The structure of a CBDC

As it is not possible to speak in general of all existing blockchains, it’s not conceivable to compare one CBDC to another, as these are different from case to case. The logic of the market determines the appearance of each CBDC according to its needs. However, it is possible to identify key metrics that all CBDC developers should refer to when deciding what form this currency should take.

  • Efficiency: which system should you choose for making payments? How much is this system based on peer-to-peer technology, and is therefore increasingly comparable to cash payments? What form does the infrastructure on which the CBDC is based take? So, what are the operational roles that central banks and other financial intermediaries will play? To what extent does the private sector collaborate?
  • Accessibility: will the chosen infrastructure be account-based or token-based? How inclusive will the chosen system be? How much will it be able to protect user privacy?
  • Resilience: will the system be based on traditional technologies that are used today in banking and financial systems or, on the contrary, on DLT (Distributed Ledger Technology)? Consequently, how robust will the infrastructure be? What form, then, does governance management take? To what extent will it be a centralised or decentralised system?
  • Interoperability: to what extent will the CBDC to be created interact with different CBDC systems?

The possible archetypes of CBDC

Three stand out among the theorised models that implement Central Bank Digital Currencies in particular. The archetypes differ from each other mainly by choice of the operational role that central banks and other financial intermediaries must play if they are involved. Another critical parameter is the structure of the credits and registers held by the central bank and the distribution of responsibilities deriving from the operational roles of the subjects within the network. Each of the models that will be illustrated will be possible to be based on account-based or token-based mechanisms.

Although the choice of the archetype strictly concerns the protagonists, such as central banks and financial actors, it is obvious to think that households and businesses are strongly influenced by the choice of one model to the detriment of another, both for functional and convenience aspects.

Direct issuing model

The model based on direct issuing is undoubtedly the one with the most straightforward intuition and the most centralised. Potentially, the role of the central bank in this model can totally override all other private institutions involved.

In fact, in this archetype, the central bank has the task of keeping track of all financial statements, retail transactions and delivering CBDCs directly to the end-user. At first glance, the direct issuing model might seem the most appealing because it is clearly the simplest to implement.

In fact, it completely eliminates the dependence on intermediaries, greatly simplifying the dynamics that arise in the system we know today. However, the scope of the risks that lie on the other side of the coin is enormous: the threats that could threaten this model are the lack of reliability, speed and efficiency of the payment system.

By making a quick comparison with today’s model, it can be quickly concluded that the private sector could help and have better abilities to correctly build and run a system of this magnitude. If the central bank were in charge of conducting services such as user due diligence and KYC processes, it would be of extreme difficulty for it.

In fact, such operations require a great deal of expansion. In this regard, we could only involve private institutions for the more complex operation procedures, such as those indicated above, which require a lot of personnel in order to make the processes more fluid.

Central banks, in this way, could concentrate on carrying out simple transitions and controlling the issuance of the currency. The direct issue model would thus be more feasible, and central banks would remain the only institution that manages payment services.

Two-level issuing model

The second archetype is that of issuing on two levels and reflects much more on the current state of affairs of the financial system. In fact, in the traditional system, private intermediaries are not only subjects who carry out operational tasks but are an integral and complete part of the infrastructure.

The most significant advantage that can be guessed at first glance is that, in this case, the central bank is not responsible for all the operations that interface with customers. However, the significant risk is that CBDCs would no longer be a credit only to the central bank but also to private institutions.

This means that in the event of financial stress or private sector insolvency, there is no way the central bank could act to honour client credit simply because it does not own it.

As a result, the two-tier issuance model poses regulatory problems and deposit insurance policies should be instituted.

Hybrid issuing model

The hybrid model represents the middle ground that is obtained by combining the two previous models. This model predicts that central banks own the credit and private institutions participate in supporting system operations.

Loans are held by the central bank separately from the retail register of payment providers. In this way, the client has a full guarantee that if the private institution fails, the system infrastructure will allow the central bank to manage the client’s transfer from the old service provider to a new and healthy one, which allows him to operate new right away. For this to be possible, the central bank needs to keep track of the entire retail balance so that it can be able to restore it.

Compared to the direct issuance model, the hybrid archetype can benefit from the active participation of private institutions, thus making the operations that take place in the network more efficient and relieving the central bank from many responsibilities to which it would expose itself; compared to the two-tier issuing model, the hybrid one certainly guarantees more stability and attracts more customer confidence.

Account-based and token-based model

The accessibility of a CBDC strongly depends on whether it uses an account-based or token-based model. Between these two possibilities, the main differences lie in the underlying data structure, the methodology of the transfer of funds and the authentication processes.

The user, therefore, can mainly access the digital tokens issued by the central bank in two different ways:

  • Account-based: the accessibility offered by this model is very similar to the systems we use today for digital payments. Ownership is connected to an overt identity. This means that the owner of the account is verifiable by anyone. As is the case when opening a bank account, the identity must be certified through a KYC procedure. In order to make a transition, your identity must be verified from time to time through a password or an OTP code. After a transition or transfer of funds has been made, the ledger is updated centrally.
  • Token-based: thanks to the use of a Public Key Cryptography Infrastructure (PKI), it is possible to link ownership to evidence: in fact, it is sufficient to use a digital signature to prove ownership of an individual’s CBDCs. This model is very reminiscent of the use of liquid money as it guarantees a high level of anonymity for the end-user. The token-based model ensures broader and more complex accessibility, which, in addition to guaranteeing a higher level of security for users, eliminates the potential problems concerning the restoration of funds. However, problems arise with regard to cryptographic key management. In fact, in such models, the only holder of the primary key of the account is the user himself. In the event that the user loses his private keys, he will no longer have access to his funds.

Furthermore, there would be no third party who could intervene to help him restore the funds in this case. However, this system can be limited by building key protection systems. Today this model represents a novelty, so we need to find the right compromise between privacy and regulation through a new AML framework.

Virtual coin based on traditional or DLT technologies

The concept of digital currency does not strictly require Distributed Ledger Technology (DLT) like the blockchain to be developed. In fact, it is also possible to implement it in the technological infrastructures that we know today and that we will call “traditional”. However, cutting-edge and hugely diverse technology like blockchain can offer the features and potential that make this a much more attractive choice. A Central Bank Digital Currency developed on DLT technology allows the creation of a totally different and cutting-edge technological infrastructure.

In fact, the service offering can only be benefited from the blockchain.

Concepts such as decentralisation and distribution of the blockchain can improve the offer of services in its resilience, continuity and accessibility. However, we must also consider the major challenges that every blockchain is trying to fight today: scalability, privacy and security. Without taking into account the substantial amount of work that such a choice would imply depending on the model chosen.

It is undeniable that the key difference between a digital currency developed on conventional technologies and a CBDC developed on blockchain technology lies in the storage, updating and sharing of data:

  • Traditional technologies primarily work centrally. The data storage and sharing are based on physical nodes owned only by those who have access to the network; data updating is also centralised: it does not require distributed consent. The extreme risk to which this approach is exposed is the total collapse of the system.
  • The decentralised and distributed nature of Distributed Ledger Technologies totally changes the way of acting with respect to the dynamics previously illustrated. Data archiving is performed on different displaced nodes, i.e., there is no central server; updating and all other processes connected to the data can only be possible through the consent of the entire network, even if the procedures change depending on how the blockchain is developed. All this makes the network more robust; however, the productivity and scalability of the system may be affected. However, it must be borne in mind that this is nothing more than a generalisation: such problems could be solved, for example, in contexts of permissioned DLT technologies.

Furthermore, another key element of the blockchain must be considered: cryptography. Thanks to the use of tamper-proof cryptographic systems, the user is highly protected from external attacks.

Furthermore, another key element of the blockchain must be considered: cryptography. Thanks to the use of tamper-proof cryptographic systems, the user is highly protected from external attacks. If we then imagined a DLT-based model combined with a token-based approach, this could guarantee a very high level of privacy comparable to the use of liquid money.

However, the choice of a traditional platform or a DLT strictly depends on the political objectives chosen and the role and effort that the central bank wants to make in creating a digital currency.

The characteristics to be taken into consideration for the development of a DLT technology

If one chooses to use DLT technology behind CBDCs, some features consequently need to be taken into consideration.

  • Control: it is necessary to decide the central bank’s powers over the accessibility of users to the network and to what extent it can influence the creation of the digital currency.
  • Resilience: it is essential to check if there is a single point of failure in the system.
  • Transparency: it is necessary to decide the level of transparency of the system, that is, to decide whether each user has access as a reader to the network or not.
  • Scalability: the blockchain must be scalable enough for it to allow for the mass adoption of a CBDC’s currency.

These are the key points to consider when deciding to program a blockchain infrastructure for CBDCs. Above all, it is essential to decide whether it is a permissioned or non-permissioned ledger.

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