Blockchain for Banking News

BIS vision of digital currency borrows from Regulated Liability Network

digital currency

Today the Bank for International Settlements published an advance chapter from its upcoming annual report. The 42-page paper on “the future monetary system” puts significant effort into attempting to dismantle the allure of the cryptocurrency ecosystem. It outlines the legislation needed and its vision for the role of central bank digital currency (CBDC). 

In discussing the potential for a wholesale or interbank CBDC, one example provided borrows from the concept of the Regulated Liability Network (RLN) outlined by Citi’s Tony Mclaughlin. This envisions a single permissioned network that is host to central banks, banks and other institutions. Hence a CBDC can exist alongside tokenized bank deposits and tokenized e-money. These currencies can be used for settlement of transactions or delivery versus payment and potentially for cross border payments.

For retail CBDCs the BIS emphasizes the central bank’s role as enabling interoperability between other payment systems and enhancing financial inclusion.

The considerable amount of effort spent recently by the BIS on crypto-assets – both in this report and previous notes – highlights the concern in the BIS community about the challenges to the central bank’s role. The goal is also to build knowledge to regulate the sector.

The crypto takedown

Some crypto innovations get the BIS stamp of approval. Programmability, composability and tokenization are seen as enabling new kinds of functionality. And DeFi has shown a way to address borderless transactions, although it highlights a lack of adequate oversight.

But much time is spent on the problems of crypto-assets, not least the recent collapse of the Terra stablecoin.

“The more serious problem is the fragmentation of the crypto universe. Which means that crypto cannot serve the purpose of money in the sense that it doesn’t recreate this virtuous circle from greater acceptance to greater use,” said Hyun Song Shin, BIS Economic Advisor and Head of Research. 

The report elaborates on the breaks in payment network effects. In order for cryptocurrency validators to remain motivated, the rewards they receive need to outstrip the potential gains from cheating. “The only way to channel rewards to validators, thus maintaining incentives, is to limit the capacity of the blockchain, thus keeping fees high, sustained by congestion.” Cryptocurrency issuance is often intentionally limited in order to keep values high. However, some might disagree that blockchain capacity is deliberately constrained.

Meanwhile, congestion results in users adopting new blockchains for lower fees, resulting in fragmentation. While there are cross chain bridges to allow transfers between blockchains, these have been vulnerable to hacks.

Blockchain’s scalability trilemma is also mentioned in which only two of the three features of scalability, decentralization and security are achievable. Although some believe new solutions can address all three. For example, permissioned blockchains are more scalable than public blockchains but are less decentralized.

On the topic of centralization, the paper points to many DeFi protocols having centralized governance and the large role of centralized exchanges that process most transactions off-chain.

Crypto regulation

The solution to some of these issues is legislation and preventing regulatory arbitrage. The BIS wants to see:

  • Crypto and Defi regulated in a similar way to other activities based on same risk, same rules
  • KYC compliance for crypto
  • Consumer protection
  • Control over the increasing involvement of financial institutions.

One of the observations was about bank funding from stablecoin issuers, including certificates of deposit (CDs). It references the Tether stablecoin as investing part of the asset backing in bank CDs. However, like other asset-backed stablecoin issuers, Tether is moving towards funding a higher proportion in Treasuries.

But regulation is not enough, according to the BIS. “Overall, the crypto sector provides a glimpse of promising technological possibilities, but it cannot fulfil all the high-level goals of a digital monetary system. It suffers from inherent shortcomings in stability, efficiency, accountability and integrity that can only be partially addressed by regulation.” Instead, the BIS says the innovative aspects needed to be grounded in more secure foundations provided by central banks.

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