Citi and Visa propose hybrid architectures for integrating CBDCs

Incumbents are for the first time acknowledging that sooner or later, CBDCs will be a reality, and are seriously thinking about how to integrate them in the existing scheme of things.

During the last two weeks, two conflicting models have been proposed for interoperability among CBDCs and other digital assets. Technically, these hybrid architectures add very little to existing toolbox of Distributed Ledger Technologies, but they mark a change in the policy of traditional finance about CBDC innovation. Out-and-out supporters (and haters) of DLT will be appalled at these hybrid architectures. In my opinion, these efforts should be praised, if not for their technical level, at least for their willingness to explore new solutions.

When DLT supporters blamed the high costs and low-reliability of international payments, traditional Banking and Finance reacted at first just by offering more of the same, i.e. revamping their instant payment offerings. The fact is those organizations are still coping with the migration to the ISO20022 standard. According to a study by SWIFT, reserve currency high-value payments systems (HVPS) will be based on that standard only by 2025. By the same date, also 90% of non-reserve currency HVPS will support ISO20022.?

While instant payments and ISO20022 are remarkable improvements, markets are asking for a lot more, and incumbents evolved a new stance about present-day payment infrastructures:

• they are already part of the system, so it is critically important for any new CBDC ecosystem to support them?
• they will be needed for interoperability across networks, payment systems, and state borders
• they can also offer CBDC-as-a-service to smaller Countries, providing notary services and hosting critical DLT appliances

Commercial Banks are no longer black-painting CBDCs, as they found more interesting foes in crypto- and stablecoins. On the other side, some of them are still playing for time, in the same way they did about instant payment systems.

Citibank: central and commercial banks, unite for “digital money format war”

Tony McLaughlin, Managing Director for Transaction Banking at Citibank is a frequent guest at blockchain meetings. On Sept 29, at Cordacon enterprise blockchain conference, he defined the concept of “digital money format war”, as a major conflict between regulated versus unregulated money:

• Central bank money, commercial bank money, and e-money are regulated currencies and represent a specific liability, no matter their technical form.?
• Cryptocurrencies and most stablecoins are unregulated commodities, as they do not represent a liability.

Any other discussion about the disintermediation of Commercial Banks and their future role obscures the central conflict between the two different formats of digital money.

• The debate between single-tier and two-tiers CBDC circulation models deepens the contrast between Central Banks and Commercial Banks.?
• When Commercial Banks issue their own private tokens for settling purposes, they are weakening the regulated sector of the economy.

His suggestion is that central banks, commercial banks, and e-money providers should establish a shared ledger, the Regulated Liability Network.? True to this, there is already an initiative grouping together the BIS Innovation Hub Hong Kong Centre, the Hong Kong Monetary Authority, the Bank of Thailand, the Digital Currency Institute of the People's Bank of China, and the Central Bank of the United Arab Emirates. They are working on a prototype platform called "mBridge". It is the next thing to a traditional RTGS and probably as efficient in moving liquidity.

Image taken from BIS - Bank for International Settlements https://www.bis.org/about/bisih/topics/cbdc/mcbdc_bridge.htm

However, according to McLaughlin, the RLN will be also a powerful tool to develop tokenized money, which he sees as the main competitor to stablecoins. While stablecoins are based on a plurality of assets, tokenized money is exclusively based on currency deposits with a Central Bank. While leaving the door open to regulated stablecoins (including Diem, and that's a first for a Commercial Bank) U.S. Banks are signaling they are going to fight against any other asset of Decentralized Finance.?

Time will tell about the Regulated Liability Network. And time will tell about Digital Assets too. As Citigroup is the third largest banking institution in the United States, in the following lines I propose an interpretation of these statements.

The Analysis: main take-aways

• do not expect the much-awaited Fed's report about CBDCs to reveal anything new or ground-breaking. Also, do not expect it soon.
• stablecoin regulation is going to be one of the first priorities of the Biden Administration
• any serious discussion about the Digital Dollar will be delayed after stablecoin regulation, and most probably after Diem market launch.??
• U.S. Commercial Banks will keep a friendly stance to European and Asian CBDC projects, but will probably hinder any Digital Dollar development at home.
• regulated stablecoin-issuing entities (including Diem) will probably be allowed to connect to the FedNow instant payment system, still slated to deploy in 2023

The American Bankers Association

During last Summer, the all-powerful ABA issued Statements for the Record about the Digital Dollar, before U.S. Senate (the House Financial Services Committee, the Financial Services Committee, and the Committee on Banking, Housing, and Urban Affairs). These statements centered against the Left Democrats' proposal of allowing U.S. citizens to open a direct account with the Federal reserve, the so-called FedAccount proposals.?

"The Federal Reserve has neither the authority nor experience to operate a consumer-facing bank. The banking industry has a long track record of serving customers. To do this, America’s banks employ more than 2 million people. Today the Federal Reserve System has about 20,000 employees."

As a secondary issue, the statements downplayed the feasibility of the Digital Dollar, comparing it sfavourably to the FedNow Instant Payment System. At the same time, the ABA cautioned the Fed about allowing nonbank institutions to access the system. According to the ABA, FedNow “does not address the additional risks that nonbank agents bring to this faster payments system,” and the Fed must "... ensure that all participants in FedNow, direct or indirect, meet similar robust prudential, security, and consumer protection standards.”

The Fed's remains undecided about CBDCs

Last May, Chairman Powell announced a report on CBDCs issues but later its deadline was moved to September.? During the Summer, several Fed governors have carried several arguments in favour and against the adoption of a CBDC.

On Sep 22, during a press conference Wednesday about the Federal Open Market Committee’s (FOMC) interest rate decision, Powell did not state a clear date for the report.?However, he said, the Fed does not feel pressured into a decision even as other nations are moving forward with their own projects.

In my opinion, the FedAccount issue stalled the debate about the Digital Dollar: both parties found strategic incentives for emphasising extreme positions and no progress was made.

The Department of the Treasury: regulating stablecoins

The Biden Administration has completed the nomination process for the chairs of the Treasury agencies, a step reputed to be a pre-condition to any regulation effort. Stablecoins are now center stage in Washington’s efforts to regulate the crypto industry.

• On April 14, Gary Gensler was confirmed as Chair of the U.S. Securities and Exchange Commission by a Senate vote.
• On Sept 13, Rostin Behnam, was nominated Chair and Commissioner of the Commodity Futures Trading Commission.?
• On Sept 23, Saule Omarova was nominated Comptroller of the Currency.

On July 19, Treasury Secretary Janet Yellen told regulators that the U.S. government must move quickly to establish a regulatory framework for stablecoins, a rapidly growing class of digital currencies. A special working group will “examine the current regulation of stablecoins, identify risks, and develop recommendations for addressing those risks” and “expects to issue written recommendations in the coming months.”?

On Sept 21, SEC Chairman Gary Gensler declared “These stablecoins are acting almost like poker chips at the casino right now,” without stronger oversight, “people get hurt”, he stated.

The crypto community has been very vocal in their requests for the SEC to approve Bitcoin ETFs (Exchange-Traded Fund). This story may be a revealing indicator of the general trend. While Bloomberg analysts expected an early approval by the end of October, the Commission has extended its deadline for another 45 days. However, the exact wording of the notice leaves space for another extension: "... the Commission designates December 8, 2021, as the date by which the Commission shall either approve or disapprove, or institute proceedings to determine whether to disapprove, the proposed rule change".

Visa develops interoperability concept for central bank digital currency payments

Universal Payment Channels: An Interoperability Platform for Digital Currencies. https://arxiv.org/abs/2109.12194v2

https://usa.visa.com/content/dam/VCOM/global/ms/documents/veei-cross-border-payments-for-cbdcs.pdf

Interoperability is the main challenge faced by most blockchain networks. Many digital tokens are confined to Ethereum-type networks as they are based on Ethereum token standards. However, many blockchains are not interoperable by design, and the transfer of crypto assets among different networks (for example Ethereum and Bitcoin) is always a problem. A team of Visa specialists proposed a hybrid solution for that.

"As the number of blockchain networks increases, each with unique design characteristics, the probability for parties of a transaction to be on the same network decreases. Thus, it is crucial to facilitate payments that are both off-chain (to save overhead and fees) and universal (to transact across networks). Envisioning a future payment network that may be built on top of DLT networks but without the limitations highlighted, we propose a payment route that can be used to support digital token transfers called Universal Payment Channels (UPC)."

The proposed solution is not new: in DLT lingo, Layer 1 is responsible for guaranteeing transactions in the distributed environment, while Layer 2 relies on the lower layer for providing enhanced services, as payment channels. These channels are set up through an initial funding transaction that takes place on Layer 1, while all the subsequent transactions will be performed off-chain, on Layer 2, without requiring further writes. When the channel will be closed by one or both partners, the balance of all the transactions will be written down on the blockchain as a single transaction. In this way, the blockchain overhead is incurred only when opening and closing the channel and the blockchain fees are spread over several transactions.?

The most basic resources allowed on blockchains are digital signature verification and hash-time locked contracts (HTLCs). HTLC allows for creating a transaction that will be committed only if the partner has provided a cryptographic proof (either a hash preimage or a valid signature) before a specified deadline.

Step 0 - Pull: In order to start, the transaction must be "pulled", that is, the merchant (aka the recipient) sends to the customer (aka the sender) an invoice proposal and a "secret" that will identify the transaction during its entire lifecycle. This message is exchanged by a communication channel external to the hub, typically a QR code shown on a point-of-sale device. After this pull, a successful UPC transaction requires the exchange of three types of messages over the hub:

Step 1 - Promise: A signed message from the sender to the recipient promises an amount conditioned on getting a secret before an expiration time. The message contains a hash of the secret exchanged at step 0.

Step 2 - Secret: A message containing a secret generated by the recipient attests that the payment promise was received and accepted.

Step 3 - Receipt: A message sent by the sender after receiving a secret associated with their promise.

All parties always maintain the receipts they received and may use them to submit their credit claims. Using the signatures submitted by the parties, the UPC contract updates the final balance of each party and settles the channel, closing it.

The architecture proposed by the Visa team is based on a hub-and-spoke model, with a Universal Payment Channel hub offering the function of foreign exchange and settling to a plurality of clients. After providing identification and collateral, wallet providers can set up channels with the UPC hub to enable cross-border payments with multiple CBDCs. Of course, when talking about wallet providers we are authorized to think about Diem and its Novi wallet.

The Diem blockchain and the Universal Payment Channel hub are two conflicting architectures: both of them want to be the center of the system. However, while the Diem blockchain is described in the whitepapers, the internal structure of the UPC hub is not described and we are allowed to think it will be some souped-up version of the existing VISA payment infrastructure.

The VISA authors admit their proposal is not yet industry-ready for several reasons:

1 - Due to the pre-funded model of UPC, it is important for the UPC hub and for its clients to keep their UPC channels well-provisioned with liquidity.

2 - Executing a transaction through the HTLC eliminates counterparty and Herstatt risk, but a liquidity crisis may lead to a catastrophic failure of the whole hub.

3 -?Present versions of the protocol allow channel funding only by Layer1 transactions, that require the payment of a fee, and are hindered by the response times of the ledger.

4 - The off-chain protocol requires transactions to be submitted and processed in a serialized fashion, meaning that the client cannot initiate a new transaction unless the previous one has been completed. This is necessary to eliminate the fraudulent behavior of a client using the same sum of money to back two different promises.

Note:?Counterparty risk is simply the default risk that the counterparty will not pay as obligated by a contract. The Herstatt risk is a special form of cross-currency settlement risk. By convention, foreign exchange transactions are settled in the home countries of the currencies involved, and this clearly conflicted with other usages about banking hours and timezones. A jam was sure going to happen, sooner or later. It happened on 26 June 1974 at 4:30 pm local time, when German regulators withdrew Herstatt Bank's license. During that day, German banks had advanced Deutsche Marks to Herstatt, believing they would receive US dollars from Herstatt's US-based accounts later in the day. However, at 3:30 pm in Germany and 10:30 am in New York Herstatt stopped all payments to counterparties.

Learning from that experience, regulators are now allowing for a grace period during which counterparties can be paid, and the name of Herstatt risk describes all the cases in which a counterparty is willing to pay but fails to do so for reasons external to its will.

Another big problem is that, while the proposal explicitly targets CBDCs, many of them are not supporting the level of programmability required by the Universal Payment Channel. The missing HTCLs could be easily implemented by some sort of gateway, leaving some space for some resourceful startup.

The principles of channel operation were described for the first time in the BitCoin Lightning Network white paper in February 2015. SWIFT and Accenture in their whitepaper of May 2021 declared to have successfully tested a payment channel between an R3 Corda DLT and a Quorum blockchain.?In June 2021, the Legislative Assembly of El Salvador voted legislation to make #BTC legal tender and adopted BitCoin Lightning as the standard for #BTC circulation in their country.