CBDC – The new AVATAR of Commercial Payments

A lot of work is being done towards CBDC globally. Latest in the lot is project Aber by SAMA and CBUAE for commercial banking, ECB for retail payments and MAS working on a concept as well. CBDC, however, is not a new word in the dictionary of banking. Well, relatively new but not entirely new.

I was highly intrigued by the CBDC (Central Bank Digital Payment), both Commercial and Retail. So interesting was the concept that I delved deeper into the role that CBDC would play in Commercial and Retail Banking.

I would attempt in two parts the CBDC concept and its applicability to the banks today.

Money and the Central Bank

Money Makes the world go around…. Cash, Online, Virtual and now DIGITAL…

Money is what we have used as a commodity for purchasing a commodity by associating a neutral value to the piece of paper that you carry in your pocket.

Central Bank has been entrusted with the responsibility of providing ample amount of this “piece of paper” at the right value for the consumers. At least traditionally it was the piece of paper.

As technology grows, so does the face of money. From coins to paper to online to digital to crypto to newer avenues. CBDC is the latest in the set which is anticipated to take things to the next level.

The BIS defined the essence of money in the Money Flower.

There are 4 key elements of the Money Flower for definition of the taxonomy.

1. The Issuer: Who issued the Money (Central Bank or Cryptocurrency)
2. The Form: The Form that money takes (Physical, Digital, Deposits etc)
3. Accessibility: Who is the Money accessible to (Central bank, Commercial Bank, General Public)
4. Technology: Digital may be present in token based (held by bearer as similar to cash) and Account Based (held in accounts)

Central Bank and CBDC

Central banks have been providing trusted money to the public for hundreds of years as part of their public policy objectives. Yet the world is changing. To evolve and pursue their public policy objectives in a digital world, central banks are actively researching the pros and cons of offering a digital currency to the public (a “general purpose” Central Bank Digital Currency (CBDC)).

The entire principle of CBDC is based around TRUST.

Role of CBDC in Commercial Banking

In Commercial Banking and in cross border payments, interbank, the role of the two central banks and commercial banks cannot be discounted. Traditionally, the banks maintain Nostro accounts for banks which are settled through the RTGS of the Central Banks for Cross Border Payments.

The Core Agenda for the CBDC is to have trust and as Decentralised a framework for settlements as possible. It relies heavily on DLT Technology.

However, CBDC is not a Bitcoin.

Commercial CBDC revolutionising Cross Border Payments

Since the early 2016-17, various Central Banks have been into discussions with each other for developing the Proof of Concepts to bring a change in the way payments are done. Some of them worked on Inter CB and some on Interbank within the country. These banks have worked on agreements with each other and evaluated the different BlockChain technologies that can be used for making it a success.

Central banks around the world have been evaluating distributed ledger technology and CBDC for wholesale payments. There have been several proof of concepts leveraging from each other’s experience.

The evolution of CBDC has gone through the different stages and as the BlockChain technology matures the Proof of Concepts gradually move to the implementation.

How it works

The lifecycle of the Digital Currency is as follows:

1. The Commercial Bank would allocate or pledge cash collateral in an account held by the respective Central Bank
2. Central Bank converts this cash collateral to produce Digital Currency.
3. Central bank transfers the appropriate value of the Digital Currency in the Commercial Bank’s Central Bank account. 
4. As part of the transaction, the Commercial Bank transfers the Digital Currency to the other Commercial Bank in the other region. 
5. The other Commercial Bank deposits and redeems the Digital Currency in the other Central Bank. 
6. The Other Central Bank destroys the Currency created for this transaction. 

Benefits of Commercial CBDC

1. Resilience

The blockchain based payment infrastructure on Distributed Ledger Technology (DLT) would resolve the issue of single point of failure. The payments would not be dependant on the Central Bank for the payments to happen.

2. Security

Being based on Blockchain and trust and the fact the there is no single ledger for the transactions to be validated, the entire concept of CBDC is much more secure. The potential attack on the structure would need to be much more elaborate as compared to a single entity.

3. Easier Settlements

While the Central Banks would still hold the key for the net settlements, the concept of CBDC ensures that the banks across borders would be able to do a settlement amongst themselves on the Currency issued by the respective Central Banks.

4. Quicker Onboarding and Offboarding of Entities

The currency once issued for a particular bank on request for a particular transaction can be exchanged for that transaction and redeemed by the other bank. Also, the entire concept of financial entity not being a bank is entirely supported by this framework. This means onboarding and off boarding an entity is relatively easy.

Different Programs run by Central Banks globally

Through 2016-17, different Central Banks have been working on the different Proof of Concepts (POCs) for the Commercial CBDC.

Since it involves jurisdictions in two different countries, the complexity increases. Also, the pegging of the currency in the two countries against a fluctuating rate of exchange poses a concern for the value of the Commercial CBDC.

The leaders in the pack of innovations have been Bank of Canada, European Central Bank (ECB), Bank of Japan (BoJ), Monetary Authority of Singapore (MAS), South African Reserve Bank, KSA SAMA and Central Bank of UAE (CBUAE).

Some of the notable projects were

1. Project Jasper: This was launched in 2016-17 and was a collaboration between Payments Canada, its FIs, Bank of Canada (BOC) and other participating entities. This was a 3 phase project in which was moved from basic to advanced settlement on CORDA Framework.
2. Project Stella: This was also launched in 2016-17 and was a collaboration between Bank of Japan (BoJ) and European Central Bank (ECB). This was also a three phase project which ended in 2019. This was built on DLT of HyperLedger Fabric.
3. Project Ubin: This was an initiative by Monetary Authority of Singapore (MAS)
4. Project Jasper-Ubin:This was a project between BOC and MAS.
5. Project Khoka: This was a project between South African Reserve Bank (SARB) and seven participating banks.
6. The latest project is Project Aber between SAMA and CBUAE and three participating banks on each side, KSA and UAE.

While the other projects did not involve actual money, Project Aber involved actual money to be exchanged using CBDC using DLT based on HyperLedger Fabric.

The Uniqueness of Project Aber

The latest PoC was done by the SAMA and CBUAE and six participating banks – UAE ( FAB, ENBD, DIB ) and KSA (Bank Al Rajhi, Alinma, Riyad Bank). The aim was to provide a platform of trust where actual transactions could be done using CBDC issued by the respective CB. The security, audibility and scalability were discussed and implemented during the PoC.

Conclusion

While at the nascent stages, the future of the Crossborder settlement lies in CBDC. This would bring in benefits in terms of security, no single point of failure and direct settlement without major dependance on the Central Bank.

Thought beneficial, the challenges for making it into a global standard would still have challenges as deciding on the exchange rate on which the currencies would be pegged for CBDC issuance and settlement, setting up accounts which are directly settled with each other, decentralised gridlock resolution, STP, role of CB and other FI, changes in regulatory and technology imperatives.

Technology is definitely a valued and the maturity of DLT and Blockchain would make such a concept a big success.

Retail CBDC is still another puzzle which we would simplify in the next blog.

References

https://www.centralbank.ae/sites/default/files/2020-11/Aber%20Report%202020%20-%20EN_4.pdf

https://www.bis.org/publ/othp33.htm