By Andrea Civelli, PhD, Principal Economist at Algorand, Inc., and Co-Pierre Georg, PhD, Member of the Economic Advisory Board of the Algorand Foundation
Virtually all central banks rely on their country’s banking sector as the primary means of implementing monetary policy. While in the era of paper money and fractional banking this model mostly worked, the rapid digitalization of finance means that central banks will have to move to new types of money and intermediaries as the world is evolving into digital and cryptographic forms of currency.
This is why countries should move forward with a hybrid blockchain-based central bank digital currency (CBDC) model, issued on a private instance of a third-generation public 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.
A system like this will in no way replace dollars and cents – the CBDC blockchain infrastructure and network will complement and help modernize a nation’s current payment system. The open nature of the blockchain will enable competition among financial service providers and therefore prevent vendor lock-in. By introducing competition, central banks will be better able to serve their constituents by adopting innovative payment solutions and business models that will ultimately drive down the cost per transaction.
For central banks to successfully introduce a CBDC, here are six design principles they should consider:
1. It must be as reliable as money
The main challenge when issuing a CBDC is that people have to trust it as much as its physical counterpart. This is one of the main reasons why issuing cash is so expensive: trust in cash requires a central bank to ensure that the notes cannot be counterfeited and that the supply chain cash is secure. Counterfeiting of CBDCs issued on a third-generation distributed ledger is impossible thanks to the ledger’s cryptographic primitives. In contrast, entries on centralized registries can be manipulated if the registry 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 analogue of money must, like its physical counterpart, have an immediate settlement finality, which means that the money is in the hands of the other party as soon as a transaction is finished. This is why it is essential that the blockchain on which a CBDC is based has an immediate settlement purpose.
2. It must be able to scale for a seamless user experience
Most blockchains to date, especially those based on a proof-of-work algorithm like Bitcoin, have been plagued with scalability issues and insufficient transactions per second to meet even the light loads placed on them. imposed by the first users. To reliably handle the transactions of a larger country with approximately 50 million CBDC users, each performing approximately two to three times per day, the CBDC would need to process an average of 1,500 transactions per second. This is a factor of 100 more than the standard process of proof-of-work blockchains today, but comfortably within reach of modern proof-of-stake blockchains.
Scalability is essential for a seamless user experience, which, in turn, is essential for adoption and acceptance of the new payment instrument. If users have to wait several seconds even for low-value transactions to clear, many critical use cases for cash will be inaccessible for a CBDC (even when central banks want a CBDC to complement, not replace, the species).
3. It should be private but fully auditable
Privacy is a human right and a necessary condition for wide adoption. For a CBDC to be successful, it is paramount to carefully balance this right 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. It is important to note that central banks must have full control over the thresholds between the different privacy layers and be able to change them if necessary.
This layered approach to privacy is both convenient and in stark contrast to the approach that private crypto assets like Bitcoin and Ethereum have taken, where there is no native notion of privacy. These blockchains instead rely on pseudonymous addresses to protect user privacy. This approach to privacy is in direct conflict with existing KYC/AML requirements. Rather than fixing this protocol flaw, it is better that a blockchain was designed for privacy from the start.
4. It must be inclusive
For a payment instrument to be universally accepted and trusted, it must be accessible to everyone in a country. This is a daunting challenge for central banks as smartphone penetration is far from perfect, even in the US where it is around 80%, and even more so in emerging markets like India. India where smartphone penetration is around 37%. With limited smartphone penetration, a substantial fraction of the population will not only struggle to transact using the CBDC, but even access it. This is particularly important for the unbanked in emerging markets, and especially for refugees.
Identity is another challenge to full inclusiveness. Especially in emerging markets, people don’t always have identity papers. In its 2016 article “A Blueprint for Digital Identity”, the World Economic Forum highlights the importance of building a digital identity infrastructure for the future of financial infrastructure. CBDC-issuing central banks will need to seek broad stakeholder engagement to solve the digital identity challenge.
5. It needs interoperability
The hardest part of designing a new financial infrastructure is developing the protocols and processes in a robust and resilient way that is compatible not only with existing systems, but also with future systems. This is why it is essential that CBDCs are built on an open platform that cannot be captured by any private actor while giving central banks and government agencies full control over authorized users and use cases. .
6. It must encourage competition
The rise of private digital assets has sparked a wave of innovation among small startups, big banks, and big tech companies. Much of this innovation, however, is occurring outside the jurisdiction of existing regulators. As a result, billions of dollars of transactions take place outside of the official view and then settle in fiat. An official, state-sponsored digital currency can allow much more of this digital innovation to happen in the light of day.
To promote competition, an open system without barriers to entry is essential. No walled garden solution can achieve this because its rules can be changed at any time by the solution provider, destroying the incentives for competition.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.