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5 December 2023
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One important question is how to minimize settlement and credit risks in transactions involving tokenized securities (token transactions). To answer this question, it is worth taking a look at how securities transactions are settled in Switzerland today. When a bank buys a security from another bank – for its own account or for the account of its customer – the transfer of money and securities takes place on the settlement date according to the principle of “delivery versus payment” (DvP). The securities are only delivered when the money is credited to the seller (and vice versa). This avoids settlement risks. Since payment is usually made in the SIC system and thus in central bank money, the credit risks are also minimized.
In the case of token transactions, the question arises as to how they can be settled according to the DvP principle and in central bank money. The Swiss National Bank (SNB) has been working on this issue for some time as part of Project Helvetia. One approach being investigated is the issuance of digital central bank currency on a DLT platform. In the first two phases of the project, the SNB conducted successful feasibility studies in test systems. The SIX Digital Exchange (SDX) platform, a DLT-based financial market infrastructure for trading, settlement, and custody of tokenized securities, served as the test environment.
In the recently launched third phase, the SNB is issuing real central bank digital currency in Swiss francs on SDX as part of a pilot project. As of 1 December 2023, the pilot banks – the cantonal banks of Vaud, Basel, and Zurich, as well as Commerzbank, Hypothekarbank Lenzburg, and UBS – will be able to settle certain transactions in central bank money instead of private token money. Banks are expected to issue several digital bonds on SDX and settle them with central bank digital currency during the pilot operation. The pilot will run until mid-2024. Other Swiss financial market infrastructures involved are SIC, SIX SIS, and SIX Repo.
The central bank digital currency as tested in the Helvetia pilot is a tokenized form of sight deposits, referred to as a wholesale central bank digital currency (wCBDC). This is an alternative technical representation of sight deposits represented on a DLT infrastructure. wCBDC represents another exchangeable claim on the SNB, in addition to sight deposit accounts and on SIC settlement accounts.
During the pilot phase, wCBDC will be available to pilot banks on selected days. Banks can convert part of their balances on their SIC settlement accounts into wCBDC. A pilot bank triggers the tokenization process by making a payment to a technical account of the SNB in the SIC system. The SNB then credits the bank with the deposited amount in the form of wCBDC on SDX. At the end of the day, all wCBDC balances must be converted back into balances on the SIC settlement account through the de-tokenization process.
Pilot banks can use wCBDC to settle token transactions according to the DvP principle. Two types of transactions are possible in the pilot: the settlement of bond issuances in the primary market and the settlement of bond transactions in the secondary market. The latter takes place across infrastructures thanks to a link between SDX and the national central securities depository SIX SIS: Payment is made in wCBDC via SDX and delivery of the securities to the buyer via the SECOM system of SIX SIS. This connection makes the tokenized bond universe accessible to all SIX SIS customers. It can thus help to prevent fragmentation of the Swiss franc bond market and, ultimately, of central bank money.
A key focus in the preparation of the pilot was the implementation of the SNB's control and monitoring functionalities for wCBDC. These functionalities ensure the SNB's control over wCBDC at all times and are thus a basic prerequisite for its issuance. An important control function is the ability to prevent settlement activities in wCBDC for individual or all participants. In addition, the SNB is granted certain inspection rights on SDX in order to be able to view the wCBDC balances of individual participants at any time. It is also important to ensure that intervention procedures are defined and tested, for example in the event of possible misuse by a participant or a malfunction of the system.
Preparations for the pilot started in January 2023, and the onboarding of the pilot banks began in spring. Around 20 employees from the SNB and SIX Group companies form the core team, which is made up of interdisciplinary experts from the fields of IT, economics, and law. Additional representatives from the pilot banks joined the team in spring.
In addition to the wCBDC, the SNB is investigating two other approaches for the settlement of the cash-leg of wholesale token transactions: a “link” of token settlement systems to the SIC system and the use of private, bankruptcy-protected token money that is backed by central bank money.
The three approaches can be defined in terms of three characteristics – namely, the issuer, the form of money, and the user base – and the settlement mechanism. The issuer can be either a central bank, i.e., the SNB in Switzerland, or a private institution. With regard to the form of money, a distinction is made between conventional book money and token money; with regard to the group of users, a distinction is made between the general public (retail) and commercial banks or other financial intermediaries (wholesale); and with regard to the settlement mechanism, a distinction is made between integrated and synchronized settlement. Integrated settlement means that money and other assets can be transferred on the same infrastructure. This is the case in the current pilot with wCBDC on SDX. In case of synchronized settlement, the settlement is done across different infrastructures.
The second approach, the RTGS link, involves the synchronized settlement of token transactions via a link to the RTGS system, i.e., the SIC system in Switzerland. Here, the settlement of the transactions’ cash-leg takes place in book money and not in token money. The issuer and user base are the same as for wCBDC (central bank and commercial banks, respectively).
The third approach, bankruptcy-protected private token money backed by central bank money, differs from wCBDC only in terms of the issuer. Like wCBDC, it is targeted at commercial banks, is tokenized, and allows for integrated settlement. The difference is that it is issued by a private institution.
Three approaches to secure and efficient token-transactions
The SNB is generally open to innovative technologies and interested in further minimizing settlement risks and increasing efficiency. The ongoing work on asset tokenization should not be seen as a declaration of intent that the SNB will issue wCBDC or offer other settlement approaches. Rather, it is about acting prudently and with foresight to ensure that the SNB can continue to fulfill its mandate in the future. The SNB will inform in due time on the findings of this work.
Technology and New Needs Drive Change in the Financial System
In addition to the settlement of token transactions, the SNB is also exploring other aspects of how it can exploit the potential of modern technologies in cashless payments and meet changing customer needs. With the migration of the SIC system to the new technical platform (SIC5), the Swiss financial center has created the technical prerequisites by end of November 2023 for processing customer transactions in real time (instant payments), thus meeting the needs of end customers for faster payment processing.
As part of the BIS Innovation Hub (BISIH), the SNB also actively tracks and shapes potential future developments in payments. Project Tourbillon demonstrated that with a CBDC it is possible to protect the privacy of the payer (both vis-à-vis the central bank and vis-à-vis the beneficiary) while fully complying with anti-money laundering legislation. In Project Mariana, the SNB, together with other central banks, successfully tested the trading and settlement of foreign exchange transactions in wCBDC on a blockchain. The entire financial sector benefits from findings of such projects. The SNB will report on the findings in due time.
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