Financial Markets
Gilbert Verdian

Central bank digital currencies could improve the payments infrastructure and provide more opportunities for financial inclusion, but if adopted they must be properly configured and implemented. By Gilbert Verdian, founder and CEO, Quant

Central bank digital currencies (CBDCs) have been gaining momentum worldwide with 19 G20 nations actively exploring this new form of money that digitally represents fiat currency using blockchain technology.

While countries see clear benefits, each jurisdiction will have a unique set of economic drivers when considering CBDC adoption. Yet CBDCs hold the potential to vastly improve the domestic and cross-border payments infrastructure, support unbanked populations and provide more opportunities for financial inclusion, and prevent fraud.

CBDCs fundamentally change the nature of money taking it beyond a medium of economic exchange. With CBDCs and commercial stablecoins, currency can become programmable and automated to streamline payment workflows. Additionally, real-time digital money can provide central banks with an accurate view of monetary risks, enabling them to proactively adjust fiscal controls and help prevent financial crises like the one in 2007-2009.  

Successful pilots have proved the technological viability of CBDCs. These include Project Dunbar and Project Jura demonstrating successful use cases for international settlement between multiple currencies. Project Hamilton, the digital dollar initiative run by the Boston Fed and MIT, showed that a CBDC can handle up to 1.7m transactions per second, a hundred times faster than card transactions. Project Rosalind, a CBDC sandbox between the Bank of International Settlements (BIS), Bank of England (BoE), other commercial banks, institutions and fintechs, sets the stage for public-private sector collaboration, interoperability and adoption into the payments landscape. Arguably, China has the most advanced CBDC pilot. As of January 2022, 261 million people have an e-CNY wallet, spending 87.5b yuan ($13.8 bn).

However, if CBDCs are to be adopted, they must be properly configured and implemented as critical national infrastructure, protected like existing payment systems and economies. The BoE concisely laid out core principles for its CBDC design — it needs to be resilient, inclusive, innovative and competitive. Critically, a digital pound must facilitate individual privacy protections. Also, CBDCs must be scalable, interoperable and comply with regulations for anti-money laundering (AML), terrorism and sanctions. Lastly, these digital assets need to be secure, implementing the highest cyber security standards against fraud and cyber attacks.

Meeting all these requirements will be a big ask but is feasible. One possible design is a two-tier model defined by the BIS, where the central bank authorises banks and institutions to issue set amounts of retail CBDCs as fiat, backed by the government. Then, banking intermediaries would manage payments between consumers and businesses, much like today’s settlement processes.

Permissioned architecture

As critical national infrastructure, the inter-bank CBDC network between the central bank and commercial bank would utilise secure, ringfenced distributed ledger technologies (DLTs) with private-permissioned architecture, meaning it is only accessible by authorised financial institutions and regulators. In addition, commercial banks would integrate their own private-permissioned DLTs within the inter-bank network, and through interoperability facilitate transactions between each other, payment companies, merchants and consumers.  

Within this permissioned architecture, similar to today’s banking system, every user is clearly identified through their existing relationship with their bank and complies with the same Know Your Customer and AML regulations. Notably, privacy protections recently cited as a chief concern by consumers and businesses in a European Central Bank CBDC survey, could be retained. CBDC privacy can be built-in where individual data, including personally identifiable information on the ledger, can be obscured cryptographically from broader visibility. Furthermore, existing controls in financial systems, such as fitness and probity, could apply to trusted staff and system operators of participating institutions within the CBDC network responsible for CBDC operations.

There are clear advantages to such a two-tiered CBDC approach. It would utilise existing payment controls and extend current regulatory structures to a new form of money. Commercial banks and payment companies would not be disintermediated; retaining instead clear roles and responsibilities with scope for competition and innovation within the ecosystem. The central bank would not need to take on significant new mandates such as becoming a ‘call centre’ for people and businesses experiencing payment issues. Instead, it would gain visibility on real-time fiscal threats provided by aggregated data from CBDC money flows. Central banks could foresee and mitigate systemic risks to soften economic impacts from inflation and deflation, and even put controls in place to head off commercial bank runs.  

Fraud prevention is another key benefit. Central banks or commercial banks could programme CBDCs for specific purposes. For example, in a government scheme to ease people’s energy costs, they could programme a CBDC as a benefit payment to be spent solely with energy suppliers. It would be impossible to use it for other purposes.

At first, this proposed CBDC model could run alongside and augment our current monetary system. And, as it proves more effective than our existing architecture by meeting privacy, resilience, innovation and economic competitiveness requirements, it could be extended even further. Adoption would, of course, depend on the CDBC being seen as a ‘force for good’ by consumers and businesses, and ensuring this digital currency is as frictionless and convenient as our current electronic payments system.

For this to happen, the authorities will need to get the pace right. This means a country might not necessarily be first to market. Working collaboratively using standards like ISO/TC 307 and ISO 20022 will prove vital, as will developing effective regulatory frameworks. Crucially, the public and private sectors will need to come together to formulate, test and agree on the design principles and implementation model to realise the benefits a CBDC can offer.

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