The Design and Deployment of CBDCs on Blockchain Based Technology

Prologue

The 21st century's technology achievements have not been impervious to the global financial architecture. The existing financial system is observing the entry of a completely new class of assets as well as evaluating the possible scope for innovation in established structures thanks to the development of technologies like blockchain. These advancements led to the creation of both cryptocurrency and CBDCs. CBDCs would be direct liabilities of the central bank, just as paper cash is, which make it a safer form of digital money than commercial bank (issued digital money).?To be clear, this article is not implying Cryptocurrencies and CBDCs are the same thing (they definitely are not). In layman's terms,?a CBDC is simply digital fiat, whereas cryptocurrencies are digital assets on a decentralised network. But the underlying technology can arguable based on the same type of technology.

We have witnessed increased interest in CBDC (Central Bank Digital Currency) studies and potential technology applications in recent years. The majority of these studies have connections to different central banks, such as the Bank of England, the European Central Bank, the Central Bank of Sweden, etc., where there is frequently no clear recommendation for the use of a certain technology (traditional rails vs. DLT-based blockchain solutions). In this regard, it is debatable whether a blockchain platform would be the best technology to accomplish a CBDC use-case. On the other side, certain technology firms create and disseminate CBDC implementation architectures, typically utilizing some form of distributed general ledger technology.

We are all familiar with the concept of checking deposits in banks and how that plays an integral part of our day-to-day lives but if not then then here is a quick primer. Checking deposits, are fiat put online and transformed by a commercial bank into a string of digital code, account for 97% of the currency in use today. But why is this pertinent to this discussion today? Many previously cash-based transactions have been converted to digital ones as a result of the digitalization of credit and debit card transactions and the creation of banking applications.

This is now slowly leading banks to a potentially new medium of issuance of fiat through the form of Central Bank Digital Currencies (CBDC). The driving force behind more dramatic transformation is coming from China, whose central bank has been testing a currency (Digital Currency Electronic Payment, DC/EP), which it hopes will replace paper money in the future.

According to a recent research by the Bank for International Settlements (BIS), 20% of global central banks and 10% of central banks globally, respectively, plan to issue retail CBDCs in the medium future. The creation of a CBDC, however, might pose risks to financial stability and data privacy. Some claim that making central bank money widely available might cause financial instability and the disintermediation of private banks. Furthermore, many worry that a digital CBDC would increase the central bank's monitoring capabilities and jeopardize data privacy [1]. But how real are CBDCs and if so, what technology would they be built on? In this latest article I'll aim to dive deeper into the applicability of leveraging blockchain technology for CBDCs.

Introduction

The banking industry has so far largely escaped the effects of the switch to digital, at least in the West, where new firms like Paypal continue to rely on users connecting the service to their bank debit and credit cards. There are a few online-only banks that have emerged, such as Chime and Nubank, but they still run on the current rails [2].

It's been observed that millions of people are growing further interested in both cryptocurrencies and central bank digital currencies (CBDCs). Although they both fall under the category of "digital assets," there are several important differences between the two and it is predicted that the CBDC would resemble "dematerialized bank notes" rather than cryptocurrencies. The world might not accept cryptocurrencies as a form of payment given the way their value has changed. The future of cryptocurrency, though, may lie with controlled digital coinage like the CBDC. But they both do have a common ground in that they can both be developed using blockchain-technology. This leads us to the next point on the underlying technical layer of Blockchain and how CBDC would potentially be developed based on its architecture [3].

Its be widely stated that in the next three years, central banks from around one-fifth of the world's population are anticipated to issue a CBDC, according to a research recently released by the Bank for International Settlements (BIS). As a digital version of central bank currency, CBDCs can include a variety of design features, such as those relating to the payment of interest, access to CBDC, operational setup, and technological choice. Numerous central banks have studied how fiat currencies could incorporate the tremendous advantages of crypto assets, such as programmable transactions, cost effectiveness, high transaction speeds, and additional efficiency gains, in order to facilitate their adoption by regular businesses and consumers.

"Interest in cashless society and digital currency has grown as a result of the appearance and advancement of cryptocurrencies and Blockchain technology. Government-backed digital currencies are thus being considered by central banks and governments all around the world, (Blockchain Council, 2021).

As with today's fintech and Big Tech digital wallets (think Venmo and Apple Pay) and the wallets provided by traditional banks, the digital code for each virtual currency unit will be held in a digital wallet in the CBDC world and transferred seamlessly by the wallet-holder to other people's digital wallets. Four state banks and three telecoms firms will be granted licenses to provide these services in China, acting as wallet distributors as opposed to currency depository institutions. To pay in-store or transfer money to other mobile wallets, users will scan barcodes with their smartphones. Periodically, copies of client data will be delivered to the People's Bank of China (PBOC) [4].

The main goal of CBDCs is to give businesses and customers the privacy, transferability, simplicity, accessibility, and financial security they need. According to the Atlantic Council, "CBDCs also decrease the maintenance necessary for a complex financial system, minimize cross-border transaction costs, and present lower-cost alternatives to those who now use conventional money transfer methods."

The risks related to using digital currencies in their current form would be reduced if central banks produced their own digital currencies. Cryptocurrencies, on the other hand, are extremely volatile, with constant value fluctuations. In terms of use cases, cryptocurrencies are categorized as both assets and currencies. People can engage in investing markets to make predictions about how a cryptocurrency will behave in terms of price. They could also adopt specific initiatives, like as Bitcoin, as a kind of value storage to protect themselves against inflation and unstable economies.

One can think of cryptocurrencies as digital information transfer mechanisms. If the information being transferred is used as an everyday payment instrument, it fulfills the role of money. In this case, a cryptocurrency can be thought of as a money and payments system. But should CBDCs be developed using blockchain-based solutions similar to cryptocurrencies?

Designing CBDCs on a Blockchain Platform

A claim against a central bank and not a commercial bank or a payment service provider is represented by a Central Bank Digital Currency (CBDC), which is a legal currency established and supported by a central bank. Potentially we would see CBDCs operate on authorised (private) blockchains, whereas cryptocurrencies operate on permissionless (public) blockchains.?CBDC is administered on a digital ledger (which may or may not be a blockchain), speeding up and enhancing the security of payments made between banks, organizations, and people. If they were to be developed on blockchain-technology then we would see CBDCs operate on authorised (private) blockchains, whereas cryptocurrencies operate on permissionless (public) blockchains.?

The Bank for International Settlements recently performed a survey (2022), and it found that more than 70% of institutions are working on CBDC proofs of concept (this statistic does not include all countries that are actively researching, as this figure would be higher than 90%) [5]. In order to develop a CBDC PoC, we first need to determine the different characteristics of digital money which is listed as follows:

1. Digital assets. CBDCs are digital assets. They are accounted for in a digital ledger (distributed or not) that acts as the single source of truth.
2. Central bank backed. CBDC represents claims against the central bank, just as banknotes do.
3. Central bank controlled. The supply of CBDC is fully controlled and determined by the central bank.

Secondly lets distinguish how a CBDC is different to Cash. We already understand that Cash is a very special type of asset that combines four features: (i) it is exchanged peer to peer (without knowledge of the issuer), (ii) it is universal (anybody can hold it); (iii) it is anonymous and (iv) it does not yield any interest. In comparison, a CBDC is an alternative to cash that is also peer to peer (P2P), but it opens the possibility of introducing changes in the other three features:

• They can be universal or restricted to a particular set of users. Likewise, DLTs can be open or closed (for instance, limited to banks or financial institutions).
• They can be anonymous (like cash) or identified (like current accounts). The first corresponds to the idea of token-based CBDCs, and the second to account-based CBDCs.
• They can pay interest or not. The delinking of cash from paper-money opens the possibility of including interest-bearing as a feature, either in the account based or in the token based variant.?

The choice a central bank makes depends crucially on the objectives pursued with the introduction of CBDCs. There are basically four possible objectives: (i) to improve the working of wholesale payment systems; (ii) to replace cash with a more efficient alternative; (iii) to enhance the instruments available for monetary policy, especially when confronted with the zero lower bound and (iv) to reduce the frequency and cost of banking crises. How these objectives match with the different options that CBDCs open as compared to cash is not in the scope of this discussion but will be covered in future articles.

Central Banks would need to be able to develop a system that supports the ability to: store a claim in local currency against the Central Bank; make payments person to person, at points of sale, and online; and buy and sell a CBDC with commercial bank money or cash. And so if blockchain technology were to be selected, it would be need to perform these actions in a real-time, offline, robust, seamless, secure and private manner.

On the topic on what type of technology should be utilized to introduce a CBDC should not not necessarily be the major focus of central banks' research because their goal is to stabilize the existing monetary and financial system. Even while employing DLT, such as blockchain technology, is frequently presumptive in the public discourse, issuing a CBDC does not always entail doing so. Therefore, it is possible for a CBDC to be issued using either a distributed ledger technology or a centralized database system (as is likely the case in Sweden). For example, on Corda's DLT, its retail CBDC prototype for the ECB will be set up, enabling partially anonymous payments [6]. But what are the fundamental technical components to a blockchain?

The blockchain is a continually expanding, replicating, and synchronizing database that runs across all blockchain nodes. Therefore, it is up to the blockchain nodes to reach agreement on the shared transactions in the blockchain network and decide whether to accept or reject the suggested transactions. There are several consensus protocols, supported by either public or private blockchain, including proof of work, proof of stake, delegated proof of stake, practically byzantine fault tolerant, etc. Every participant in the blockchain network, which is often open-source and used by the community, has access to the public blockchain. Blockchain systems like Bitcoin and Ethereum, for instance. In contrast, only known or trustworthy entities may create, manage, and access the private blockchain (e.g. a blockchain platform like Hyperledger Fabric, for instance).

Any blockchain, whether public or private, needs four essential components to work. The first four are blocks, chains, networks, and smart contracts. The block is a group of transactions, each of which has a time stamp and contains information on any activity, such as a payment between a payer and a payee.

By linking one to the other using a hashing method, the chain depicts the connections between the new and earlier blocks. Blockchain nodes, which maintain a complete record of all valid blocks, are part of the blockchain's network. However, the smart contract is a program that indicates the multiple functions of any blockchain application stored on the blockchain network. This smart contract executes automatically by triggering an event on the blockchain network.

The Benefits

The different types of benefits that have been highlighted from blockchain advocates include the following:

• System faith. Central banks may manage the currency with the help of a blockchain-based CBDC, while end users' privacy and independence are maintained. In order for consumers to trust and utilize the CBDC, it is crucial in our opinion that intermediaries not lock users into contracts.
• Programmability. To make compliance easier, CBDC restrictions, such as wallet thresholds or third-party access to the system, can be hard-coded into the protocol.
• Data accessibility. Blockchains and other distributed systems enable data availability and resilience as well as trust and openness around transaction history. Ethereum has demonstrated its ability to sustain very large networks with more than 10,000 nodes and a million users.
• Innovation. The cutting-edge goods and services being developed throughout the open source blockchain ecosystem, including as non-custodial wallets, zero-knowledge encryption, and decentralized finance, are advantageous to a blockchain-based CBDC. With over 350,000 developers, Ethereum has the largest blockchain ecosystem in the world.

How Would it be Implemented

To begin with, Central Banks would need to develop and install the CBDC-blockchain enabled platform as a private, permissioned blockchain protocol implementation. The CBDC ledger will operate as a centralised platform, under the management and oversight of the Central Bank. These decisions would need to be captured as part of an initial phase (P1 - Foundation Stage).

Use case providers would need to be determined by identifying industry participants responsible for the design and operation of their own technical platforms to implement their approved use case applications in the project. A two-tier model is likely to be more common and preferred model where the central bank outsources some of the tasks to commercial banks who essentially functions as payment interface providers (PIPs). It is likely that central banks would want to control the issuance and redemption of CBDCs. Note that use case providers will not be permitted to deploy any code or smart contracts on the pilot CBDC platform (this would be determined during P2 - Assessment Phase).

By using an interface with the pilot CBDC platform, KYC providers will certify that holders of pilot CBDC have had their identities validated. Providers of use cases may also serve as KYC service providers for their own end consumers (this would be determined during P2 - Assessment Phase).

Other considerations regarding the following parameters would need to be scoped as well:

• The CBDC would need to be a liability of the Central Bank and denominated in a local currency.
• The smallest denomination will be one unit (i.e. cent).
• The amount of CBDC issued will be capped at an amount to be determined by the Central Bank considering the requirements.
• No interest will be paid by the Central Bank on any holdings of the CBDC.
• Only locally-registered entities and resident individuals may hold the CBDC. All (end user) holders of the CBDC will need to be invited for participation in the project.

Approved use case providers would then need to be identified to be able to access and interact with the CBDC platform via specified Application Programming Interfaces (APIs) and ERC-20 smart contract interface functions. These interface specifications, as well as a platform for testing, will be provided separately, only to selected use case providers. The API will offer additional functions to manage and support the privacy of user data. This would be covered under Phase 2.

The CBDC platform will need to have technical capabilities for security, reliability and performance sufficient to support the operation of pilot use cases. Whitelisting and firewall rules will be used to restrict access to the CBDC platform. The platform will also need to have transaction throughput limits (with 2-5 second latency) that are not expected to impact the operation of use cases selected for the pilot project (all determined during Phase 3 of the system pilot).

Challenges using Blockchain Technology

Of course, there are a number of disadvantages to adopting DLT for a CBDC. The technology has been around for just over a decade, but it is not yet fully developed. Furthermore, transaction speed can be increased but transaction efficiency is decreased through energy-intensive consensus procedures like proof of work. However, if an energy-efficient consensus method is adopted and the DLT system is fully tested before being put into operation, both risk considerations may be controlled. Of course, the exact design principles, CBDC objectives, and technology aspects will all influence whether adopting DLT is advantageous. We warmly encourage the ECB and other central banks around the globe to research the benefits of DLT technology and create CBDC prototypes using DLT technologies.

The Bank of Korea finished the second stage of its simulations of retail central bank digital currency (CBDC) in late June and released the findings today. While the central bank expressed satisfaction with several elements of its digital currency simulations, such as deploying CBDC for cross-border transfers and offline payments, it also drew attention to performance difficulties with blockchain technology [7]. It specifically found that the Ethereum-based blockchain's total performance, including the evaluated scaling solutions and privacy technologies, was insufficient.

The Bank of Korea stated that there will be certain restrictions on real-time transaction processing during busy periods. In one of its experiments, 4,200 transactions per second (TPS) were maintained for 30 minutes to replicate peak demand. Users occasionally had to wait up to a minute for a response at that level of activity. Although the system can manage an average TPS of 1,000, which is typical of many Korean micropayment systems, peak times like lunchtimes or payment deadlines are not supported.

An further performance issue with employing zero knowledge proofs This technique can demonstrate who owns the CBDC without disclosing any personal information. The central bank discovered that each transaction involving ZKP might take up to 14 seconds. ZKP is also well known to have performance issues, however this may be somewhat offset by using alternate strategies. Which ones were used is unclear.

The bank also tried cross-border CBDC remittance and transfers between ledgers using various blockchain technology for the acquisition of non-fungible tokens. It made use of hash time lock contracts (HTLC) and found them satisfactory. Commercial banks were utilized as middlemen in the cross-border CBDC simulation with the United States.

In addition, The Bank of England's Deputy Governor, Jon Cunliffe has stated that the bank intends to publish a research paper before the end of the year regarding how a retail CBDC may appear. Cunliffe is in charge of the bank's work on central bank digital currencies (CBDCs). He anticipates that it will be at least five years before digital pounds are accessible to consumers, and I'm confident that this is a conservative estimate given that a retail CBDC must satiate the expectations of numerous conflicting stakeholders, which will take time to clarify and resolve [8].

Many cryptocurrency enthusiasts, who believe some type of blockchain to be at the core of any digital currency system, were shocked by such comments. However, the Bank of England's opinions in this regard concur with those of the Digital Currency Initiative of the Massachusetts Institute of Technology and the Federal Reserve Bank of Boston. They discovered "a distributed ledger functioning under the control of diverse parties was not needed to fulfill our goals," according to their "Project Hamilton" Phase 1 executive report.

They stated that no blockchain is required to create a CBDC in simple English. Additionally, they claimed that a distributed ledger did not adhere to the "trust assumptions in Project Hamilton's approach," which presumes that the platform will be run by a single, central actor (such as a central bank), and they discovered that even when this architecture is used, it still results in "performance bottlenecks."

In other words, the main finding was that a Federal Reserve digital currency of any kind would not have any untrusted third parties, but a blockchain is a highly specialized answer to the problem of creating consensus in the presence of such parties.

Further, the "tokens or accounts" category is inadequate and insufficient to surface the complexity of choices in access, intermediation, institutional responsibilities, and data retention in CBDC, as the Project Hamilton folks point out, and CBDC design choices are more granular than generally imagined. In general, the difference between the two — as mentioned in different publications from the BIS, Bank of Canada, IMF, and others — is that an account-based system requires confirming the legitimacy of the object used to pay, but a token-based system does not.

However, in practice, no central bank will permit an anonymous token-based system, therefore digital identity will be crucial to CBDC roll-out. This is why, even after the criteria, aims, and limits of a national digital currency have been agreed upon, I believe it will take some time for all of these architectural decisions to be worked through. This wide range of design options, in my opinion, is not a problem but rather a hopeful message to regulators and policy makers: if you can actually tell us—the digital financial services industry—what you want from a digital currency, then we can provide it because we are aware that all the technologies required to create it already exist.

The Argument for Blockchain Based Technology

Because of the potential for smart, programmable money, some individuals believe that a blockchain is essential for a digital currency. I agree that one of the most intriguing aspects of retail digital money will undoubtedly be its programmability, but that does not entail "smart" "contracts" and blockchains. Here, I'm referring to CBDC sold in stores. The complete range of smart contract capabilities may be acceptable when trading more complicated instruments in wholesale CBDC for institutions.)

As far as I can ascertain, I believe most central banks are not interested in running a digital currency scheme themselves. They all imagine "two-tier" structures where they control the strategy but other people carry it out. The Bank of England refers to these third parties as Payment Interface Processors (or PIPs), which I find to be a bit too vague. I would have opted for Currency Connectors (CCs) or a comparable product instead.

Smart contracts, or "permanent scripts," as they need to be called, have some really exciting capabilities. However, because immaculate code and logic must be used, they put a great deal of responsibility on people who build them. Unavoidably, any logical or coding faults will be exploited by attackers. Even a cursory glance at the bitcoin news feeds will reveal how regularly this happens. I can't imagine how a central bank might alter a nation's currency to solve a smart contract issue.

If the intermediaries offered a complete and well-defined set of APIs for the wallet providers to utilize in order to deliver services to end users, we would have the foundation for innovative new goods and services without the problem of testing, certifying, and policing smart contracts. Given the frequency and severity of the smart contract errors we find on public blockchains, such APIs are very intriguing.

Summary

Blockchain technology has special benefits for financial systems and CBDC. Blockchain is perfect for meeting CBDC criteria because of features like auditability and immutability. Additionally, the blockchain-based CBDC model provides the benefit of regulation, which can lower costs and increase payment efficiency. Even though several central banks have previously said that they are developing a blockchain-based CBDC, the adoption of Blockchain is still up for debate.

All things considered, it appears that blockchains are neither required nor desirable for a retail digital currency, and since there is still plenty of time to investigate alternative architectures that are better suited to serving as an electronic fiat alternative, as claimed by the Bank of England, the Fed, the Bank of Japan, and others, retail CBDCs do not yet have a "burning platform" and will take time to reach the general public.

Finally, a number of central banks are anticipated to issue a retail CBDC over the next several years, according to the most recent BIS survey. However, the adoption of a retail CBDC raises questions about both the stability of the economy and the security of client information. These risk factors may be minimized, though, as demonstrated in the following two recent ECB papers: DLT and anonymity vouchers can be utilized to create digital payment anonymity, and the recommended Tier 2 CBDC system is well suited to ensuring monetary stability. Whether blockchain solutions will be leveraged in the near-future is still uncertain but with the advent of technology growth in this space, we're certain to see improvements and enhancements that may make the case for blockchain more compelling for central banks.

Citations:

1. https://philippsandner.medium.com/does-the-ecb-work-on-a-blockchain-based-digital-euro-65c393f34497
2. https://hbr.org/2021/10/what-if-central-banks-issued-digital-currency
3. https://www.thestatesman.com/business/how-blockchain-based-cbdc-and-crypto-are-different-1503128776.html
4. https://consensys.net/solutions/payments-and-money/cbdc/
5. https://www.bis.org/publ/bppdf/bispap125.pdf
6. https://www.bis.org/publ/arpdf/ar2022e3.htm
7. https://www.ledgerinsights.com/bank-of-korea-performance-cbdc-blockchain/
8. https://www.bankofengland.co.uk/speech/2022/november/jon-cunliffe-keynote-speech-and-panel-at-warwick-conference-on-defi-digital-currencies
9. https://www.forbes.com/sites/davidbirch/2022/08/03/when-the-cbdc-revolution-comes-it-wont-be-on-the-blockchain/?sh=61cbfa5183af