Banks Continue the Mortgage Lending Party In A Fog

The latest data form APRA on the banks (ADI’s) portfolios for October 2015 tells us a little, but much is lost in the fog of adjustments which continue to afflict the dataset. In fact, APRA now points to the “corrected” numbers which the RBA publish.

Some banks have reclassified housing loans that originated as investment loans to owner-occupied based on a review of customers’ circumstances or as advised by customers. See the Monthly Banking Statistics Important Notice for more information. These reclassifications will affect growth rates for investment and owner-occupied housing loans for October 2015. Questions about specific data should be directed to the relevant bank.

The Reserve Bank of Australia publishes industry-level housing loan growth rates in Growth in Selected Financial Aggregates. Table D1 in particular contains investment and owner-occupied loan growth rates, which have been adjusted for these reclassifications. Table D1 is available on the RBA website athttp://www.rba.gov.au/statistics/tables/index.html”

The RBA data shows that investment loans are probably growing a little below 10%, and owner occupied loans at about 6%.

RBA-HL-Growth-D1-Oct-2015The monthly banking stats do not contain these adjustments, so cannot be directly reconciled. However, some interesting points are worth noting nevertheless. First is that total lending for housing rose by 7.5 bn to 1.4 trillion in the month. The RBA lending figure for the whole market (including the non-banks) was 1.5 trillion.  This is another record.  Investment lending sits at 37% on these numbers.  Net movements for OO loans was up 2.73%, whilst investment loans fell 2.95%.

Beyond that, if we take the APRA data at face value, then Westpac continues to reclassify loans. In the monthly movements we see more than $15bn swung into the owner occupied category, with an adjustment to the investment side of the ledger. There were smaller movements in the other banks, but some of this looks like further adjustments.

APRA-MBS-Oct-2015-1So the current market shares are revised to:

APRA-MBS-Oct-2015-2In our modelling of the monthly movements, based on the APRA data, where we sum the monthly movements for the past year (and include adjustments where we can), it appears Westpac is now in negative territory for investment loans, and that the growth rates for the other majors is slowing. The imputed annual market movement is 4.4% against the RBA data above of just under 10%.

APRA-MBS-Oct-2015-4For completeness we also show the owner occupied movements. These too are impacted by reclassifications, and the imputed growth rate is 10%, compared with 6% from the RBA.

APRA-MBS-Oct-2015-3 The net effect of all this is that there is no true information about what individual banks are doing in their loan portfolios. Having tried to talk to a couple of them to clarify the story, I discover they are not willing to share additional data and refer back to the [flawed] APRA data.

The convenient “fog of war” will continue for some time to come. There is also no way to cross-check the RBA adjusted data, and no underlying detailed explanations. We are just supposed to trust them!

 

 

Cash flow is king as technology changes the way SMEs will do their banking

From SmartCompany.

Small business owners, banks and fintechs can all gain valuable insights from a recent survey of SMEs conducted by research company Digital Financial Analytics (DFA).

The results reinforce the critical importance of cash flow management and identify a number of telling behavioural and demographic trends within this all important sector.

The DFA Small & Medium Business Survey 2015 of 26,000 businesses with turnover of less than $5 million reveals 57% of all business borrowing is for working capital.

Extended payments terms and late payments are the main reasons why managing cash flow has become one of the biggest challenges facing SMEs.

With average debtor days running at between 50 and 60, managing cash is a juggling act that can be made even more difficult by some big customers that display little regard for the plight of their smaller suppliers.

This is where the relationship between the SME and the bank becomes so critical. The extent to which business owners feel their bank is there to support them in tight times is one of the key determinants of satisfaction levels and also the propensity to switch banks.

Satisfaction and switching

Thirty-five per cent of SMEs surveyed by DFA are either “satisfied” or “completely satisfied” with their bank, so clearly many customers are happy.

But this also means that two in every three business customers have at least some level of dissatisfaction with their bank. The main causes of frustration can be traced to lack of service, compliance requirements and poor understanding by banks of their needs.

So how does satisfaction translate into shifting intentions? Seventy five per cent of SMEs indicated a preparedness to shift for a better deal yet 60% have never changed banks.

This begs the question: why don’t more SMEs change banks?

Possible explanations are that SMEs don’t proactively seek alternative financing proposals because they either feel “it’s all too hard” or “all the banks are pretty much the same anyway”.

Others may have tried to move but have found no joy because they overestimated their attractiveness to another bank.

When it comes to how much profit banks make from their SME customers, 20% of customers generate around 80% of bank profits.

Perhaps surprisingly, 30% of all SMEs are actually unprofitable for the banks. The problem for many business owners is that they don’t know how attractive they are as a customer and this makes it tricky when it comes to negotiating with banks.

 

Luddites, migrants and natives

DFA divides business owners into luddites (14%) who are late adopters of technology and hardly use smart devices and services at all; migrants (52%) who are now active users but have had to learn new skills and adapt to the new services; and natives (34%) who have always been digitally aligned. Age is a good proxy for digital take-up with younger business owners firmly in the native category, whilst those over 45 are more likely to be luddites.

Natives are more likely to borrow than migrants, who are more likely to be credit avoiders. The natives also spend considerably more time connected to online services and want all their banking (from product purchase through to service) via smart devices. Natives are significantly more profitable customers for banks in relative terms.

Migrants have a mix of channels with 20% still preferring the bank branch whilst luddites are strong champions of branch access. Luddites provide profitability for branches but as the proportion of luddites decline, it will become even increasingly expensive for banks to support the remaining numbers.

With 86% of businesses either natives or migrants, the future is digital.

 

Fintechs

Financial Technology (fintech) is a term used to describe the range of innovative digital businesses including online lending and payments platforms.

Creating awareness is one of the many challenges faced by online lenders although many digital natives are very aware and are considering applying or already have applied for an online business loan. Migrants have mixed attitudes to online lenders whilst luddites are just not aware or interested.

Natives are also most likely to consider borrowing via payments platforms like PayPal’s cash flow services, whereas migrants are only using PayPal to make payments and luddites are not engaged at all.

Natives are well advanced in their use of cloud-based services whilst migrants are on the journey. Luddites have not yet started to engage.

 

Gender

According to the DFA survey, 73% of all SMEs are run by men and the bigger the business, the more likely a male will be the boss.

Only 8% of businesses run by females have more than 100 employees, compared with 16% of businesses run by males.

The proportion of SMEs run by females is increasing slowly from 23% in 2006 to 26% in 2010 and now 27%.

 

Credit cards

Businesses that employ less than four people rely heavily on debt from personal credit cards. This is usually unsecured debt and with 60% of bank write-offs being for unsecured lending. This partly explains why credit card debt is more expensive than secured business debt.

 

Failure

Half of all SMEs will fail within five years of starting up. Failure rates are highest amongst businesses involved in transport, financial services and information media and telecommunications, whist businesses in accommodation, food services and healthcare are less likely to fail.

 

Technology is changing the game

As challenging as it is to run an SME these days, technology is opening up possibilities for those business owners keen to embrace it.

Banks remain dominant players in lending and payments but increasingly SMEs are able to tap into new avenues of funding and transacting business.

The banks will innovate and also collaborate with fintechs in order to maintain their standing. Despite the advantages the new players possess, we haven’t yet seen how they operate in a severe economic downturn and it’s going to take time for them build critical mass, earn the trust of their customers and produce an acceptable ROE for shareholders.

There will be casualties along the way.

DFA concludes there is a significant opportunity available to players who construct compelling offers to the SME sector.

Understanding the needs and aspirations of small business owners is paramount and the parties who best articulate and most importantly deliver on this this will be the ones that come out on top.

But business owners cannot afford to sit back and wait for things to happen, they need to invest time and effort in exploring what options are available and best suited to their own immediate and future needs.

 

Neil Slonim is a business banking advisor and commentator and thefounder of theBankDoctor.org, a not-for-profit online resource centre for SMEs dealing with the challenges of funding a small business. 

Housing Lending Up Again In October to $1.5 trillion.

The latest RBA credit aggregates for October 2015, released today are not easy to interpret because of the myriad of adjustments.   Housing loans have more reached $1.5 trillion, another record.  But are these numbers trust-worthy?

At the aggregate level, total credit rose a seasonally adjusted 0.61% in the month, or 6.11% in the past year. Lending to business grew 0.84% in the month, and 5.88% in the last year. Business lending as a proportion of all lending sits at 33.2%, from an all-time low of 32.9% in July, but clearly business investment continues to be constrained. Housing grew 0.58% in the month, and 7% in the past year, whilst personal credit fell 0.89% in the month and 0.27% in the year, a sign that households remain cautious.

Credit-Aggregates-Oct-2015Turning to housing finance in more detail, and this is where it get complex; lending for owner occupied loans rose 2.62% in the month, representing 9.41% growth in the past year, while investment lending fell 2.8% in the month, and grew 3.03% in the year. But there are so many adjustments in these numbers, as the banks reclassify more loans, thanks to a combination of internal review, and customer request. Specifically, the differential movement in investment loans is making people check their loans are correctly classified, and RBA estimates $30bn of loans have been switched. Investor loans on book comprise 36.35% of all housing, down from its recent heights of 38.55% in July. The only thing we can be sure of is the numbers will move again next month. I discussed the recent RBA comments on this issue recently.

Housing-Aggregates-Oct-2015The RBA makes the following caveats:

All growth rates for the financial aggregates are seasonally adjusted, and adjusted for the effects of breaks in the series as recorded in the notes to the tables listed below. Data for the levels of financial aggregates are not adjusted for series breaks. Historical levels and growth rates for the financial aggregates have been revised owing to the resubmission of data by some financial intermediaries, the re-estimation of seasonal factors and the incorporation of securitisation data. The RBA credit aggregates measure credit provided by financial institutions operating domestically. They do not capture cross-border or non-intermediated lending.

Following the introduction of an interest rate differential between loans to investors and owner-occupiers a number of borrowers have changed the purpose of their existing loan; the net value of switching of loan purpose from investor to owner-occupier is estimated to have been $30.6 billion over the period of July 2015 to October 2015. These changes are reflected in the level of owner-occupier and investor credit outstanding. However, growth rates for these series have been adjusted to remove the effect of loan purpose changes.

The APRA ADI data is also out today, and we will look at this later.

Be sure to read the fine print in Turnbull’s mid-year economic update

From The Conversation.

Since his swearing in as Prime Minister in September, Malcolm Turnbull has often referred to himself as a “reformer”. In particular, Turnbull has made clear that the time for a change has come.

The Abbott-Hockey plan to “end the age of entitlement” is over, and growth will be placed at the centre of Turnbull’s economic agenda. An expansionary fiscal policy, based on borrowings to fund public infrastructure such as roads, urban public transport, ports and water infrastructure is something the prime minister is seriously considering.

While public spending may intuitively be seen as one of the drivers of economic growth, the academic evidence in favour of it is mixed. True, there’s some evidence in favour of large output returns from fiscal spending. But this evidence typically arises when spending is implemented in particularly severe economic recessions, and not necessarily in mild economic downturns. Moreover, a well-designed fiscal plan should explain not only the spending side, but also the revenue one. How is the government planning to cover public spending?

Of course, if public spending is presented hand-in-hand with expectations of prosperous future growth, public sustainability falls out of the discussion. After all, why shouldn’t we spend now if resources to cover this spending will emerge in the future? However, expectations of prosperous growth must be formulated with care.

As we now know, and as predicted, the Abbott-Hockey plan to return the budget to surplus was conditional on overly-optimistic assumptions regarding future growth – a 3% rate of growth for potential output was envisioned.

In his address to the Australian Business Economists Conference delivered two days ago in Sydney, Treasury deputy secretary Nigel Ray talked about a slowing down of future working-age population growth to 1.5%, lower than the 1,75% growth assumed by the budget last May. The result? Fewer people engaged in working activities, all else being equal, implies a more moderate future growth of Australia’s potential output, which is now expected to be 2.75%, below the 3% assumed by the budget.

And a lower amount of resources in the future, combined with an ageing population, implies more public spending for health care and less revenues from taxation, which means a bigger deficit. Consequently, adjustments must be made to keep the level of public debt under control.

To be clear, financial markets still point to the Australian economy being a solid one, and the debt service promised by the Australian government in order to issue its public debt is still among the lowest among industrialised countries.

To support the perceptions held by financial market operators, Turnbull should clearly communicate his fiscal plan, and how it differs from that of Abbott-Hockey, conditional on the latest revisions on Australia’s future growth. This communication should be constructed on two pillars. Firstly, on credible assumptions on the fiscal multipliers the government expects public spending to generate, and secondly, on cautious predictions on economic growth. Figures on future growth coming from independent sources external to the government should be employed to construct future scenarios which account for the inescapable uncertainty surrounding economic predictions.

It’s not surprising this year’s Mid-year Economic and Fiscal Outlook, due mid-December, is being eagerly awaited by so many Australians.

Author: Efrem Castelnuovo, Principal Research Fellow, Melbourne Institute of Applied Economic and Social Research – Associate Professor, Faculty of Economics and Business, University of Melbourne

 

 

Mobile Microfinance: Delivering Financial Inclusion to the World’s Poor

From Juniper research.

As outlined in Juniper’s recently published research report, Mobile Financial Services: Developing Markets 2015-2020, the mobile device is becoming the core enabler for the world’s poor to seek financial inclusion, with users of such services set to grow to 283 million by 2020.

Enabling the World’s Poorest

The unbanked populace in developing regions are being introduced to financial services through the use of mobile money platforms. This extends from simply sending remittances, to being able to receive life-saving services and provisions through sophisticated mobile money transactions, which include such offerings as loans, savings, and insurance.

1.jpg
Barriers to Financial Inclusion in Emerging Markets

The mobile device has proven a game-changer in financial development for poorer nations due to a number of reasons.

Firstly, the fact that consumers can register with their mobile device through widely available outlets and branches in local stores, means that people are no longer required to travel long distances. Thus avoiding the use of poor transport systems, and travel over long distances, to reach major cities to register with a bank.

Additionally, Microfinance providers themselves face a hurdle with regard to the initial start-up costs associated with their services. In many developing nations profit is not feasible by traditional methods and, as a result, MFIs (Mobile Financial Institutions) have been reluctant to set up shop. The mobile form of finance delivery offers cheaper start-up costs, and far reaching services.

Juniper’s Mobile Financial Services research discusses the further implications that mobile banking poses for developing nations, as well as the current trends and key services on offer in this sector. For an overview of the microfinance industry download the white paper Microfinance with Macro Potential.

Apple Pay Users Replace Credit, Debit Cards with Mobile Payments

From eMarketer.

 

ANZ to launch new internet banking site

ANZ today announced a significant upgrade to its internet banking platform that will see it become the first major Australian bank to have a consistent user experience across desktop, tablet and mobile.

Launching this weekend, ANZ’s 2.1 million internet banking customers in Australia will be able to access the full suite of internet banking features from any device as well as improved security features.

ANZ Managing Director Products and Marketing, Matthew Boss said: “We know our customers are looking to do more of their banking via digital channels and we also know we need to continue to make banking as simple and secure as possible.”

“This upgrade complements our existing mobile banking application ANZ goMoney™ and allows customers to do more of their banking when and how they want with no instructions required.
“Given smartphones are expected to account for 90 per cent of all internet traffic by 2020, we’re pleased to be able to provide our customers with internet banking that is quick and simple to use on any device,” Mr Boss said.

Additional features of the Internet Banking upgrade include:

  • Ability for businesses to now approve payments on-the-go using mobile internet banking
  • Easy new menu navigation to help customers update contact details, pay a bill or open a new account
  • State-of-the-art visual design where accounts look like the actual card in the customers’ wallet.

ANZ has also strengthened the security of internet banking with the introduction of ANZ Shield, which authenticates transactions and activity using a one-time security code to allow customers to increase pay anyone limits or instantly reset their password.

PayPal joins eftpos and plans to connect to the Hub in 2016

eftpos today announced that PayPal had become the latest payments company to join the eftpos membership, with plans to connect directly to the company’s new real time, centralised payments infrastructure, the eftpos Hub, in 2016.

eftpos Managing Director, Mr Bruce Mansfield, said PayPal was a popular payment option for Australian consumers and merchants and was a welcome addition to the eftpos Membership.

Mr Mansfield said eftpos had recently upgraded its infrastructure for Online payments and would work with PayPal and other Members to ensure that eftpos would be available to consumers and merchants as a payment option for online transactions. PayPal is only the fourth new eftpos Member to join since the inception of eftpos as a payment system in 2009, following ING Direct, Tyro and Adyen.

“We are very pleased that PayPal has decided to join eftpos and directly access the real-time processing capabilities of the eftpos Hub infrastructure and other benefits of being a Member,” Mr Mansfield said. “PayPal plays an important role in Australian Online payments and eftpos should be available as a payments choice for PayPal users. “eftpos is happy to work with PayPal to make eftpos payments available to more Australian consumers and merchants on new platforms.”

The eftpos Hub is a robust, reliable, secure and scalable centralised infrastructure that aims to provide the industry with cost effective, real time payments processing, as well as an enhanced capability to implement new products and services.

Since being launched in September 2014, the Hub is already processing almost 3 million eftpos CHQ and SAV transactions a day.  Ms Libby Roy, Vice President and Managing Director of PayPal Australia said, “eftpos is an established and important part of the payments landscape in Australia with a strong consumer base. We’re very happy to be working together to enable eftpos payments through the PayPal network. “Our membership of eftpos takes us one step closer to giving consumers the ability to use any funding mechanism through PayPal to transact securely and conveniently online and via mobile devices.”

eftpos is the most widely-used card system in Australia, accounting for more than 2.3 billion CHQ and SAV transactions in 2015 worth more than $140 billion.

APRA On Securitisation

APRA has released a consultation paper on proposed revisions to the securitisation regime in Australia, including the explicit recognition of funding-only securitisation. The likely net effect will be to encourage greater use of this vehicle by banks as part of their capital management programmes.  The proposals also reflect the Basel III changes. APRA invites written submissions on the proposals by 1 March 2016.

The Australian Prudential Regulation Authority (APRA) has released for consultation a discussion paper on its proposals to revise the prudential framework for securitisation for authorised deposit-taking institutions (ADIs). APRA is also releasing a draft Prudential Standard APS 120 Securitisation (APS 120).

APRA’s objective in revising the prudential requirements for securitisation is to establish a simplified framework, taking into account global reform initiatives and the lessons learned from the global financial crisis. One of these lessons was that securitisation structures had become excessively complex and opaque, and that prudential regulation of securitisation had become similarly complex.

APRA first consulted on initiatives to simplify its prudential framework for securitisation in April 2014. Following consideration of the issues raised in submissions, APRA has amended its proposals in some areas. APRA’s amended proposals include:

  • dispensing with a credit risk retention or ‘skin-in-the-game’ requirement;
  • allowing for more flexibility in funding-only securitisation; and
  • removing explicit references to warehouse arrangements in the prudential framework.

These amended proposals are expected to assist ADIs to further strengthen their funding profile and provide clarity for ADIs that undertake securitisation for capital benefits.

In December 2014, the Basel Committee on Banking Supervision (Basel Committee) released its updated securitisation framework (Basel III securitisation framework). The changes aim to enhance the Basel Committee’s existing securitisation framework and to strengthen regulatory capital standards.

APRA’s latest proposals incorporate the new Basel III securitisation framework, with appropriate adjustments to reflect the Australian context and APRA’s objectives, and will be applicable equally to all ADIs. Subject to consultation on this discussion paper and draft prudential standard, APRA proposes to implement these changes in line with the Basel Committee’s effective date of 1 January 2018.

In proposing revisions to its securitisation framework, APRA has sought to find an appropriate balance between the objectives of financial safety and efficiency, competition, contestability and competitive neutrality. APRA considers its proposals will deliver improved prudential outcomes and provide efficiency benefits to ADIs, particularly through the explicit recognition of funding-only securitisation within the prudential framework.

APRA invites written submissions on the proposals in this discussion paper by 1 March 2016. APRA also intends to release a draft prudential practice guide (PPG) and reporting standards and reporting forms, for consultation in the first half of 2016. APRA expects that the final prudential standard, PPG, reporting standards and reporting forms, will be released in the second half of 2016.

Background

Q: What is securitisation and is it important in Australia?

A: Securitisation is a form of funding where a ‘pool’ of assets, often residential housing loans, is separated from the originating ADI into a special purpose vehicle (‘SPV’). Cash flows from the pool of assets are used to make payments to investors in debt securities issued by the SPV. These payments are effectively secured by the pool of assets, hence the name “securitisation”.

The debt securities issued to investors will typically have a different order of priority claim over the assets in the pool. The senior class will have first claim, while more junior (or subordinated) class(es) will be utilised to absorb losses in the event of non-performance by some or all of the assets. The senior class of debt securities is therefore normally considered to be of lower risk than that of the underlying pool of assets, and this allows ADIs to source funding on attractive terms.

Sometimes an ADI will arrange for only the senior class to be sold to investors. Alternatively, where an ADI arranges to sell the junior class(es) to investors, they have transferred substantially all the credit risk of the pool to external investors. In these circumstances an ADI may also obtain regulatory capital benefits as APRA will, subject to meeting the specific requirements of APS 120, no longer require the ADI to hold capital against the credit risk of the pool.

Having a robust securitisation market therefore allows ADIs to strengthen their funding profile, and can offer capital management benefits as well. For smaller ADIs that may not have efficient access to unsecured wholesale debt markets, securitisation can be a valuable source of funding and, potentially, capital efficiency. As such, securitisation can support competition in the banking industry.

Q: How has APRA simplified the prudential framework?

A: APRA’s main proposals relating to the simplification of the prudential framework for securitisation are:

  • the explicit recognition of funding-only securitisation. A simple structure facilitates a strong funding-only regime, where the originating ADI retains the junior securities and obtains funding from third parties through the sale of the senior securities. The explicit recognition of funding-only securitisation will assist ADIs to further strengthen their funding profiles;
  • well defined thresholds for capital relief securitisation, which better articulate the requirements to be met for regulatory capital relief; and
  • streamlining the approaches to determining regulatory capital requirements for ADIs’ securitisation exposures, and harmonising them for ADIs using standardised or internally-modelled risk weights.

Q: How will APRA’s proposals assist in facilitating a larger funding-only securitisation market?

A: The explicit recognition of funding-only securitisation, including the flexibility for bullet maturity structures that include a date-based call option, are likely to increase the potential size of the term securitisation market by attracting a broader investor base. These structures have not been permitted within the prudential framework previously.

Q: Why is APRA proposing not to include a ‘skin-in-the-game’ requirement in the prudential framework?

A: Skin-in the-game requirements are intended to address the misalignment of incentives whereby lenders may lack motivation to originate higher quality loans, since they may not have exposure to the loans once they are in a securitisation. A variety of skin-in-the-game requirements have emerged internationally and introducing an additional Australian requirement would run contrary to APRA’s objective of creating a simplified framework. In addition, Australian ADIs already have linkages to their securitisation — such as servicing of the underlying loans and entitlement to residual income — that reinforce incentives to maintain the quality of lending standards.

Q: How is APRA proposing to treat warehouse arrangements?

A: Warehouse arrangements allow ADIs to aggregate assets into pools before securities are issued to third parties. This can enable some ADIs to improve access to wholesale funding markets and raise funds at more competitive rates. The current regulatory requirements for warehouse arrangements have, however, created a gap in the prudential framework, such that less capital is held in the banking system relative to the risk retained in the system.

APRA is seeking submissions on viable approaches that maintain the benefits of warehouse arrangements but also address the gap in the prudential framework. In the absence of any such submissions APRA has indicated it will take a principles-based, rather than rules-based approach and will remove explicit reference to warehouse arrangements in APS 120. In these circumstances warehouse arrangements can still be entered into, but would need to meet the relevant requirements in APS 120 to be considered a securitisation.

The Disruptive Power of Digital Currencies

The BIS Committee on Payments and Market Infrastructures just published a report on Digital currencies.  New digital platforms have the potential to disrupt traditional payment mechanisms. Much of the innovation is emerging from non-bank sectors and in a devolved, decentralised, peer-to-peer mode, without connection to sovereign currencies or authority. So how should central banks respond?

One option is to consider using the technology itself to issue digital currencies. In a sense, central banks already issue “digital currency” in that reserve balances now only exist in electronic form and are liabilities of the central bank. The question is whether such digital liabilities should be issued using new technology and be made more widely available than at present. This raises a wide range of questions, including the impact on the payments system, the privacy of transactions, the impact on private sector innovation, the impact on deposits held at commercial banks, the impact on financial stability of making a risk-free digital asset more widely available, the impact on the transmission of monetary policy, the technology which would be deployed in such a system and the extent to which it could be decentralised, and what type of entities would exist in such a system and how they should be regulated. Within the central bank community, the Bank of Canada and the Bank of England have begun research into a number of these topics.

Overall, the report considers the possible implications of interest to central banks arising from these innovations. First, many of the risks that are relevant for e-money and other electronic payment instruments are also relevant for digital currencies as assets being used as a means of payment. Second, the development of distributed ledger technology is an innovation with potentially broad applications. Wider use of distributed ledgers by new entrants or incumbents could have implications extending beyond payments, including their possible adoption by some financial market infrastructures (FMIs), and more broadly by other networks in the financial system and the economy as a whole. Because of these considerations, it is recommended that central banks continue monitoring and analysing the implications of these developments, both in digital currencies and distributed ledger technology. DFA questions whether this “watch and monitor” response is a sufficient strategy.

Central banks typically take an interest in retail payments as part of their role in maintaining the stability and efficiency of the financial system and preserving confidence in their currencies. Innovations in retail payments can have important implications for safety and efficiency; accordingly, many central banks monitor these developments. The emergence of what are frequently referred to as “digital currencies” was noted in recent reports by the Committee on Payments and Market Infrastructures (CPMI) on innovations and non-banks in retail payments. A subgroup was formed within the CPMI Working Group on Retail Payments to undertake an analysis of such “currencies” and to prepare a report for the Committee.

The subgroup has identified three key aspects relating to the development of digital currencies. The first is the assets (such as bitcoins) featured in many digital currency schemes. These assets typically have some monetary characteristics (such as being used as a means of payment), but are not typically issued in or connected to a sovereign currency, are not a liability of any entity and are not backed by any authority. Furthermore, they have zero intrinsic value and, as a result, they derive value only from the belief that they might be exchanged for other goods or services, or a certain amount of sovereign currency, at a later point in time. The second key aspect is the way in which these digital currencies are transferred, typically via a built-in distributed ledger. This aspect can be viewed as the genuinely innovative element within digital currency schemes. The third aspect is the variety of third-party institutions, almost exclusively non-banks, which have been active in developing and operating digital currency and distributed ledger mechanisms. These three aspects characterise the types of digital currencies discussed in this report.

A range of factors are potentially relevant for the development and use of digital currencies and distributed ledgers. Similar to retail payment systems or payment instruments, network effects are important for digital currencies, and there are a range of features and issues that are likely to influence the extent to which these network effects may be realised. It has also been considered whether there may be gaps in traditional payment services that are or might be addressed by digital currency schemes. One potential source of advantage, for example, is that a digital currency has a global reach by design. Moreover, distributed ledgers may offer lower costs to end users compared with existing centralised arrangements for at least some types of transactions. Also relevant to the emergence of digital currency schemes are issues of security and trust, as regards the asset, the distributed ledger, and the entities offering intermediation services related to digital currencies.

Digital-Money-BIS-1Digital currencies and distributed ledgers are an innovation that could have a range of impacts on many areas, especially on payment systems and services. These impacts could include the disruption of existing business models and systems, as well as the emergence of new financial, economic and social interactions and linkages. Even if the current digital currency schemes do not persist, it is likely that other schemes based on the same underlying procedures and distributed ledger technology will continue to emerge and develop.

The asset aspect of digital currencies has some similarities with previous analysis carried out in other contexts (eg there is analytical work from the late 1990s on the development of e-money that could compete with central bank and commercial bank money). However, unlike traditional e-money, digital currencies are not a liability of an individual or institution, nor are they backed by an authority. Furthermore, they have zero intrinsic value and, as a result, they derive value only from the belief that they might be exchanged for other goods or services, or a certain amount of sovereign currency, at a later point in time. Accordingly, holders of digital currency may face substantially greater costs and losses associated with price and liquidity risk than holders of sovereign currency.

The genuinely innovative element seems to be the distributed ledger, especially in combination with digital currencies that are not tied to money denominated in any sovereign currency. The main innovation lies in the possibility of making peer-to-peer payments in a decentralised network in the absence of trust between the parties or in any other third party. Digital currencies and distributed ledgers are closely tied together in most schemes today, but this close integration is not strictly necessary, at least from a theoretical point of view.

This report describes a range of issues that affect digital currencies based on distributed ledgers. Some of these issues may work to limit the growth of these schemes, which could remain a niche product even in the long term. However, the arrangements also offer some interesting features from both demand side and supply side perspectives. These features may drive the development of the schemes and even lead to widespread acceptance if risks and other barriers are adequately addressed.

The emergence of distributed ledger technology could present a hypothetical challenge to central banks, not through replacing a central bank with some other kind of central body but mainly because it reduces the functions of a central body and, in an extreme case, may obviate the need for a central body entirely for certain functions. For example, settlement might no longer require a central ledger held by a central body if banks (or other entities) could agree on changes to a common ledger in a way that does not require a central record-keeper and allows each bank to hold a copy of the (distributed) common ledger. Similarly, in some extreme scenarios, the role of a central body that issues a sovereign currency could be diminished by protocols for issuing non-sovereign currencies that are not the liability of any central institution.

There are different ways in which these systems might develop: either in isolation, as an alternative to existing payment systems and schemes, or in combination with existing systems or providers. These approaches would have different implications, but both could have significant effects on retail payment services and potentially on FMIs. There could also be potential effects on monetary policy or financial stability. However, for any of these implications to materialise, a substantial increase in the use of digital currencies and/or distributed ledgers would need to take place. Central banks could consider – as a potential policy response to these developments – investigating the potential uses of distributed ledgers in payment systems or other types of FMIs.