Use of Blockchain technology for Central Bank Digital Currencies (CBDC)

The creation of digital currencies and blockchain technology is speeding up the process of developing CBDCs, according to central banks around the globe. Less paper money is used in the rapidly evolving digital world as more and more transactions are handled online. Governments are choosing digital currencies to be updated with new trends in economics and businesses. Blockchain, the fundamental technology of most cryptocurrencies, is also investigated in CBDC research and prototype trials. Considering the advantages of blockchain technology, the CBDCs can use it to offer more secure financial services to people. In this article, I aim to investigate how blockchain technology can improve CBDCs and what challenges might create obstacles against applying this new model.

Central Bank Digital Currencies

A type of digital currency that a nation’s central bank issues is known as central bank digital currency or CBDC. They resemble cryptocurrencies, but they are equivalent to the nation’s fiat currency and have a fixed value set by the central bank.

The Federal Reserve System’s Board of Governors. “Central Bank Digital Currency (CBDC).”

CBDCs are being developed in many nations, and some have already put them into practice. Given that so many nations are looking into ways to move toward digital currencies, it’s critical to comprehend what they are and the implications for society. 

CBDCs come in two varieties: wholesale and retail. While consumers and businesses use retail CBDCs, financial institutions are the main users of wholesale CBDCs.

Having wholesale CBDCs is like having reserves at a central bank. An institution is given an account by the central bank to deposit money or settle interbank transfers. Then, in order to control lending and determine interest rates, central banks can employ monetary policy instruments like reserve requirements or interest on reserve balances.

Retail CBDCs are digital currencies that are backed by the government and are utilized by both businesses and consumers. Retail CBDCs remove the intermediary risk, which is the possibility that private digital currency issuers will go bankrupt and forfeit the assets of their clients. 

The central banks all over the world are exploring CBDCs, and 36 active CBDC pilots, including the digital euro, represent a record high. Currently in the preparatory stage, the European Central Bank (ECB) is carrying out real-world trials and settling some transactions in a regulated setting. The two-year preparatory phase for the digital euro will conclude in 2025.

Blockchain Technology

Distributed ledger technology, or blockchain, uses cryptographic methods and consensus algorithms to accomplish attributes like security, anonymity, traceability, immutability, and decentralization. Decentralization is a fundamental component of blockchain technology, serving as a decentralized distributed ledger that can lower costs and boost productivity. On the blockchain, only verified transactions are allowed to be stored. Transactions cannot be changed after they have been verified by additional nodes. Every node in the blockchain network is able to validate transactions since every transaction on the network is timestamped and validated. Since the ledger is shared by every member of the blockchain network, transparency may be achieved. Blockchain can ensure that data recorded on the ledger cannot be altered by using cryptographic techniques.

A smart contract is one of the key components of blockchain technology. When specified conditions are satisfied, a smart contract can be automatically executed, which can increase transaction efficiency, lower transaction costs, and simplify transactions.

How Blockchain Technology Functions

Every transaction gets recorded as a “block” of data as it happens. These exchanges demonstrate the flow of an asset, which may be material (a product) or immaterial (knowledge). You can choose which information to record in the data block: who, what, when, where, and how much. Even conditions, like the temperature of a food shipment, can be recorded. Every block has links to the ones that come before and after it.

When an asset is transferred or ownership is changed, these blocks come together to form a chain of data. The blocks securely link together to prevent any block from being altered or a block from being inserted between two existing blocks. They also confirm the precise time and order of transactions.

A blockchain is an irreversible chain of blocked transactions. Every new block strengthens the previous block’s verification and, by extension, the blockchain as a whole. delivering the primary strength of immutability and making the blockchain tamper-evident. removing the potential for malicious actors to tamper with, and creating a trusted ledger of transactions for you and other network users.

Types of Blockchain

Public, consortium, and private blockchains are the three different types of blockchains.

The public blockchain allows anyone to participate and is permissionless. Although the public blockchain is very decentralized, there are certain issues with security, privacy, and performance. There are two well-known public blockchains: Ethereum and Bitcoin.

Consortia with multiple organizations constructs permissioned blockchains. Every organization is a single node on the blockchain; consortia permission is required for other organizations to join the consortium blockchain. Compared to a public blockchain, a consortium blockchain offers better performance and higher throughput, but it is less decentralized. Quorum, Hyperledger Fabric, and Corda are examples of consortium blockchains. An enterprise version of Ethereum is called Quorum.

Comparing private and public blockchains, the former is more centralized and permissioned. A single entity controls the private blockchain; it decides who can participate, how decisions are made, and how the shared ledger is kept up to date. Compared to a consortium blockchain, a private blockchain performs significantly better and enjoys greater participant trust. 

Advantages of Blockchain

If we want to explore the advantages of blockchain, we should think about the issues in the present financial systems. Operations frequently squander time and resources on redundant record-keeping and external validations. Systems for keeping records are susceptible to fraud and cyberattacks. Insufficient openness may cause data verification to lag. And the number of transactions has skyrocketed since the introduction of IoT. Because of this, business is slowed down, the bottom line is depleted, and a better approach is required. The blockchain technology can solve these issues.

Innate Capabilities

The “out of the box” features that tokens provide greatly aid in the exchange of digital values. They make it possible for exchanges to happen instantly and atomically, opening up new avenues for payment versus payment (PvP) and delivery versus payment (DvP) transactions. It is anticipated that tokens will become the norm for payments in machine-based applications and the Internet of Things (IoT).

Ability to Program

The final product of the digitalization of value is represented by tokens. Tokens can assume the functionalities required to interact independently with the network and to enable conditional, complex, layered, and triangulated transactions thanks to the possibility of endowing them with embedded business logic or smart contracts. Programmability opens up new avenues for enhancing the usefulness of money. 

Multiple-tiered Distribution

Token portability allows for distribution via a multi-level hierarchy. The current two-tier banking system, in which funds are disbursed by the central bank to commercial banks, who then disburse them to end users, is strengthened by this. By limiting the central bank’s interactions to intermediaries, CBDC promotes bank intermediation.

Act of Diversification

Because the tokens will transact on new payment rails, the payment system will be more diversified, and the central bank will have more autonomy because it won’t be as reliant on the current payment networks. Tokens can foster financial inclusion and deepening by acting as a settlement medium for emerging token-based financial market infrastructures and advancing a more diverse payment system.

Innovation in Finance

Tokens are a new financial market infrastructure as well as a new medium. They ought to spark financial innovation and act as a catalyst for it. By facilitating high-quality settlement, tokenized central bank money boosts the confidence of financial ecosystems and encourages the development and spread of new financial applications.

Offline Functionality

Payments must be unaffected by telecommunications coverage interruptions and power outages. Through their wallet functions, tokens allow for peer-to-peer exchanges in the vicinity of payers and payees.

How Can Blockchain Technology Help CBDCs?

Generally, the central bank and commercial banks would collaborate to operate the blockchain network. The network would work together to validate transactions, while the central bank would have authority over the issuance of CBDC. This makes it possible for transactions to be completed even in the event that certain operators or nodes—including the central bank—go down. All transactions would be permanently recorded on the blockchain, which would also guarantee the network’s stability and integrity. Tokens would be stored in electronic wallets that provide complete control over the tokens and facilitate network interaction for payment transactions. The private keys that govern the tokens would be stored in the wallets; transferring the tokens would require transferring the private keys to a new wallet.

The networks that protect CBDC’s operations must be built in a way that guarantees the necessary supervisory and prudential controls are upheld. Either technological considerations or the economic policies that the networks are meant to support should inform this design. The first, which typically consists of a single network for each participant, aims to determine the ideal network layout that maximizes transaction throughput and performance. The second design is the one that is recommended in situations where creating new, distinct networks would result in excessive adoption costs, unneeded duplication of current infrastructure, or restricted scalability in a cross-border environment. Its goal is to preserve jurisdictional and prudential boundaries.

Blockchain-Based CBDC Pilot Projects

Various central banks are testing blockchain-based CBDC through pilot projects. Some of them used a Bitcoin-based system. For example, the Dutch Central Bank created DNBcoin/Dukaton, a blockchain-based CBDC prototype, in 2015. The initial iteration of DNBcoin prioritized payment system sustainability and was modeled after the Bitcoin blockchain. The Dutch Central Bank then experimented with four more blockchain prototypes, testing various consensus and validation techniques. Ultimately, the Dutch Central Bank came to the conclusion that, due to its limitations in terms of capacity, efficiency, and payment certainty, blockchain technology could not be a viable option for financial infrastructure. Regretfully, the Dukaton project’s technological details are not available to the public.

A blockchain-based CBDC prototype system called RSCoin was proposed in 2016 by the Bank of England and University College, London. The UTXO (Unspent Transaction Output) model underpins RSCoin, which is modeled after Bitcoin. In RSCoin, there are two types of ledgers: low-level ledgers and high-level global ledgers. The central bank is in charge of managing the high-level global ledger and issuing currency. Payment interface providers are in charge of maintaining the low-level ledger, which will be sent to the central bank. Between payment interface providers and end users, payment interfaces serve as a middlemen. In addition, the central bank is in charge of handling transaction conflicts and ensuring the global ledger’s consistency.

Central banks have been experimenting with the application of consortium blockchain in CBDC as a result of the maturity of permissioned blockchain. The four consortium blockchains that are most frequently used in CBDC are Quorum, Hyperledger Fabric, Ethereum, and Corda. These projects’ primary application scenarios include settlements and payments between and within banks, as well as cross-border payments.

The Bank of Canada introduced Project Jasper, a wholesale CBDC based on blockchain technology, in 2016. A proof-of-concept payment system for large-amount interbank transfers was created by Project Jasper. Ethereum is used in the first phase to facilitate payments between participants. The Corda blockchain is being tested in the second stage. The two stages show how a blockchain-based wholesale payment system can help central banks by cutting expenses and increasing efficiency. In 2017, the Central Bank of Canada expanded Project Jasper and created CAD-coin, a blockchain-based CBDC prototype, in an effort to investigate additional blockchain applications. In addition to the Bank of Canada, numerous commercial banks joined forces to construct the CAD-coin experimental interbank payment system.

Obstacles and Unresolved Problems

The majority of central banks support blockchain-based CBDC schemes; several have even put forth CBDC prototypes based on blockchain technology. Nevertheless, no central bank has established a blockchain-based CBDC, and these banks only investigate the use of blockchain in CBDCs. Because there are still issues with performance, scalability, cross-chain interoperability, and usage scenarios that need to be resolved with both blockchain technology and blockchain-based CBDC.

Scalability and Performance

As an extension of Hyperledger Fabric, FastFabric was proposed in 2019 and boosts transaction throughput from 3000 to 20,000 TPS (transactions per second). Visa, on the other hand, can handle 76,000 transactions every second. The present blockchain system’s performance is still inferior to that of conventional centralized systems. Additionally, the blockchain ought to be scalable enough to handle an increase in transactions. Nevertheless, there aren’t any ideal blockchain solutions to deal with these problems. For blockchain-based CBDCs, performance and scalability remain two of the biggest obstacles.

Cross-Chain Communication

As various nations and central banks investigate blockchain-based CBDC programs, various blockchains—including Corda, Ethereum, and Fabric—are selected. For instance, Ethereum will be used in Australia’s CBDC project, Corda is used in Project Jasper/CAD-coin and E-krona, and Quorum is adopted in Project Khokha. Regarding international transactions, these various CBDC networks built on blockchain technology must interact and share information. Nonetheless, distinct blockchains may employ disparate hashing algorithms, digital signature schemes, transaction structures, block sizes, and encryption and consensus algorithms. A significant obstacle for blockchain and blockchain-based CBDC schemes is cross-chain interoperability between various blockchains. If CBDC’s primary focus is on domestic payments, cross-chain interoperability might not be taken into account.

Usage Scenarios

Regarding usage scenarios, blockchain-based CBDCs ought to take into account matters such as offline payment, user privacy, security, regulation, and ease of use. Similar to cash, dual offline payment support and user privacy protection should be provided by CBDC. Hardware-based wallets are the most popular proposal for dual offline payment methods. Therefore, the secret to the security of user funds is the hardware wallet’s security. Blockchain-based CBDC should be accessible and easy to use for everyone, even those without smartphones, just like fiat money. Therefore, these usage scenario-related issues must be fixed as soon as possible.

Conclusion

The use of blockchain in CBDC design is a topic of intense discussion. Blockchain features fit the design specifications of the CBDC. Overall, the permissioned blockchain is better suited for CBDC design than the permissionless blockchain. Nevertheless, no central bank has put in place a CBDC that is based on blockchain technology because certain issues with blockchain-based CBDCs need to be resolved, such as issues with usage scenarios, performance, scalability, and cross-chain interoperability. Our work is timely and can offer design guidelines for CBDCs based on blockchain technology.