...by Daniel Szego
"On a long enough timeline we will all become Satoshi Nakamoto.."
Daniel Szego

Sunday, July 26, 2020

CBDC and the Blockchain

In recent years, news has risen one after another about various CBDC (Central Bank Digital Currency) studies and possible technological implementations. Most of these studies can be linked to various Central Banks (such as the Bank of England, the European Central Bank, the Central Bank of Sweden ...), where there is usually no specific proposal for the implementation of a specific technology. In this sense, it is questionable whether a blockchain platform to implement a CBDC use-case would be the right technology. On the other hand, specific technology companies, usually using some distributed general ledger technology, develop and publish CBDC implementation architectures. An example of such an developed technology architecture is the CBDC proposal based on Consensys Ethereum, R3 Corda and Algorand platform. In this article, we take a closer look at Consensys ’Ethereum-based proposal (source: https://consensys.net/solutions/payments-and-money/cbdc/ ).

For the successful implementation of a CBDC, it is worth summarizing the requirements of the CBDC at both technology and use case level in general:

1. Type of CBDC: The very first question is whether the CBDC should execute a retail, interbank, or both type of transaction.

2. Token or account based.

3. Monetary policy and token allocation: an important planning question is what monetary policy is for digital money, how much of it is in circulation on an annual basis, and who determines the output. Examples of such issues include determining interest rate and / or token inflation.

4. System change and decision mechanisms (governance): similar to the previous point, another question is who can change the various parameters of the system and how.

5. Privacy versus transparency: it is generally technically difficult to comply with both properties and, in addition, to comply with all possible AML / KYC regulations. Here, it is worth setting the priorities differently for each user case.

6. Performance, robustness, stable operation, and scalability: While stable operation, robustness, and high availability are a matter of course for most blockchain protocols, speeds such as the number of transactions per second cannot in many cases be met trivially.

7. Legal requirements and applicable legal environment.

8. Risk Analysis: One of the biggest challenges for CBDC is perhaps its risk-free implementation without compromising the existing financial ecosystem.

Consensys proposes a multi-tier architecture in general to implement a CBDC.

- The core of the system consists of a consortium block chain network that runs at the central bank and similarly significant players and regulates the issuance and administration of the fund token (layer 1).

- The second layer connects this basic system with other major financial actors through so-called state channels, which allow private and fast asset / token transfer (layer 2).

- The third layer implements the quasi-retail BCDC with channels subordinated to the main system, so-called side channels (layer 3).

 - The latest layer of the system would provide services to end users, either directly or through additional technology and / or fintech providers (layer 4).

Although the system outlined is not a plain blockchain protocol, but a combination of several decentralized systems, state and side channels, it is expected to meet the requirements for a CBDC:

- Token issuance is fully controlled by the Central Bank.

- Quasi real-time token transfer.

- High number of transactions per second.

- Large number of participants with different roles.

- Well controllable and configurable transaction visibility, compliance with various KYC / AML regulatory requirements.

- An acceptable amount of energy required to maintain the system (Proof of Stake).

To the best of our knowledge, an Ethereum-based CBDC implementation does not yet exist. Thus, of 
course, an interesting question to be answered in the future is exactly how well the architecture outlined by Consensys fits in with a particular CBDC implementation.

Friday, July 24, 2020

The digital dollar project

The Digital Dollar project is a study to implement a possible US CBDC (Central Bank Digital Currency). The study does not represent an official FED position but is a joint effort of a non-profit company (the digital dollar project: https://www.digitaldollarproject.org/) and Accenture, yet we are confident that it will greatly influence a potential U.S. CBDC realization. The digitized dollar would act as an official currency in addition to, but not in competition with, the currencies currently in use. Digitized dollars could be converted into paper dollars or equivalent account money, among other things, targeting the following major uses:

- Retail: To support financial transactions between individuals, commercial units and companies, complementing existing credit card and Clearing House's Electronic Payment Network (EPN) systems.

- Wholesale: To implement transactions between banks and other financial institutions, supplementing or even replacing Fedwire, National Settlement Service (NSS) solutions.

- International: To support international financial transactions.

In terms of implementation, it is not a question of complementing existing financial systems, but of designing a new financial infrastructure. This is also conceivable with distributed general ledger technology by incorporating AML / KYC requirements into the associated digital wallets.

Two independent dimensions are usually taken into account when implementing digital central bank money.
Based on the structure of the CBDC, it can be:

- Account-based: in this implementation, each user would create an online account with the central bank, similar to a normal bank account. However, the advantage of the solution, its simple feasibility, but its disadvantage is that the central bank would have to issue end-user accounts, which does not necessarily cut its profile, on the other hand, it would be a direct competitor to commercial banks.

- Coin (Token) based: here the CBDC would be implemented using digital coins issued and withdrawn by the central bank, either directly or indirectly through financial institutions to economic agents. In monetary terms, the system is similar to paper money-based systems and requires more, but with a good chance, new financial infrastructure (eg blockchain). However, token-based systems are expected to have several advantages over account-based systems, e.g. decentralization, flexibility, greater security and privacy. The US CBDC would be basically built on a token basis, the main reason being that it would ensure the smoothest possible transition between the current financial structure and digital central bank money.

Regarding the structure of CBDC, two main models are known:

- Single-tier: here, the central bank is in direct contact with all economic agents, either by keeping their accounts or by issuing them with digital coins. The disadvantage of this solution is that, as the central bank emerges as a direct competitor to commercial banks, it could cause a restructuring of the entire financial sector, which could significantly shake up overall financial stability.

- The tiered system would reflect the current institutionalized financial hierarchy, where the central bank would provide CBDC services to economic actors not directly but through other financial institutions.

The following figure shows a possible digital dollar implementation with token-based digital dollar issuance and a tiered structure that would build on the current banking system in a similar way to the current dollar-based two-tier banking system:

- The Fed controls the monetary policy, issuance and possible withdrawal of the digital dollar.

- The digital token issued will first be received only by qualified financial institutions, which guarantee further distribution.

- At the end-user and retail level, the system would work like cash, apart from being completely digital, of course: Individual actors would be able to exchange value with a purely digital wallet, in a P2P way, ie without any institutional involvement.

There are no proposals or roadmaps for concrete implementation yet, so it is not certain that this will happen in the short term. However, if implemented, the ideas and architectural elements mentioned above will be an integral part of the digital dollar.

European Blockchain Infrastructure

EBSI (European Blockchain Service Infrastructure) is a blockchain service provided by the European Union in a test phase for the time being, with the aim of providing a single blockchain service to Member States. The antecedents of the project include the European Blockchain Agreement of 2018, to which Hungary also joined in 2019. On the other hand, the Alastria network, which provides the countries of the Iberian Peninsula with a quasi-state distributed general ledger technology platform, using a modified Ethereum / Quorum technology.

The development of the platform runs on several levels: on the one hand, they try to integrate as many countries as possible at Member State level and run local nodes in as many places as possible. From this point of view, the system can be considered as a consortium blockchain: no one can connect to the network and run their own node completely freely, but it is possible to create a fixed number of dedicated nodes per country. On the other hand, there is a strong emphasis on developing the base platform. This is not a completely new distributed general ledger technology, but the integration of existing and somewhat functional blockchain platforms into a single framework. Currently, the platforms to be integrated are a consortium solution from Ethereum, the Hyperledger Fabric consortium blockchain solution, and the Hyperledger Indy framework for decentralized identification. However, this list is not necessarily final, new basic blockchain technologies may be used in the future.

In addition to the development of the basic platform, the testing of use cases at the small experimental level has also started in parallel. In 2019, the following applications were launched:

- Notarisation: one of the features of the blockchain is that it is very difficult to change the entered transactions, so it is excellent for auditing the consistency of critical data and contracts. In practice, digital fingerprints of sensitive data and an associated timestamp are usually written into the blockchain so that the state of a given document at a given point in time can be audited.

- Diploma: the user case allows university diplomas awarded in the territory of the Union to be verified and easily exchanged between countries.

- European identity system: the use case aims at digitizing the various solutions used for identification in the Union.

- Authentic data sharing: aims at reliable and credible data sharing between the different institutions of the EU Member States.

The list is by no means final. It is planned that new application cases will be selected and implemented each year.

Technologically, the EBSI framework is organized into layers:

- The lowest infrastructure layer is responsible for a reliable and secure network connection between the nodes.

- The “chain and storage” layer implements the specific blockchain services by supplementing it with a so-called off-chain solution suitable for distributed storage.

- “core services” implements EBSI’s core services in a blockchain agonistic way, allowing the underlying blockchain platforms to change.

- The “user-case” layer implements the application cases listed above.

- The aim of the top tier is to enable the Union's industry to implement complex business applications using the layers mentioned above.

As mentioned at the beginning, EBSI is by no means a final service, after the 2019 start-up and initial deployment cases and test phase, new deployment cases will be selected in 2020, followed by the second version of the base platform from 2021. While it is still conceivable that we will have to wait a year or two before we can develop productive applications over EBSI, it is definitely worth keeping an eye on the evolution of the technology.