Commentary: Central bank digital currencies make headway, but can they coexist?

American Banker Antony Welfare CBDC

Central bank digital currencies make headway, but can they coexist?

Published in American Banker 

John Adams January 09, 2023, 9:00 p.m. EST 8 Min Read

The argument in favor of central bank digital currencies increasingly hinges on whether different ones can play nicely with one another — a concern that is as much about politics as it is about technology.

At the end of last year, the Federal Reserve Bank of Boston and the Massachusetts Institute of Technology 2 announced the end of Project Hamilton, an agnostic effort to determine the technical feasibility of a CBDC. The project did not take a position on whether the U.S. or any country should digitize its currency, but it did provide some ideas as to how a CBDC could coexist with other forms of payments.
Interoperability is a vexing and often politically charged concern that has delayed decisions on whether to move forward with CBDCs in many countries.

“There’s no one single design or set of features. Each country will focus on CBDCs from a different perspective based on their own local needs,” said Neha Narula, director of the Digital Currency Initiative, which is part of the MIT Lab that focuses on cryptocurrencies and blockchain technology. “There are problems but they are solvable. The time frame depends on the resources that get dedicated to the CBDC projects.”

Project Hamilton produced a theoretical transaction processor for a CBDC. Called Open CBDC, it’s capable of processing 1.84 million transactions per second and provides settlement in under one second. Other functions include audit and programming tools that can measure the performance and security of a CBDC. MIT and the Boston Fed promised to release more details in the coming months.
A CBDC project at the Boston Fed and MIT has produced a potential model for how a digital currency could work.

CBDC projects are relatively slow, often with multi-year horizons. The conclusion of Project Hamilton and the advancement of CBDC projects globally suggest that momentum is building in the new year.

“There’s more of an awareness emerging that CBDCs are a thing,” said Ceclia Tamez, chief strategy ofcer for the money transfer segment at Euronet. “CBDCs aren’t new, but people are looking more for a retail purpose, to make digital currencies more accessible for consumers.”
While wholesale CBDCs, or digital currencies designed for transactions involving banks and other large parties, are considered easier to develop because there are fewer stakeholders, retail CBDCs for consumers have begun drawing more attention, Tamez said.
Retail CBDCs, which exist mostly in countries that are considered emerging markets, such as the Bahamas and Nigeria, can bring more people into the financial system.

While most of the live launches of CBDCs have been in emerging economies, retail digital currencies can boost financial inclusion in all markets, Tamez said. “Twenty percent of the U.S. population is underbanked,” Tamez said. Global charge

Project Hamilton is just one of about 100 CBDC projects around the world. There are about a dozen active CBDCs, according to the Atlantic Council, which counts another 17 in pilot and more than 70 in research and development; overall, nearly 80% of central banks are at least considering CBDCs. And since 2023 began, the Central Bank of the Republic of Turkey started piloting a digital Turkish Lira, successfully completing the rst payments with more tests scheduled for later this quarter. And the Federal Reserve Bank of New York has its own projects underway, separate from Project Hamilton.

The Federal Reserve Bank projects do not advocate for a digital dollar, but are focused on guring out how a digital dollar would work, especially in an a world where there will be a mix of wholesale CBDCs for large bank transfers, retail CBDCs for consumers, other digital assets such as stablecoins and more traditional payments.

“This is a very exciting step forward for the CBDC industry to address one of the biggest challenges in payments — interoperability, where different systems need to work together,” said Antony Welfare, senior advisor for CBDC and Global Partnerships at Ripple.
Welfare has also worked with the U.K.’s government and building use cases for a potential digital pound.

“The growth of CBDC trials and tests are building momentum, and with each there are distinct solutions that will ultimately require interoperability between different technologies and protocols, existing payment schemes, and across borders,” Welfare said.

Different currency options will need to work together, and across borders. There are still concerns over how digital currencies will impact traditional currencies and commercial banks. As such, the organizations testing

CBDCs are reporting to authorities that still haven’t made up their minds over whether a government digital currency is even necessary.

One of the primary worries is that CBDCs will adversely impact traditional commercial bank accounts.

“There could be a drain on commercial banks if people feel there is more stability in a central bank,” Tamez said.
“So central banks are going to move very carefully.”

In countries such as China, the CBDC model is focused on a centralized structure within the central banks that controls transactions. While in India, the central bank is engaging more with third parties, according to Tamez, adding there is an argument to involve private companies.
There’s a danger that central bank digital currencies will stie development of and innovation in private digital currencies by banks and ntechs, according to Eric Grover, a principal at Intrepid Ventures. A U.S. digital dollar would reduce if not eliminate ntechs’ appetite for issuing and innovating in stablecoins, he said.

Stablecoins, whose values are pegged to traditional currency such as the U.S. dollar, are designed to mitigate the volatility of other digital assets such as cryptocurrencies. Stablecoins are also seen as enabling nancial inclusion by reducing reliance on a centralized delivery system for financial services.

CBDCs are often positioned as having those same goals, though with the backing of a central bank.

“New government payment systems should bear a higher burden of proof,” Grover said. State-operated payment systems should be privatized unless there’s a compelling national interest, he said. “Underperforming government systems often get more resources. Most payment innovation comes from the private sector.”

Beyond interoperability and concerns over CBDCs competing with other forms of payments, there are also concerns over privacy for a payment form that uses decentralized technology and has ties to central banks.

“There will be a need to balance privacy with rules that we have around data collection and anti-terrorism and money laundering,” Narula said.

A role for banks

If a CBDC is to be adopted, it must be properly configured and implemented as critical national infrastructure, protected in the same way as existing payment systems, and must be scalable, interoperable and comply with anti-money-laundering regulations, according to Gilbert Verdian, CEO and founder of Quant, a blockchain company.

The digital assets need to be secure, implementing the highest cybersecurity standards against fraud and cyberattacks. “Meeting all these requirements in 2023 will be a big task, but is ultimately feasible,” Verdian said.

One possible design is a two-tier model proposed by the Bank for International Settlements (BIS). Central banks authorize nancial institutions to set aside a portion of retail CBDCs as traditional currency, which is backed by the government. The banks would then manage payments between consumers and businesses.

“That’s much like today’s traditional settlement processes,” Verdian said.

In this model, a CBDC network between central banks and commercial banks would use private blockchains. Financial institutions would need authorization to access the network, and commercial banks would link their own private blockchains to the broader CBDC network. “This interoperability would facilitate transactions between each other, payment companies, merchants and consumers,” Verdian said.
Commercial banks and payment companies would not be disintermediated, according to Verdian.

“Instead, they retain clear roles and responsibilities with plenty of room for competition and innovation within the ecosystem,” and central banks would not be responsible for commercial bank tasks such as customer relationships, he said. Developing CBDCs with open-source technology can additionally address the challenges around interoperability as it builds a path for the global community to collaborate and build standards by which CBDC’s can function simpler and quicker, Welfare said.

“With CBDC’s, stablecoins and existing payments, there is no ‘one size ts all,’ and so to successfully achieve this interoperability, it cannot be done in silos but rather as a payments ecosystem,” Welfare said.

There will also likely be a CBDC management role for commercial banks, global card networks and other payment companies.
The U.S. government is divided on the role banks should play. Republicans are pushing for a greater role for commercial banks in a digital dollar, and Democrats favor a more direct relationship between consumers and the central bank. In this environment it’s unlikely there would be a digital dollar that didn’t make use of the existing commercial bank infrastructure.
Government agencies additionally do not often engage directly with consumers for retail banking tasks, creating opportunities for commercial banks.

“Central banks are not accustomed to dealing with the public,” Tamez said. “They don’t have the infrastructure in place to deal with issues like someone’s lost wallet or card, for example.”

CBDCs will also add an option rather than push other payment choices aside, according to Narula.

“CBDCs will not replace any form of money or payments that we already use,” Narula said. “CBDCs will coexist.”

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