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The missing legal framework for central bank digital currencies

8 minute read

REUTERS/Mohamed Azakir

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October 19, 2021 - Central banks around the world, most notably in China, the United States and United Kingdom, are actively considering whether to adopt or create their own Central Bank Digital Currency (CBDC). The geopolitical pressures are high, with China far enough along in trials that it plans to roll out this new currency for international visitors as early as the 2022 Winter Olympics in Beijing. Other countries, keen to embrace the "tech revolution," are vying to be early adopters of CBDCs. South Korea, Sweden, Cambodia, the Bahamas and Hong Kong are among various countries with pilot programs. Jurisdictions such as the U.S., U.K. and the Eurozone are in the exploratory stages, and risk being left behind if they do not move quickly.

CBDCs offer an opportunity for central banks to embrace the crypto revolution while retaining control over monetary policy by making changes to current frameworks and methods. CBDCs are not, and are not intended to be, just another electronic token that happens to have been created by a central bank. Instead, they should be seen as their own type of product, different in nature and subject to centralized control.

CBDCs benefit from some of the features of other crypto assets, including the ability to achieve instantaneous transfers, or "delivery versus payment," thereby de-risking the financial system by avoiding the payment delays inherent in traditional fiat currency arrangements. Several central banks are already seeking to test these benefits for the international settlement of financial transactions. At the same time, the element of central bank control over CBDC issuances gives them stability and predictability that is often absent from crypto products.

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Cryptocurrencies like Bitcoin are growing in popularity. Although China has banned these currencies, the situation is different elsewhere, with Bitcoin now constituting legal tender in El Salvador. Yet, for a currency controlled by a central bank, new arrangements will be needed, which must be tested for security and financial soundness. The role of commercial banks and the traditional banking system could be affected. Privacy is also a consideration, with centralized control and an immutable record of transactions raising sensitive issues relating to the collection and use of citizens' data.

The most significant concerns, however, are law and regulation. Ideally, authorities would address, on the international plane, the critical unresolved issues of how to secure clear legal and regulatory arrangements for CBDCs. However, there is currently no meaningful international agreement on such matters. The OECD and IOSCO have noted the lack of global consensus on regulating crypto tokens. There is thoughtful discussion on how to regulate cryptocurrency issuers, and some nations, such as Germany and Liechtenstein, are developing regulations for crypto trading. However, these domestic measures address matters in isolation, which is not the same as creating a global CBDC system that is workable and safe.

This leaves us with no agreement on what these forms of currency actually are and how they are regulated. Legal and regulatory systems can take very different views of how to treat them, and the ensuing confusion creates opaqueness and possible legal and regulatory challenges. Some countries may view the development of their own CBDCs as creating a competitive advantage over other countries, further undercutting attempts at an agreed-upon legal framework. As things stand, even if a country can create a CBDC that works within its current, domestic legal scheme — itself no small task — the cross-border capabilities inherent in CBDCs mean that a clear, international legal and regulatory path still needs to be found to allow for their widespread adoption.

Fortunately, much can be accomplished under existing laws around the world. In the 1990s, the U.S. clarified rules on the law governing dematerialized securities. This provided clear rules for determining whose system governed such securities, when the market moved from having a paper backing to electronic form.

The result is a consistent global framework based on the location of the accounts in which the securities are held. A revised Article 8 of the Uniform Commercial Code facilitated the development and use of a system where securities are held through one or more intermediaries, ultimately including a central depository such as the Depository Trust Company (for most corporate securities) or the Federal Reserve (for U.S. treasury securities). A similar approach was (albeit imperfectly) adopted in Europe and elsewhere, in a formulation known as the Place of the Relevant Intermediary Approach, or PRIMA; and PRIMA was broadly provided for in the Hague Securities Convention of 2002.

The clarification of the governing law enabled the global custody market to operate safely. A bank in New York can hold securities through a sub-custodian in Paris, for example, knowing that the interest that the New York bank has in the asset on the sub-custodian's books is subject to French law. This means that investors can cross between civil and common law jurisdictions around the world because there is an international understanding that the property law entitlement surrounding the securities, and any insolvency treatment, will be determined solely by the law applicable to the intermediary holding it.

CBDCs need similar legal certainty to be of any broad use to central banks or interest to traders and investors. Fortunately, it will in some cases be possible for the existing Article 8 and PRIMA schemes for securities to be used for CBDCs, particularly if CBDCs can be held in securities custody accounts. Just as for dematerialized securities, the relevant legal provisions successfully address the main area of law that needs to be tackled: property law.

The successful implementation of this new arrangement will require central banks and financial regulators to take a three-pronged approach.

First, the central bank issuer would need to choose the governing law for disputes over transactions in its CBDC. The temptation will be to design and implement a law that has political considerations at its core, but that could prove counterproductive. Much of the success of a digital currency will be user-driven, which means any state-driven control of trading is likely to knock confidence and undercut the usage of CBDCs, as users will adopt what works best for themselves.

For example, New York or English law, which are already chosen as the governing laws for financial trading contracts around the world, are both "common law" systems that have a proven track record of respecting the intentions of the parties and evolving to meet new circumstances as they arise. Central bank issuers might choose this legal framework in order to instill confidence in a successful trading environment for their CBDC.

Secondly, the governing jurisdiction must be selected, which will generally be the same as the governing law. Countries that are signatories to the Hague Convention 2005 (of which there are many, including the U.K., EU and Singapore) will recognize this choice of court to settle disputes, as will the vast majority of national legal systems.

Thirdly, if accounts are used, property laws then apply to transfers in a manner that is generally based on the law of the jurisdiction of the intermediary where the account of the seller is located. That legal system should ensure that the account details are updated once a judgment has been given in the selected court as to whether a transaction has validly taken place. In an insolvency, if CBDCs are being transferred between parties and one party goes bankrupt, that party's domestic jurisdiction is generally tasked with sorting out which assets (or fractions of assets) belong to whom. In doing so, the starting point will be to look to the ownership interests recorded in the account, governed by the legal system governing the account.

In a similar way, the regulators split their roles between those responsible for overseeing the seller, those supervising the buyer, and those who regulate the firm managing the securities account, with deference given by each to the other.

This entire approach provides a practical option for the safe, widespread use of CBDCs in the short term, avoiding the need to persuade the world's legislators and regulators of the value of an unfamiliar new system. Ancillary legal issues will of course still need to be navigated. The central bank will wish to control the money supply. It may also wish to have a central register to determine ownership, although it is unlikely to have the administrative resources required for maintaining such a register, not least because of the extensive anti-money laundering checks needed in such a structure. Instead, the accounts could be held by local commercial banks, FinTech companies or other providers. A more sophisticated arrangement is likely to be required for cross-border CBDC dealings, utilizing existing custody structures.

Building and relying on a system of bank custody accounts may appear to cut against the nature of crypto. However, resolving points of potential legal uncertainty and systemic risk, by fitting within the existing legal framework for the conflict of laws, is a prerequisite to the future of CBDCs. Such an approach is essential if we are to provide for the safe, international usage of CBDCs, unleashing the benefits of central bank governance.

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Opinions expressed are those of the author. They do not reflect the views of Reuters News, which, under the Trust Principles, is committed to integrity, independence, and freedom from bias. Westlaw Today is owned by Thomson Reuters and operates independently of Reuters News.

Barnabas (Barney) Reynolds is a partner and Global Head of the Financial Services Industry Group at Shearman & Sterling, in the London office. He advises banks, asset managers, insurers, financial infrastructure providers, governments and public bodies on regulatory, governance, enforcement and securities law matters, and has extensive experience helping clients with their domestic and cross-border legal and regulatory issues. He can be reached at barney.reynolds@shearman.com.

Donna Parisi is a partner and the Global Head of Financial Services and FinTech at Shearman & Sterling in New York. She advises founders, investors and institutional participants on how to navigate the regulatory landscape in the digital asset space. She can be reached at dparisi@shearman.com.

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