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Blockchain for Business Series:

Understanding Business and Technological Design Imperatives of Central Bank Digital Currency (CBDC)


By Nitin Gaur - Director, IBM WW Digital Asset Labs at IBM


This article originally appeared on LinkedIn, published February 28, 2020.

Image Credit: nanopay

I.             Introduction: What is Central Bank Digital Currency (CBDC) and Why Is It Important?


In this post we plan to expend some time and energy in understanding Central Bank Digital Currency or CBDC. While the notion of “Central Banks” implies centralized control and governance structure the term itself may be against the doctrine of decentralization which lays the foundation of the cryptocurrency framework. We will attempt to focus on the distributed or, one can say, a quasi-decentralized model that aims to provide a structure that not only preserves the supervisory role of the Central Bank, but also conforms to various regulatory, compliance, and monetary frameworks of a central banking as a system. The focus of this post to devise a model that factors into a payment modernization agenda while advocating for the right fit in blockchain technology design is driven by industry acumen as well as business design and economic imperatives.


CBDC has gained traction and a lot of attention primarily due to the rise of cryptocurrency and alternative payment instruments, but also CBDC is an integral part of payment systems and payment infrastructure modernization agendas. In an already complex and fragmented payment ecosystem, CBDC conversation adds to the payment modernization agenda with its own set of complexity and promise as an ultimate solution to the store of a value, fungible unit, and a settlement instrument.


While many CBDC conversations are addressing a domestic payment agenda, the implication and design imperatives extend beyond just the domestic payment systems. The solution design consideration includes (but is not limited to): cross-border payments, high value payments, securities settlements, and more. We also think it is important to compartmentalize various payment infrastructures and impacts of CBDC on them from the core conceptual elements of CBDC itself. CBDC in current parlance is broadly categorized into wholesale, which is Real Time Gross Settlements or RTGS systems which are primarily for interbank settlement and retail. These address the domestic payment systems reaching to the edges of the domestic and global economy with cash as an ultimate store of value and a fungible settlement instrument. While we may in this short post not be able to cover all aspects of CBDC, we will attempt to highlight the salient features, business, and technology considerations and structure and design criteria. Let’s explore below.


CBDCs can be defined as digitalized instruments issued by the Central Bank for payments and settlements. They can be described simply as an electronic extension of a form of cash. It is different from money held in Central Bank accounts, as the public may be able to access the CBDC, which remains a liability on the Central Bank balance sheet. 2.


In my post on Forging ahead with Blockchain, I cited tokenized fiat as one of the essential pillars needed for the industry to realize the promise of blockchain in value transfer. Essentially, if blockchain is a network that facilitates value transfer without intermediaries and resulting costs and friction, many of these value transfers will rely on the duality of a transaction—i.e., an exchange in some sort of a crypto asset or cash—i.e., fiat. Now, we all understand the challenges of money movement domestically and cross-border. It is an industry laden with heavy regulatory oversight, a series of intermediaries, and internal systems and processes chipping away at value at every stage of transfer by excessive fees and unrealized potential of locked capital. But cash or fiat provides ultimate fungibility to many products and services, be it natively digital (music, movies, gates, etc.) or tokenized assets (real estate, gold, silver, etc.), are essentially claims or IOUs of sorts. Cash or fiat also provides a definite unit of measurement of value to many products and services. Fiat or cash becomes essential to the movement of value as a fungible unit in a system, like our present economic and financial system. Fiat or cash in any system is a part of a Central Bank Agenda in that every country has a Central Bank that governs its monetary policy (money supply, interest rates, etc.), and it alone has the jurisdictional authority to issue fiat.


While many Central Banks in many countries are experimenting with blockchain as a technology platform to host applications such as a crypto assets, digital fiat, or Central Bank (issued) Digital Currency (CBDC) both at wholesale (RTGS systems) and retail (distribution through retail banks), as these experiments mature the Central Banks’ points of view at every stage of maturity, in the absence of a Central Bank issuing digital fiat, stablecoins fill in the gaps of addressing transaction finality by addressing settlements with fungible units. So, while there is an enormous amount of business complexity, costs structures, and governance challenges (to be discussed later), stablecoins provide a key service to a digital transaction network promise of blockchain technology. I also view stablecoins as an interim step to CBDC retail—i.e., the network is future-proofing itself with stablecoins today and will be ready for the CBDC of tomorrow. There will be more on this topic as we dig deeper.



Source: BIS report on Central Bank Digital Currencies. Based on Bech and Garratt (2017)



II.            Central Bank Digital Currency (CBDC): Business and Economic Imperative


Fueled by the emergence of cryptocurrencies and crypto-assets such as stablecoins as alternative payment and settlement instruments, backed by various collateralization models discussed in this post, CBDC has become a global priority for many Central Banks. Motivation may range from gaining and retaining sovereign control on the money supply, including volume and velocity of distribution, but must also address the payment system modernization agenda domestic, cross-border, or even regional influence.


Blockchain as a trusted transaction system has enabled rethinking possibilities to not only connect global disparate transaction systems, but also by adhering to blockchain fundamentals of trade, trust, and ownership. This facilitates a systemic vehicle to transfer value enabling a modernized system to not only address domestic transfers but to also have the systemic ability to connect and converge. This notion of convergence has the potential to adapt to any standardized, both technologically and adhering, global compliance apparatus so as to move value. This core idea of moving value which today bubbles up to Central Banks systems would be systemic, seamless, and real-time. The various systemic considerations for CBDC system design may include the following. While not an exhaustive list, these systems represent majority of payment systems that interface with Central Banks ledger systems:


a)    Real-Time Gross Settlement or RTGS


b)   Cross Border Payments


c)    High Value Payments


d)   Domestic Payment System and Infrastructure


e)   Payment Modernization Agenda


The particular design of a CBDC--chiefly whether or not it bears interest--would determine its effectiveness as a monetary policy instrument and any consequential financial stability implications. Practically, the operation of a CBDC is likely to rely on some sort of public-private partnership. Central banks could outsource the distribution of the CBDC to private financial institutions, which could also be involved in the onboarding of users. Difficult questions of interoperability, regulatory demands, and cross-border use must also be answered. 1


III.         Central Bank Digital Currency (CBDC) : Technology consideration


As discussed, earlier CBDC conversations add to the payment modernization agenda with its own set of complexity and promise as an ultimate solution to store of value, fungible unit and a settlement instrument. The technical design of such a system can embark on novelty and complexity, especially as to integration around existing systems. The technology consideration can be fairly complex. It depends on the design of CBDC wholesale, retail, or a hybrid model that extends the wholesale, i.e. RTGS systems to retail or other adjunct systems such as cross-border and high value transfer system. We envision that linkage between CBDC wholesale design and CBDC retail design as intricate and inseparable. An open and modular technology design is not just an imperative, but essential to holistically address the technology requirement needed to address the business imperative and payment modernization agenda. In this section we aim to address the features and core design elements of such an extensible system.


Features Enabled by Technology:


Real-time settlement and liquidity optimization


•      Reduce time and uncertainty


•      Better liquidity positioning and buffering


Infrastructure Resiliency


•      Eliminate centralized dependencies


•      Better predictability and traceability


Central Banks supervisory role


•      Liquidity resolution


•      Audit control


Core Technical Design Elements:


Payments Digitization and Systems Modernization


The core RTGS capabilities of Central Bank Digital Currency (CBDC) includes systemic modernization with high resilience and reduced dependency of system maintenance, which is the Central Bank’s system management function today. At the same time, the technical design elements should include the supervisory function such as resolving liquidity gridlocks and liquidity injection to member banks and institutions while preserving privacy and confidentiality. Therefore, the preservation of the supervisory function of Central Banks is imperative.


Resiliency Achieved Through Decentralized Processing and Systemic Overhaul


The system should extend resilient infrastructure with no single point of failure. This can be achieved via distributed (or in some cases decentralized) system design principles. The idea is to ensure the system designs are in line with the modern-day digital commerce systems aiming to address the real time payment requirement with increased velocity. The technology design needs to consider not only the various netting obligations, but must also preserve the bi-lateral and, in some cases, multilateral transactions between various banks and institutions. As discussed above, the technology design should preserve the supervisory function of Central Banks.


Efficient Handling of Payment Queue and Liquidity Optimization


As discussed before, technical design elements should include the supervisory function such as resolving liquidity gridlocks and liquidity injection to member banks and institutions while preserving privacy and confidentiality. Some of these are implemented with efficient use of uniform queueing systems with prioritization, holding, and cancellation functions. The banks must be given greater control over payment prioritization and liquidity optimization while queuing certain payment and processing others to maintain consistent payment policy. This would include scrutiny that may be needed based on jurisdiction, payment size, and other workflow requirements.


Maintaining Transactions Privacy and Confidentiality


One of the most important technical design imperatives is to ensure that only relevant parties in bi-lateral and or multilateral transactions will have visibility to transaction details. While central banks as a supervisory entity may have visibility of all systemic transaction details, it is vital to protect liquidity positions and other transaction processing details such as a payment queue and liquidity optimization tools employed by banks and financial institutions. Technology design consideration includes (but is not limited to) visibility of the queuing flows during gridlock resolution and liquidity injection during deadlock resolution.


Finality of Settlement Using Digital Settlement Instruments


One of the most significant technical design considerations of introducing a Digital Asset as a settlement instrument is a final and irrevocable settlement. The use of Digital Asset (DA) or even Digital Obligation (DO) should include payment instructions and settlement with deterministic finality. With the emergence of instruments like Stablecoins**, usually collateralized IOU, or Digital Assets, storing value on a chain will create the notion of settlement finality. The use of DA as a settlement instrument vs the use of DO indicating settlement with off-chain/network flows can often muddle the differentiation between messaging and settlement. The technology design should factor in this difference.(**Note: Stablecoin is a Digital Asset that is collateralized by a price stable asset (such as Euro, USD) issued, collateralized and guaranteed by a regulated Financial Institution, for purposes of transaction processing and settlement on a blockchain powered business network).


Enhancing Systemic Liquidity Optimization with Central Bank Intervention


One important aspect of technology design which is driven by business requirements is to devise a model that systemically implements a netting engine and provides a facility to devise a contextual gridlock resolution algorithm to maximize liquidity efficiency and optimization. Since this is a CBDC supervisory function, appropriate and fractional visibility of the business function should be available for all member banks and institutions.


Cybersecurity Risk and Infrastructure


Since the current Blockchain and CBDC and subsequent payment market infrastructure is dependent on existing networking and internet protocols (TCP/IP), the Cybersecurity risk of the infrastructure poses a significant threat. Cybersecurity risks are one of the most significant technology infrastructure considerations, given that the current distributed (DLT) or Decentralized (Blockchain) Infrastructure is built on the same foundation of the Internet protocols. This assumption also implies that the infrastructure also inherits the advantages (maturity and skills) and vulnerabilities. In addition to the issues around Digital Assets and obligations being used as a settlement instrument, the implication of risk analysis and risk modeling is of much higher profile due to the impact of infrastructure vulnerability exploits and breaches due to the criticality of market and payment infrastructure. This topic warrants its own dedicated discussion.


Digital Identity Design


In plain speak, we cannot assign digital (under the guise of as crypto assets or CBDC) to driver’s licenses or passports as proof of identity; rather, we need to rely (and perhaps devise) a Digital Identity infrastructure. While a Digital Identity is essential to any blockchain network (be it institutional or individual), it is an essential requirement for CBDC for both wholesale (institutions) and retail (individuals). Almost all CBDC projects either have parallel Digital Identity projects or have a dependency on a Digital Identity utility. Be it CBDC wholesale, i.e. interbank settlement, or CBDC retail, the technology design needs to consider the assignment and mapping of a digital asset to a digital identity. This would be true be it for an institution or an individual. We have discussed some elements of Digital Identity in this post.


Digital Wallets – Account Management


Digital Wallets not only represent identity (KYC/AML elements) but also are a vehicle to participate in a transaction network, for purposes of transaction processing, account management, identity, and establishing the tenets of ownership, trade and transfer. The technology consideration with respect to Digital Wallets should be in the context of an account management and a vehicle to enforce various compliance and governance controls. The notion of a Wallet comes more from an element of a holding account and assigning ownership elements to a digital assets and digital obligations but also mapping the Wallet(s) to Digital Identities creating an abstraction between identities and various classification of accounts they represent. We have discussed some of the elements of AML and KYC in this post.


IV.         Central Bank Digital Currency (CBDC): Structure and Design


CBDC wholesale and CBDC retail present an interesting dichotomy of solution design, which ranges from institutional participation to the edges of economy with solving for the last mile i.e. retail payments for basics such as food and utilities. While today the wholesale and retail system are linked with intricate systems, CBDC has the potential to simplify not only the flow as value through the economic system but also to provide a natural integration by collapsing the two systems into a single system that facilitates movement of value, seamlessly across the economic systems. Furthermore, by extending the seamless movement of value--cross border, which is actually not only a big deal but also an end goal--it should facilitate the connecting of global payment systems to move value at scale, lower cost, and with no friction.


A WHOLESALE Central Bank Digital Currency may lead to significant improvements in efficiency, speed and resilience, as well as lower the cost and complexity associated with existing payments systems. The current system is susceptible to technical faults and errors. The layering of different technologies on top of the real-time gross settlement system adds to this complexity. A system based on distributed ledger technology can reduce the number of steps in the process. 2


It is a central task of government to provide adequate payment systems as they are uniquely public goods. Means of payment in contemporary economies are based on trust, are fundamentally non-rivalrous and produce benefits enjoyed simultaneously by all citizens. Facilitating and securing the operation of payments systems is part of a central bank’s mandate, for good reason: a smoothly functioning payments system is critically important to the performance of an economy. Payments connect buyers and sellers, borrowers, and lenders. The ability to make payments securely and irrevocably is fundamental to sustaining confidence in the financial system. The nature and form of the methods consumers use to transact have changed significantly, requiring Central Banks to remain alert to shifts in payments habits.1


V.           Conclusion


Fiat or cash becomes essential to the movement of value as a fungible unit in a system, like our present economic and financial system. Fiat or cash in any system is a Central Bank agenda item in that every country has a Central Bank that governs its monetary policy (money supply, interest rates, etc.), and it alone has the jurisdictional authority to issue fiat. The CBDC has gained traction and a lot of attention primarily due to the rise of cryptocurrency and alternative payment instruments, but also CBDCs are an integral part of payment systems and payment infrastructure modernization agendas. In an already complex and fragmented payment ecosystem, the CBDC conversation adds to the payment modernization agenda with its own set of complexity and promise as an ultimate solution to the store of value, fungible units, and as a settlement instrument. CBDC in current parlance is broadly categorized into wholesale, which is real-time gross settlement or RTGS systems which are primarily for interbank settlement. This goes along with retail which addresses the domestic payment systems reaching to the edges of the domestic and global economy with cash as an ultimate store of value and a fungible settlement instrument.


While today the wholesale and retail system are linked with intricate systems, CBDC has the potential to simplify not only the flow as value through the economic system, but to also provide a natural integration by collapsing the two systems into a single system that facilitates movement of value. This would move seamlessly across the economic systems and, furthermore, would extend the seamless movement of value--cross border, which actually is not only a big deal but also the end goal--connecting global payment systems to move value at scale, lower cost, and with no friction. Blockchain as a trusted transaction system has enabled rethinking possibilities to not only connect global disparate transaction systems, but while also adhering to blockchain fundamentals of trade, trust, and ownership thereby facilitating a systemic vehicle to transfer value. This would allow a modernized system to not only address domestic transfers, but also have the systemic ability to connect and converge. This notion of convergence has the potential to adapt to any standardized, both technologically and adhering global compliance apparatus, and move value. This core idea of moving value which today bubbles up to Central Banks systems, would be systemic, seamless, and real-time.


Interesting readings and references:


  1. https://www.omfif.org/wp-content/uploads/2019/11/Retail-CBDCs-The-next-payments-frontier.pdf

  2. https://www.omfif.org/ibm/

  3. https://www.weforum.org/whitepapers/central-bank-digital-currency-policy-maker-toolkit

  4. https://cointelegraph.com/news/wef-report-40-central-banks-are-considering-digital-currencies-blockchain-tech

  5. https://lists.w3.org/Archives/Public/public-payments-wg/2016Jul/att-0054/sc7n673_Presentation_of_the_report_of_the_study_group_on_digital_currenc....pdf


Authors: Nitin Gaur and Sridhar Narayanan

Nitin Gaur - Director IBM Digital Assets Lab IBM
Sridhar (Sri) Narayanan - Executive Architect IBM Financial

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In November 2019, Nitin Gaur was a speaker at our Austin Chapter. Nitin discussed Digital Assets for the Enterprise. The podcast from that event is available here.







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