CBDCs With a Twist: The Public-Private Solutions Needed for Adoption

On May 26, Tommaso Mancini-Griffoli, a representative from the International Monetary Fund, stated that moving forward, the best way to harness the potential of central bank digital currencies would be by fostering synthetic partnerships between the private and public sectors.

Further expounding his views on the matter, the deputy division chief of the IMF’s monetary capital and markets department stated that the vision behind CBDCs being completely under the control of a central bank is now an outdated one and that the entry of private players could help spur innovation.

When asked about how such a partnership could even start to become conceptually feasible, he suggested that in cases of synthetic partnerships it should be the role of the private sector to concentrate on things such as innovation, interface design and client management, while the public sector should focus on issues related to regulation and confidence building.

This joint effort, in Mancini-Grifolli’s view, will not only allow CBDCs to flourish but also allow such unique financial offerings to operate smoothly within the confines of a regulated framework, thereby maximizing financial stability.

The pros and cons of synthetic CBDCs

To get a better understanding of the matter, Cointelegraph reached out to Luisa A. Blandon, a representative for Micobo GmbH, a software development and technology consultancy company with a focus on distributed ledger technology for capital markets. She pointed out that the suggestion of a public-private CBDC is not a new one and that forward-looking central banks such as the People's Bank of China already require payment operators such as Alipay and WeChat Pay to hold customers' funds in the form of reserves.

Blandon also alluded to the fact that other central banks, such as the Bank of England, have also considered the option. Not only that, but even the Reserve Bank of India, the Hong Kong Monetary Authority and the Swiss National Bank offer special-purpose licenses to nonbank financial technology firms, allowing them to hold reserve balances, subject to an approval process.

In terms of the benefits of synthetic CBDCs, the foremost advantage of such a partnership would be the increased stability of “e-money.” Synthetic CBDCs can disregard market and liquidity risks as well as mitigate default risks, two points that seem to be constants when considering how easy the issuance of e-money can be. Not only that, but public-private CBDCs can also ease the audit and control of client funds being issued using e-money, especially if the funds are dispersed across many banks. Given this fact, CBDCs can remain credible by offering lower risks as well as staying redeemable, meaning they hold the same value as the domestic currencies.

Another advantage of this approach is the direct involvement of central banks in e-money issuance. Using DLT, all reconciliations between participants can become more efficient and transparent, ultimately protecting consumers and reducing transactional costs. Additionally, audit processes and compliance procedures can be automated and encrypted, thus increasing the resiliency of the financial network in question. Moreover, the public-private partnership also ensures healthy market competition, given that the network can be controlled by a central banking authority, thereby disincentivizing the emergence of monopolies.

On a somewhat contrary note, Matthew Unger, the CEO of iComply — a regulatory technology and Know Your Customer/Anti-Money Laundering services firm — stated that if structured correctly, the public-private partnership model may enable blockchain technology to be applied to CBDCs sooner than any other alternative. However, he added:

“As with many things, the devil is in the details. Who is the ‘private’ party - Huawei? They already own the hardware for about half of the central banks in the world and have been advocating for blockchain based CBDCs for several years.”

Commenting on the disadvantages of the public-private setup, Blandon pointed out that if synthetic CBDCs were to go mainstream in the near future, they would end up “transforming the current system of Fractional banking to a Narrow banking one.” Furthermore, she added:

“During times of economic crises, it is entirely possible that massive runs of bank deposits may go to e-money and if client funds supporting e-money were held as wholesale financing banks, the run could be reversed as customers would likely to seek the protection of the banks’ deposit insurances. Conversely, if those funds were held as central bank’s reserves, the run risks would not be able to be discounted, provoking a migration of uninsured deposits from banks to e-money providers.”

Will central banks entertain the idea?

Even though CBDCs based on synthetic partnerships sound extremely appealing on paper, it is still worth looking at whether central banks are even willing to entertain such a compromise idea and part with so much of their power.

Cointelegraph spoke with Rich Foster, the former head of North America settlements for market and securities services at Citigroup and the founder of E2E Blockchains, a project that seeks to facilitate settlement finality with central bank currencies. In Foster’s view, many established banks are already exploring the idea of synthetic CBDCs. In this regard, he alluded to a recently formed consortium called Fnality International that has devised its very own central-bank-denominated digital currency: a hybrid CBDC that will still hold funds in each country’s central bank account and will be available for wholesale use only, not for retail.

The consortium is backed by many of the largest commercial banks and national exchanges across the globe such as UBS, Barclays, Banco Santander, the BNY Mellon, CIBC, Commerzbank, Credit Suisse and ING, among others. Foster added: “From a more retail-based standpoint, the Digital Dollar Project is another solution currently in the public discussion phase.”

Also, with the banking sector continuing to lose consumer confidence across the globe, the idea of private entities acting as substitutes for certain banking functions as well as distributors for CBDCs would most likely be viewed as a positive development.

Lastly, some believe that it would be ideal if CBDCs were backed and issued by central banks with the distribution side of things handled by private institutions. This is because private entities may not only warrant a higher settlement efficiency in the use of CBDCs for retail payment and settlement purposes but also in whole payment variants, which include large value, high priority transactions.

Could privacy be a major factor?

Privacy concerns in relation to public-private CBDCs have risen considerably over the past few months, especially as the financial sector has leaned more and more toward digitization. However, where traditional banking setups fail in terms of privacy, crypto-related technologies such as zero-knowledge proofs and smart contracts provide users with a highly secure transaction environment. In this regard, the wallet architecture for the distribution of CBDCs should ideally be designed using advanced cryptography such as homomorphic encryption or other similar methods.

Blandon opined that with a synthetic CBDC, many extra layers of technical complexity can be avoided, such that supervisory authorities can be given direct but pertinent access to encrypted transactions instead of going through rounds of requests, thereby making payments way more streamlined and hassle-free. She added:

“And while such modifications may change today’s existing due-process standards, the outcome would be the same, i.e. the information will easily be available for all the parties involved, especially if their aim is consumer protection.”

Unger believes that with the advent of client-side authentication software, zero-knowledge proofs and frameworks such as the Massachusetts Institute of Technology’s OPAL — or Open Algorithms — project, fears related to KYC and AML can largely be alleviated. However, he did add that without proper controls for privacy and governance, a public blockchain CBDC could be the “most privacy-invading citizen surveillance tool we have ever seen.”

E-money all the way

It seems quite clear that institutional and traditional financial players are aware of the fact that the future of payments and stores of value lies within the domain of e-money. However, it still appears as though they are yet to fully understand and embrace such technology with open arms.

That is why the synthetic CBDCs offer many risk-averse mainstream players an opportunity to leverage developments that have successfully been implemented by private initiatives. Also, mainstream banks may now have to rethink their role and start enhancing their capabilities to become better, more trusted and efficient e-money providers.

Synthetic CBDCs would definitely change many of the roles that banks currently handle, but they could also make consumer protection much more efficient, reducing risks and compliance costs.