How finance sector treasurers can get ready for CBDCs and stablecoins

With pilot programs ongoing around the world, central bank digital currencies (CBDCs) and private-issue stablecoins are attracting the attention of numerous financial institutions. Banks and other financial-market participants see potential impacts across core business activities including payments, financing, and capital markets. Critical to these applications will be the role of treasurers, who will be responsible for managing the new iterations of money and attendant financial risks.

In this article we discuss the ways treasurers may resolve outstanding questions, viewed through the lenses of institutional risk appetite, regulation, and technology infrastructure (exhibit). We examine potential impacts on products, technology, risks, and accounting, and offer some thoughts on potential solutions, especially in the context of European and North American regulatory jurisdictions. Finally, we touch on the strategic choices facing treasurers if their organizations are to embrace the opportunity fully.

Treasures will assess digital assets along three dimensions.

The rise of CBDCs and stablecoins

Both CBDCs and stablecoins are designed to function as digital representations of fiat currencies.1CBDC and stablecoins: Early coexistence on an uncertain road,” McKinsey, October 11, 2021. They differ in that a digital currency issued by a central bank is legally a unit of currency—a digital euro will function as a euro and a direct claim against the central bank, while stablecoins are representations of fiat currency issued by private-sector institutions. Stablecoins aim to maintain a stable peg through verifiable reserves or mathematical controls matching supply to demand. In this article we focus primarily on the former—private-issue stablecoins.

Central banks are piloting CBDCs for either retail or wholesale purposes. They are exploring a variety of models characterized by varying levels of centralization. At one end of the spectrum is a fully centralized model, such as the one seen in the Eastern Caribbean islands.2 This requires end users to directly access accounts with the central bank. At the other end of the spectrum, a decentralized infrastructure is intermediated by banks, which offer bearer CBDCs and act as settlement agents. The central bank issues CBDCs directly onto third-party platforms, moving away from the established account-based system. The central banks of China and Nigeria are proponents of this model. Between these two poles are a number of alternatives—for example, offering bank-intermediated access to central bank accounts.

The circulation of stablecoins is growing rapidly, primarily as a settlement currency for trading in cryptocurrencies. Stablecoins have also been used by investors, especially in decentralized finance (DeFi), to earn a passive yield on their assets. Multiple models have emerged based on the underlying value anchor. At one end of the spectrum, some stablecoins (such as USD Coin) are fully reserved. This means that for every dollar token issued, an equivalent value is deposited as cash or cash equivalent in audited reserve accounts, thereby tokenizing deposits.

Common to all models is the issuance of tokens representing real-world fiat currency on a public permissionless blockchain (or several blockchains), the underlying protocol of which enables each token to be associated with a piece of self-executing code (or smart contract) that makes each stablecoin programmable. Furthermore, such wallet-based holdings can be frozen by stablecoin issuers—for example, if the sender or recipient is deemed to be fraudulent or subject to sanctions by the US Department of Treasury’s Office of Foreign Assets Control.

One particular variety of digital assets representing stable value is private network tokens, issued by institutions within their own networks. Signature Bank, for example, has launched Signet, a closed-loop network through which member banks can use tokenized bank deposits to trade and settle directly. Notably, these are not classified as stablecoins, since they represent tokenized deposits rather than an explicit currency.

In 2021, dollar-pegged stablecoins circulating on public blockchains saw explosive growth, with a combined circulating supply of nearly $150 billion by year end, a more than 500 percent increase from the previous year.3 They funded nearly $1 trillion of digital-asset transactions a month.4 By contrast, despite pilots in China, the Eastern Caribbean, Jamaica, and Nigeria, the circulation of CBDCs is still relatively limited.

The Bank for International Settlements reports that more than 90 percent of central banks globally are experimenting with or researching CBDCs.5 However, no country has yet chosen to adopt a CBDC as its primary currency. Even the largest pilot in China reports only around $13 billion in circulation, at least an order of magnitude smaller than the volume of stablecoins.6

Some of the stated goals of CBDCs include financial inclusion, a reduced cost of cash, and privacy by design—similar to the historical anonymity of cash. The clear intention is to minimize the challenge for end users to obtain an account (with wallet-based transfers) and to reduce friction and costs for businesses and banks handling cash. In many ways, the benefits of stablecoins mirror these goals: they are wallet-based rather than account-based, can be transferred with low friction (and on some blockchains at extremely low cost), and provide institutions with accounting and efficiency benefits. A material difference is their programmability. DeFi applications have grown out of the ability to combine stablecoins with smart contracts, enabling decentralized financial functions including lending, swaps, and insurance.

While the issuance of CBDCs falls under the remit of a sovereign central bank, rules governing the issuance, security, resiliency, and redemption of stablecoins are still evolving. In a report published in November 2021, President Biden’s administration recommended a range of new requirements, including that stablecoin issuers should be insured depository institutions, affiliation with commercial entities should be limited, and wallet providers should be strictly monitored.7

Some individual US regulatory agencies have committed to taking action. For example, banking agencies have said they will evaluate risks associated with stablecoin issuance and related services conducted by banks or third-party service providers. Potentially, certain activities will be classified as systemically important, bringing a range of additional prudential, or even capital, requirements. Moreover, specific legislation is envisaged to protect end users, mitigate payments system risks, and prevent monopolies or abuses of power.

In June 2022, the Basel Committee on Banking Supervision issued its second consultation paper for crypto asset exposure.8 It differentiates between two groups of crypto assets. The first includes tokenized traditional assets and crypto assets with an effective stabilization mechanism vis-à-vis the underlying exposure. Such assets are expected to be treated more in line with the existing Basel capital framework. The second group comprises all other crypto assets, which will require more conservative treatment.9

Potential implications for treasurers

For treasurers, the emergence of a range of digital-native payment and stable-value tokens gives rise to a number of implications for the management of money and financial risks. These fall into four main categories:

  • Products. Could stablecoins and CBDCs be used for activities such as cross-border payments, corporate deposits, or even financing and investment products? What impact might they have on daily cash flow and liquidity?
  • Technology. What technological changes are necessary? How should banks manage access to real-time market data, provide for compliant customer and transaction monitoring, create enhanced operational controls, and offer secure custody solutions?
  • Risk management. What are the risks and regulations that would apply to these varieties of digital assets, and what knowledge and experience is required to mitigate risks?
  • Accounting and reporting. How would the assets be accounted for on a firm’s balance sheet, and what would be the income, expense, and tax implications?

These implications should be considered against the changes that would be required to meet investment and risk coverage needs should either CBDCs or stablecoins enter the mainstream. Next we take a closer look at these considerations.

Products

Digital-native assets, including CBDCs and stable­coins, could enable the creation of new investment solutions for a range of business lines, including fixed income, rates, equities, and foreign exchange. These will require treasurers to make choices concerning capital adequacy and reserve ratios, as well as to liaise with appropriate regulatory agencies. In particular, treasury management teams will need to consider design choices for deposit liabilities (highly liquid short-term government securities as stablecoin reserves, for example) and capital requirements (such as those prescribed by the Basel Committee). They would also need to address reserve requirements and potentially also stability mechanisms prescribed by the central bank.

Digital-native assets could enable the creation of new investment solutions for a range of business lines, including fixed income, rates, equities, and foreign exchange.

There is no reason why CBDCs or stablecoins cannot be held as commercial bank deposits, with banks engaging in fractional reserve lending and maturity transformation as normal.10 If integrated effectively into existing products and services, both could facilitate more efficient investment in securities, foreign exchange, and various cash instruments. Indeed, according to the Board of Governors of the Federal Reserve System, the replacement of physical cash (banknotes) with stablecoins could result in more credit intermedi­ation.11 It would also reduce the cost of cash handling and improve the safety and efficiency of payments services. Provision of adjacent digital-asset custody services, payments, lending, and issuance offer potentially interesting avenues for exploration.

An important opportunity for digital assets is in cross-border payments and settlement, which are historically slow, expensive, and opaque. While both CBDCs and stablecoins offer benefits that address these challenges, stablecoins could enable a wide range of payments and serve as a gateway to other (decentralized) financial services. Many stablecoins today are issued on a limited number of blockchains, often using a standard token format and common coding language, such as Solidity.

Among incumbent financial institutions, this standardization creates the possibility of interoperability and efficient foreign exchange of digital fiat. In a world of decentralized financial services, stablecoins could facilitate the equivalent function via foreign-exchange swaps. While the adoption of stablecoins could replicate the role of transaction accounts and boost competition, the challenge for treasurers will be to ensure they are a safe store of value and reliable method of payment, as well as to offer high levels of consumer protection, legal certainty, and compliance with regulation.

Some financial institutions have developed reserve-backed tokens, known as tokenized deposits. These institutional tokens are implemented on permis­sioned (private) blockchains and are used by financial institutions and their clients for efficient B2B and wholesale transactions. The best known is JPM Coin, offered by Onyx by JPMorgan Chase, whose clients can use it for transactions such as intraday repurchase agreement settlements and to manage internal liquidity. Similarly, institutions such as Signature Bank allow their customers to instantly settle commercial transactions through tokenized deposits with any other member of the Signet ecosystem.

Treasurers considering a similar strategy should consider how to facilitate issuance and network management, based on a deep understanding of the risks and their organizations’ risk appetite and management frameworks. In particular, the hazards involved with both of these digital-asset products and their capital requirements must be recognized and mitigated. Treasurers should think about the impact of possible migration away from deposits into digital assets and how this would impact credit provision. According to analysis by the US Federal Reserve Board, the impact could be positive, negative, or neutral, depending on the reserve framework. Equally, treasurers should consider funding, liquidity management, and hedging strategies specific to digital assets.

Technology

Whether issued through a centralized network (such as CBDCs) or distributed ledger (such as stablecoins), digital assets will require treasurers to engage with new technologies and related services to ensure reliability. Receiving, holding, and transacting in stablecoins will require a secure digital wallet. For institutions, this will involve the creation of multifactor authentication and multi-signature user accounts. To truly participate in financial services involving stablecoins, institutions may need to set up a validator node on each blockchain issuing the stablecoin. And holding digital assets will require access to secure custody solutions, either in-house or contracted through a specialty third-party provider that can build robust cybersecurity defenses.

Holding digital assets will require access to secure custody solutions, either in-house or contracted through a specialty third-party provider that can build robust cybersecurity defenses.

Furthermore, treasurers will need access to real-time market data, which may be sourced from exchanges or directly from individual blockchains. Alternatively, it may be accessed through dedicated “oracles,” whose data feed automated decisioning in smart contracts. Assets issued on private block­chains may be harder to track. Not only are there challenges with obtaining a single source of truth but a new generation of such oracles will be required.

Finally, treasurers can avail themselves of new tools that enable close monitoring of transactions being recorded on blockchains. So-called on-chain solutions enable institutions to monitor digital wallets, the inflow and outflow of funds, and potentially associated wallets for individual customers. That can satisfy know-your-customer, anti–money laundering, and sanctions compliance requirements.

Treasurers can access a range of tools to assess the risk of individual deposits in pooled digital assets and will decide on liquidity requirements based on the risk composition of such funds. One particular trade-off that requires careful consideration on a public blockchain is the need to maintain data privacy while also satisfying transaction monitoring requirements. Mature solutions to this challenge of transaction privacy on a public blockchain arguably have yet to fully emerge.

All of these technological advancements pose a fundamental challenge to treasurers: the extent to which they wish to compete or collaborate with emerging fintech companies (especially digital-native companies) in developing their own solutions. Conventional wisdom suggests legacy institutions may fare better by partnering with new providers. But formally onboarding and relying on an immature provider presents its own unique challenges. For example, the provider will not have proven its operational resilience over time. In this instance, strategic decisions about participation in the future of digital assets, including CBDCs and stablecoins, can take into account many unique risks and rewards. At a minimum, a thorough understanding of the technology and assets should be required.

Risk management

The switch from cash to digital-native cash-equivalent deposits creates risks, including counter­party risks associated with stablecoin issuers, and the operational and compliance risks of engaging with wallet-based virtual assets. For example, digital assets are likely not to be interest bearing (to avoid classification as securities). This will lead to a wider repricing of deposits. At the same time, treasury teams should build liquidity buffers and put in place risk frameworks that reflect the valuation, liquidity, governance, and technological uncertainties associated with the new assets.

In the case of CBDCs under a centralized (rather than a federated) model, the central bank would effectively become the sole intermediary of financial transactions. Banks would no longer compete for retail or business cash depositors, instead borrowing wholesale from the central bank to finance their lending activities. With this even funding playing field, margins would shrink, putting pressure on institutions to develop new services. Meanwhile, competition for deposits may be transplanted with competition for electronic wallets.

Treasurers should consider the impact of digital assets on funding. The future treatment of the liquidity coverage ratio and net stable funding ratio will need to be considered for different types of digital assets. Treasurers should also revisit transfer pricing, so that the full cost of funding is reflected in product sales. Another useful exercise is likely to be an assessment of the potential impacts of outflows, and the application of these analyses to inputs for regulatory stress tests.

Enabling transaction products and services involving CBDCs and stablecoins requires fresh assessment and management of institutional risks. These can include market and capital risks, as well as operational risk. But they can also result from a reliance on novel technology that requires new knowledge and experience—including the ability to manage reputational risks associated with the broader digital-asset class.

The perception of a lack of regulatory clarity concerning digital assets, especially in Europe and North America, could pose thorny issues for treasury management. Still, the regulatory playing field is evolving, suggesting the picture may soon become clearer. New rules in the pipeline include the Lummis-Gillibrand Responsible Financial Innovation Act in the United States, the Markets in Crypto-Assets regulation in Europe, and new restrictions on stablecoins in Singapore.

Besides closely monitoring any new announce­ments, it would be sensible for treasury teams to make adequate preparations for a world in which the regulatory environment becomes clearer, more permissive, and potentially more prescriptive.

Accounting and reporting

The final consideration for treasurers should be changes to accounting and reporting practices in relation to digital assets. In particular, there will be implications for income, expense, and tax reporting.

Accounting for intangible digital assets under generally accepted accounting principles is certainly not trivial. Potential challenges include recognition and initial measurement, as well as valuation of digital assets and possible impairment charges (which could apply to stablecoins if their peg is not absolute). If a financial institution holds digital assets in a third-party-hosted wallet service (a crypto custodian), it remains to be seen whether it should recognize the assets on its own financial statements or those of the custodian.

Similarly, taxation should be considered, amid continued inconsistencies between jurisdictions. It is possible that an institution’s financial statements and reporting for tax purposes will not align—for example, an impairment event may not translate into a tax deduction for unrealized losses. Equally, some digital-asset transactions (transferring and exchanging digital assets, for example) have historically been treated as nontaxable events until conversion back into fiat currency. This treatment varies, with jurisdictions such as Germany currently choosing not to tax low levels of profits from trading digital assets.12 While both CBDCs and fully reserved stablecoins should be largely immune to such taxation, institutions choosing to invest their customers’ deposits in cash-equivalent securities would probably trigger further tax exposures.

As digital assets become more common in main­stream financial services, one thing is clear: those charged with preparing and auditing financial reports—and those responsible for governance—need to stay up to date with developments and recognize the implications of rapidly evolving taxation and reporting regimes.

In judging the feasibility of any digital-asset program, treasurers will likely consider three key variables: their risk appetite, for example, market, capital, liquidity, operational, and reputational risk; the regulatory outlook, including tax treatment and compliance obligations; and technology infrastructure—specifically whether relevant financial-market infrastructures can guarantee smooth operations. Their thoughts on these will dictate how far and fast they wish to proceed.

Certainly, CBDCs and stablecoins present the potential to create more efficiency in almost every aspect of treasurers’ daily activities. However, as they approach these new options, treasurers need to consider a number of implications: risks and uncertainties around legal status, governance, investment rules in stability mechanisms, the safety and efficiency of payments systems, cybersecurity and operational resilience, and data privacy. That is a lot to ponder. However, with banks now beginning to use underlying distributed ledger technology for transacting in a range of asset classes, the priority for treasurers is to engage, understand, and act.

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