Key considerations for the adoption of digital currencies

In this blog, Arjeh van Oijen, Head of Product Management, Icon Solutions, explores how digital currencies have given rise to a new clearing and settlement mechanism, and why this is underscoring interoperability as a key priority for banks.

Amid geopolitical, technological and economic shifts, global momentum behind the development and adoption of digital currencies is ramping up.

Central banks across 66 countries are now in the advanced phases of exploring Central Bank Digital Currencies (CBDCs), with 44 pilots including the digital euro already underway. The popularity of stablecoins is also reaching new heights. The transfer volume of stablecoins hit highs of $717.1 billion in April.

But digital currencies do not stand on their own. They will need to co-exist with existing clearing and settlement processes and infrastructures, and this means interoperability is crucial. Let’s explore.

A new way of settling transactions

Firstly, when we talk about digital currency we are referring to the registration of a fiat currency (such as the pound) on a Distributed Ledger Technology (DLT)-based network with a 1:1 relationship to the fiat currency. Digital currencies can be issued by central banks (aka. CBDCs), commercial banks (aka. tokenised deposits and stablecoins) or non-banks (aka. stablecoins).

While the risks, application areas and technologies can differ per the digital currency issuer, the concept and principles that underpin them are the same. The DLT network provides a highly secure and reliable platform for the exchange of the digital currency as part of clearing and settlement. This can concern payments, conditional payments (a DLT based version of a letter of credit) and the post-trade settlement of securities and derivates (including margin calls).

DLT networks also offer ‘out-of-the-box’ capabilities like high availability and resilience, real-time transactions, low latency, immutability of data, security and programmability of transactions. This makes it easier to implement new infrastructures with relative speed and limited effort compared to traditional technologies, allowing banks and developers to focus on functional characteristics that can add more value.

The potential applications and use cases

DLT-based digital currencies introduce a new settlement mechanism for faster, lower cost and more efficient transactions. This offers several advantages in use cases where existing infrastructures like Real-Time Gross Settlement (RTGS) face limitations with respect to (24/7) availability, performance and integration with other infrastructures and applications.

A typical use case is the clearing and settlement of international payments. By removing the need for correspondent banks and facilitating direct transfers, digital currencies can improve transfer times and enhance the efficiency of cross-border payments.

Trade finance is another area. The addition of programmability means DLT can embed business logic into transactions to support smart contracts and conditional payments. This stands to address administrative pain points by reducing the risk, time and effort of issuing and settling Letters of Credit and Bank Guarantees.

By creating a new infrastructure for instant settlement, 24/7 trading and composability, digital currencies could also disrupt the securities market. This includes the post-trade clearing and settlement of securities transactions like FX, stock and bond trades. It may also see digital currencies being used alongside other digital assets (securities) as underlying collateral.

The impact of DLT on existing market infrastructures

In addition to delivering a new settlement mechanism, we see how DLT is catalysing the innovation of existing market infrastructures.

Although DLT networks will be used to transfer and settle transactions, banks will still need to use existing systems like RTGS to acquire and redeem digital currencies back into fiat money. This means that they must be compatible.

In response, expanding RTGS mechanisms to support DLT payments has become a priority. The European Central Bank recently launched a consultation on extending the hours of its RTGS system, T2. Although not a key driver, this would support the settlement of DTL payments like the digital euro. The Bank of England is also considering wholesale central bank digital currency solutions, which would allow for the exchange of tokenised assets and tokenised central bank money via DLT.

Why interoperability is a key priority

In addition to existing systems, it will be crucial to ensure interoperability between DLT networks themselves. There are various flavours of DLT networks available, all of which can differ in the way they handle aspects like transactions and / or confidentiality. Regardless of the difference, for the success of a large-scale adoption, they will need to be able communicate with each other.

They will also need a way to interface with the different systems used by the participants of DLT networks. This includes banks and clearing institutions but also asset issuers (like CSDs), brokers, non-financial institutions like fintechs and businesses, and other supply chain actors.

To minimise disruption, this requires the adoption of flexible and open solutions that can form the bridge between existing processes and systems used processing financial transactions, and newer DLT networks. In doing so, it will be easier to leverage the advantages that digital currencies and digital assets stand to bring in the years ahead.