International Finance

Sep

2023

Let’s talk mBridge!

To listen to this article, please click on the play button above.

Reading up on the previous article will give you a better context to understand this article.

The Innovation Hub of Bank for International Settlements did a pilot phase of Project mBridge in Oct 2022 with the central banks of Thailand, UAE, China & Hong Kong to settle real transactions (i.e real world business transactions and not merely a test). A platform based on a new blockchain – the mBridge Ledger – was built by central banks to support real-time, peer-to-peer, cross-border payments and foreign exchange transactions using Central Bank Digital Currencies (CBDCs).

Ok lets cut to the chase. How do we understand mBridge payment mechanism with an analogy?

Think of UPI.

For readers outside India who are unfamiliar with UPI, this is India’s Instantaneous payment mechanism. A super-fast, super-convenient immediate end-customer settlement mechanism that brings cash like finality. It is app based and works at a monstrous scale that processes 10 billion transactions a month.

In UPI, both the sender and receiver of the payment have an app. They both have a unique identifier called UPI ID that is linked to their bank accounts. When the sender wishes to send money to the receiver, he opens the app, inputs the receiver’s UPI ID, fills in the amount and authorises the payment with a password. Bingo, the amount is instantaneously credited to the receiver, who also gets a notification on her device. Payment is complete and is final.

In mBridge, a similar thing happens but between banks that participate in the mBridge network.

To participate in the mBridge system, each bank needs to have a digital version of their country’s money a.k.a CBDC.

How do they get that? By exchanging regular money (paper or bank account) with their central bank & getting digital money of the same value. Banks can do the opposite too, redeem their CBDC for regular money.

Then comes the most important transaction of cross border payment.

Say, when one of the corporates in Thailand wants to send 1 million THB to a supplier in UAE, they simply perform a single one way payment transaction to the bank of the supplier. Just like a UPI transaction.

If you observed carefully, there are three important differences in this transaction from the present-day cross border mechanism. (read about the present day cross border payment mechanism here)

(a) No NOSTRO account was involved.

(b) No SWIFT message was sent

The 1 million THB is now credited into the wallet of the UAE bank that received the payment for further credit to their end customer.

And all this happens in less than a minute as compared to about 2 days it takes in the correspondent banking system. Simply because there aren’t a chain of banks that need to be involved.

But behind the scenes there are a few additional steps that the central banks take to ensure risk management – just like in UPI. But at this introduction stage, lets keep it simple from an end customer point of view.

The mBridge set-up (see footnote 1) is such that the central banks have the ability to monitor in real-time, the transactions happening in its jurisdiction and in the currencies it has issued. It also has the ability to set, monitor and enforce transaction limits & balance limits – .i.e how much the banks can hold in their respective wallets. But once the payment is made, it is final. No one can reverse or cancel the transaction – just like UPI.

The third type of transaction mBridge allows is ingenuous and is a real game changer for banks. Say HSBC bank in HongKong performs an FX contract to buy 10 million RMB from Agricultural Bank of China (in China) by paying 10.7 million HKD. This is a transaction where one party has to pay another party RMB and receive HKD in return. In the present NOSTRO based correspondent banking system, because the HKD balances and RMB balances lie in two different banks in two different countries, each bank pays their obligation and hopes the other party also lives up to its end of the bargain. There is no way to ensure the other party pays up. Just in case the other bank doesn’t pay up (for various reasons), the one that paid up first, loses their money. This is well recognised in banking community as “Settlement Risk” [or Herstatt Risk after the infamous German bank that failed to pay up its obligations setting a series of heartaches across the world].

In one fell swoop, mBridge eliminates this risk. Using smart contracts, both legs of the transaction, i.e. HSBC HongKong paying 10.7 million HKD and Agricultural Bank of China paying 10 million RMB are “tied” to one another as conjoined twins. So when each bank initiates their transaction in this FX transaction type, mBridge will NOT execute it unless the other bank has also initiated the second leg of the transaction. While in blockchain parlance it is called an “Atomic” transaction, mBridge calls this as PvP – Payment vs Payment transaction. I.e. both legs “together” make a single transaction. This feature eliminates (not just reduce) settlement risk and hence the overall cost of transaction (in risk capital / risk management processes / insurance etc.) for all parties. Sweet, isn’t it?

In summary, the below picture tells us the three main transaction types mBridge currently supports.

Now let’s see the overall benefits mBridge offers.

The Platform works on Central Bank money issued on Ledger and not on any arcane blockchain token. This not only makes the central bank guarantee the value of money, but also avoids pricing differences as CBDC behaves like a stablecoin (i.e a blockchain token having a fixed exchange rate with a traditional currency).

The mBridge platform can be integrated with the respective countries’ local payment systems like RTGS / NEFT in the same currency reducing transaction costs.

The use of locally issued CBDC also ensures compliance with jurisdiction-specific policy, legal requirements, regulations and governance needs of the central bank in its country.

Allows offshore money. I.e allows currency issued by one country to reside in another country. In our first example, THB went from Thailand to UAE. Once the transfer was complete, THB was really held by a bank in UAE in a wallet. In today’s world of correspondent bank based payments, money doesn’t cross borders at all – despite the moniker “cross border payments”.

24 X 7 Settlement finality. The mBridge platform is designed to work 24 X 7 and each payment is final.

Atomic Payment vs Payment. I.e. Both legs of the transaction settle together eliminating settlement risk.
mBridge claims the settlements happen within 2 seconds including consensus in the pilot. This may not hold when more participants onboard on to the platform. But even if it takes an hour, it is much better than the 2 days in the current mechanism.
The simpler transaction process, lesser time to transfer money & more importantly, the much lower cost of transaction will help all of us common people, who need to remit money across shores – either for business or personal reasons.

All this looks like a magic pill to end all the ills of the correspondent banking system, but we need to remember that before being rolled out across the world, central banks and governments across the world need to agree on jurisdiction, governance & legal matters.

To my mind, the powers that be will bring in a common legal character to this cross border payment mechanism with its own judicial system. This would end the hegemony of a set of countries that have a tight grip over current system. So it is likely it might be some time before mBridge gets implemented across the world. But the pace of implementation of CBDCs across the world shows the world is building financial infrastructure at a good pace to participate in such projects. That makes the prospects bright.

Take for instance India. The Reserve Bank of India launched CBDCs for both retail (for use by individuals) and wholesale (for use by banks & treasuries) use since Nov 2022. Several individuals and organisations have opened their CBDC accounts for eRupee, although transactions haven’t picked up except in random retail transactions and government bonds settlement. Now RBI has mandated a pilot to settle call money transactions between banks in CBDC from Oct 2023. Such progressive expansion into interbank transactions within the country will get banks accustomed to CBDC settlements. We will continue to watch the progress in CBDC use both in domestic and international transactions. That progress will sure be a subject of discussion in our next article. Until then…

Notes & References

Footnote 1: The CBDCs are blockchain based wholesale CBDCs (to be used between banks) and uses a permissioned consensus protocol. This is for blockchain aficionados. The rest of us can pretend we didnt read this.

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Sep

2023

The Shifting gears of cross border payments with CBDC

The gears of Cross Border Payment mechanisms are shifting in favour of CBDCs. To listen to this article instead of reading it, press the play button above.

The previous article on CBDC ended by saying that “a new mode of money is born, a new mechanism of payment & settlement is in progress and it is here to stay and transform international settlements.”

Let us see explore each of these statements & understand how it changes the status quo.

As we saw earlier in the series of articles, money is digital, sits in bank accounts, and any cross border payment utilises

(a) a network of trusted relationship between banks called the correspondent network (remember NOSTRO?) and

(b) requires the SWIFT network – a trusted messaging system, that is reliable & has widespread use.

Based on the instructions in the SWIFT messages, banks that service the NOSTRO accounts, transfer money and effect the international transfer. And banks as we know, will have to obey regulatory pressures like how US banks had to stop doing business with Russian entities. But if a bank or the banks in a particular country are banished from the SWIFT network, their international trade (and even national trade if that is how the country’s financial infrastructure is built on) can be crippled in one fell swoop.

Even otherwise, due to the multiple hops messages take through banks in different time zones, cross border payments are slow (takes about two days) and are costly, as each bank in the chain takes a cut.

This is where CBDCs change the game.

Several central banks have been working on a few important settlement mechanisms among themselves – directly & automatically instead of having to go through the SWIFT network. And since this CBDC network will be a multilateral arrangement, no country gets to monopolise it or have its finger on the kill switch.

A few proofs of concept have already been made.

1. Project Jura: This project explored the direct transfer of Euro and Swiss franc wholesale central bank digital currencies (wCBDCs) between French and Swiss commercial banks on a single blockchain platform operated by a third party. The multinational banks of Swiss & French origin – UBS, Credit Suisse & Natexis – performed a pilot with real value Foreign exchange transactions to validate technical feasibility. The result established the feasibility of DIRECT transfer of two currencies across banks instead of routing through correspondent banks and SWIFT network. The blockchain platform allowed both message and money to be transferred simultaneously. See below picture that makes it obvious.

1. Project Dunbar: This project went a step further to understand the challenges that would be faced in settling multiple country issued CBDC transactions. It worked with CBDCs issued by the South African Reserve Bank, The Reserve Bank of Australia, Bank Negara Malaysia & the Monetory Authority of Singapore. The project was spearheaded by the innovation hub of the Bank for International Settlements (BIS). They worked with two technology parters (R3 & Partior – both working on blockchain platform in the finance space) in building two prototypes. The project showed the technical feasibility of the solution and identified bottlenecks in regulatory & governance issues across the jurisdictions of three countries and in how commercial banks within the country can access the multicountry platform.

BIS is the acronym for Bank for International Settlements headquartered in Basel, Switzerland. Established in 1930s and owned by 63 central banks from around the world, its mission is to support central banks’ pursuit of monetary and financial stability through international cooperation, and to act as a bank for central banks

3. Project mBridge: Although now called mBridge, the project had metamorphasised from Inthanon to Project LionRock to mCBDC Bridge to the now popular mBridge platform.

This project too has been spearheaded by the BIS Innovation hub, but with four other central banks across the world. I will write a more detailed next article on mBridge so that we understand the details.

But first I want to make some common observations from the above projects.

1. A realisation grew among all countries that cross border payments are too unwieldy, slow, costly and favours only those with (correspondent) “relationships” with other banks.

1. There was disquiet among developing countries that the international payment system was controlled by a few countries in the world and a growing desire took root among them that this needed to change.

1. So as part of the 2020 declaration, the G20 endorsed a roadmap prepared by the Financial Stabilty Board jointly with the Innovation Hub of the Bank for International Settlements in Switzerland. These projects we discussed above and a few more, are a consequence of this.

1. Considering BIS being the guidepost of all Central Banks around the world, the initiatives taken up by BIS in this area have a greater chance of becoming reality.

1. The new CBDC settlement mechanism across borders will help countries perform international trade in their own currencies instead of having to use a trade currency of a third country.

1. This will further reduce the need for countries to stock up on huge reserves of the currently dominant trade currency(ies) (i.e. USD, EUR, etc) which makes them dependent on moving money through the banks of USA or Europe. This also makes the trading countries vulnerable to the rules of the third country. [Please recall the example of how a trade between Saudi Arabia and India had to comply with the rules of USA as explained in this article.]

1. The new mechanism also reduces the huge dependence of countries on the SWIFT network over which the lifeblood trade & payment messages flow.

1. In the previous article we saw how about a 100 countries are in various stages of implementing CBDC. This is a clear indication of the acceptance of these countries to the new mechanism and is a harbinger of the change in International trade settlements.

In the next article, we will see how mBridge system works and that gives us insights into the future of international cross border payments

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Dec

2022

CBDC – A new form of money.

Image by Gerd Altmann from Pixabay.

To listen to this article in audio form, please press the play button above.

Let us understand what is CBDC, why it is special and attempt to answer some questions that are bound to come up. This one will be a slightly longer read than the other articles on this website. So pick your favourite cup of coffee or another brew that works for you.

I get CBDC stands for Central Bank (Issued) Digital Currency, but what is it?

The responsibility of ‘issuing’ currency in a country rests with its Central Bank. Traditionally Central Banks have been issuing currencies in the form of Notes and Coins. Now Central banks across the world have come up to issue currency in digital form also, in addition to Notes and coins.

Isn’t money already digital?

Yes money in the sense that ordinary people & companies use, is mostly in digital form. Our account balances held with banks don’t sit in physical (notes & coins) form but as entries in the banks’ digital core banking system. We pay each other digitally using apps and other electronic means. In that sense our transactions have become digital. However, originally as money, the central bank issued it in some physical form. As ‘users’ of money, we use it digitally but still retain the ability to convert our digital money to cash. So now Central banks also want to issue currency digitally. Such digital currency will never see any physical form.

Ok, but if we already have digital transactions, why need CBDC at all?

This is a question that needs more elaboration in different dimensions. Stay along as we explore.

Monetary stability

Central banks are tasked with managing the monetary system of their respective countries. This includes maintaining a trustable currency which is the foundation of the monetary system. The last decade has seen several crypto currencies gaining popularity that seem to offer an alternate monetary mechanism – outside the purview of governments. Some people are attracted to private digital currencies for the data privacy it offers. There are growing concerns of banks accumulating enormous data of their customers’ transactions. With increased technological capabilities of AI, ML, and cheap computing power, the privacy concerns of many law-abiding citizens are real. Such customers, especially those who either have the technical familiarity or have excess wealth to experiment with, gravitate towards such cryptocurrencies. This brings in unknown (and sometimes undesirable) private enterprises creating a parallel monetary system which seems to offer alternate payment mechanisms. This creates an apparent & even real impression that central banks ceding control of monetary policy to private actors. To remedy this situation, central banks are pushed to publish their own digital currencies that offer most, if not all of the features private currencies do.
As the Global Financial Crisis of 2008 indicates, money chasing dubious assets creates far-fetched misery in the larger economy – even across borders in our connected world. Central bankers and governments want to avoid such crises. Many people who convert real world money to crypto currency, do so out of greed (the lure of supposed superior returns), and some, for de-risking themselves from govt sanctions through the existing financial system or for genuine privacy concerns. In addition to bringing financial misery to the individuals who purchase those crypto currencies, at an aggregate level it diverts national resources to unproductive & purely speculative assets. So central banks across the world are forced to take notice and do something about it.
Currently people transacting through private crypto currencies do so outside the purview of the regulatory framework. With a view to leveraging the blockchain technology of cryptocurrency and also bring much of these transactions inside the regulatory purview, central banks first want to launch their own digital cryptocurrencies before a possible ban on private currencies across the world.

Strategic reasons

We will address this in an answer to a subsequent question.

Improving operational efficiency

Today Central banks spend a lot of money in printing cash in security (read expensive) paper, store it in high security vaults (read high costs), transfer to banks’ currency chests (incurring transport & transit insurance costs), plan and arrange for checking counterfeits & reissuing soiled notes (more expenses). All these costs can be avoided if currency is issued digitally. Of course, this will entail costs in hardware, software, network, application building & maintenance etc. But these costs will not be directly proportional to the amount of currency issued. So there will be net savings by issuing currency digitally. The shift to a digital currency -instead of cash- is a step towards reducing cash in the economy in the coming years. If the CBDC projects of different countries pass their pilot project and move into production mode, we will progressively see lesser and lesser cash in our economies going forward.
Distribution of bulk cash, along with being a risky activity, is a tedious activity too for some countries. Take countries that are far-flung, dispersed over several islands of an archipelago (The Bahamas and Jamaica, which straddle multiple islands, mention this as a primary reason they are going digital with their currency).
A digital currency makes a brilliant case for efficient implementation of targeted social welfare programs. Let’s take an example. A country provides cash subsidies to its farmers to purchase fertilizers. The farmers are issued cash, with the intent they will use it to buy fertilizers only. But cash being fungible, can be used to buy anything. From a genuine farmer using it to buy liquor, to a conman pretending to be a farmer just to get some free money, the subsidy can be misused. Being digital, CBDCs can be issued like tokens with numbers on them, so it can be used only at fertilizer shops (as an example). Or it can have an expiry date, so the subsidy is not rolled over to a different season / year.
Built in blockchain technology, CBDCs can be integrated with a variety of platforms. We saw a brief example in this artice where CBDC can be automatically settled between two traders through smart contracts, without the need for costly trust providers.
Banking is also undergoing another change. Many markets, for instance in Europe and in India, have Open banking, which allows customers to hold accounts in one bank, allows another operator to transfer it and the end customer to own her data – not the banks. In this “open banking” era and the growing data governance to safeguard customers’ privacy, the use cases for CBDCs are plenty!
The CBDC allows an alternative to cash and if implemented in “anonymous” mode (called a “token” based system),, one doesn’t need an account with a bank to even transact it. Just like how two people can transact in cash without having a bank in between, two people can transact in CBDC using their smartphones through an app.

But if a bank account is not needed, does it mean that the central banks are sidestepping the banks and the banking system in their respective countries?

The banking system and banks will continue to be the essential nervous system of the economy of the country. To dissuade people from sidestepping the banking system, central banks are making it clear that the CBDC held by people will NOT earn any interest. It is exactly like cash in our wallets and under the mattress. Even today we all hold some cash and at an aggregate level, forms a very small fraction of the overall money supply. CBDC will be like that. People will hold it in small quantities – if at all.

If it is not going to be held in large quantities and by large number of people, why at all issue CBDCs then? What are the central banks trying to achieve?

CBDCs are being issued in two variants.

(i) CBDC-Retail, meant to be used by general public like you and me

(ii) CBDC-Wholesale, meant to be used by banks for their interbank settlement – amongst themselves, across borders. It is this feature that is a bigger and more important use of CDBC. The ability to settle between banks directly without the need for regular channels of banking or using messaging platforms like SWIFT. This alternate cross border payment mechanism can be a redundant payment rail for payments supporting trade or a conscious route to de-risk economies from being sanctioned & sabotaged. Read more about these risks in this Show Me My Money! and The Kill Switch. articles.

How many countries are getting into CBDC?

119 countries are in various stages of issuing CBDC. Yes 119. That is most of the countries.

11 have launched and are using it now. This includes Nigeria (eNaira), the Bahamas (Sand Dollar), Jamaica (JAM-DEX) and 8 countries in the Eastern Caribbean island countries. Most of these countries have gone the CBDC-retail way. The biggest success has been in the Bahamas and in Jamaica, which had trouble in managing cash logistics across the archipelago.

Some 17 countries have launched pilot projects. Notable among them are China, Thailand, the UAE, Hong Kong and India that have launched the CBDC- Wholesale variant. This is significant because of its usefulness in cross border payment & settlements

The remaining countries are in research and development mode. The below pictures gives an idea of which countries are in what stage.

Image Credit:Atlantic Council

This widespread blooming of CBDCs across the continents tells us a story, that a new mode of money is born, a new mechanism of payment & settlement is in progress and it is here to stay and transform international settlements.

To listen to an audio version of this article, please press the play button above.

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Let’s start with answers to the questions posed in the previous article.

Q1: In this entire chain of cross-border payment transaction- where a company in India paid a company in Saudi Arabia, in which leg did the money actually move?

A: Money actually moved from one bank in the US to another in US. It did not cross any border!

But wasn’t this supposed to be a cross border payment? Money from India to Saudi?

Indeed! But because the payment was in USD, the transfer happened between two NOSTRO accounts in the US itself.

But what crossed borders, if money didn’t?

Messages! Yes just messages went beyond borders.

So if Adam Savage (of the popular TV show “Mythbusters”) were to investigate this, he would proudly proclaim – Busted!!

Contrary to popular perception in cross border payments, money doesn’t cross borders, only messages do.

But the companies in India and Saudi didn’t have USD accounts, they had INR and SAR accounts. Surely there must have been some conversion that must have happened?

Yes, that’s brings us to question no 2.

Q2: Where exactly did the currency conversion from INR to USD or USD to SAR happen?

In their respective countries.

INR- USD was done by SBI Mumbai and USD -SAR was done by AL Rajhi bank, Riyadh.

The banks in US don’t determine the exchange rate for any of the legs of this particular transaction.

Q3: Which countries’ compliances and regulations had to be applied in this transaction?

It is easy to guess that the compliance of governments in India and Saudi Arabia apply to these transaction as the buyer and seller are in these respective countries.

But here is the kicker. Just because the payment passes through banks in US, the compliance rules of the Govt. of the US of A also apply to this transaction.

If we zoom out of this single transaction and have a satellite’s eye view (a bird wouldn’t have so much of a span for our purposes), since most international trade happens in USD, ALL (yes all!) of those transactions have to comply with the rules of the Govt. of US of A.

-we can say that, just because USD is the world’s popular trade currency, central banks around the world buy and store it as a major reserve currency, thereby increasing the demand for USD perennially.

-the US govt is able to apply it’s writ on international transactions between two random foreign entities that are thousands of miles away from the shores of US, despite the fact the goods don’t come anywhere near the US.

Is this a good thing or a bad thing? Depends!

Depends on where you stand or how friendly one or both of the trading countries are with the US of A.

Let’s take just two examples to see the impact of this.

FATCA. Citizens of almost all countries around the world had to declare their FATCA status with banks around the world. Why? Because the US govt said unless each bank (called an FFI – Foreign Financial Institution) in every country collected and reported relevant data to the US on their FATCA status, US govt will withhold 30% of the value of bank’s qualifying (this is a subset of all txns) transactions going through US, done for FATCA non-compliant customers living in a foreign country. Considering almost all major banks around the world need to have USD NOSTRO accounts with banks in US, they have no choice but to comply.

FATCA (Foreign Asset Tax Compliance Act) is a US law since 2010 to track the income from the foreign assets of US citizens, living and maintaining accounts abroad. These assets could be Savings or fixed deposits in banks, Mutual Funds, Insurance products, real estate etc. As an example, if a US citizen has an account in Italy, the US govt wants to know. While most govts ask their citizens to declare their foreign assets and income voluntarily, the US govt goes one step further. It asks the banks’ and financial institutions of other countries to report, if any of the accounts they service for their customers, are for US citizens. To know this, the banks need to ask ‘every’ account holder to give a declaration of their US citizenship status.

With the US Dollar’s unique position of being an international trade currency, US was able to enforce compliance on every financial institution in 90 countries of the world, for an internal tax program. Who bears the operational costs and inconvenience of this compliance? – the respective banks. Who will the banks recover this cost from? Their respective customers. So here is an internal tax compliance program of the US govt, being paid for and complied with, by citizens of other countries around the world.

The second example is what happened as part of sanctions on Russia following the Ukraine-Russia war. US was able to successfully stall all (well, almost all) international trade if one of the trading partners was a Russian entity.

How is this even possible? Recall the organisation and messaging platform called SWIFT? And that it is owned by banks across Europe and US. (you can read more about SWIFT here). Also, if you recall the details of the SWIFT message in this article, you will know that every SWIFT payment message contains information on who originated the payment and who the beneficiary is. Combined with the fact that each USD transaction will have to go through banks in the US, it is easy for banks in the US to know who are the entities in an international transaction. As a result, the enforcement of this ban was quick, because US banks had a switch to identify and kill transactions, if one of the trading parties was Russian.

We need not get into the merits of the war or the sanctions. But if you look at it purely from a risk manager’s point of view, any country is at risk of immediate suspension of its international trade if they fall out of favour of the US. In that sense, the kill switch to the world’s international trade is in the hands of a few western nations.

Isn’t this a risk for other behemoths of international trade? like say – China? Yes and that’s why they try to wean away their international transactions from USD and are promoting Yuan based transactions. Or even trade based on bilateral currencies between China – Saudi Arabia, China- Iran, China- Russia (that’s no surprise). But it is not easy, because it is not just in the realm of economics or trade, but a matter of geo-political dominance. This game has had its players and many haven’t lived to tell their story.

There has been a recent challenger to this – albeit a tiny one- having some acceptance across countries, including the USA. You must have heard about Bitcoin and its cousins. These are & will be limited to miniscule, marginal, esoteric or arcane transactions and will not enter the mainstream as a force to reckon with.

But a bigger challenger is on the slow brew. The war that has already started in eastern Europe, and more wars that are about to start, are a reaction to it. Lets cover that in the next article.

Click on the urls below the images below to view the previous and next articles in this series