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#Digital Currency Ecosystem

Demystifying tokenized currencies

Global Trends
11 Mins.

Central and commercial banks are moving progressively closer to the issuance of tokenized money. But there are important differences between the models, solutions, and use cases currently under development. From retail and wholesale CBDCs to commercial bank money tokens and CBDC-backed stablecoins, we define and examine the propositions, comparing the role each will play – and their interdependencies – within the fast-evolving tokenized ecosystem.

The introduction by PayPal of a US dollar-backed stablecoin signals that tokenized currencies are entering the mainstream. The move comes as central banks around the world edge toward the design and introduction of central bank digital currencies (CBDCs) – and as commercial banks explore their role in supporting token-based digital money.

There are numerous influences driving such momentum:

  • Consumer and retailer interest levels in using digital forms of transfers, payments, investments, and savings
  • Central banks’ mandate to protect and evolve the financial system for the digital age
  • Commercial banks looking for more efficient settlement and cross-border transfer mechanisms that meet evolving client needs
  • Businesses and industry wanting to use new forms of money that will support IoT payments and other use cases built on programmability and offline transactions, to name a few.

However, such developments also promote a certain level of confusion. What is the exact meaning of the different terms being used? What is the scope and role of each proposed new form of tokenized money? And how do the various approaches relate to crypto-assets such as Bitcoin and the collateralized stablecoin Tether? 

A useful starting point then for any discussion of the different implementations of tokenized currencies might be a short definition of the main candidates.

Defining tokenized money

Retail CBDC  Highest in profile, retail CBDC is a digital representation of a country or region’s existing currency. It is a digital form of cash issued by a central bank as legal tender. A retail CBDC is designed to be used by the general public and merchants for retail payments and peer-to-peer transfers. Retail CBDC will co-exist with other forms of payment. It will be an additional form of money, exchangeable one to one with cash and bank balances.

Wholesale CBDC  Wholesale CBDC is a currency issued by a central bank in digital form, designed to be used exclusively by financial institutions that hold reserve accounts at a central bank. Its primary purpose? Settling large, low-frequency, high-priority transactions using tokenized assets (including cross-border transactions). Like traditional settlement systems, it is not accessible to the general public.

Commercial bank money token  Conceived as complementary to CBDC, CBMT is a tokenized form of “commercial bank money,” the class of money in an economy that is created through debt or deposits issued by commercial banks. The focus of CBMT is to support the ongoing digitalization of business processes (notably, Industry 4.0 initiatives). Though 1:1 convertible into commercial cash (and CBDC in the future), liability rests with the commercial bank issuer rather than with the central bank. Some models explore the possibilities of wholesale CBDC-backed CBMT.

CBDC-backed stablecoins  CBDC-backed stablecoins are digital currencies issued by commercial banks (or other private non-bank entities) and backed 1:1 by wholesale CBDC (but with the liability remaining with the issuing bank/entity). The distinction from CBMT? CBDC-backed stablecoins are bearer instruments, meaning that the holders are the owners, and they can be freely transacted with other users outside of issuing banks without the banks’ necessarily tracking ownership transfers.

Privately issued stablecoins  The conventional forms of stablecoins that have been around for almost a decade are crypto-assets with unit values pegged to another asset class – such as a public currency, commodity, or secondary “cryptocurrency” – or whose target price is controlled algorithmically. Introduced to provide an alternative to the high volatility of popular crypto-assets such as Bitcoin, they are primarily used as a medium of exchange, serving as the preferred instrument to settle the cash leg of crypto-asset exchanges, but also as a temporary store of value on exchanges.

Comparing the functions of different digital currencies

Although these digital currency solutions (with the exception of traditional stablecoins) feature in the plans of different central or commercial banks around the world, each is designed to fulfill a different – but related – set of functions:

Retail CBDC: general purpose, inclusive, online/offline

Expectations are running high in many countries around the issuance of CBDC in the short term, with almost a quarter of central banks already piloting a retail CBDC.1 Predictions are that institutions behind major currencies, such as the European Central Bank, will introduce the general-purpose digital currency around the turn of the decade

The introduction of a retail CBDC, to exist alongside traditional cash, would help to bridge people’s changing preferences and options for digital payments, with the benefits of a central bank-backed digital equivalent of cash.

But there are numerous other drivers, including the opportunity for central banks to maintain greater financial stability, to make the digital payment ecosystem more inclusive, to foster innovation and enhance competition in the payment sector, and to increase payment efficiencies.

In particular, financial inclusion is a key policy objective for central banks. Through the introduction of easy-to-use CBDC wallets in the form of smart cards, many unbanked or underbanked populations will gain access to the digital payment system without having to open a bank account. CBDC can then serve as an on-ramp to the broader financial system, helping to establish individual credit histories and borrowing capabilities.2 

In that context, an essential design feature of a truly inclusive CBDC is an offline capability. Many groups of people have no reliable access to the internet, mobile communications, or even an electricity supply, so a CBDC that supports transactions in all circumstances is seen as a must. That is particularly important in conditions where both the payer and payee are in offline mode – what is known in the industry as dual offline transactions. Designs also need to support the possibility of re-spending amounts received offline while being still in an offline mode (known as consecutive offline transactions). Those are both key design features of G+D’s CBDC solution Filia®.

While retail CBDCs will be issued by the central bank or monetary authority, they will be distributed by commercial banks, financial service providers, and merchants – just like cash. A key objective of this two-tier distribution model is to also preserve financial stability and maintain the stability of the national payment system and its stakeholders. The anticipated level of public and private collaboration is demonstrated by the fact that nine out of 10 central banks say they are already engaging with outside stakeholders when designing proofs of concept and pilots for their CBDCs.1

A recent example of such close collaboration involved Standard Chartered Bank Hong Kong’s work with G+D on the Hong Kong Monetary Authority’s Pilot Programme for an e-HKD. The team’s tests and experience sessions included a range of real-life scenarios involving public transport, restaurants, small retailers, and a university campus, designed to explore the hypothetical e-HKD’s potential benefits. It demonstrated how a digital currency can operate without being connected to the internet while enabling real-time and secured consecutive dual offline payments.

Wholesale CBDC: removing friction from interbank settlement 

While retail CBDC is all about the creation of a public digital currency, wholesale CBDC is focused on the settlement of interbank transfers and related wholesale transactions – a fundamental part of the infrastructure that underpins the smooth functioning and stability of the financial system of a country or region. 

Traditional systems have a delayed settlement due to the complex nature of each transaction. They rely on the trust that the counterparty involved will be able to pay, allowing final settlement to be executed in a batch process at a later point. 

As Fabio Panetta, European Central Bank board member, has pointed out, wholesale CBDC projects are about making digital interbank transactions (such as securities settlement, and cross-currency payments and their settlement) much more efficient and safer.3 

By removing intermediaries and improving the speed and reliability of settlements, wholesale CBDCs will reduce the cost and complexity of
cross-border payments. A wholesale CBDC would add a further advantage: transactions can be settled atomically and automatically based on predefined conditions. 

Wholesale CBDC could also be an enabler for various design and distribution architectures of tokenized money options, such as retail CBDC, CBMT, and CBDC-backed stablecoins issued by commercial banks (see below). In the case that such digital currencies are authorized for use, they will be based on the requirement that commercial banks hold equivalent wholesale CBDC as an alternative to their conventional digital reserve accounts.

A machine processes a workpiece using a laser

Commercial bank money token: empowering Industry 4.0

Commercial bank money token (CBMT) plays a different, business-focused role than that of CBDC. Importantly, it will support the ongoing digitalization of business process automation and IoT payments, improving costs, speed, and efficiency of intercompany transactions, both domestically and internationally. 

CBMT will be issued by commercial banks within the existing fractional reserve system, i.e. CBMT won’t require the issuance of one-to-one backing. Nonetheless, commercial banks will be required to hold wholesale CBDC for interbank CBMT settlement with the CBMT as a liability of the issuing bank.

Multiple models of CBMT issuance exist. In some cases, each commercial bank will run its own network; in others, participants will all run on the same network but use different tokens. In any case, CBMT issuance models will need to deal with interoperability, since ultimately these are tokens of different issuers that need to be redeemed by their individual issuer (a commercial bank).

Most notably, CBMT is gaining a momentum in Germany, driven by the German banking association and the country’s strong, tech-savvy manufacturing base. As the German Banking Industry Committee argues: “Commercial bank money as it is available today must adapt to the same technologies as Industry 4.0 … so it can become an inherent part of industry’s business value chains and leverage the potential of the technology in the banking sector. A CBMT still represents commercial bank money, with all its features and services provided by banks, but it might enable new and additional functionalities leveraging DLT [distributed ledger technology], smart contracts, and microtransactions. CBMT can be seamlessly integrated into industrial processes and thus become an integral part of the value chain.”4

CBDC-backed stablecoins: providing an anchor

The notion of stablecoins being issued by commercial banks and backed 1:1 by CBDC presents some intriguing opportunities. And it’s a prospect well-illustrated by Project Aurum, a study by the Bank for International Settlements in collaboration with the Hong Kong Monetary Authority to examine the feasibility of CBDC-backed stablecoins.

The project created a technology stack comprising a wholesale interbank system and a retail e-wallet system, with two different types of tokens: intermediated CBDC with a direct liability of the central bank and CBDC-backed stablecoins in the interbank system, which constitute a liability of the issuing bank. 

Aurum chose to explore CBDC-backed stablecoins because, conceptually, they are a direct parallel to Hong Kong’s current currency system, in which the banknotes are issued not by a central bank but by the three note-issuing banks.

By implementing these two types of retail CBDC architecture – intermediated CBDC and CBDC-backed stablecoins – it demonstrated some interesting advantages. Among others, the traceability of tokens to the backing assets provided greater safety to end users in the case of a commercial bank bankruptcy. The two-tier architecture also provides additional privacy for the end users, because the interbank system does not record any personal data.5

Making digital money real

While central banks and commercial banks are exploring all of these options, regulation will ultimately play a deterministic role in defining and permitting the existence/co-existence of any tokenized currency. Central banks will lead the formulation of the necessary regulatory landscape. This will serve as the basis for the establishment and launch of tokenized currencies and for determining the criteria for issuance and the architecture of distribution. But it will take the input and commitment of the whole banking ecosystem to bring these to successful fruition.

What is clear, though, is that the multiple moves toward digital money are gaining considerable pace. And as the different strands of development take shape they will present enormous opportunities – to deliver leaps in efficiency, security, inclusivity, convenience, and trust in digital currency.

Key takeaways

  • Digital currency will take different forms to suit different business, bank, and societal requirements.
  • Retail and wholesale CBDCs will remove friction from the payments ecosystem – each in its own way.
  • Commercial bank money needs to adapt to the digital needs of Industry 4.0.
  1. Making headway – Results of the 2022 BIS survey (PDF), Bank for International Settlements, 2023

  2. Central Bank Digital Currency’s Role in Promoting Financial Inclusion, International Monetary Fund, 2023

  3. Demystifying wholesale central bank digital currency, ECB, 2022

  4. Working Paper on Commercial Bank Money Token, German Banking Industry Committee, 2023

  5. A Prototype for Two-tier Central Bank Digital Currency (CBDC) (PDF), Bank for International Settlements, 2022

Published: 07/12/2023

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