Digital payment instruments and the future of Canadian transactions

 
Blockchain-powered payment is entering the mainstream. Peter Aziz, co-head of Torys’ Payments and Cards group, Mohammed Muraj, head of Torys’ Digital Assets practice, and Dr. Peter MacKenzie, Senior Policy Analyst at the C.D. Howe Institute, discuss these payment instruments and their potential impact on the Canadian financial services industry.

Peter Aziz: There are three use cases for blockchain powered payment: stablecoins, tokenized deposits and central bank digital currencies (CBDBs). How do these digital assets compare?

Dr. Peter MacKenzie: The major differentiating factors between these payment instruments are 1: who the issuer is and 2: what is maintained as a reserve asset for each one.

• Stablecoin is issued by a private issuer, i.e. anyone can issue it. It is tied to a reserve of assets and there must be at least a one-to-one reserve. For instance, if you issue $1 million worth of stablecoins, then you must have $1 million in a reserve so holders can redeem the stablecoins and get their $1 million back.
• With a tokenized deposit, the issuer is a deposit taking institution. The tokenized deposit represents a claim against the issuer's balance sheet. For example, if I deposit money in a bank then the bank has an obligation to redeem that deposit on demand, which is a liability on the bank's balance sheet. While there are reserve requirements for deposit taking institutions, the reserves are fractional (i.e., if a $100 is deposited, the deposit taking institution needs to maintain only a fraction of it as reserves (such as 10% for example) and are not a one-to-one reserve like a stablecoin.
• Central bank digital currency (CBDC) is issued by the government. In our case, it would be the Bank of Canada. It is considered legal tender and not linked to a reserve asset.

Peter Aziz: What are the use cases for these payment instruments?

Dr. Peter MacKenzie: A main advantage is that settlement becomes 24/7. For example, if I were to transfer $10 to someone via Interac eTransfer, they would receive it within minutes—for the user, it is almost instant. However, behind the scenes there is a delay. So, if I transfer money to someone on the weekend, they will receive it straight away, but that payment won’t clear on the back end until Monday. This creates a deadweight loss in the payment rails. With digital assets, there is no wait time on the banks’ end.

There are also advantages for cross-border payments. If you were to make a traditional cross-border payment with your financial institution you could incur fees and, until recently, those fees often restricted the ability to transfer lesser amounts. With stablecoin, cross-border payments become cheaper and easier, so smaller transactions are quite easy to do.

Programmability is also an exciting use case. For instance, if you are doing an M&A deal there is usually an escrow agent involved in the process, but with stablecoin you could theoretically set up the coin program to only release funds when certain conditions are met. Similarly, an independent contractor or freelancer who is paid in stablecoin could automatically put a certain amount towards taxes or expenses allowing for an instant, 3^rd-party free process.

There is a great opportunity to serve underbanked constituencies. In Canada, we have high rates of people with bank accounts, but there is a small segment of the population that does not have a bank account or are not operating with the full financial capabilities that they could be. Stablecoin could help bring these people into the financial system and give them access to digital financial tools.

Peter Aziz: How are stablecoins of any type held?

Mohammed Muraj: There is currently no option to hold stablecoin in a Schedule 1 bank in Canada. It can be left on the platform or withdrawn and kept in an online or hardware wallet. The latter option, where you hold onto it yourself, is riskier—you lose the password to the wallet or you misplace the hardware wallet. Having a third-party custodian hold on to it is a safer choice, however, you are subject to their control as they hold the keys to your wallet.

Peter Aziz: The recent C.D. Howe paper on digital payments notes that the country faces two fundamental risks which are 1: erosion of monetary sovereignty if US dollar-linked stablecoins become the preferred means of payment, and 2: loss of control over domestic payment rails. Peter, can you walk us through those risks?

Dr. Peter MacKenzie: If US dollar-linked stablecoins become the preferred means of payment within Canada, this currency switch could impact monetary sovereignty. If people are holding more USD-backed stablecoins than Canadian dollars, the Bank of Canada's monetary policy decisions around interest rates may not have the same effect on the overall economy. On the other hand, because Canadians are paid and taxed in Canadian dollars, there will be a natural ceiling for demand for USD-backed stablecoins. When looking at control over domestic payment rails, the risk comes from using US companies to issue and manage Canadian-backed stablecoins. If US companies are running the ledgers for Canadian-backed stablecoins, or potentially even making Canadian-backed stablecoins, then we could enter a situation where US regulatory rules are above Canadian rules and we do not have regulatory control over our payment systems. It is also fundamentally less lucrative. We don’t want to use another country's currency for en masse domestic purchases. That is not only a concern for the Canadian government, but across other governments too.

Peter Aziz: The paper makes a unique recommendation regarding Bank of Canada liquidity lines. Can you expand on that?

Dr. Peter MacKenzie: Right now, the Bank of Canada liquidity facilities are extended to major financial institutions, like the Big Six banks. For public confidence in stablecoins to grow, it will be important to have these liquidity facilities extended to fully regulated, approved stablecoin issuers. Redemption surges could cause major volatility in the bond market. Having liquidity facilities can prevent major bond market volatility brought on by issuers having to sell all their assets. Ideally, they could pledge the assets to the Bank of Canada, who could provide the money to repay stablecoin holders in a disorderly market.

Peter Aziz: The paper notes that, “a Central Bank Digital Currency could serve as the foundation for Canada's future digital monetary system, including stablecoins and tokenized deposits”. People generally consider CBDCs to be effectively dead, but you are recognizing an opportunity here.

Dr. Peter MacKenzie: Yes, I think there's a lot of opportunity in Canada for a CBDC on the wholesale end. I think it can improve efficiency in interbank transfers and liquidity lines. On the retail end, if we have a system with different stablecoin issuers and tokenized deposits from different financial institutions there can be a neutral settlement layer. For example, if Peter is holding one stablecoin and I'm holding another, and we are both using different exchange platforms, there is a sort of interoperability at the issuer, platform and stablecoin level. Particularly as we are moving into a more networked environment, we are going to see a proliferation of distributed ledger technology payment instruments. Having a centralized digital currency allows for more efficient settlement of it.

 
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