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Blockchain’s critical role in central bank digital currency
Central bank digital currency (CBDC) represents a potential digital sea change in the daily function of finance. The key innovation is the adoption of a value-based, or token-based, approach to money. CBDC tokens can exhibit features akin to those of a bearer instrument—such as a bank note—encapsulating all of the properties needed to assign value, ownership and transfer of ownership.
The technology best suited to offer the required functionality is distributed ledger technology (DLT), of which the best known example is blockchain. In addition to its capabilities for facilitating token issuance, assignments, and swaps or exchanges, blockchain enables central bank money to become “smart” while enhancing needed prudential controls and security.
CBDC rests on tokens. This money format not only delivers innovation, it also adds many advantages that existing money formats cannot meet.
Key advantages of blockchain technology
#1: Native functionality
Tokens offer “out of the box” functionalities that strongly support the transaction of digital values. They enable instant and atomic exchanges, creating new possibilities to conduct delivery versus payment (DvP) and payment versus payment (PvP) transactions. Tokens are expected to be the standard for payments in the internet of things (IoT) and other machine-based applications.
Tokens represent the end-state of the digitalisation of value. The possibility of endowing tokens with embedded business logic or smart contracts allows them to assume the functionalities they need to interact independently with the network and to enable conditional, complex, layered and triangulated transactions. Programmability offers a new set of possibilities to equip money with new utility.
#3: Multi-tier distribution
The portability of tokens enables distribution through a multi-tier structure. This bolsters the preservation of the existing two-tier banking system, in which the central bank distributes money to the commercial banks, which in turn distribute it to end-users. CBDC supports bank intermediation by allowing the central bank to interact only with intermediaries.
The tokens will transact on new payment rails, offering greater diversification of the payments system and affording greater autonomy for the central bank by making it less dependent existing payments networks. Tokens can serve new token-based financial market infrastructures as a settlement medium and advance a more varied payments infrastructure, while supporting financial deepening and inclusion.
#5: Financial innovation
Tokens are both a new medium and a new financial market infrastructure. They should give rise to and serve as a catalyst for financial innovation. Tokenised central bank money lends confidence to financial ecosystems by enabling high-quality settlement, which in turn supports the emergence and proliferation of new financial applications.
#6: Off-line capabilities
Payments need to be impervious to power outages and interruptions in telecommunication coverage. Tokens enable peer-to-peer exchanges in the proximity of payers and payees through their wallet functionalities.
The benefits of blockchain
Blockchain technology allows for efficient processing of tokens, due to the validation of token flows by a decentralised group of actors in the blockchain network. Validation is performed by tracing the token to its origin to verify if the token is genuine. This allows the network—rather than a single entity—to assess the validity of a token and a transaction. All of this supports more decentralised operations while fostering resilience and security.
The blockchain network would normally be operated jointly by the central bank and commercial banks. While the central bank would control the issuance of CBDC, the network would jointly validate transactions. This allows transactions to be processed even when individual operators or nodes are down, including the central bank. The blockchain would record all transactions immutably and ensure the integrity and robustness of the network. The tokens would be held in electronic wallets that allow interaction with the network for payment transactions and afford full control of the tokens. The wallets would hold the private keys that control the tokens; the tokens could only be transferred by assigning the private keys to a new wallet.
The networks that secure the function of CBDC must be designed in a way that ensures the required prudential and supervisory safeguards are being maintained. This design should be based either on technological considerations or the economic policies which the networks are intended to support. The first seeks to identify the optimal network layout that maximises transaction throughput and performance; it normally consists of a single network for all participants. The second aims to maintain jurisdictional and prudential boundaries, and is the preferred layout where the establishment of new separate networks incurs undue adoption costs, leads to unwanted duplication of existing facilities or limits scalability in a cross-border setting.
Building a secure network
The single-network approach is in conflict with that used by existing domestic networks, and also with the separate-network approach that spans networks. The objective function of the operators will determine the feasibility of both networks and influence their preferences, choices and trade-offs.
The network would allow different forms of access—and network operation and network access must not be congruent. Entities that operate the network would have full access and would process transactions, while those that hold an electronic wallet but are not operators of a network node would be able to conduct transactions but not process them. The two main benefits of blockchain platforms are the superior and more secure tools to administer access and other user rights, and the potential to operate across networks.
CBDC as a business function
The programmability of tokens enables CBDC to be embedded with a given business logic. It should allow CBDC to observe prudential and other supervisory requirements and controls, irrespective of the transaction or parties to the transaction. This programming could be used to execute more complex operations, offer automated escrow functions and exhibit self-executing functions upon meeting certain pre-determined thresholds.
CBDC has also been associated with account-based approaches that replicate and expand existing arrangements. These arrangements normally involve extending, to the non-bank public, accounts at the central bank or in its large-value payment system. Similar options have always been available but are seldom used, largely due to the unwillingness of central banks to deal directly with the non-bank public. The innovation of account-based systems would be that broader access would be granted to the central bank accounts only, while the inherent limitations of existing arrangements would remain in place.
Ultimately, user preferences and demands will likely drive the innovation and adoption of CBDC around the world. Many steps have been taken already, with several central banks outlining their intentions and plans for transformation.
In our fourth and final post in this series, we’ll explore how CBDC can drive growth and innovation in retail, wholesale, and in international payments. For further reading, please visit The (R)evolution of money II Blockchain empowered CBDC.