CBDCs Need to Focus on Compatibility or Else Risk Total Failure
- Written by Sky Guo Op-Ed
Central Bank Digital Currencies (CBDCs) are rapidly emerging. But to prevent bottle-necking, maximize resource utilization, and bypass the trappings of physical cash, sovereign nations need to cooperate to ensure interoperability between these instruments.
The coronavirus is only fueling this impetus behind CBDCs. As innovation spurs amid the pandemic, digitalization is at the forefront of experimentation. This sentiment was echoed in June by Benoît Cœuré, co-chair of a central bank collective researching CBDCs.
"COVID-19 will be remembered by economic historians as the event that pushed CBDC development into top gear," Cœuré noted.
And he isn't wrong. Momentum toward a fully digitalized global banking system is gathering at pace. The bank of international settlements (BIS) estimates that over 80% of central banks around the world are investigating the potential of CBDCs. And a fair few, including China's DCEP, are already in pilot mode.
Unlocking the Potential of CBDCs
Several variants of CBDC exist. These include wholesale CBDCs, which aim to expedite interbank settlement and retail CBDCs, which represent a digital version of fiat currency. Typically utilized within everyday transactions, these retail CBDCs will likely present a genuine game-changer.
Retail iterations promise to eliminate costly intermediaries and reduce transaction costs, and credit risks — especially across borders.
Moreover, in terms of individual use cases, CBDCs could satisfy the basic needs of those the world's 1.7 billion unbanked, permitting access to severely sought after financial services in poverty-stricken countries.
Should these functions come to realization, retail CBDCs could generate one of the most significant financial switches in history. But this is highly dependent on achieving interoperability.
The interplay between emerging CBDCs will be one of the greatest challenges and perhaps the biggest opportunity of digital bank currency. Unfortunately, this opportunity could be squandered unless governments and central banks heed the lessons learned from physical fiat.
Cash is confined to regional jurisdiction. While the US dollars retain purchasing power in the US, they won't be useful for much in central China. As such, cash is almost entirely incapable of meeting the goals of interoperability. By contrast, CBDCs facilitate an entire host of opportunities — chief among them being transferability.
The problem is, most CBDC proposals simply mimic the existing fiat system rather than innovating anew. Cross-chain compatibility has therefore arisen as a fairly recent afterthought, where it should have been one of the prime factors driving development.
China Leads the Way
DC/EP was created with interoperability in mind. Payment services such as Alipay and WeChat Pay control roughly 90% of China's payments market, and around 20-25% of retail spend across the country. Instead of merely supplanting them, DC/EP integrated the two fintech firms — securing their entire market share and almost entirely guaranteeing mass adoption.
It's this forward-thinking play toward collaboration that places China so far ahead in the race toward a functioning CBDC. But it's not just its ability to integrate existing infrastructure, DC/EP is built on a foundation of integrability, providing the perfect case study for other sovereign iterations.
DC/EP operates under a two-tier structure, permitting interoperability on a domestic scale and, as such, will be controlled and disseminated by both the People's Bank of China (PBoC) and commercial banks. By ensuring the interplay between these institutions, DC/EP can maximize resource utilization, and avoid financial disintermediation and foster further collaboration, integral to its ongoing development.
DC/EP's two-tier system harnesses the resources of commercial banks, including research, development, talent reserve, IT equipment, and other existing technology. By integrating with existing tech, and encouraging cooperation, the PBoC and the commercial banks can collectively develop DC/EP and its extended infrastructure.
Under single-tier CBDC systems, where the central bank distributes to citizens directly, collaboration becomes suffocated. However, the inherently collaborative construction of multi-tiered CBDCs, such as DC/EP, helps keep the developmental and operational risks of DC/EP to a minimum. Single Tier systems also neutralize the inherent advantages of CBDCs, expanding the costs of social financing, and potentially aiding financial disintermediation.
Exercising this multi-tiered collaborative approach on a global scale is paramount to dodge the trappings CBDCs were designed to avoid.
Aiding Interoperability
With CBDC designs at varying degrees of construction, implementing cross-chain compatibility is a far greater hurdle than first anticipated. A CBDC operating on one blockchain network, won't natively work with another employing DLT. As such, a linchpin is needed to bridge the operating gaps between two distinct CBDCs.
A solution is required where two different CBDCs can interact via a mediated system, allowing cross-chain validation of transactions via a uniform consensus mechanism. Such a system would assure that transfer information is consistent with data on either side, ensuring compliance with sovereign monetary policies and transfer rules such as KYC and AML controls, while bypassing the double-spend dilemma.
With sovereign CBDCs still in their early stage of development, there's still time to innovate beyond the concept of the existing financial system and secure cross-chain compatibility — not just domestically but on a global scale.
About the Author:
Sky Guo is Chief Executive Officer at Cypherium. His extensive knowledge of blockchain consensus, transaction, and cryptographic algorithms stems from his background in computer science. With a B.S. from Pepperdine University and a degree in Entrepreneurship from Draper University.
