Blockchain as a technology to support CBDCs
Central Banks' digital currencies: what you need to know.
This article was written based on the book Bitcoin, CBDCs, Stablecoins e DeFi.
Recently, the Brazilian Federal Senate called on representatives of the Central Bank to better understand what is the Digital Real, the Central Bank's digital currency (CBDC).
Brazil is part of the group of countries that have already publicly assumed that they are developing research and intend to issue the Digital Real starting in 2022.
In today's article, after a brief introduction to Central Banks' digital currencies, the difference between CBDCs and cryptocurrencies, the types of CBDCs, we will cover which Central Banks are considering blockchain as a technology to support their CBDCs.
The various stages of development of CBDCs
Around the world, there are numerous projects in various stages of development, including Europe, Ukraine, and Uruguay.
Uruguay has already completed its pilot.
The Central Bank of the Bahamas has also gone through a pilot and has gone further, launching its national digital currency.
China, and the Central Bank of the Eastern Caribbean have launched pilots, which are at a very advanced stage. We will comment further on the Chinese CBDC, known as the Digital Yuan, at the end of this article, in a comparison with the Digital Dollar and the Digital Euro.
The BIS - Bank for International Settlements - in its 2020 annual report published a study where 80% of the Central Bank representatives stated that they are focused on working on CBDCs. And this percentage points to a quantitative increase over the previous figure raised in the BIS annual report of 2016/2017 when 65% of the representatives nodded that they had already started studies with CBDCs.
The fact is that the Central Banks' digital currencies are knocking on the door. This is a fact. But before we go any further, let's look at the difference between a CBDCs and a cryptocurrency.
CBDCs Vs Crypto currencies
Cryptocurrencies are not tied to any Economy or country; they are a new type of asset, digital and with global reach, secured by cryptographic algorithms and decentralized protocols running on an open source blockchain.
For the Central Bank of Brazil, for example, calls cryptocurrencies "virtual currencies" or "cryptocurrencies," and differentiates them from electronic currencies by giving them similar treatment to that adopted by the New York State Regulatory Framework.
For him, cryptocurrencies have their own form, i.e., they are a unit of account distinct from currencies issued by sovereign governments, and are not characterized as an electronic device or system for storage in reais. And analyzing its press releases and positions on the subject, one can see that the Brazilian monetary authority is accurate in its diagnosis, when it shows awareness and attention to the private nature of cryptocurrencies.
A Central Bank "digital currency," on the other hand, also called a CBDC - Central Bank Digital Currency - looks nothing like a cryptocurrency.
CBDCs have a central authority responsible for occurrences and problems, usually a monetary authority linked to a particular country, which regulates the state of transactions on the network.
The first CBDC: the Sand Dollar
The first monetary authority to issue a Central Bank Digital Currency - CBDC - was the Central Bank of The Bahamas on October 20, 2020. Called the Sand Dollar, the first CBDC deployed is a digital version of the Bahamian dollar, and is designed to bring more "inclusive access to regulated payments and other financial services”.
The first phase of the Bahamas' CBDC implementation envisions private sector participants, such as financial institutions and credit unions, preparing compliance checks for personal and institutional wallets to support the Sand Dollar.
The digital wallets have been configured to have protection with multi-factor authentication and will run on cell phones, serving 90% of the population with smartphones.
Here, it is worth mentioning that some advocate Venezuela's Petro as the first CBDC issued by a central bank.
Official motivations for a CBDC
One can see a fairly clear delineation between the motivations given by monetary authorities in emerging markets and developing economies and those in advanced economies.
Central banks in emerging markets and developing economies tend to focus on things like the digitalization of the economy and financial digitalization, reducing the cost of physical money, and reducing risk. For example, one of the reasons given by the Central Bank of Uruguay is that the financial structure ecosystem will leap forward with the issuance of a CBDC, in terms of digital offerings. That is, a CBDC will accelerate the modernization of commercial banks and other players in the Uruguayan financial market.
Already, Central Banks of more advanced economies such as Sweden and Canada, as well as China, to some extent, seek a CBDC to increase payment system competition. For more examples, see here.
CBDCs and the duel between privacy and transparency
Technically, it is possible to design CBDCs with various combinations of privacy versus transaction traceability.
And who will decide on the balance between privacy and transparency will be the Central Banks.
Here, a survey conducted by the ECB on the Digital Euro that pointed out where privacy featured prominently is worth noting. In the result of the survey, which had 8,221 responses, when faced with the choice of an offline solution for a privacy-oriented digital euro versus online with innovative, value-added services, 53% of European citizens prefer offline, another 34% seek a hybrid approach and only 13% want online only.
While each monetary authority is free to come to its own conclusions, one option that has been considered by Central Banks is to provide high privacy for small transactions by retail users, similar to cash today, while programming in high traceability for larger transactions, whether by individuals or businesses. This would allow the implementation of Know Your Client (KYC) / Anti Money Laudering (AML) procedures on these transactions.
Who will arrive first? The Digital Dollar or the Digital Yuan?
Jerome Powell recently surprised when in February 2021 he called the digital dollar "a high priority project for us," and stressed that "We are committed to solving the technological problems, and consulting broadly with the public and very transparently with all interested constituents on whether we should do that."
On the same day as this statement by Powell, the Federal Reserve published a paper exploring the preconditions for a retail central bank digital currency (CBDC) titled "Preconditions for a general-purpose central bank digital currency."
The US call to action coincides with China's announcement in early February of a significant partnership with the SWIFT international payment system, removing all doubt that Beijing intends to internationalize the digital yuan.
China at the same time concluded a free trade agreement with Mauritius, the first with an African state, in a deal that aims to create a digital financial testing ground. According to a publication in the World Economic Forum, as China develops its digital currency plans, it may be that Mauritius will lead the way in this area for Africa.
All of this development came after Beijing took advantage of Chinese New Year celebrations on February 12 to roll out three large-scale pilot projects to distribute Digital Yuan worth approximately $1.5 million in "bundles" of about $30 in value each.
Along those lines, in the last week of February 2021, China expanded its digital currency testing program to the city of Chengdu, the country's fifth most populous city.
Although there is no official timeline for the launch of China's sovereign digital currency, it seems that the intention of the Chinese authorities is to implement the digital yuan before the 2022 Winter Olympics in Beijing.
In this context, if the U.S. is slow to establish itself in the financial technology innovation race, against a backdrop of the weakening global dominance of the dollar, the benefits for Beijing would be considerable.
Euro Digital on Blockchain
The Governing Council of the European Central Bank (ECB) has decided to launch the research phase of a prototype Digital Euro project within two years.
This research phase will last 24 months and will aim to address key issues related to design and distribution. A digital euro should be able to meet the needs of Europeans, while helping to prevent illicit activities and avoiding any undesirable impact on financial stability and monetary policy. This will not prejudice any future decision on the possible issuance of a digital euro, which will only come later. In any case, a digital euro would complement cash, not replace it.
Such a decision by the European monetary authority came after the publication of recent research commissioned by European regulators that attested to the viability of blockchain as a supporting technology for the Digital Euro.
According to the research, both the Euro system's Instant Payment Settlement (TIPS) and blockchain have been shown to be capable of processing more than 40,000 transactions per second. The experiments also suggested architectures that combine centralized and decentralized elements are possible.
Also, among the professionals who provided additional comments on their choice of innovative features, one in five think that innovation can be provided without relying on intermediaries, as is the case with a decentralized model supported by blockchain technology.
Also, for one in ten respondents blockchain technology was seen as the most obvious solution to ensure compliance with know your customer (KYC) and AML / CFT rules, while providing a certain level of privacy.
Finally, the ECB survey concludes that it found no major technical obstacles in the four test areas, namely: 1) the euro in blockchain; 2 -privacy and anti-money laundering; 3) limits on the circulating Digital Euro; 4 - end-user access while not connected to the Internet. Translated with www.DeepL.com/Translator (free version)
And in Brazil? What will the 'Digital Real' look like?
Fabio Araujo, responsible for the Real Digital project within BACEN, recently stated in a Webinar that in 2022 Brazil will start the proof of concept (PoC) of the Real Digital, and one of the possibilities to be tested will be the feasibility of using blockchain.
Araujo points out that the Central Bank believes that there are plenty of gains for the national financial system by using a blockchain solution for a CBDC, highlighting, however, that it is still necessary to exhaust all the possibilities of the Pix before exploring a new platform.
As for how the Digital Real will work, in a presentation organized by IG Portal, Fábio Araújo ruled out any possibility of following the steps of El Salvador or nations like Argentina and adopting Bitcoin as legal tender or as a financial alternative in the country.
It's hard to choose...
Most people, when they hear about CBDC, immediately think of a kind of digital bearer instrument for Central Bank money.
Many imagine that it's just taking the paper notes, transforming them into the format of a "token" - which is the digital representation of something -, and issuing that token.
But the truth is that there are a variety of different options and models of approach that Central Banks can implement with respect to a CBDC. There are very specific definitions that can be applied to CBDCs, and many articles have been written about these many different options in terms of implementing a Central Bank digital currency.
There are account-based models, token-based models, value-based models, and also, hybrid approaches.
In addition to these models approach and implementation, we also have a variety of technologies that can be the basis of a CBDC, and at the same time, it is not very clear what role various intermediaries that exist in the financial market play.
What role would they play in the future with a central bank digital currency? Also, what are the different options with regard to wholesale and retail, and how would cross-border applications of CBDCs play out? What are the different dimensions of CBDC and where might interoperability and standardization be possible?
In wholesale markets, there is clear interest in a CBDC for securities settlement, for example in commercial bank transactions, as well as great potential in the cross-border space, given the various frictions and frictions in these fields. What would be the role of a central bank digital currency in these environments?
We will probably only get the answers to these questions as more and more projects move from the pilot phase, to large-scale applications.
Did you enjoy the article? Have you considered the impacts of a CBDC in terms of transaction privacy? Check out more in-depth aspects of this subject in the Bitcoin, CBDC, Defi e Stablecoins book.
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