Fed, BIS See Smart Contracts Transforming Central Bank Liquidity Management

The digitization of money, and the movement to decentralized finance, begs the question: What happens to financial institutions, central banks and central banking policy?

The banking system itself may seemingly be upended by stablecoins, cryptocurrencies and the prospect of digital dollars. The landscape is still fragmented, with regulations still in flux, and with some banks (but not all) choosing to launch their own coins.

In an interview with PYMNTS CEO Karen Webster from 2022, Rob Hunter, deputy general counsel and director of regulatory and legislative affairs at The Clearing House (TCH), said, “There’s no reason why banks shouldn’t be allowed to use a new technology to perform functions that are clearly within the business of banking itself … functions like deposit taking and transferring value that banks have been doing for hundreds of years.” Go back a bit further, to 2021, and the Boston Fed’s Jim Cunha, SVP of secure payments and FinTech, told Webster that blockchain rails set up new ways to move constructs like contracts with capabilities to make whatever is traveling across those rails “smart.”

Making Central Banks Nimbler

More recently, research last week from the Federal Reserve Bank of New York and the Bank for International Settlements (BIS) Innovation Hub, in the study “Project Pine: Central Bank Open Market Operations with Smart Contacts,” contended that central banks could use these automated setups to conduct monetary policy in ways that would be “instantaneously carried out” across “varying market conditions” that would improve liquidity.

Liquidity, we’d add, is a critical ingredient in the banking system, impacting lending and borrowing, among other activities. And as the report indicated, banks themselves may lead the way, paving the path for the central banks to embrace tokenization. “If the private financial sector adopts tokenization on a broad scale in wholesale markets, central banks may need to participate in novel financial market infrastructures and interact with digital tokens to continue effectively implementing monetary policy,” the BIS and the Fed wrote in the report.

Stablecoins and cryptocurrencies are not mentioned in the document — and so the read-across is that the digital representations of deposits and assets are firmly housed within the confines of “traditional” money.

The paper, technical in nature, and spotlighting Project Pine, which created a prototypical “tokenized toolkit” for paying interest on reserves, asset purchases and swaps, founds that:

“Central banks could use smart contracts to easily and quickly create new facilities or adjust existing ones to optimize the implementation of monetary policy in a tokenized environment,” and could be “nimbler in uncertain conditions.”

Different Layers, Automated Activities

The report noted that the technical explorations are still at an early stage, but the paper revealed the construct of the system, with different layers of automated processes and where the tokens themselves are programmed with “smart contracts” tied to pre-specified conditions.

In the assumed “world” of these wholly digital interactions, per the Fed and BIS, “central bank reserves are digital tokens that exist in the token arrangement with other types of money and securities … Above the settlement layer is the ‘asset layer,’ consisting of the wholesale money and securities issued … These tokens represented the reserves, commercial bank deposits, securities, and unsecuritized assets that would be used in testing scenarios.”

The use of smart contracts in the service of traditional monetary functions and among traditional players was further underscored by the mention that in all of the tested scenarios, “there was always a central bank, which issued reserves, held high-quality assets, and used smart contracts to meet a target interest rate. There were different types of commercial banks, which issued deposits, held reserves and a variety of assets, and interacted with the central bank smart contract.”