CBDC's, Simplified!

CBDC, Central bank digital currency is a high-security digital instrument; unlike banknotes printed on the paper it exists only in a digital form and used as means of electronic payment denominated in the sovereign unit of account, which can serve both as medium of exchange and must store value equivalent to the national currency of the respective central bank. In a recent news SWIFT which is the global standard for payment and securities trade transactions is advancing cross-border payments involving digital currencies, focusing on interlinking between various CBDCs being developed around the world.

CBDCs are also known as Digital fiat currencies or digital base money since other forms of virtual monies may get derived or baselined to the CBDCs, Digital currency is thus an associated term, which implies that the electronic representation of money is denominated in a specific unit of account and deep rooted to the sovereign currency. There are various characteristics for CBDC design, such as..

• Access - Widely vs Restricted use
• Degree of Anonymity ranging from complete to none
• Operational Availability ranging from current opening hours to 24 hours a day and seven days a week etc
• Interest bearing characteristics few instruments may yield the interest based on the usecase

To better understand the concept of CBDC, it is essential to know the difference between physical cash transactions and electronic tokens of stored value. Further, the digital currencies are either token-based, or resides in balances in reserve accounts and most forms of commercial bank money are account-based and transacted between accounts thus inherits trust by default since the accounts are known and operated by known entities of respective banks. A key distinction between token- or account-based money is the form of verification needed when it is exchanged while in transaction. The Token-based money (or payment systems) rely critically on the ability of the payee to verify the validity of this payment object. In cash transactions the risk could be counterfeiting, while in the digital for the worry is whether this token or “coin” is genuine or not (electronic counterfeiting) and whether it has already been spent and ceased its value it carried.

CBDCs differ from E-Money as it also exists as a digital representation of value denominated in a sovereign currency distributed by a private entity, which is subject to government regulation where the record of funds is stored on an electronic payment system such as prepaid cards, mobile phones, or on electronic ledgers of the respective e-money issuer. Typically, when e-money issuers are not banks, they are required to retain in central-bank money the corresponding amount of the issued e-money in order to guarantee the value of the digital representation issued to end users. There are four key properties of any transaction, there is an issuer (typically a central bank); the form (digital or physical); its accessibility (widely open or restricted); and the underlying technology (token- or account-based etc.)

CBDCs are also fundamentally different from privately issued digital currencies such as stable coins, which are a liability of private entities that seek to maintain stability in their price and are another form of cryptocurrency designed typically through being reserved, backed, or pegged to an underlying asset such as a commodity or currency, or through algorithmic mechanisms to its referenced asset. On the other hand Crypto-assets as they exist are not issued by a central bank, can be highly volatile, and are not widely used or accepted for payments as yet. We must understand that the technologies or wider “ecosystem” in which a CBDC operates, including the supporting infrastructure that allows CBDC balances to be managed and payments made or the fundamental technologies used to operate are two sides of the same coin but not one and the same.

Benefits

CBDCs are making way forward with internal studies and tests by governments and central banks in order to assess, acknowledge and augment positive implications it contributes to financial inclusion, economic growth, technology innovation and increased transaction efficiencies.

CBDC design options ..

The Design features of CBDCs determine how it may serve as a means of payment and a stores of value. These choices will have implications for payments, monetary policy and financial stability. These features are tightly linked with the CBDC propositions and thus help define the operating aspects and impact thereof.

• Availability - CBDCs could be available 24 hours a day and seven days a week or only during certain specified times of the payment systems it represents. CBDC could be available permanently or for a limited duration, for example it could be created, issued and redeemed on an intraday basis etc.
• Anonymity - Token-based CBDC, in principle can be designed to provide different degrees of anonymity in a way that is similar to private digital tokens. A key decision for society is the degree of anonymity vis-à-vis the central bank, balancing, among other things, concerns relating to financing of terrorism, money laundering and privacy of the transacting entity.
• Transfer mechanism - The transfer of cash is conducted on a peer-to-peer basis, while central bank deposits are transferred through the central bank network, which acts as an intermediary. CBDC may be transferred either on a peer-to-peer basis or through an intermediary, which could be the central bank, a commercial bank or a third-party participant via electronic means.
• Interest-bearing - Like other forms of digital central bank liabilities, it is technically feasible to pay interest (positive or negative) on both token- and account-based CBDCs. The interest rate on CBDC can be set equal to an existing policy rate or be set at a different level to either encourage or discourage demand for CBDC.
• Caps or Limits - Different forms of quantitative limits or caps on the use or holdings of CBDC are often mentioned as a way of controlling potentially undesirable implications or to steer usage in a certain direction.

The different combinations of such features mean that there are many opportunities or implementation of potential CBDC usecases or variants. The introduction of a general purpose or a wholesale CBDC could bring a number of potential benefits to payment, clearing and settlement systems, but it could also pose several risks and challenges. In deciding the usecases for CBDCs, central banks will always compare them with existing or enhanced payment, clearing and settlement solutions and technologies to enhance convenience, increase safety and improved resilience.

CBDC Payments Architecture

In line with the central banks mandate to provide a resilient and universally accepted means of payment, CBDCs use case deployments must support direct and indirect modes of payments yet fully backed by the central bank providing fair play to private sector banks who in turn would act as intermediates for the CBDC implementation managing  the operational dimension and effectiveness of the payment system managing customer-facing real-time payments and allied processes such as clearing, onboarding / know-your-customer and ongoing due diligence, dispute resolution and related front end services.

The illustration showcases three scenarios for direct and indirect channels of CBDC implementations, in the direct method central bank directly makes the payments and KYC processes for the retail customers, whereas in the indirect method central bank operated fully supported wholesale payments of CBDCs for private intermediates thereof and remains resilient, accessible and responsible for implementing stringent governance and control to provide cash-like safety, convenience and user privacy for all peer-to-peer CBDC payments.

Central bank of the future – Digital Banking 2.0

Central banks have moved beyond conceptual discussions on CBDCs and are now in the phase of large scale experimentation with acceptance and familiarizing themselves with the bits and bytes of digital money alongside the emerging technologies as enablers. Rolling up their sleeves on policies, processes and consultations depending upon different use cases since all economies, circumstances needs and legal frameworks are not the same. In few cases the motivation levers could be path to financial inclusion wherein geography can be an obstacle to physical banking, on the other hand it could serve as an essential backup in the event that other payment instruments fail due to unforeseen events or natural disasters. The history of money is getting disrupted with technology yet attempting to strike a balance on the traditional monetary and financial systems.

Distributed ledger technology (DLT), the best known of which is blockchain, has in recent years emerged as a promising alternative to technologies that are based on centralized ledgers. Central banks are contemplating these technologies cautiously as DLT is still developing, and its capacity and suitability are being explored. The World Economic Forum in its report of CBDC Technology Considerations highlights definitive goals for CBDC and allied technology considerations for each goal towards technical governance that includes consideration of CBDC network and infrastructure management, data hosting, privileges of law enforcement and Safe and reliable custody as the critical considerations.

Cybersecurity is listed as one of the main concerns regarding CBDC since there are many actors with different roles and the incentives for malicious entities to attack and impact on CBDC systems can be significant as payment services are common targets for cyberattacks. Key factors are..

• Credential theft and loss - Access credentials for CBDC may come in different forms based the implementation. They could be given in the form of a passphrase that could be easily communicated even on paper, or they could come in the form of a hardware token which stores the private keys. Regardless of the form in which access credentials are provided, the threat of theft and loss of such credentials will be significant and the impact of credential theft and loss could be extremely damaging to an individual’s or entity’s savings held in CBDC, and it could also damage the central bank’s reputation.
• Privileged user roles – another concern of CBDC users is that government institutions, law enforcement and other entities may have roles which allow privileged actions, such as the freezing or withdrawal of funds in CBDC accounts without the user’s consent, such capabilities could be in line with today’s compliance requirements in regulated payment systems and may be a functional requirement of a CBDC as well, the risk of misuse or a compromise in such role or access could lead to the threat of malicious insiders abusing the CBDC system and warrants a cybersecurity risk management plan to cover such privileges.
• Denial of service – DDos attack or even threat of malicious CBDC end-users issuing too many transactions simultaneously is an important cyberrisk, for example with very large number of CBDC users (possibly controlled by the same organization) were to issue transactions simultaneously, the CBDC system could overload and stop serving other legitimate users, potentially losing benign transactions. Another threat which could lead to such a denial of service is a natural or technological calamity (e.g. flood, fire, power-outage etc.) close to the infrastructure on which the CBDC systems are running or experience loss of connectivity for larger part of the distributed CBDC network.
• Double spending or Digital counterfeiting - In case of CBDC end-users trying to spend their digital tokens/currencies/funds from their wallets in multiple places or cross border networks, constituting a form of digital counterfeiting or even trying double spending as incase of offline CBDC capability. Anonymity in CBDC accounts aggravates double spend risk in offline payments, as the central bank or authorities may have greater difficulty identifying the attackers or blacklisting wallets that are used on a one-time or ephemeral basis.
• Technology Advancement – it also cited as the risk, the implementation of the CBDC system using a DLT- or non DLT-based solution involves cryptographic primitives for protecting the confidentiality and integrity of the data being stored and transmitted.  Use of emerging technologies such as AI/ML on Quantum computing may be able to break current cryptography techniques without detection and could compromise major data encryption methodologies widely used today for sure.

Cybersecurity, along with technical resilience and robust governance framework, policies and legislations are the most important elements of CBDC design. Failure to implement a robust cyber security strategy and consider the risks introduced above could compromise user privacy, data integrity and security of funds being transacted and may severely impact success of the CBDC adoption.

In Summary, IMF in this paper aptly mentions that if the CBDCs are designed prudently, they can potentially offer more resilience, more safety, greater availability, and lower costs than private forms of digital money.

CBDCs are becoming reality yet the robustness of possible CBDC technologies must ensure robust risk management framework as an essential component in design, adoption and enablement towards smooth functioning of an economy. The fundamental requirements such as  security, integrity, scalability and resilience are core to the very principle of digital financial inclusion agenda and impacts digital sovereignty of any country demanding robust operational risk management and governance. What say?

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May 2022. Compilation from various publicly available internet sources, authors views are personal.

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