The case for non-bank access to central bank accounts in the EU is stronger than ever
This article is an updated version of the article first published in Cointelegraph on May 18th.
Within 11 days in March, four banks in the US and one in Switzerland collapsed. First Republic Bank followed in May. Three of the four largest-ever U.S. bank failures occurred in the past two months. These events are a painful reminder that banks bear significant risks. These risks, as we witnessed with the collapse of the Silicon Valley Bank, can quickly spill over to other industries.
Ironically, despite a heavy focus on how the crypto-asset sector could introduce risks to traditional finance, we experienced bank failures becoming a critical stability risk to the crypto-asset industry instead.
Financial regulation should aim at mitigating financial stability risks in the first place, and, where possible, limiting contagion risks to prevent further damage, independent of the direction of the contagion.
Today, regulated stablecoin issuers are forced to rely on banking partners in order to fulfill the minting and redemption through fiat-money. The indirect access to fiat settlement inevitably exposes e-money institutions in the EU - future issuers of regulated stablecoins a.k.a e-money tokens - to disproportionate cost and counterparty risk, according to the EU Commission’s assessment of the Payment Service Directive (PSD). Ultimately, it constraints innovation and competition in the payments market.
Granting regulated fiat stablecoins (e-money tokens in the EU or payment stablecoins in the US) access to central bank accounts would therefore not only be a crucial step for the safety of fiat currencies on the internet, but also for payments innovation writ large.
It would allow issuers to eliminate their exposure to risks associated with uninsured deposits and separate high-velocity payments activity in stablecoins from the illiquidity of loan portfolios in banks.
The landmark MiCA regulation (Markets in Crypto-Assets) in the EU brings tremendous opportunities to the EU industry. However, as it was already agreed at the end of June 2022 before the inherent banking risks became apparent early 2023, it mandates e-money token (EMT) issuers to hold at least 30% of their reserves with credit institutions. What was supposed to be a measure to improve the liquidity and risk-exposure of EMT-issuers, will ultimately burden EMT-activity with banking and counterparty risk. The recent banking crisis has taught us that in an age of social-media-centered flow of information and mobile-based banking, we need to change our assumptions about the runnability of liquid liabilities backed by illiquid assets.
The solution to this problem is by no means new. EMT-issuers, and all e-money institutions, should have the ability of accessing central bank accounts directly. By giving access to a Central Bank account, EMT-issues could shield EU customers from the credit risk of private banks by moving fiat funds to the central bank directly.
In the UK, e-money institutions have enjoyed direct access to the Bank of England’s settlement layer since 2017. This would “help increase competition and innovation in the market for payments” and create “more diverse payment arrangements with fewer single points of failure” according to the Bank of England. The former Bank of England Governor described this legislative change as “potential to deliver a great unbundling of banking into its core function of settling payments, performing maturity transformation, sharing risk and allocating capital”.
But even in the EU, safeguarding e-money reserves at the central bank is already a common practice in one member state, namely Lithuania. The Central Bank of Lithuania allows e-money institutions (EMIs) and payment institutions (PIs) to open settlement accounts and access the clearing system directly. As of the end of 2022, out of the 84 regulated e-money institutions in Lithuania, 63% held customer funds with the central bank. Overall, more than two thirds of e-money reserves in Lithuania are held with the Central Bank of Lithuania.
It is time to level the playing field and open up this possibility to all e-money institutions across the EU.
The window of opportunity for legislation to accomplish this has never been greater. What it needs is a targeted review of the Settlement Finality Directive (SFD), possibly as part of the review of the Payments Service Directive (PSD) or the Instant Payments Regulation (IPR).
Current negotiations on the IPR are already establishing a political consensus that such a review is necessary, as resolving direct access to settlement would also support and accelerate the rollout of instant payments in the EU.
And the impact assessment of the PSD couldn’t be clearer about the need to level the playing field between banks and non-banks in the payment market. On June 28, the EU Commission will unveil its new proposal for a revised Payments Service Directive and a first Payments Service Regulation. In all likelihood, it will introduce the possibility of direct participation of PIs and EMIs to all payment systems (incl. central bank payment systems), with additional clarifications on admission and risk assessment procedures.
The Commission, payments-focused MEPs in Parliament, and some Member States have long recognised that non-bank payment service providers like EMIs have been at a disadvantage to banks, stemming from fragile – but required – bank-to-non-bank partnerships.
Non-bank payment transactions and usage in the EU have been growing steadily in the last 20 years, and it’s finally time to tackle the economic inefficiencies, higher costs of commercial operations, and the overall negative impact on EU competitiveness that result out of the missing direct access for non-bank payment institutions to central bank settlement systems.
The benefits to the safety and liquidity of non-bank financial institutions, but also to greater innovation in a financial system that is becoming increasingly concentrated amongst global systemically important banks, are evident. The case for granting e-money institutions access to central bank accounts has never been stronger, and the EU should not miss this unique opportunity to make its financial system more competitive and resilient.