Three design choices for a central bank digital currency

Can Central Bank Digital Currency (CBDC) reduce the cost of payments? Of course not. Can blockchain reduce the cost of payments? Without a doubt.

The reason these answers are different is that CBDC is an instrument and blockchain is an infrastructure. But combining the two – a new instrument on a new infrastructure – introduces novel solutions to some long standing problems in financial services.

To make your journey towards understanding CBDC simpler, we describe the three key design choices that central banks are considering today. But first, let’s set the stage with a definition.

1. Types of central bank digital currencies (CBDC)

In short, Central Bank-issued Digital Currency is a digital twin of cash. That is to say, it is a binary representation of the notes that you hold in your hand. Since it is digital, it would be linked to a digital identity and held in a wallet.

CBDC is also a novel form of money. It is an addition to the category of money known as M0 which includes cash and reserves. Like other forms of money in that category, it is also legal tender and a claim on the central bank. In traditional economics, M0 represents central bank-issued money, like cash and central bank depository accounts. CBDC is included in M0, or will be once it is issued.

Importantly there are several important clarifications about what CBDC is not:

  • It is not mined/minted by unknown parties. And it is not pegged to any real-world assets
  • a payment but a means for payment.
  • infrastructure and does not pose any threat to the incumbents of the financial industry.

CBDCs can be of different types. The first is wholesale CBDC – this is an instrument that is available to financial institutions. The second type is retail CBDC – this is an instrument that is available to the general public at large (i.e., consumers and businesses).

2. Three design choices (technical perspective)

In recent years three general design considerations have coalesced in the discussions taking place about CBDCs. These include the question of who issues the CBDC, how it is distributed and where it is held. We discuss each in some depth below and bring to you the feedback that we have received from R3’s CBDC Working Group.

Design Consideration 1: Who issues the CBDC

Direct model – This model is designed for disintermediation where central banks issue directly to end customers. This model can disrupt the current financial system and will put additional burden on the central banks in terms of managing customer on-boarding, KYC, AML checks, which may prove costly to the central banks.

The first alternative is the indirect model – This model is like our current system. In this, banks re-issue central bank money and banks execute the function of customer on-boarding including AML compliance.  The main drawback of this model is the risk to end customers.  Like bank deposits, end customers will not be able to claim 100% of their entire CBDC holdings as it is co-mingled with the bank’s balance sheet.

The second alternative is the hybrid model – This model enhances the current intermediation model by segregating the risk (or balance sheet) of financial institutions from the CBDC holdings of end users.  This means that end customer CBDC holdings are not tied to the bank’s balance sheet, so it is 100% portable (and 100% claimable as a legal tender).  The hybrid model also introduces an important innovation by allowing the central bank to move CBDC holdings of end users if a bank is in distress.

For this question, working groups have seen greater approval for the hybrid model.

Design Consideration 2: How is the CBDC distributed

Single tier set up – In this model, there is no hierarchy of distribution of CBDCs and it is more suitable for the direct model, where the central bank issues digital currencies to all its users – financial institutions and citizens, upon doing the KYC and AML checks.

Two-tier set up – In this model, there is a hierarchy of distribution. That is, central banks issue digital currencies to commercial banks, which in turn distribute them to consumers and businesses.

In this question, the two-tier setup is the one in which central banks have expressed the most interest as it retains their role as the custodian of central bank money and holding it on behalf of end users.

Design Consideration 3: In what form is the CBDC held

And the final question is around whether the end user should hold an account or a token. There are two alternative models that are being explored.

The first model is token-based holders. In this model, each digital currency is represented as a token with specific denomination, mostly 1:1 with cash. It has the DNA of cash, which means a transfer from one party to another does not require settlement or any reconciliation because the transfer of ownership is instant and atomic.

The alternative is account based – each user of digital currency holds an account with the central bank or alternatively with commercial banks in a two-tier distribution model. An account-based model may ease AML and KYC compliance but can be a large overhead for central banks in a single tier model.

For this question, working groups have seen greater approval for a token based model.

3. What does this mean for the business process

Taking the feedback into consideration, we have implemented a token based, two tier and hybrid CBDC model in R3’s Sandbox for Digital Currencies. No one design is perfect, but this combination has given us the flexibility to explore new business models around –

  1. Multi CBDC networks
  2. Cross border payments
  3. Greater transaction and currency controls
  4. Implement new liquidity management solutions
  5. Programmable money

The above has led us to visualize a regulated DeFi with CBDC as a legal tender and risk-free instrument, at the core of it. Commercial banks and corporations have an opportunity to explore these newer models which ultimately will help them reduce cost, improve operations, deliver on customer satisfaction and explore newer revenue streams.

In a world of open finance, DLT based applications and multi Central Bank digital currencies potentially transcending borders, we aim to explore the art of possible on Corda for CBDCs and bring to you the exciting opportunities with some of these models and the downside to them.

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