Opinion

Opinion

Central bank digital currencies: Central banks go blockchain

by Jonas Gross

6 months ago

Introduction

Motivated by the appearance of cryptocurrencies like Bitcoin and Ether, the first central banks started to analyze a potential introduction of an own digital currency as early as 2014. The announcement of the worldwide cryptocurrency project “Libra” in 2019 has further accelerated this process, and an increasing number of central banks are now exploring launching their own central bank digital currency (CBDC). The focus of worldwide central banks on digital currencies is further driven by the declining demand for cash in most regions worldwide. In Sweden, for example, cash is now used on rare occasions only. Consequently, Swedish central bank money is mainly displaced by bank money yielding higher systemic risks and dependencies on private financial institutions. In the event of a financial crisis, turmoil in the financial sector could amplify due to the lower role of central bank money and could lead to a broader global reach. Central bank digital currencies represent a digital form of central bank money and are considered as alternatives to cash, as the classical physical form of central bank money.

CBDCs have the potential to address important (macroeconomic) issues and can yield significant improvements. First, transactions can be made more secure and more resilient to attack vectors. Second, payment efficiency could be improved by increasing transaction speed and decreasing transaction costs. Third, financial inclusion could be increased since unbanked people living in remote areas could participate in the financial system.

This article provides basic insights into CBDC by defining CBDC, explaining the design principles of CBDC, discussing current CBDC projects and evaluating if a CBDC should be issued on a blockchain system.

Definition and design principles of CBDC

First, let us start with a (rough) definition of CBDC. A CBDC is a digital currency issued by a central bank, which constitutes legal tender in the respective economy. CBDC can feature various design principles (among others) and has different dimensions:

  • Interest payment: A CBDC can be designed as an interest-bearing In this case, citizens holding CBDC would receive an interest rate in return for providing funds similar to bank deposits (in times of positive interest rates). On the other hand, a CBDC can also be non-interest-bearing. A non-interest-bearing CBDC would not yield interest income and would be similar to physical cash.
  • Access system: Access to CBDC can be restricted to specific players of an economy, such as financial intermediaries or other financial institutions. In this case, the CBDC would be called a “wholesale CBDC.” A CBDC available to the general public is called a “retail CBDC.
  • Operational setup: Further, a CBDC could be designed as either account-based or value-based. In the case of an account-based CBDC, clients hold their funds in an account at the central bank. Consequently, the central bank would be responsible for managing these accounts. In the case of a value-based CBDC, the CBDC would be emitted directly in the real economy similarly to physical cash and would not require a high amount of operational capacities of the central bank.

CBDC projects: Who is pioneering?

By the end of 2018, more than 60 central banks worldwide had analyzed CBDC. In 2019, more and more central banks announced CBDC projects and in some cases have introduced prototypes. But which countries and central banks are currently pioneering in CBDC?

If considering larger economies, the Chinese central bank and the Swedish central bank are currently closest to market introduction of a CBDC. The People’s Bank of China announced in autumn 2019 that a digital version of the yuan will be issued in the near future. This Chinese CBDC is supposed to be a value-based, non-interest-bearing, retail CBDC. Experts expect the market introduction to take place in the first half of 2020. The Swedish Riksbank has been analyzing CBDC since 2017 and has recently announced the introduction of an e-krona prototype.

Besides Sweden and China, various smaller countries and islands are at the forefront and have developed their own CBDC prototypes. Some central banks have gone even further and announced plans to actually issue a CBDC soon. These countries are, among others, the Marshall Islands, Cambodia and the Bahamas. An overview of current retail CBDC projects can be found here and here.

What about the European Central Bank (ECB)? The ECB is researching CBDC intensively and has developed an own prototype for a wholesale CBDC together with the Bank of Japan (project “Stella”). Christine Lagarde announced in her first press conference as ECB President in November 2019 that ECB will intensify efforts and will set up an own CBDC task force. In December 2019, the ECB published a paper about a prototype of a (partially) anonymous CBDC and announced plans to test this prototype. Hence, it can be seen that the ECB is very active and will further intensify efforts to analyze CBDC in 2020.

Should a CBDC be blockchain-based?

Issuing a CBDC does not necessarily imply using distributed ledger technology (DLT), such as blockchain technology, even if this technological choice is often assumed in the public debate. Hence, it is imaginable for a CBDC to be issued either via a centralized database system (probably the case in Sweden) or via a distributed ledger technology (as in China). The retail CBDC prototype of the ECB will be set up on the Corda DLT. Using DLT to issue a CBDC can be beneficial in various dimensions:

  • Data privacy: By design, a blockchain can be beneficial in reaching a high degree of data privacy. The underlying cryptography can easily be implemented in a way to feature anonymity. The CBDC would become similar to cash, which is an anonymous means of payment. However, it should be kept in mind that there is a trade-off between data privacy and the use of cryptocurrencies for illicit activities. If transactions are entirely anonymous, then the origin of the money and the identity of the sender cannot be inferred. This anonymity increases data privacy on the one hand but also increases the risk of illicit activities, such as money laundering or terror financing. The ECB proposes in its current paper a system of “anonymity vouchers,” which would allow anonymous transactions to a certain extent (only).
  • Security: Due to the underlying cryptography, DLT systems are typically very secure and hard to hack. This mechanism makes transactions very secure and operationally resilient.
  • Speed: Today, in the classical financial system, transactions, especially in form of cross-border payments, are typically not efficient. According to data from the World Bank, a transaction costs on average 7% of the transaction volume in fees and takes several days to process. These limitations can be addressed by using a CBDC operating on a DLT system featuring cryptography and energy-efficient consensus mechanisms, such as proof of stake or proof of authority.
  • Smart contracts: A blockchain-based CBDC would enable euro-denominated smart contracts, so that machines, cars and sensors can offer services directly on a pay-per-use basis including leasing and factoring. The implications of such a digital fiat currency are, thus, especially promising in the context of the machine economy. It is estimated that more than 20 billion devices will be connected to the Internet in 2025 — three times as many devices as there are people currently living on earth. Some of these devices will also be integrated into a payment network. This network will soon cover hundreds of millions of devices, such as cars, sensors and machines. Blockchain technology is best suited for equipping millions of devices with a computer chip and, with it, with their own wallet. Then, a device will be able to receive payments and transfer money — and produce SAP-based accounting records and invoices in euro denomination. For these millions of devices, blockchain technology can easily provide the opportunity to participate in a payment network and integrate them into automated business processes (e.g. through smart contracts).

Of course, using DLT for a CBDC also has various drawbacks. Currently, the technology is not 100% mature and has a track record of just over a decade, since blockchain technology was invented in 2008. Further, energy-consuming consensus mechanisms such as proof of work can even decrease transaction efficiency and increase transaction times. However, both risk factors can be managed if an energy-efficient consensus mechanism is used and if the DLT system is thoroughly tested before its implementation. Of course, determining whether using DLT is beneficial depends on the specific design principles, goals of the CBDC and technology factors. Nevertheless, central banks should not neglect DLT entirely and at least test it to see if benefits materialize. Most CBDC projects might be more promising on DLT systems than on centralized systems.

Conclusion: Do we really need a CBDC?

On the one hand, pioneering central banks that issue a CBDC have a reputation to lose in case the project flops. On the other hand, they also have a first-mover advantage. The digitalization of the payment sector is essential and will sooner or later materialize. Central banks should stay open-minded and should test and deeply analyze innovations such as DLT. Even if some central banks argue that the risks of issuing a CBDC on a DLT system are currently higher than the benefits, the benefits will further show up and increase in importance if DLT-based prototypes are tested. Testing and experimenting with DLT pilots is essential and should be carried out by all major central banks. This technology has tremendous potential and this potential should not be wasted.

About the Author

 

Jonas Gross is a project manager and research assistant at the Frankfurt School Blockchain Center (FSBC). His field of interest is primarily cryptocurrencies. Besides, in the context of his Ph.D. thesis, he is analyzing the impact of blockchain technology on monetary policy of worldwide central banks. He mainly studies innovations such as central bank digital currencies (CBDC) and other cryptocurrency projects such as “Libra.” You can contact him via e-mail (jonas.gross@fs-blockchain.de), LinkedIn, Xing (https://www.xing.com/profile/Jonas_Gross4), or follow him on (Twitter Jonas__Gross).

Please note: This is third-party content and does not represent an endorsement by Blocks99, nor does it necessarily reflect the views and opinions of Blocks99 and its editorial team.

Subscribe to our newsletter and follow us on social media – Facebook LinkedIn Twitter Telegram Youtube – to be the first to read the latest and most relevant blockchain and digital asset news in the European and Southeast Asian regions. You’ll also find interviews with top industry experts, provocative opinion pieces and brief introductions to key blockchain topics.

ADVERTISE