The development of digital currencies capable of underpinning a new generation of financial contracts took an unexpected twist in May.

While the world’s attention was focused on Covid-19, Societe Generale quietly achieved a first: the settlement of a securities trade using a central bank-backed digital currency. The French bank issued a covered bond in the form of a securitized token on a public blockchain. It then bought back the debt using digital euros issued by the Banque de France.

The deal was not large—at €40 million it could be described as a token gesture—but it’s a significant step in the creation of smart contracts that enable instant trade settlement.

The move trumps more prominent initiatives such as R3 and Utility Settlement Coin, which were also racing to settle an all-digital securities trade.

These private sector blockchain consortiums had made often bold claims about their progress. The first trade using USC—a digital currency backed by 14 major banks and one exchange—was expected to happen as early as 2019. The timeline has now been pushed back to the end of this year at the earliest.

In addition to experiments with central banks in Asia and Canada, R3 is working with Sweden’s Riksbank to create a digitized version of a central bank currency for its platform. A spokesperson for R3 was unable to give an update on the projects’ progress.

It’s easy to see why groups of commercial banks are keen to create digital currencies. The initiative promises to help cut trade processing costs and liberate billions in capital that is tied up during lengthy settlement procedures.

For central banks, though, the equation is not so clear-cut as they weigh up whether digital currencies could disintermediate commercial banks. Some of the largest central banks are perceived to be dragging their heels on the issue.

R3 co-founder Todd McDonald says: “I think the Fed would be looking at the activity of other central banks and judging themselves behind. There needs to be more of a sense of urgency.”

Meanwhile, work continues at Societe Generale’s blockchain subsidiary, Forge. More trades using digital euros from the Banque de France are in the pipeline, and involving different counterparties.

“We have a number of other transactions for security issuance planned towards the end of the year and the first quarter of 2021,” says Jean-Marc Stenger, chief executive of Forge. “The next will be either an unsecured bond or a structured product, with the issuer being a financial institution and an investor such as an asset manager.”

A Day in the Life

In the trial run with Forge, the Banque de France created digital euros in exchange for reserves and transferred them to the account of the investor, Societe Generale. The investor paid the bond issuer, also Societe Generale, in digital euros using a delivery-versus-payment mechanism. After settlement, the BdF credited the issuer’s account with euros and destroyed the digital currency by redeeming it against reserves, later in the same day.

The digitized euros were kept in a Target2 escrow account on the BdF’s private blockchain. They were moved from the account of Societe Generale to the account of the issuer of the security but did not leave the BdF blockchain.

The push to introduce central bank digital currencies (CBDCs) is partly a response to long-standing gripes over the financial system’s creaky plumbing. Settlement can take up to three days, during which time banks must hold capital against the risk of a trade failing to settle.

CBDCs could slash the time and cost of settlement, unlocking trapped capital that could be used for other activity and so boosting intraday liquidity.

I think the Fed would be looking at the activity of other central banks and judging themselves behind. There needs to be more of a sense of urgency

Todd McDonald, R3

Valerie Fasquelle, director of innovation and payments infrastructure at the BdF, says: “What a CBDC is expected to bring to bank transactions is the possibility to carry out end-to-end operations, including final settlement, in one technological environment. This could be a distributed ledger technology (DLT) environment, which has the potential to make correspondent banking operations speedier, and thus to help banks save liquidity.”

A revival in correspondent banking activity would please the Financial Stability Board, which has previously expressed concerns about the decline in such relationships.

By limiting the likelihood of settlement failures, CBDCs can also help reduce counterparty risk, especially as the currencies carry the sovereign credit risk of central banks. Lower counterparty risk means banks have to hold less capital against trades under Basel rules.

USC research has shown that on average, across the consortium’s original 16 members, a 1% reduction in counterparty credit risk achieved by speeding up the settlement cycle was worth $300 million of risk-weighted assets to each bank.

Flip side of the coin

However, others believe the jury is still out on whether CBDCs could improve intraday liquidity in the correspondent banking network. In Sweden, Stefan Ingves, governor of Sveriges Riksbank, says: “It is too early to answer this question. This is something we are currently looking into in the E-krona project.”

At the BdF, Fasquelle says one important hurdle to overcome for cross-jurisdictional CBDCs will be interoperability between the various blockchains used by different systems.

As well as technical barriers between blockchains, private sector initiatives have run into problems aligning cross-jurisdictional central bank policies.

Daniel Heller, head of regulatory affairs at Fnality, the company created by USC backers to build a network for the currency, says a particular challenge has been convincing central banks “to grant a license for foreign banks to hold Fnality accounts in domestic currency”.

Fnality says the technology is in place for making digital payments in one currency, as well as payment-versus-payment for cross-currency settlement. But, says Olaf Ransome, an adviser at Fnality, “more work will have to be done around delivery-versus-payment, because you could have a couple of flavors of that. You could have euro-denominated assets against euro currency. Or you could have euro-denominated assets that are not in Europe and settling against euros.”

USC is talking to five central banks—the US Federal Reserve, Bank of England, European Central Bank, Bank of Japan and Bank of Canada—about backing its digital currency with deposits. Discussions with the first three are further along, though nothing is certain.

“At this point in time, the best we could hope for will be to get one of [the first three] to say yes sometime in the third quarter, and maybe the other two by the end of the year,” says Ransome.

UBS, the bank that initiated USC, says the first live transaction expected towards the end of this year will be “a simple bilateral payment, low value and low volume, but fully legally compliant”.

Co-head of principal investments and strategic ventures for UBS’s investment bank, Hyder Jaffrey, says the USC is not exactly a CBDC, however. As commercial bank money backed by funds held at a central bank it is “a pre-funded asset that has the characteristics of central bank money”.

He explains further: “CBDCs are central bank-issued. You then have the commercial type of stablecoins [such as that created by JP Morgan]. The USC sits somewhere between the two.”

Jaffrey argues Fnality is well placed to tackle the interoperability challenge between multiple jurisdictional currency blockchains, “because it can mediate between legal and regulatory frameworks which differ from sovereign to sovereign”.

UBS acknowledges that central bank digital currencies could render the USC obsolete. But given the pace that many central banks are working at, this may not happen any time soon.

Digital dollars

The front-foot approach of the BdF—it invites applications to experiment with a CBDC for interbank settlements and says it welcomes the participation of other commercial banks and central banks in its projects—contrasts with less urgency perceived at some other central banks, for both wholesale and retail CBDCs, the latter admittedly more ambitious undertakings.

R3 is backing a project led by former Commodity Futures Trading Commission chairman Christopher Giancarlo that is lobbying the Fed to step up plans for a digital dollar. It argues a US CBDC is needed in part to counter Chinese plans to roll out a digital yuan, which the People’s Bank of China is reportedly trialling.

R3’s McDonald says of the digital dollar project: “They’re pulling together work done on CBDCs, creating a playbook to get CBDC into production and doing it in terms that regulators will understand.”

While the Fed states it is conducting research into CBDCs, its chairman Jerome Powell, in February testimony before the House Financial Services Committee, said it is an “open question” whether a digital currency would help preserve the dollar at heart of the financial system, especially for its own economy that still likes to use cash.

In the same month over the border, Timothy Lane, deputy governor of the Bank of Canada, did not preclude eventually adopting a CBDC, but said: “Canadians are well served by the existing payment ecosystem, so we believe there is no need for the Bank of Canada to issue its own digital currency at this time.”

Likewise, a spokesperson for Australia’s central bank says: “The Reserve Bank of Australia does not plan on issuing a central bank digital currency in the immediate future.”

In Europe, Germany’s Bundesbank states it is for the European Central Bank to make the first move on a digital currency: “The ECB and the national central banks of the Eurosystem co-ordinate their activities concerning monetary policy and CBDC because of their joint responsibility for the euro,” a spokesperson says.

The Swiss National Bank says it is currently experimenting with wholesale CBDCs in two proofs-of-concept, with the Bank for International Settlements and Six, a Swiss exchange.

The Bank of Japan did not respond to a request for comment, while the Bank of England responded with a link to a March paper outlining its latest position.

In a January BIS survey covering 66 central banks, around 80% were found to be engaged in CBDC work – but only 10% are likely to issue a digital currency within three years. The BdF has a decent claim to having arrived in the first meaningful way.