deposit insurance and lender of last resort backing. In fact there might be numerous feedback loops between a stablecoin and the traditional banking system. A run on a stablecoin may necessitate the liquidation of the reserve portfolio at fire sale prices with potentially systemic effects on the banking system. On the other hand, the stablecoin itself may be exposed to the credit and liquidity risks of the banks that maintain deposit accounts as part of the reserve. Liquidity issues at the bank may affect redeemability at par of the stablecoin with an ensuing loss of confidence. Also, where confidence in one or more banks has been eroded, the ready availability of a global stablecoin may exacerbate the fragility of the banking system: bank deposits may decline, and bank funding may shift into more expensive and volatile wholesale funding. Thus, the interactions and potential spillovers between a global stablecoin system and the traditional financial system are manifold. Systemic risk may lurk in many corners. In order for a global stablecoin to be a safe alternative, a robust legal and regulatory framework will have to be developed over time.

A widely accepted global stablecoin would weaken the effect of monetary policy on domestic interest rates and credit conditions. It is therefore not surprising that numerous central banks have explored the option of a CBDC. The implications for the financial system are hard to predict. Units of CBDC compete directly with bank deposits. Presumably, they would be legal tender without counterparty credit risk or run risk, rendering CBDC superior to bank deposits. As a consequence, commercial banks would have to find alternative sources of funding, and in order to remain attractive to customers would have to offer additional benefits and services, perhaps higher interest rates on deposits. Whereas deposits would become less reliable as a source of funding for commercial banks, CBDC could provide an alternative payment system that is immune to systemic crises.1411 In any case, a CBDC would be disruptive to the financial system and require a comprehensive rethink in both economic and legal terms.

  • [1] Fiedler et al (2019) 10; T Mancini-Griffoli, M Soledad Martinez Peria, I Agur, A Ari, J Kiff and A Popescu, ‘Casting Light on Central Bank Digital Currency’ (2018) IMF Staff Discussion Note SDN/18/08 (November 2018) 6. 2 Fiedler ct al (2019) 17; Mancini-Griffoli ct al (2018) 7. 3 Fiedler ct al (2019) 18; Mancini-Griffoli et al (2018) 8. 4 Fiedler et al (2019) 18; Mancini-Griffoli et al (2018) 9. 5 E Gerba and M Rubio, ‘Virtual Money: How much do Cryptocurrencies Alter the Fundamental Functions of Money’ in European Parliament, The Future of Money - Compilation of Papers, Study requested by the ECON committee (December 2019) 3155. 6 For example, Libra 2.0 (https://libra.Org/en-US/white-paper/#cover-letter). 7 In addition, there are issues of anti-money laundering/countering the financing of terrorism, data protection, tax compliance and many more, for a comprehensive overview G7 Working Group on Stablecoins (2019); FSB (2020) 14-20, Annex 2 and 3. 8 Zetzsche et al (2019) 17-23; Gleeson (2018) para 10.01-10.71; FSB (2020) 14-20.
  • [2] G7 Working Group on Stablecoins (2019) 6. 2 Bullmann et al (2019) 12. 3 Zetzsche et al (2019) 7. 4 Ibid., 7-9; G7 Working Group on Stablecoins (2019) 6. 5 G7 Working Group on Stablecoins (2019) 10. 6 Zetzsche et al (2017) 36-37. 7 Zetzsche et al (2019) 26; FSB (2020) 20. 8 G7 Working Group on Stablecoins, Investigating the Impact of Stablecoins (October 2019) 11. 9 Zetsche et al (2019) 15-16. 10 G7 Working Group on Stablecoins (2019) 12-13; FSB (2020) 11-14.
  • [3] Claeys and Demertzis (2019) 93. 2 G7 Working Group on Stablecoins (2019) 13-14. 3 Ibid.; FSB (2020) 11-14. 4 FSB (2020) 24-33. 5 G7 Working Group on Stablecoins (2019) 15-16. 6 Zetsche et al (2019) 16. 7 Fiedler et al (2019) 19-20. 8 Zetsche et al (2019) 16. 9 Hayek (1990).
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