Guidance on Managing Outsourcing Risk
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The monetary system is used by people all over the world to conduct payments and other financial transactions. The organizations and structures that surround and support monetary exchange make up the monetary system.
The central bank, which maintains the system’s fundamental functions and issues money, is at the center of the monetary system. Trust in the central bank ultimately underpins confidence in the monetary system.
The majority of payments are carried out by commercial banks and other private payment service providers (PSPs), who also provide services to customers. This separation of roles encourages competition.
Although the central bank-centered monetary system has done a good job historically, new demands are being placed on it by technical advancements brought on by digital innovations such as those in the crypto universe.
Decentralization is a foundational principle in the crypto universe. To make the system self-sustaining and free from the influence of strong entities or groups, crypto envisions checks and balances provided by several anonymous validators. Decentralized finance, also known as “DeFi,” aims to replicate traditional financial services in the crypto universe.
Recent occurrences have shown that the crypto ideal and its actuality are different.
Retail, fast payment systems (FPS) and central bank digital currencies (CBDCs), and decentralization and permissioned distributed ledger technology (DLT) are well-positioned to serve the public interest. They do so by lowering costs and increasing convenience while upholding the integrity of the system. Faster, safer, and less expensive payments and settlements are supported by these developments domestically and internationally.
The monetary system, which comprises money and payment systems, is a collection of institutions and structures that facilitate monetary exchange.
Challenges faced by today’s monetary system include:
Stablecoins, which aim to tie their value to fiat currencies, highlight the crypto industry’s desire to capitalize on the legitimacy offered by the unit of account issued by the central bank. Stablecoins’ dependence on the legitimacy of central bank money is a major structural weakness that is readily apparent. Additionally, stablecoins are less stable than their issuers claim they are.
The abundance of coins also highlights another crucial weakness in the structure of cryptocurrencies, namely their fragmentation into numerous incompatible settlement levels.
The fragmentation of the cryptocurrency market reveals its challenge. The more users flock to a single blockchain system, the worse the congestion and the higher the transaction fees. Consequently, this invites newer competitors who might forgo security in favor of greater capacity.
Crypto gives a sneak preview of potential functionality. These result from the ability to bundle transactions and carry out the automatic settlement of bundled transactions in a conditional manner, enabling higher functionality and speed.
Bitcoin presented a revolutionary concept that gave rise to cryptocurrency: a decentralized method of transferring value on a permissionless blockchain. Any participant acting as a validating node can validate transactions on a public ledger. Record-keeping on the blockchain is carried out by various anonymous, self-interested validators as opposed to depending on trusted intermediaries (such as banks). Cryptocurrency transactions are validated by decentralized validators and recorded on the public ledger.
A buyer broadcasts the specifics of the transaction when a seller wishes to send cryptocurrency to them. Validators compete for the opportunity to verify the transaction, and whoever is chosen to do so adds the transaction to the blockchain. The exact names of the parties involved in transactions are therefore kept a secret, but the history of every transaction is publicly viewable and linked to particular wallets.
In order to make the system self-sustaining, miners and validators receive financial rewards for carrying out their duties in accordance with the rules. Cryptocurrency rewards can be received in the form of transaction fees or from rentals earned by “staking” one’s coins in a blockchain that uses proof-of-stake. The more frequently a node acts as a validator, and the higher the rents are, the higher the stake.
Many blockchains and cryptocurrency coins have emerged since the creation of Bitcoin, most notably Ethereum, which enables the use of “smart contracts” and “programmability.” The use of self-executing code known as “smart contracts” can automate market processes and do away with the middlemen who were previously needed to make choices. Smart contracts are transparent and less susceptible to manipulation because the underlying code is open to the public and can be examined. The ability of smart contracts to integrate many parts of a system is a key aspect. Users can conduct complicated transactions on the same blockchain by merging several instructions into a single, smart contract. By “tokenizing,” they can turn assets into digital representations.
Since smart contracts cannot directly access data that is “off-chain” or outside the specific blockchain, they depend on intermediaries to supply this information (so-called oracles). But these modifications also bring new issues. More centralized validation techniques are frequently used to boost capacity, which weakens security and concentrates insiders’ benefits.
With the stated goal of reshaping the financial system by eliminating middlemen and lowering costs, decentralized finance provides financial services and products. Lending, trading, and insurance are the three major forms of financial activity, though the DeFi ecosystem is expanding quickly.
Lending: Users can make interest-bearing loans of their stablecoins to borrowers who pledge other cryptocurrencies as security on lending sites.
Trading: Decentralized exchanges (DEXs) are venues for direct trades between holders of cryptocurrencies or stablecoins.
Insurance: Users of DeFi insurance platforms can protect themselves against things like improper handling of secret keys, exchange hacks, and unsuccessful smart contracts.
Due to their pegs to fiat money or other assets like gold, stablecoins are essential to the DeFi ecosystem. They value the credibility that the asset or unit of account issued by the central bank offers. Their primary use case is to combat the extreme price volatility and limited liquidity of unbacked cryptocurrencies like Bitcoin. Their use also prevents costly, frequent conversions between cryptocurrencies and bank deposits in fiat currencies.
The two main types of stablecoin are asset-backed and algorithmic.
Asset-backed stablecoins like Binance USD and USD Coin are typically administered by a central intermediary who invests the underlying collateral and organizes the generation and redemption of the coins.
Algorithm stablecoins. To sustain their value in relation to the target currency or asset, algorithmic stablecoins rely on sophisticated algorithms that automatically rebalance supply.
The reliability of stablecoin stabilization methods heavily rests on the quality and transparency of their reserve assets, both of which are frequently terribly deficient.
Stablecoins lack the characteristics required to support the upcoming monetary system.
The inherent limits of permissionless blockchains, which eventually result in system fragmentation, congestion, and excessive costs, are a problem for cryptocurrencies. Transactions are recorded on the blockchain by self-interested validators.
In order to maintain the decentralized consensus system, validators must be motivated by financial rewards that are sufficiently high. Sincere validation must generate more rewards than possible gains from cheating. If compensation becomes insufficient, validators may be tempted to cheat and compromise the security of the cryptocurrency.
The blockchain’s capacity must be restricted in order to maintain incentives for validators and keep fees high enough. In times of congestion, users may offer larger fees to have their transactions processed more quickly because validators have the discretion to determine which transactions are approved and processed.
The so-called scalability trilemma is manifested in the restricted scale of blockchains. Only two of the three properties—scalability, security, or decentralization—can be attained by permissionless blockchains by virtue of their design. Decentralization and incentives improve security, but maintaining incentives through fees causes congestion, which restricts scalability. As more recent blockchains that compromise on security have entered the crypto universe, the restricted scalability of blockchains has caused the crypto world to become fractured.
There are increased dangers of theft and hacking in a system of rival blockchains that are not interoperable but are supported by speculation. Interoperability refers to the ability of users to access, share, and validate transactions across several blockchains. Since each blockchain represents a distinct settlement record, interoperability is not possible in practice. To enable the movement of coins between blockchains, a few “cross-chain bridges” have emerged. These bridges depend on a small number of validators who, in the absence of regulation, must be believed to refrain from engaging in unethical activity. However, a surge in hacks has coincided with the growth of these bridges.
In contrast to the network effects that develop in conventional payment networks, the crypto world is highly fragmented. In a conventional payment network, a platform gains more users as more individuals use it. Trust and affordability are essential to such platforms. Contrarily, cryptocurrency’s propensity for fragmentation and excessive fees is a fundamental structural fault that disqualifies it from serving as the basis for the next generation of money.
High price correlations between various cryptocurrencies and blockchains might be caused by speculation. Increased demand drives up prices even further. Strong price co-movement is present. When the rate of new users suddenly declines, there are significant worries about what would happen to a system that depends on selling new coins.
The DeFi ecosystem exhibits a propensity toward centralization despite its name. Voting is used to make a number of important decisions among the owners of “governance tokens,” which are frequently given to developer teams and early investors and are thus highly centralized.
Since it is impossible to specify in contracts what to do in every scenario, conflicts must be settled by some central bodies.
Additionally, newer blockchains typically rely on concentrated validation processes to increase throughput and speed up transactions.
Incentives conflicts and hacking danger arise as validators become more centralized.
Furthermore, there are currently no regulations governing the screening of Oracle providers. As such, anyone in control of Oracle can undermine the system by reporting inaccurate data.
The cryptocurrency market is likewise centralized, with investors favoring centralized exchanges (CEXs) over decentralized ones (DEXs). Similar to traditional banking, CEXs keep off-chain records of the orders that traders have posted. Due to their cheaper expenses, CEXs also draw greater trading activity than DEXs. Since 2020, CEXs have experienced significant expansion and attained quantities that qualify them as important from the financial stability perspective.
Before adopting relevant regulatory regulations, it is necessary to assess the parallels and divergences between the crypto market and traditional finance.
To address the immediate risks in the cryptocurrency monetary system, regulatory action is required.
Authorities need to take regulatory arbitrage seriously. They should make sure that crypto and DeFi operations adhere to the legal requirements for similar traditional activities, operating under the guiding premise of “same activity, same risk, same regulations.” The recent collapse of numerous stablecoins has brought attention to how urgent the situation is.
Policies are required to promote the integrity and safety of the financial and monetary systems. A fine or closure should be imposed on cryptocurrency exchanges that conceal the identities of parties to transactions and disregard fundamental know-your-customer (KYC) and other Financial Action Task Force (FATF) rules. They could otherwise be used to dodge taxes, finance terrorists, or get around economic restrictions. Similarly, banks and credit card firms need to demand user identity and carry out KYC compliance.
Consumer protection laws. Investors ought to be able to invest in riskier securities, such as cryptocurrencies, but there needs to be sufficient disclosure. This entails sound regulation of the frequently deceptive advertising of digital assets. Front-running-like behaviors can necessitate the application of innovative legal strategies.
The exposure of banks and nonbank financial intermediaries to the cryptocurrency ecosystem poses dangers to the stability of the financial system that central banks and regulators must reduce. Traditional financial institutions are investing in cryptocurrencies rapidly, meaning that shocks to the cryptosystem might have a ripple effect. Large traditional banks have so far only had minor exposures, and their direct investments in businesses engaged in cryptocurrency markets are still modest compared to their total capital. Sound guidelines for bank exposures to cryptocurrencies must be implemented to address these risks.
It is crucial to discover regulatory entry points and close data gaps. A multitude of new centralized intermediaries has popped up as a result of the cryptocurrency market’s expansion. The traditional financial institutions and these centralized entities serve as a natural entry point for regulatory responses.
The worldwide nature of crypto will necessitate collaboration across all regulatory fields. In order to sanction non-compliant actors and platforms, authorities may need to actively exchange information and conduct coordinated enforcement measures.
Overall, the cryptocurrency industry offers a glimpse of exciting technological potential, but it is unable to achieve all the major objectives of a digital monetary system. It has flaws such as stability, effectiveness, accountability, and integrity that legislation can only partially resolve. Fundamentally, cryptocurrency and stablecoins result in a fragmented and weak monetary system that comes from the economics of incentives rather than technological limitations.
The goal is to harness the beneficial cycle of network effects by not only enabling valuable functionalities like programmability, composability, and tokenization but also putting them on more secure bases. Central banks are utilizing the best aspects of new technology to serve the public good, along with their attempts to regulate the crypto universe and address its most pressing issues.
New technical advancements and a more accurate representation of central bank money at its core should combine to create the future monetary system. The benefits of new digital technologies can therefore be gained through interoperability and network effects because they are rooted in trust in the currency.
As one of its primary functions is to issue central bank money, which acts as the basis of the future monetary system and the unit of account in the economy, central banks are ideally positioned to provide it.
Using its balance sheet, the central bank’s other function is to provide the means for the ultimate finality of payments. It’s a trusted middleman who debits the account of the ultimate payer and credits the account of the ultimate payee.
Another function of the central bank is to ensure enough liquidity available for settlement to support the smooth operation of the payment system. L liquidity provision ensures no bottlenecks will obstruct the smooth operation of the payment system.
The central bank’s other responsibility is to protect the payment system’s integrity through regulation, supervision, and oversight. The central bank is in a good position to provide the groundwork for cutting-edge services in the private sector thanks to its interconnected roles.
The future monetary system expands on these central bank functions and responsibilities in order to provide room for new capabilities of central bank money and cutting-edge services to be built on top of them. New private applications will be able to function on more advanced technology representations of central bank money rather than stablecoins. Thus, innovations at the central bank can support numerous new activities.
The future monetary system will be based on the tried-and-true division of labor between the central bank, which supplies the framework of the system, and the private sector organizations, which handle customer-facing operations. Additionally, new standards, like application programming interfaces (APIs), can be created to dramatically improve the interoperability of services and related network effects.
This vision includes elements at the wholesale and retail levels that make a variety of new features possible. At the wholesale level:
Programmability. It can facilitate transactions between financial intermediaries and provide new capabilities. Using permissioned distributed ledger technology (DLT), CBDC transactions allow programmability and settlement, enabling transactions to be conducted automatically when predetermined conditions are met.
Composability. Make it easier for transactions to be composed by enabling the combination and execution of a variety of different functions.
A wider range of financial intermediaries. New capabilities not only enable a far larger range of financial intermediaries to participate in transactions but also allow for an increase in the types of transactions.
Multi-CBDC arrangements. Additionally, Central Bank Digital Currencies (CBDCs) collaborate internationally through multi-CBDC agreements, including various central banks and currencies.
Tokenization. When deposits are tokenized, they are decentralized, settled, and given a digital representation on the distributed ledger technology (DLT) platform. This might make it easier to exchange new technologies, including fractional ownership of stocks and other assets, opening the door to creative financial services that go far beyond simple payment processing.
At the retail level:
Interoperability. Users of one platform can send messages and commands to others that are linked to it with ease through APIs. Retail innovations encourage more competition, decreased costs, and increased financial inclusion in this way.
Instant payments. Households and businesses can easily access retail CBDCs. Through various interfaces and competing private Payment Service Providers, they enable immediate payments between end users.
Data architecture. The Central Bank Digital Currencies (CBDCs) are backed by a data architecture that includes digital identity and APIs that allow for safe data interchange, enabling more user control over financial data.
Open platform. They facilitate lower costs in payment services by fostering efficiency and better competition among private sector PSPs through the provision of an open platform.
Inclusive design. Both can help financial inclusion for people who do not already have access to digital payments through inclusive design elements.
The central bank serves as the solid base of the metaphorical tree that represents the future monetary system. The tree metaphor illustrates that the monetary system is founded on payment finality through eventual settlement on the central bank’s balance sheet.
The central bank-based monetary system fosters a thriving ecosystem of participants and activities where rival private-sector Payment Service Providers can employ creativity and innovation to serve users better.
When viewed from a distance, the world’s monetary system can be compared to a forest, whose canopy makes cross-border and cross-currency activities possible. Infrastructures like multi-CBDC (Central Bank Digital Currencies) platforms function as crucial new system components in the canopy.
Innovation is crucial. For private innovation to serve the public good, the fundamentals must be done correctly. Public infrastructures can enhance the payment system by utilizing many of the purported advantages of cryptocurrencies without the downsides, as demonstrated by ongoing work at central banks. How central banks may assist interoperability and data governance is demonstrated through wholesale and retail CBDCs as well as open banking initiatives.
A Central Bank Digital Currency (CBDC) is a digital payment instrument that is directly owed to the central bank and is valued in the country’s unit of account. Retail CBDCs are available to both individuals and companies. However, unlike domestic commercial banks, wholesale CBDCs provide additional payment and settlement capabilities to a considerably wider range of intermediaries, potentially spurring innovation.
Multi-CBDC systems involving several central banks and currencies can benefit from decentralized governance. Functions such as self-executing smart contracts are essential because they enable users to limit the settlement of their transactions to the event that certain predefined conditions are met (programmable). Through such automation, payments, and delivery of securities can be done only all at once or not at all, accelerating settlement and reducing counterparty risk.
Wholesale CBDCs have the advantage of potentially being accessible to a far broader range of intermediaries than domestic commercial banks. By allowing nonbank PSPs to conduct CBDC transactions, competition, and vitality could increase significantly.
Payments could be finalized with wholesale CBDCs. In a digital system, establishing the source or “provenance” of the transferred funds is necessary to ensure that payment is genuine. Cryptography is used to conceal real names while openly displaying the complete history of all transactions made by all parties.
The tokenization of regulated financial instruments, including retail deposits, can be supported by central banks. Commercial bank deposits can be represented digitally through tokenized deposits. Tokenized deposits would be programmable, “always on” (24/7), and covered by deposit insurance, making them suitable for a wider range of retail payment applications, such as autonomous ecosystems. This approach could make it easier for other financial assets, like stocks or bonds, to be tokenized, enabling fractional ownership of those assets.
One potential tokenized deposit system would include a permissioned platform that keeps track of every token transaction the participating institutions produce. Retail investors (depositors) would store tokens in digital wallets and send tokens between wallets to make payments. This might occur concurrently as a result of smart contract-enabled single atomic transactions. Digital representations of bonds and stocks might potentially be possible with the same system.
In autonomous ecosystems, programmable CBDCs might also facilitate machine-to-machine payments. Machines can manage their own budgets and make direct purchases from one another for goods and services. Their integration will enhance the need for programmable money and smart contracts, lowering any settlement risk. For instance, this might result in huge efficiency savings in the goods logistics industry, where transactions are still primarily paper-based and can take several days.
The advantages of atomic settlement and open-source protocols can coexist peacefully, with central banks serving as the main hubs for validation.
Wholesale and retail CBDCs have a lot in common. Retail CBDCs provide consumers and companies with digital access to money from the central bank. Retail-facing payment services are provided by PSPs, both bank and nonbank. Thus, retail CBDCs are occasionally referred to as “digital cash.” As transfers take place in real-time or close to real-time, on an almost 24/7 basis, they have great speeds and availability.
Contrary to crypto, which needs high rents, has limited scalability, and is congested, Central Bank Digital Cryptos and retail Fast Payment Systems (FPS) provide broader use, which lowers costs and results in better services.
Retail Fast Payment Systems (FPS) have already made notable strides toward lowering costs and promoting financial inclusion for the unbanked, particularly in Brazil, where two-thirds of the adult population use their retail FPS Pix.
Retail CBDCs can be created to assist financial inclusion by examining retail CBDC design elements that address particular barriers to financial inclusion, such as through novel interfaces and offline payments. The cost of payment services for the unbanked can be decreased by central banks through tiered CBDC wallets with simpler due diligence for users transacting in lower values, promoting more access to digital payments and financial services.
As every transaction in the digital economy leaves a trace, generating issues with privacy, data misuse, and personal safety, retail Central Bank Digital Cryptos (CBDCs) and Fast Payment Systems (FPSs) can be created with privacy protection and improved user control over data in mind. Since there isn’t a single, comprehensive record of every transaction in conventional payment systems, individual Payment Service Providers (PSPs) have more control over data. Every PSP, however, only records its own transactions. Even the central operator is unaware of all payments in full. Thus, the promise of confidentiality by the central operator and the mix of segregated record-keeping are used to protect the privacy of payments.
Crypto advocates claim permissionless blockchains give consumers back control over their personal data, yet this poses serious threats to users’ privacy and integrity. Retail FPSs and CBDCs’ underlying structures can allow users control over their personal data while protecting their privacy and promoting consumer welfare. Additionally, central banks can genuinely build systems in the public interest because they have no financial interest in personal data.
Systems that provide law enforcement authorities with access to information while maintaining the necessary legal protections can be created with clear mandates and public accountability. These methods are currently being considered for retail CBDCs and are already standard practice in the form of bank secrecy rules.
Retail CBDCs and FPS have the potential to enhance accountability in comparison to the current system and the crypto universe. The role of the central bank in retail payments needs to be discussed publicly as a result of new systems, and legal regulations will need to be modified in order for them to operate. Private service providers would be integrated into a strong regulatory and oversight framework under a system based on public infrastructure.
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In this chapter, we provide a comparison of the standardized approach, the alternative... Read More
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