By Andrea Civelli, PhD, Senior Economist at Algorand, Inc., and Co-Pierre Georg, PhD, Algorand Foundation Economic Advisory Council member
Practically all central banks rely on their country’s banking sector as their primary means to enforce monetary policy. While in the era of paper money and the fractional bank system this model mostly worked, the rapid digitalization of finance means that central banks will need to shift to new types of monies and intermediaries as the world evolves to digital and cryptographic forms of currency.
This is why countries should move forward with a blockchain-based, hybrid model of central bank digital currency (CBDC), issued on a private instance of a public third-generation blockchain directly overseen by their central banks. In this model, central banks retain full control over the CBDC, while simultaneously allowing commercial banks, remittance providers, and other fintech companies to facilitate currency distribution and transactions.
By no means will a system like this replace dollars and cents—the infrastructure and network of the CBDC blockchain will instead complement and help modernize the current payment system of a nation. The open nature of blockchain will allow for competition among financial service providers and hence prevent vendor lock-in. By introducing competition, central banks will be better able to serve their constituents by embracing innovative payment solutions and business models that ultimately drive the cost per transaction down.
For central banks to successfully introduce a CBDC, here are six design principles they need to consider:
1. It needs to be as trusted as cashThe key challenge when issuing a CBDC is that people need to trust it as much as its physical counterpart. This is one of the main reasons why cash issuance is so expensive: trust in cash requires a central bank to ensure that notes cannot be counterfeited and that the cash supply chain is secure. Counterfeiting CBDC issued on a third-generation distributed ledger is impossible thanks to the ledger’s cryptographic primitives. By contrast, entries on centralized ledgers can be manipulated if the ledger’s database is hacked or otherwise compromised. Eliminating cybersecurity risks will, therefore, be absolutely essential for centralized digital currencies.
Another element of trust is that the digital-analog of cash must, like its physical counterpart, have immediate settlement finality, meaning money is in the hands of the other party as soon as a transaction is complete. This is why it’s vital that the blockchain a CBDC is built on has immediate settlement finality.
2. It needs to be able to scale for a seamless user experienceMost blockchains to date, particularly those based on a proof-of-work algorithm like Bitcoin have been plagued by scalability issues and an insufficient number of transactions per second to meet even the light loads placed on them by early adopters. To reliably handle the transactions for a larger country with about 50 million CBDC users, each of which transact about two to three times per day, the CBDC would have to handle on average 1,500 transactions per second. This is a factor of 100 more than the standard proof-of-work blockchains process today, but comfortably within reach of modern proof-of-stake blockchains.
Scalability is key for a seamless user experience, which, in turn, is key for the adoption and acceptance of the new payment instrument. If users have to wait several seconds even for low-value transactions to clear, many essential use cases for cash will be inaccessible for a CBDC (even when central banks want a CBDC to complement, not replace, cash).
3. It needs to be private but fully auditablePrivacy is a human right and a necessary condition for broad adoption. For a CBDC to be successful, It is paramount to balance this right carefully with the regulatory need to ensure that transactions are KYC/AML compliant. This requires a layered approach to privacy with adjustable limits for fully private, partially private, and fully auditable transactions. Importantly, central banks must have full control over the thresholds between the different layers of privacy and be able to change these as necessary.
This layered approach to privacy is both practical and in stark contrast to the approach private crypto assets like Bitcoin and Ethereum have chosen, where there is no native notion of privacy. These blockchains instead rely on pseudonymous addresses as a means of protecting user privacy. This approach to privacy is in direct conflict with existing KYC/AML requirements. Rather than fixing this protocol flaw, it is better for a blockchain to have been designed for privacy from the beginning.
4. It needs to be inclusiveFor a payment instrument to be universally accepted and trusted, it needs to be available to everyone in a country. This is a significant challenge for central banks because smartphone penetration is far from perfect, even in the United States where it stands at about 80 percent, and more so in emerging markets like India where smartphone penetration sits at around 37 percent. With limited smartphone penetration, a substantial fraction of the population will not only struggle to transact using CBDC, but even to gain access to it. This is of particular importance for unbanked people in emerging markets, and especially for refugees.
Another challenge to full inclusivity is identity—especially in emerging markets, people do not always have identity documents. In their 2016 paper "A Blueprint for Digital Identity," the World Economic Forum highlights the importance of building digital identity infrastructure for the future of financial infrastructure. Central banks issuing CBDC will have to seek broad stakeholder engagement to solve the digital identity challenge.
5. It needs interoperabilityThe hardest part of designing new financial infrastructure is developing the protocols and processes in a robust and resilient way that is compatible not just with legacy systems but also with future ones. This is why it’s vital CBDCs need to be built on an open platform that can’t be captured by any private actors while giving central banks and government agencies full control over which users and use cases are allowed.
6. It needs to incentivize competitionThe rise of private digital assets has set off a flurry of innovation among small startups, large banks, and big tech companies alike. A lot of this innovation, however, happens outside of the purview of existing regulatory bodies. Consequently, billions of dollars worth of transactions are happening outside of official sight, and then settled to fiat. An official state-sponsored digital currency can allow much more of this digital innovation to happen in the light of day.
To foster competition, an open system without barriers to entry is paramount. No walled garden solution can achieve this because its rules can be modified at any time by the solution provider, destroying incentives for competition.
https://www.nasdaq.com/articles/6-design-principles-for-a-successful-central-bank-digital-currency....
Here we have a write up with a list of proposals for the future format CBDCs should adhere to.
There have been a few different drafts and proposals released for feedback since venezuela 1st announced its petro cryptocurrency based CBDC some years ago.
One early proposal for a CBDC I read called for CBDC currency to be issued with an expiration date to prevent it from being saved over the long term. I'm glad newer drafts and proposals appear to have done away with that design feature. Some of the latest CBDC proposals are looking much more refined and polished.
I'm curious as to how they would propose to make CBDC accessible to unbanked demographics. Bitcoin claims to cater to an unbanked demographic of 4 billion around the globe. Certainly that must be the growth demographic offering the most potential.
The last design principle #6 could be impossible due to the trust based system CBDC functions on requiring a greater number of staff, brick and mortar establishments and infrastructure in contrast to crypto. The greater overhead and reduced efficiency could make it difficult to compete with crypto which trends towards being more barebones in design under trustless architecture. But still it is nice to see people thinking and coming up with new ideas and approaches to things.
