Central bank digital currencies (CBDCs) are already set to become part of national financial systems. In part one of a two-part series, Bitt.com’s Simon Chantry describes how the design and configuration of these networks is trending and how this is likely to affect us in the future interconnected world.
Efforts to mitigate the spread of COVID-19 have impacted all industries, with the financial and payments industries being no exception. Prior to the pandemic, central banks were moving towards digitalisation of their national currencies as a way to exploit advances in financial technology, and to mitigate the rising threat of global private currencies that have emerged over the past decade in the form of permissionless cryptocurrencies and stablecoins. Central banks have leveraged technology throughout their history to address issues such as inefficiency, traceability, and counterfeiting, and to augment their monetary policy toolset. Today, these institutions are once again evaluating the ever-evolving technological landscape to determine the technology and policy strategies that will help them better achieve their mandate and respond to a post pandemic world where digitalisation takes on new importance in the context of health.
With many countries moving towards central bank digital currencies (CBDCs), we can begin to imagine a future where all countries utilise national currency networks, each interconnected to facilitate exchange and trade, as well as many new use cases yet to be developed. While the goals of introducing CBDC networks may vary from country to country, a number of common elements apply, including the synergistic effects of having multiple CBDC networks integrated with one another despite the geopolitical and economic specifics of the countries involved.
CBDCs in national financial systems
Beginning with a domestic perspective, national financial systems consist of multiple institutions that transact with each other for a variety of purposes, each requiring some level of trust with the others. While the current system enables trusted interactions to a degree, it relies on multiple systems to do so which results in latency, complexity, risk, and inefficiency. In addition, some types of transactions occur in stages where settlement occurs days after the initiation of the transaction itself, largely due to the transactions taking place as a function of secure messaging between counterparties on one network followed by settlement on other networks. A CBDC network can provide for a consolidation of elements of the financial system into a programmable currency network with all financial stakeholders playing a role in the operation and governance components, providing visibility or privacy as required, yet maintaining accountability and immutability in all transactions. The design of national CBDC networks is shaping up as follows:
- A distributed (possibly blockchain-based[1]) network, where all nodes[2] are known to the central bank;
- Nodes are run[3] by the central bank, and can also be run by approved or designated institutions including, amongst others, licensed financial institutions (LFIs), commercial banks, government institutions, regulators and oversight bodies and technology service providers;
- Node functionality – including access to the information on the network – will vary based on the nature of the hosting institution, and will correspond to the mandate of the particular institution;
- Nodes will achieve consensus on the state of the network based on a number of rules that ensure the integrity and immutability of the system, including having full copies of the ledger stored on multiple nodes;
- Settlement finality will be deterministic and not probabilistic;
- Permissioned applications could interface with the network (through APIs[4]) provided by approved participants including institutions licensed by the central bank, e.g. LFIs, payment service providers (PSPs), etc. Each will be given unique API keys to achieve functions related to their activities, including the ability to:
- Create new public/private key pairs ie. wallet (account) generation;
- Authorise/execute a CBDC transaction;
- Query the network for details about a transaction; all transactions cannot be viewed by all stakeholders, rather only transactions to which one is a counterparty, or servicing a counterparty by way of a payments application, would be accessible to view details such as wallet addresses, amount, and timestamp.
- Personally identifiable information (PII) will not be stored in the CBDC network, rather it is stored in segregated databases held by LFIs and PSPs. Significant opportunities exist for the integration of digital identity solutions, which would further minimise the extent to which LFIs and PSPs handle PII;
- Classification as critical infrastructure is likely to be warranted, especially given the cyber-security risks associated with operating such a network. While security features are designed into the network itself, ongoing security audits and multi-party verification will be required for further assurance and risk mitigation.
- CBDC networks may be built to common international standards in order to better achieve interoperability, cross currency exchange, and to leverage operating and design experience across multiple central banks. Such standards are being developed by top tier educational institutions in collaboration with bodies like the ITU and the ISO.
Having such a network deployed can bring about a variety of efficiency gains for participating firms and the clients they serve. Consider the technical and operational efforts that commercial banks and PSPs have had to undertake in the past in providing digital payment services to their clients. With a CBDC network, a large part of the back-office functionality for PSPs is provided by the central bank, effectively consolidating redundant back office functions traditionally managed by individual firms, and upgrading them to meet the requirements of critical infrastructure.
Put simply: in providing a secure national currency network, central banks:
- Reduce the risk of loss of client funds due to failures of PSPs;
- Lower the barrier to entry for PSPs, and enable such firms to focus more on their core value propositions, user experience, support, etc., and less on back office and accounting, thereby increasing competition in payment services.
This means that central banks would be essentially providing a secure digital currency backbone as a public good. In times where transaction and account fees continue to rise, and where credit instruments dominate the payments landscape bringing with them additional fees and the need for customised hardware, central banks have the opportunity to give their economies a powerful digital financial infrastructure and enable a new era of efficient, secure and reliable transaction capabilities. Such a backbone would effectively leverage advancements in IT infrastructure that have occurred over the past few generations, and could very well make use of distributed ledger technology that has evolved over the past decade.
The extent to which CBDCs affect the financial system and economy will depend on the scenarios in which they are used. While there are multiple value propositions for both retail and wholesale CBDCs, there are significant efficiencies to be gained from deploying hybrid CBDCs that satisfy both wholesale and retail use cases on one network. Real time gross settlement (RTGS) systems have existed for many years, and serve effectively as wholesale CBDC networks for large value transactions of central bank money, while automated clearing house (ACH) networks enable lower value payments and typically clear transactions in batches.
There are a number of reasons why such networks have historically been kept separate – one being the technology that was available at the time these networks were commissioned could not have handled large transaction volumes of all types; another being the fact that such networks were commissioned for use by participating financial institutions looking to settle transactions strictly amongst themselves. Other reasons include the momentum behind legacy system operations, and the tendency of large institutions to maintain the status quo (which is not a negative quality in and of itself and is a direct result of being risk averse so as to maintain full operational continuity). The end result is a financial system composed of multiple networks which, at the end of the day (literally) serve to settle central bank money transactions between the various institutions that provide financial services to economies.
CBDCs in international financial systems
Advancements in technology over the past decade, including the rise of distributed ledger technologies for the provision of value storage and transfer functions, indicate that our financial system could experience great efficiency gains should this technology be implemented effectively. Some nations stand to gain more than others in relative terms given that many countries have been able to constantly upgrade their payment systems as their economy grows, while many developing nations have not. Thankfully, the proliferation of the internet and smart devices will serve to enable nations of all types to participate in the experimentation and deployment of CBDCs.
Maintaining operational continuity is of the utmost importance in the process of introducing CBDC networks. This is why we are likely to see these networks deployed as standalone in the initial stages in order to test, analyse, and iterate on the configuration and operational elements, while not impacting the current systems. Once sufficient testing has taken place, integrations will occur incrementally, ensuring that risks are identified and mitigated where possible. Opportunities to address market problems and realise efficiency gains should be assessed and tested in full in order to understand how CBDC networks will enable the drivers of economic growth. Central banks worldwide should collaborate with their counterparts in foreign institutions to share standards, experience, and best practices as they seek the common outcome of better serving their economic stakeholders. In addition, they will discover the efficiencies to be gained from promoting interoperability between multiple CBDC networks for the purpose of cross currency exchange and multilateral settlement.
The interconnected future
Central banks are moving forward with research and development of CBDCs while continuing to work on improving elements of existing systems, such as those relating to cross-border retail transactions. They do this with the expectation that it will provide them with enhanced technical functionality that will make them better able achieve their mandate of regulating the money supply, and promoting economic and financial stability. Policy makers also need to be proactive in identifying legislation that may require change, while studying areas of policy that could be better achieved through the deployment of CBDCs, of which there are many.
In the next post we will explore the design considerations and opportunities posed by CBDCs in the context of cross border and cross currency payments. Until then, find more information on CBDCs at Bitt’s CBDC Hub.
[1] While blockchain networks offer a number of benefits over traditional database structures, the optimal design and associated standards have not yet been set for CBDCs. Blockchain networks face technical challenges in the realms of scaling and throughput, however improvements and innovations are constantly occurring. In addition, tokenization of currencies through blockchains offers significant and wide-reaching opportunities and value propositions.
[2] Nodes are defined as the physical hardware that runs specific software to enable a particular network’s operation and design functionality. Network nodes can store, send and receive information based on the rules of the network.
[3] ‘Running nodes’ is largely an automated process and can include: 1. Hosting the nodes on premise, 2. Hosting the nodes in a local data centre, 3. Hosting the nodes via trusted cloud service providers. Given that CBDC networks are likely to be classified as ‘critical infrastructure’, standards for node hosting will become more explicit in the coming years. Google cloud security standards for reference: https://cloud.google.com/security/compliance.
[4] API stands for Application Programming Interface; APIs define how software intermediaries can interact with one another.
On the level 