CBDCs would reduce foreign exchange risk – LSE study

The introduction of central bank digital currencies (CBDCs) would make foreign exchange safer and smaller currencies more attractive, analysis from the London School of Economics claims.

In a blog post published on December 4, LSE visiting fellow Ousmène Jacques Mandeng argues that the use of CBDCs could trigger “a collapse” in the foreign exchange life cycle. Adopting such currencies, he says, would enable the instant settlement of payments to take place “atomically”, with both legs of a transaction having to succeed for the exchange to be executed.

This would nullify the need for “netting”, whereby banks consolidate multiple transactions with other financial institutions. Instead, a single net amount would need to be received or paid out.

Mandeng adds that FX transactions would no longer be subject to credit and settlement risk. Netting brings with it credit exposures and is subject to “considerable systemic risk”, he says. Settling FX transactions “normally takes two days from execution but can take considerably longer”. This, Mandeng explains, poses a form of settlement risk.

Banks also face credit risk when they settle FX transactions in a large-value payment system. As these lenders do not typically have access to foreign large-value payment systems, “they need to make or receive payments using correspondent banks”.

Mandeng says the banks mitigate these risks by minimising their exposure to counterparties through netting and by setting aside capital to absorb possible losses.

A different multi-currency system – continuous linked settlement, or CLS – offers “important risk mitigation mechanisms through multilateral netting and payment-versus-payment arrangements”. However, only 18 currencies can be cleared through it, Mandeng explains.

Instead, settling in a CBDC could mean that “each bank’s position is always balanced”, with one leg of the transaction funding the other.

“The conditions produce an environment where money velocity becomes infinite, producing important liquidity savings,” he says.

Banks have to hold regulatory capital as liquidity buffers to address risks. Eurozone banks hold about €3.8 trillion ($4 trillion) in high-quality liquid assets (HQLAs), Mandeng notes. He says it is not certain how much of this is used to cover foreign currency exchange risks, but that using CBDCs could enable banks to make savings as they would be required to hold less in the way of HQLAs.

This would produce entirely new market conditions, Mandeng says.

“The introduction of alternative settlement approaches could rebalance the foreign exchange market, reduce concentration and allow smaller currencies to become relatively more attractive,” he argues. He adds that with the dollar present in nine of the 10 most popular currency pairs, using CBDCs could also reduce market concentration.