As central banking moves towards the inevitability of digitization, global institutions and their governing countries must move in lockstep to ensure the compatibility of central bank digital currencies (CBDC). In doing so, these separate entities can block financial disintermediation, maximize resource utilization, and avoid bottle-necking. However, with such staggered stages of development, this crucial goal may only be achieved via arbitrated interoperability.
From national iterations such as China’s incipient DC/EP to supranational ventures such as the digital euro and Libra, CBDCs are fast becoming integral facets of the financial system.
Arguably, the People’s Republic of China’s work on DC/EP is head and shoulders in front of the rest, and we’ll touch on why that’s so important later on. First, however, it’s crucial to grasp the intrinsic benefits of CBDCs, especially as they begin to permeate our everyday lives.
CBDCs often get shoehorned into the category of electronic or digital cash. However, the differences are dramatic. For one, electronic cash has been around for decades. It’s often a digital representation of fiat money, typically displayed on central banks’ monitors. A CBDC meanwhile isn’t merely a representation of money, but money itself. CBDCs do not rely on the archetypal bank accounts and credit cards associated with electronic payments. Their technical architecture and user experiences also differ greatly.
These distinctions hold enormous repercussions for the global financial system. For example, unlike electronic cash as we know it, CBDCs can eliminate unnecessary intermediate links, improve payment efficiency, reduce transaction costs and credit risks, and integrate seamlessly with the existing centralized payment system.
As more governments start to assess and develop CBDCs, the functions they incorporate will have significant implications on privacy, financial inclusion, monetary sovereignty, geopolitics, and more. However, these factors pale in comparison when it comes to the importance of defining the way these domestic instruments interact on an international scale.
DC/EP: A Case Study on Interoperability
As noted, one of the most actualized versions of a CBDC to date is China’s DC/EP.
DC/EP’s two-tier architecture extends domestic interoperability between the PBoC, the country’s commercial banks, and its people, providing an appropriate model for international CBDCs—particularly the controls it renders toward collaboration, adaptability, and adoption.
Why? Because a two-tier operating architecture maximizes resource utilization, fosters collaborative development, and avoids financial disintermediation.
When it comes to maximizing resources, DC/EP’s two-tier system makes extensive use of existing resources of commercial banks. This includes IT equipment, talent reserve, technology, research, development, etc. Using these, the central bank and commercial banks can jointly operate and further develop digital currencies. This, in turn, aids collaborative development, allowing institutions to diversify and resolve risks. Compared with single-tier operations, the cooperation between the central bank and a host of commercial banks will vary the developmental and operational risks of DC/EP—or of any CBDC for that matter.
Under the single-tier operation, a CBDC endorsed by a central bank will crowd out the deposit currency of commercial banks. This could result in a decline in the ability of commercial banks to absorb deposits, thereby increasing dependence on the interbank market and raising capital prices.
Consequently, single-tier structures tend to obfuscate the far-reaching benefits of CBDCs, increasing social financing costs, and eventually leading to even more extreme situations of financial disintermediation.
As such, adopting a similar multi-tiered approach on the world stage is incredibly important.
Fostering CBDC Compatibility Worldwide
For retail consumers, interoperable CBDCs can facilitate swift and affordable cross-border transactions; for governments and financial institutions, interoperability means global liquidity and ease of trade. Institutions will be able to access credit much quicker, allowing money to move through channels faster. Cross-border transactions will require less documentation and far shorter time to settle. This will enable accelerated global trade and enhance transparency and traceability—allowing nations to, among other things, reduce criminal activities such as tax evasion, money laundering, and drug trafficking.
Moreover, being interoperable on a supranational level could aid emerging and struggling economies who suffer from diminished purchasing power.
Nevertheless, as seen with so many different projects at staggered stages of development, reaching an accord may be a near impossibility.
In this instance, CBDCs would need to communicate across an arbitrated system which allows two different CBDCs to validate cross-chain transactions via a consensus mechanism. This would ensure that transfer information is consonant with details on both sides of the transfer—thus guaranteeing compliance to state transfer rules such as AML regulations and monetary policies while avoiding any double-spend issues.
CBDCs currently under development need to heed lessons from China’s DC/EP and strive toward cross-chain compatibility—not only between commercial and central banks but among national and supranational CBDCs.
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, Sky also serves as a columnist for Caixin, China’s top financial media outlet.