3/3 FAIT ACCOMPLI: Central banks must create digital risk free assets (dRFA)

SUMMARY There is substantial debate on if and when any central banks will issue digital currencies. However, before one addresses that debate, I believe that one should consider the role of a central bank in creating digital risk free assets (RFA) for digital Financial Market Infrastructure (dFMI).

As with existing “real” RFA of cash bank notes (& coins) and government debt securities, the future of digital risky assets (dRA), such as credit bonds, equities, etc., is a hollow ambition without the parallel creation of digital risk free assets (dRFA). (Note: risk-free is just a market term, governments can also default on their bank notes and debt!)

Without an equivalent dRFA, there will be a bifurcation of risk management between real assets (off-chain) and digital assets (on-chain) for all of those institutions (financial & non-financial) that wish to participate in digital assets.

This will also impact individuals who will need to access a digital version of cash in order to participate in dFMI. At present the alternative is a digital stablecoin provided by their deposit/payment bank of choice.

Moreover, in the event that dRFA do not exist, then central banks will face an outcome where private enterprises will fill the gap. This would lead to weakening of system-wide creditworthiness (e.g. no ability for investors to hold dRFA in order to negate taking private enterprise counterparty risk; and, no ability to have a digital lender of last resort to negate systemic risk).

Related to the full set of dRFA (the dRFA yield curve) is the foundation of that yield curve, namely: the CBDC (Central Bank Digital Currency, which has a maturity of zero and pays zero interest). This is critical to the creation of a complete dRFA yield curve and the creation of an associated payment mechanism using central bank equivalent currency in dFMI.

HISTORICAL IMPORTANCE OF RISK FREE ASSETS The entire fabric of the global financial system is based upon each country having a set of risk free assets (RFA), denominated in their national, fiat currency.

(Note, some countries have adopted foreign currencies, such as Panama and Ecuador, but these are the exception. In the case of the Eurozone, the Euro is, de jure, the national currency of each of the member countries, thus, a single currency is used in more than one country, but that single currency is used for different RFA per country.)

In the current world, for most users RFA take the form of either bank notes or government debt securities. By volume, the former is typically used by individuals and small businesses, while the latter is the domain of the professional/wholesale corporate, investment and banking markets.

The RFA form the basis from which all other risky assets (RA) are priced, typically at a positive spread over the corresponding RFA rate. With the exception of systemic crises, when anomalous circumstances may arise for short periods of time, this pricing rule holds true.

FUTURE IMPORTANCE OF digital RISK FREE ASSETS In the same manner as RFA, the emergence of digital assets on a dFMI will require dRFA for the simple reason that without it there will be no sustainability of the dFMI to withstand a crisis. This, I believe, is the test for whether a new dFMI will have longevity. Without dRFA, the dFMI will likely fail at the first major crisis and all on-chain, digital assets will have to revert to off-chain real world assets for crisis resolution.

CREATING A DIGITAL GOVERNMENT BOND MARKET IS CRITICAL TO dFMI If the emerging dFMI is to be durable and withstand a crisis, then it is critical that the first step in the development of digitised securities is for government debt securities.

While other securities, such as credit bonds, equity securities, etc., could gain some traction in dFMI, they are unlikely to gain material traction in the absence of the creation of dRFA.

The first stage of evolution of dRFA is likely to be in smaller markets by value, perhaps smaller countries and emerging market countries. This is because these countries may be able to be early adopters due to their lower impact on global markets. However, it is the evolution of dRFA for the larger countries that is critical to the success of dFMI.

The dRFA Yield Curve and CBDC We are all familiar with yield curves. They are the returns for lending to governments for different lengths of time. It is reasonable to believe, given the established practices in this asset class, that creating a digital equivalent is achievable for participants in the dFMI.

However, in the creation of the digital yield curve (dYC), there is one point on that curve that is special, unique one might say, namely: the zero maturity, zero yield RFA, known to most as “cash”.

At present, private sector banks that hold reserves at central banks do indeed hold them as “digital” assets. However, individuals and the majority of private companies do not have access to such digital assets at a central bank. When we think of giving every individual and every private company access to a central bank digital currency, CBDC, to hold as an asset and to make and receive payments, then the question arises: how is this achieved in the dFMI?

The creation of a CBDC is a more complex issue than the rest of the dYC, and, therefore, I address it in a subsequent article. However, it is possible to start with the digitisation of government bonds and later examine the introduction of a CBDC.

So, my view is that the market should proceed with digitising government bond markets to aid the development and maturity of the dFMI and then add additional features, such as CBDC. This incremental approach will be much more likely to succeed than trying to implement everything at once. After all, the current financial market infrastructure took a long time to create and it is still far from perfect.

[SOURCE: this is an extract taken from “The Emergence of a New Digital Financial Market Infrastructure”, a series of thought leadership articles by Johnny D. Mattimore. For the full series see his LinkedIn Posts at: and select “Articles”.]