Central Bank Digital Currencies (CBDCs) are primed to generate a significant financial shift in our lifetimes. However, unless these instruments heed the lessons learned from fiat currency, innovation will be for nought. Interoperability persists as one of the most significant hurdles to both CBDC adoption and functionality. As such, it's integral that central banks converge on this idea and harness compatibility.
The term CBDC is a slight misnomer. There are, after all, several types. These include retail CBDCs, which essentially act as digital fiat, used for daily purchases and transactions. Then, there’s wholesale CBDCs, which would primarily facilitate interbank settlement. Regardless of the CBDC classification, the same regulatory rules, inclusive of AML and KYC compliance and monetary policy, apply.
However, it's retail CDBC that's causing the biggest stir. If their inherent benefits, such as ease of storage, usage and speediness are realized, regional retail iterations of CBDC could readily challenge the dominance of the US dollar.
Until recently, bankers and regulatory leaders alike had been somewhat reticent around the notion of CBDCs—particularly the retail variety. It wasn't until the looming possibility of Facebook's Libra, and China’s progress with its own iteration that they truly pricked up their ears. Nevertheless, many now regard the advantages of CBDCs (i.e., reducing the costs and inefficiencies associated with cross border payment) as essential.
China's CBDC, known officially as DC/EP, is by far the most comprehensive, actualized example of a bank-issued retail digital currency. DC/EP is already in its beta phase, undergoing testing within several regions around China. DC/EP's raison d 'être is arguably to rid the country of dollarization. To do so, however, The People's Bank of China has had to design its imminent CBDC with ubiquitous payment services such as Alipay and WeChat Pay in mind. Allowing interoperability with these services lends itself well to DC/EP mass adoption especially given the popularity and prevalence of these payment apps. But, if it is to truly succeed—and even rival the dollar dominance—China's implementation needs to take that interoperability, apply on a worldwide scale, and become easily interchangeable with other sovereign digital currencies.
Since China broke ground with DC/EP central banks the world over have taken a tremendous leap in CBDC innovation. According to the Bank of International Settlements (BIS), 80% of central banks are actively researching or creating a CBDC. This includes the Bank of England-led central bank consortium into the utility of CBDCs, as well as the US' own iteration: the Digital Dollar, which recently gained momentum amid Covid-19 as a proposed medium for stimulus handouts.
In Europe, progress toward a digital Euro is accelerating as well, with French, Dutch, and Italian central banks vying to take leading roles in its creation. In May, the Banque de France successfully completed a CBDC trial—tokenizing €40 million worth of covered bonds on the blockchain and executing settlement via a CDBC. Meanwhile, the Italian Banking Association (ABI) broke ground by establishing guidelines for a digital Euro.
However, while representing a positive step forward, the highly fragmented nature of national projects may push CBDC into the same trappings as fiat currency. Fortunately, via interoperability, these pitfalls can be negated.
Interoperability or Bust
At its most basic function, interoperability would allow multiple CBDC's to interact and exchange data with each other. The issuance of internationally compatible CBDCs could cease reliance on costly and sluggish cross-border money transfer services such as Western Union and reduce dependence on interbank messaging services such as SWIFT.
The prevailing legacy system has been in use by major financial institutions since the 1970s. While it's scalability and dependability has kept it in-vogue for many years, innovative alternatives that cannot go ignored any longer. Not only is SWIFT expensive and slow, but it doesn't transfer any funds—it merely makes an account of transactions. By that logic, SWIFT is little more than a glorified messaging system. In contrast, with a CBDC, the transfer is both recorded on an immutable blockchain or digital ledger and physically (or rather digitally) forwarded to its final destination. Unless CDBCs are made interoperable, however, this intrinsic benefit will be squandered.
Unfortunately, interoperability isn't that simple. To achieve full compatibility, CDBC's would need to share the same infrastructure, code languages, and standards, as well as the relevant regulatory systems.
According to a survey undertaken by the Official Monetary and Financial Institutions Forum (OMFIF), some central banks have already settled regional agreements for creating interoperability frameworks. Nevertheless, some CBDC projects are beyond the developmental stage—making this a practical impossibility.
Ironically, what might be required is a contemporary SWIFT-like system. A third-party mediator between two distinct CBDCs, or indeed digital currencies, could validate cross-chain transfers via a consensus mechanism—ensuring that transaction information is consistent with data on both sides of the transfer. This would guarantee state transfer rules such as AML regulations are abided by while dodging the double-spend issue.
The Era of Digitization Is Here
As touched upon, rising dollarization acts as a quasi-case study into the urgent need for CBDCs. This dollar-based substitution of domestic currency typically occurs in countries exhibiting hyperinflation or instability. It’s also one of the rationales behind China’s expedited entry into the CBDC market.
For Mark Carney, former head of the Bank of England, the basis for a retail CBDC falls in line with that of China.
During a seminal speech at a central banker symposium in Jackson Hole last year, Carney argued for an instrument eerily similar to that of Libra to replace the dollar's dominance and promote global liquidity.
Dubbed by Carney as a "synthetic hegemonic currency" (SSHC), the CBDC-esque instrument would—similarly to Libra's original intentions—be anchored to a basket of fiat currencies, acting not unlike a global reserve currency.
In actuality, a universally agreed reserve currency is a rather remote possibility—if not wholly implausible. Still, the advantages of a single world currency fall in line with that of interoperable CBDCs. Not only would it remove exchange fees, but it would increase the flow of trade, promoting greater economic stability, fostering financial inclusion and potentially end reliance on the US dollar.
While the pros and cons of dollarization require another article altogether, its surge highlights the inadequacy of global fiscal policy and economic stability. Preliminary research into CBDCs suggests that they could offer further financial stability and reduce the moral hazard of banks. Moreover, much like Carney's vision of a SHC, as well as China's DECP, CBDCs may well dislodge the dollar's homogeny.
But all of these advantages may be void unless the myriad of CBDCs looking to flood the market find some commonality.
About The Author
Sky Guo is a founding member at the OMFIF Digital Monetary Institute the global central banking think tank helping policymakers to navigate CBDCs, and CEO and founder of Cypherium who has developed the first cross-chain, interoperability solution for China’s new Central Bank Digital Currency.
The views and opinions expressed herein are the views and opinions of the author and do not necessarily reflect those of Nasdaq, Inc.