Decentralization is the final frontier for CBDCs

Published at: April 25, 2021

As central bank digital currencies, or CBDCs, continue to garner mainstream traction across the global financial landscape in recent years, almost all central banks are actively researching the benefits and risks of offering a digital currency to the public.

In its most basic sense, a CBDC is a digital form of fiat money, backed by a suitable amount of monetary reserves like gold or foreign currency reserves. Each CBDC unit acts as a secure digital instrument equivalent and can be used as a way of payment, a store of value and an official unit of account. What distinguishes them from stablecoins — similar digital offerings whose value is pegged to fiat — is that they are government-issued and backed by central bank-issued money, making them completely regulated.

China’s Digital Currency Electronic Payment, or DCEP, project is arguably the most advanced CBDC trial, which has already been rolled out for consumer testing across major regions of the country including Beijing, Suzhou, Shenzhen and, most recently, Chengdu. With the country aiming to release the digital yuan before next year’s Winter Olympics, China is positioning itself as a global leader within the digital currency sector.

While the digital yuan was initially quite limited in its overall scope of use, its expansion has been quite explosive over the course of the last few months, with the digital currency most recently being utilized for a number of large-scale digital transactions including online shopping, ATM withdrawals, etc.

Furthermore, to help people understand the value proposition put forth by CBDCs, the Chinese government has already engaged with several educational blockchain projects, to help its population deepen their understanding in regard to decentralized technology, smart contracts and other niches related to this ever-evolving space.

Decentralized CBDCs conceptualized

As things stand, in order for a CBDC to be adopted by any state, it needs to comply with the region’s existing monetary policies. Central banks, while curious about CBDCs, are still quite apprehensive about digital assets, since they introduce a level of decentralization into the equation that quite directly challenges the way in which their existing governance protocols work.

For those governments looking to digitalize their economies through the use of CBDCs, it seems quite obvious that in order for these offerings to truly succeed, they need to benefit from arguably the most revolutionary aspect put forth by cryptocurrencies and blockchain tech as a whole: decentralization.

While most of the CBDC projects that have been envisioned over the last few years seek to enable peer-to-peer transactions, they tend to make use of governance frameworks that are authoritarian in nature — i.e., they are centralized and controlled by a single body. However, as public trust in governments and banking institutions continues to erode, there is little incentive for consumers to adopt such kinds of CBDCs.

Therefore, it stands to reason that there truly does exist a real window of opportunity for the creation of digital currencies that are decentralized in their governance and overall scope of utilization. In fact, there are already solutions in the market today that can help make this vision a living reality.

There are blockchain ecosystems that come replete with decentralized digital identity solutions that can allow central banking institutions to quite easily and efficiently weed out the identities of individuals suspected of committing crimes while protecting the privacy of its other CBDC users.

Such platforms do not require users to upload information directly onto a server, but instead upload encrypted information that is only transmitted via a secure end-to-end encrypted network that cannot be intercepted. What’s more, since such frameworks allow CBDCs to function in a totally decentralized, transparent manner, they can facilitate the creation of complex logic contracts and financial instruments such as bonds, derivatives, etc.

Here’s why decentralization is better

The most commonly employed architectural design for retail CBDCs comes in the form of a permissioned distributed system that does not have to necessarily reside on a blockchain. As a result, these systems tend to feature a single point of failure, and given how important CBDCs can potentially be to a country’s economic growth, such risks need to be mitigated at all costs.

That being said, if a CBDC were to be devised in a distributed fashion, the aforementioned risks could be completely eliminated from the picture.

Another point to consider is that centralized blockchains are still relatively slow, thus the use of decentralized solutions, such as distributed ledger technology, stands to make CBDC transactions much faster and far more streamlined. To help digital currencies grow, transaction speeds need to be extremely efficient, otherwise a payment system that is reliant on such tokens is unlikely to succeed.

Decentralization also allows individuals to own their own wallets, as well as be in possession of their private keys — basically meaning that the custody of one’s coins is always with the individual, not with a centralized body. This can help avoid many of the data breaches we’ve seen in the past, which could otherwise be catastrophic if, for example, the funds were stored in one single location.

ECB wants veto powers over stablecoins operating in the eurozone

Another argument for the decentralization of fiat-backed cryptocurrencies is that as more and more countries start to make use of CBDCs and stablecoins, central banks all over the world will try to tighten their regulatory purse strings over these offerings, since they stand to put a dent in their control over payments, banking and the supply of money.

In this regard, the European Central Bank, or ECB, recently told European Union lawmakers that it wants complete veto authority when it comes to the launch of stablecoins, such as Facebook’s Diem in the eurozone, as well as a larger role when it comes to the supervision and regulation of digital assets.

EU members have been working toward creating a comprehensive set of rules for the governance of crypto assets — including stress tests and capital and liquidity requirements — since September 2020. A recent guideline reads as follows:

“Where an asset-reference arrangement is tantamount to a payment system or scheme, the assessment of the potential threat to the conduct of monetary policy, and to the smooth operation of payment systems, should fall within the exclusive competence of the ECB.”

Even the ECB is working on its own digital euro, with the asset most likely to make its way into the global financial ecosystem after thorough regulatory scrutiny and testing within the next four years or so.

The views, thoughts and opinions expressed here are the author’s alone and do not necessarily reflect or represent the views and opinions of Cointelegraph.

Sky Guo is CEO of Cypherium. His extensive knowledge of blockchain consensus, transactions and cryptographic algorithms stems from his background in computer science. With a Bachelor of Science from Pepperdine University and a degree in entrepreneurship from Draper University, Sky also serves as a columnist for Caixin, a Chinese financial media outlet.