Long reads

CBDC: Powering the future of money in the digital era

Rajashekara Maiya

Rajashekara Maiya

VP, Infosys

This is an excerpt from Finextra’s report, 'The Future of Digital Banking North America 2023'.

The last couple of years have witnessed a revolution in digital currencies globally. Rapid advancements in technology and decline in cash transactions, particularly through the pandemic, have further fuelled their rise. A report by UNCTAD in 2021 indicated significant growth in the usage of digital currencies across several countries. 12.7% of the population in Ukraine owned digital currencies, 11.3% in the Russian Federation, 10.3% in Venezuela, 9.4% in Singapore, 7.3% in India, and many more.

Digital currency comes in various forms - virtual currencies (currency alternatives), cryptocurrencies, stablecoins, and central bank issued digital currencies (CBDCs). Non-fungible tokens (NFTs) and credit cards are also considered stores of value in digital form.

CBDCs and their potential benefits

The CBDC is a digital form of a country’s fiat currency; a form of currency that is not backed by a physical commodity such as gold or silver, but by the government that issued it. It is considered to be legal tender, and offers an equivalent claim as the physical currency on the country’s central bank.

Countries worldwide are increasingly moving towards alternatives to physical currency. Many are in the process of implementing or initiating pilot projects to issue their own CBDCs. The objective is to issue electronic money, backed by the full faith and credit of the government, equivalent to the country’s fiat currency, thus enabling faster transactions.

A 2021 survey by the Bank of International Settlements (BIS) revealed that 86% of central banks globally were actively researching the potential for CBDCs, while 60% were experimenting with the technology and 14% were deploying pilot projects.

Essentially, a CBDC would encompass most of the use cases serviced today by physical currency, including person-to-person transfers, person-to-merchant and merchant-to-person payments, merchant-to-merchant transactions, government-to-person transfers and government-to-government transactions.

Moreover, CBDCs also present greater opportunities not adequately addressed by physical currencies. This extends to:

  • Minimising the cost of currency
  • Substantially reducing cash-based counterfeit currencies
  • Decreasing the effect of a shadow economy
  • Ensuring financial inclusion
  • Making cross-border transactions faster and efficient

As the liability of CBDCs lies with the central bank, payments made can be settled immediately. This renders CBDCs an ideal payment mechanism for smart contracts. Foreign exchange contracts using smart contracts can reduce settlement costs and also cross-currency settlement risks. A joint research report by Oliver Wyman and J.P. Morgan indicates that a full-scale multi-central bank digital currency (mCBDC) network that facilitates roundthe-clock, cross-border payments in real time can potentially save global corporates up to $100 billion in transaction costs annually.

Seven potential design constructs to deploy for CBDC

1. Centralised ledger vs. Distributed ledger

The centralised approach is used for settlement of physical currencies and is the easiest one to build a CBDC ecosystem on. Centralised ledgers can lead to bottlenecks and are vulnerable to cyber-attacks. The distributed ledger is much less vulnerable to unauthorised or malicious tampering. With this approach, the nature of the financial industry encourages consideration of permissioned ledgers, passing on some amount of control to the regulator while still offering its advantages.

2. Account-based vs. Token-based

In account-based CBDC, ownership is linked to an identity such as an account, and transactions are authorised based on identification. This approach is simple and easy to implement on a mass scale. With token-based CBDC, transaction authorisation happens solely on the basis of a digital signature, which may provide advanced security. Another approach is a combination where ownership of the CBDC can be token-based and consumers can be account-based.

3. Interest-bearing vs. Non-interest-bearing

As in the case of physical currency, interest disbursal by the bank for holding digital currency may be similar but with additional considerations. With an account-based approach, depositing digital currency with a holding institution (such as a commercial bank) may entail an interest pay-out. With a purely token-based approach, the currency cannot be made interest-bearing since it resides in the consumer’s wallet. With a combined approach, CBDC deposited in an account with an intermediary bank may earn interest, while CBDC residing as tokens in the consumer’s wallet will not earn interest.

4. Direct vs. Indirect vs. Hybrid

In the direct CBDC construct, the central bank maintains a ledger of all transactions and carries out retail transactions, given that CBDC is a direct claim on the central bank.

The indirect or synthetic CBDC approach entails a payment system operated by intermediaries that mirror narrow payment banks. Consumers have claims on these intermediaries who operate retail payments. They need to completely honour all liabilities to retail clients with claims on the central bank.

In a hybrid CBDC approach, intermediaries maintain the accounts and utilise money deposited for various purposes, while the CBDC remains a direct claim on the central bank. The central bank also maintains a central ledger of all transactions and operates a backup technical infrastructure allowing it to restart the payment system if intermediaries fail. With this approach, central banks can disseminate CBDC to commercial banks like they do with cash presently, while commercial banks would distribute these to individuals and businesses by setting up and managing digital wallets.

Another advantage of this model is that it minimises disruption to the prevalent banking system since it can leverage existing processes such as customer onboarding, identity checking and AML monitoring by commercial banks.

5. Privacy and transparency

Currently, for transactions involving commercial bank accounts, details of the customer’s identity and transactions are visible to the account-holding institution and participants involved. For cash currency-based transactions, details of currency movements are not visible to either the central bank or the intermediary financial institutions involved.

In the CBDC context, with a distributed ledger, the account and transaction data, encrypted and digitally signed, may be shared with multiple intermediaries participating in the financial system. In addition, the movement of token-based CBDC from one to another customer’s digital wallet may provide traceability for individual currency tokens.

The issue of privacy has been addressed to some extent with PSD2 and open banking. GDPR protects the confidentiality of identity and sensitive information. These two complementary and balanced regulations can also be extended to address CBDCs.

6. Digital identity verification & authorisation

Another aspect to consider from a regulatory compliance perspective is digital verification of the customer’s identity. While verification through various KYC processes is applicable for CBDC holders too, newer approaches for creating digital identity authentication are available now. These are based on a permissioned distributed ledger technology, supported on the blockchain platform. One example of implementing digital identity verification and authorisation is the Finacle Blockchain Identity Solution.

For transaction authorisations, either hardware-based or software-based authorisation tokens, certificates or OTPs (one-time passwords) would need to be implemented for customers to be able to digitally sign transactions.

7. Cloud deployment of the ledger

Across all design constructs for CBDCs, especially with options involving availability of a centralised full-copy ledger of transactional movements with the central bank, or with permissioned distributed full-copy ledgers with multiple intermediary financial institutions, the size of the ledger would grow at a tremendous pace. Leveraging cloud infrastructure to deploy the account management and ledger platforms would be a good way to ensure scalability, high performance, and support possible consensus-mechanism-based reconciliations.

CBDCs: Preparing for the future of money

If rightly implemented, CBDCs have the potential to become the next strategic change driving the banking and payments industry globally. Their potential to enhance economies, reduce transaction time and costs, help drive financial inclusion and simplify cross-border transactions are leading governments and central banks worldwide to keenly explore the introduction of CBDCs.

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