Over the last few years, central banks and governments around the world have started looking into how they might use blockchain technology to digitize their national currencies. The benefits of doing so range from the benign, such as lower transaction fees for businesses and efficiency gains, to the more sinister motivations of improved censorship and societal control. The extent of interest ranges from small scale research to widespread trials and the imminent deployment of a digital currency by the People’s Bank of China. This month we will explore what technical options a government has when rolling out a digital currency. We will assess what is currently being proposed and the likely timeline to adoption.
Central Banks have existed since the seventeenth century and are at the heart of an economy, pumping in money to keep it healthy and growing. On a micro level, a large supply of easy money leads to greater spending and easier access to personal loans. On a macro scale, the money supply has a significant impact on GDP, growth and unemployment rates. As a result, monetary policy has become a primary tool used by governments to steer their economies. As the world digitizes at an ever increasing rate, the idea of creating “central bank digital currency” (CBDC) is gaining traction and blockchain technology is perfectly placed to facilitate this transition.
On a basic level, a CBDC is an application of blockchain technology whereby digital tokens are minted by a central bank. These tokens are equivalent and redeemable for the domestic currency. There are numerous possible uses for this digital currency.
While it is possible for governments to create digital currencies without blockchains, there is a security benefit of using the technology that makes it a better fit than centralized databases. Traditional databases are less secure than blockchains owing to their centralized data storage and processing. A successful attack on a master database could give the attacker the power to mint currency at will and amend account balances. This is much harder to do in a blockchain system given that there is no single database to corrupt, but a network of many replicated databases that are frequently communicating and arriving at consensus.
Aside from excellent security, blockchains allows for fast and cheap transactions, particularly when dealing with cross-border payments. There are no longer a series of connected banks each with their own databases to update, but instead a single shared database that can be viewed by the transacting parties. For consumers looking to hold their savings, a blockchain system also means that they are depositing money directly with the central bank and are not at risk of holding funds with a commercial bank that could default.
In terms of the architecture behind a CBDC, there are two routes that a government can go down; using public blockchains or private permissioned chains. A true cryptocurrency would need to operate on a public blockchain, with any user able to run their own node to verify the sequence of transactions. The vast majority of government trials so far have not used public blockchains. Central banks are understandably cautious and have opted for the privacy and control of permissioned chains. The most popular implementations to date have been R3’s Corda, the Linux Foundation’s Hyperledger Fabric, J.P. Morgan’s Quorum, or a private configuration of the Ethereum blockchain.
The use of private permissioned blockchains means that participants in the network must be granted access to participate by the central bank. The government can regulate the parties that are validating transactions and in extreme cases it could force validators to roll back transactions. In addition, the government could mandate that users pass KYC and AML checks before being given access to the system and it could make user accounts “recoverable”, meaning that the user’s private key is not entirely private. While some of these features are beneficial, it is easy to imagine some countries using this immense power for increased censorship and control.
There are at least 40 central banks around the world that are researching and experimenting with CBDCs. It has been widely reported that the People’s Bank of China is looking to have cash replaced by a digital version, with Xi Jingping endorsing blockchain as “an important breakthrough”. A Chinese digital currency will almost certainly operate on a permissioned blockchain, with the PBOC and select Chinese institutions having the ability to issue and distribute it. It is understood that the currency will be price-pegged to RMB and will be backed by a reserve of RBM, making it comparable to other dollar-pegged cryptocurrencies. At least five banks have signed up to the system as well as Alibaba and Tencent.
In France, the central bank already has a fully deployed blockchain system for a specific use case. The Bank of France has replaced its sharing of SEPA Credit Identifiers (SCI) with a blockchain based solution. The system automates all SCIs using smart contracts that run on a private instance of Ethereum. The Bank of France claims the system to be a success, citing benefits of auditability, disaster recovery and greater accountability for commercial banks.
While there are clear efficiency benefits for all countries to issue digital currencies, it is emerging countries that have the most to gain. The National Bank of Cambodia is in the process of rolling out a blockchain-based payments system for consumers and commercial banks. Assistant Governor at the National Bank of Cambodia, Serey Chea, has said that blockchain payments will enable greater financial control and remittance efficiency. Chea said that the main interest of the National Bank of Cambodia is cross-border transactions, with the central bank now collaborating with the Malaysian bank Maybank.
Along with legitimate trials for digital currencies, we have also seen murkier digital currency deployments. In 2018, Venezuela launched the “Petro”, a token that runs on the NEM blockchain and that is supposedly backed by the country’s oil reserves. Most people view the Petro as a mechanism for Venezuela to circumvent international sanctions and it is not clear what claim the tokens have on the underlying assets. While cryptocurrencies are designed to provide transparency and auditability, it is ironic that some governments will use the technology to evade sanctions and strengthen the role of the state.
In the short term, we expect to see an increasing number of governments using blockchain technology in digital currency trials. However, once China launches its digital RMB the global movement towards state backed currencies will accelerate dramatically. China’s strategy is to create the dominant digital dollar, replacing the USD in world trade. The first step in achieving this is through powerful Chinese internet companies incorporating the digital RMB into their products, allowing the currency to seep into other countries. Other countries will react by releasing competing digital currencies, leading to a mesh of different blockchain systems supporting national currencies.
In the scenario described above, if each country has its own private permissioned ledger, there will be friction in global trade. Assuming that there is an incentive for governments to remove this friction, there are two possible outcomes. Either countries move their digital currencies on to public blockchains or they work to integrate their private permissioned chains together using an interoperability protocol. At CMCC Global, we are excited to see this play out. We hold both the leading smart contract platforms and the leading interoperability protocols in our portfolios. We foresee a future in which these platforms form the backbone of the global financial system.