Digital Currencies And the Future of Payments

Stablecoins in particular hold significant promise for such functions as cross-border payments. But banks will need to make important adjustments.

Innovation in the payments space is occurring at an astonishing rate, with new technology capabilities enabling huge strides to be made in enhancing speed, transparency, and efficiency in transaction processing.

Developments including real-time payments, SWIFT gpi, artificial intelligence (AI), and distributed-ledger technology (DLT) are increasingly being leveraged by banks to improve the client experience for domestic and cross-border payments. Ultimately, it is expected that moving money instantaneously, 24/7/365 and with full transparency, will become a reality.

There is no single, fixed route for the industry to take to arrive at this point, however. With multiple innovations and initiatives emerging and adding value throughout the end-to-end payments process, banks need to equip themselves with a comprehensive toolbox of payment solutions to support their clients now and in the years to come.

Indeed, innovation in the payments landscape continues to evolve. And, as we look to the future, another development has the potential to play a key role in shaping the evolution of payments: digital currencies.

A New Model

Money that exists only in electronic form and that is stored and exchanged using DLT networks can be divided into three categories: cryptocurrencies, central bank digital currencies (CBDCs), and stablecoins.

With cryptocurrencies susceptible to highly volatile prices and limited scalability, and CBDCs still a long way off because of fundamental regulatory considerations (including their impact on monetary policy), stablecoins are sparking growing interest in the payments space.

Stablecoins share many of the features of cryptocurrencies, but by linking their value to a pool of assets, the coins can be stabilized, thereby mitigating the risk of high levels of volatility. And while there are still regulatory and governance issues to overcome, stablecoins seemingly have the most immediate potential to come to fruition and deliver tangible benefits for payments.

Much of the buzz around digital currencies stems from their ability to enable an entirely new processing model for some forms of payment and settlement.

Current payment rails are based upon a centralized model. Furthermore, even new real-time payment rails—including the Real-Time Payments (RTP) network in the United States—are restricted in terms of the value that can be transferred. This is an issue for wholesale payments in particular, where values significantly exceed such ceilings.

By contrast, digital currencies could enable payments to be made instantly, irrespective of value, 24/7/365. Their potential lies in the fact that they are token-based. This means that they can be held directly by the participants in a transaction and therefore transferred on a peer-to-peer (P2P) basis.

Three Key Applications

This approach would deliver benefits in at least three key areas: cross-currency foreign-exchange (FX) swaps, securities settlement and, if the model proves successful, cross-border payments.

By applying digital tokens to payment versus payment (PvP) transactions, cross-border FX payments could be made in real-time, around the clock. This would significantly widen the window in the day in which banks could make such transactions, rendering the cut-off times that currently dictate same day cross-currency FX swaps far less of a factor. And the transfer in the two currencies takes place simultaneously, reducing risk.

Tokenized transactions can also address the issue of cross-border payments crediting the recipient with a different value from that sent by the originator. Currently, this can occur due to FX fees, rate fluctuations, and the different costs involved as the payment makes its way along the chain.

But as a digital-token swap is made P2P and in real-time, these factors are removed. And so is the issue of a lack of transparency that can be experienced as the payment is routed through multiple banks.

As for securities settlement in delivery-versus-payment (DvP) transactions, mechanisms are applied that ensure the securities leg is implemented only after the payment has been made and finalized. Therefore, as it is the settlement of the payment that creates the time lag, the key to enhancing asset settlement is the ability to digitize the payments leg.

Stablecoins could do just that. Tokenizing both legs of the transaction could facilitate an instant atomic transaction, with the buyer and seller simultaneously receiving their respective asset and payment through a P2P transaction and removing the need for third parties. This approach could reduce reconciliation efforts, capital costs, and settlement and counterparty credit risk.

With cross-border payments—whether wholesale, retail, or consumer—the current processing system uses a correspondent-banking model involving numerous parties. This can lead to multiple costs, risks, and a process that can take multiple days.

But if stablecoins were to achieve a network effect in the industry, ultimately, cross-border transactions could be settled P2P, securely, 24/7/365. The immediate settlement would reduce counterparty and institutional risk, as well as provide additional risk mitigation due to there being no credit lines or locked capital held in accounts.

Bankers’ Toolkit

With digital-currency transactions increasingly likely to gain a foothold in the payments space, it is important to note that the concept of an intermediary will not become redundant. Rather, the correspondent-banking model will likely evolve.

Not every counterparty will be a direct participant in a P2P system. That means that banks will need to become a gateway for P2P systems, providing tokens and settling on a third party’s behalf.

The roles of liquidity provider and solid partner institution will also be paramount, as digital settlements will occur on a T-instant (as opposed to today’s T+2) basis. Organizations will be required to adapt to real-time liquidity management and forecasting.

Banks will therefore need to ensure clients are positioned to manage liquidity more efficiently and effectively, delivering intraday liquidity options should scenarios arise in which money to pay for an instant transaction is not instantly accessible.

As the landscape shifts, it is also important to recognize that some payments will be affected more than others. SWIFT payments through Fedwire and CHIPS, ACH settlement, real-time payments, and even cross-currency FX will continue to be executed through traditional means. Digital tokens and fiat money will therefore coexist, with different rails and channels remaining relevant and supporting different payment needs.

And, of course, the future of payments is by no means being shaped by digital currencies alone. A combination of capabilities will enable payments and settlements to be truly optimized. Banks will be required to meet the varied needs of clients through a toolkit of solutions and services.

This means: investing in the advancement of payments through industry initiatives and emerging technologies, including SWIFT gpi, AI, and real-time capabilities; supporting and driving ongoing enhancements to traditional rails; and becoming the gateway provider of choice for tokenized payments, and a valued liquidity provider.

—Vivek Kohli is emerging technology head, treasury services digital office, at BNY Mellon.