The advance of central bank digital currencies (CBDCs) represents a fresh slate for the global economy – an opportunity to build a financial future detached from the pitfalls of the past. But that can't happen unless we heed the lessons, and failings, of traditional currency. To do that, we must embrace collaboration and foster interoperability between global CBDCs.
For both retail and institutional beneficiaries of CBDCs, interoperability can stimulate advantages that disjoined instruments would otherwise omit. For institutions, such as central and commercial banks, cross-chain compatibility can prove to maximise resource utilisation, decrease bottlenecking, and combat against financial disintermediation.
For retail, CBDCs could flatten costly remittances and cross-border transfers as well as meet the basic requirements of some 1.7 billion people without access to financial services.
Before getting carried away in the reverie of a financial utopia, however, it's necessary to make a few distinctions. There are, after all, several distinct varieties of CBDC. These include wholesale CBDCs, which primarily centre around the interbank settlement, and retail CBDCs, which essentially symbolise digital fiat currency. It's the latter, though, which holds the key to real economic innovation.
Following China's Example
Retail CBDCs aim to eliminate pain points within the current interbank payment methods, and generally modernise the financial system. They promise reliable, resilient, fast, and efficient financial transactions while harbouring all the hallmarks of money as we know it.
In Asia, Europe and – even gradually – the US, these retail iterations are beginning to take form.
But none is more actualised than China's digital Yuan – dubbed DCEP. Having already undergone several trials within the platforms of Tencent-backed delivery giant Meituan-Dianping and Chinese ride-hailing service DiDi, the digital Yuan recently turned its attention to formal deployment. After rigorous testing of its digital wallet in Shenzhen, DC/EP is primed to go live in the Greater Bay Area.
Comprised of Guangdong, Hong Kong, and Macau, and representing a conjoined GDP of $2 trillion, it's hardly a surprise that the Greater Bay area was chosen as the official deployment zone for DCEP. With its firmly established business links and high volume of international trade, Guangdong is likely to be a significant district for DCEP expansion, especially when it comes to cross-border adoption.
But this wouldn't be possible without interoperability instilled by DCEP infrastructure. The digital yuan is built within a two-tier formation – a more collaborative approach in which development and distribution can occur via both central and commercial banks, endowing far more compatibility between the PBoC, commercial banks, as well as their business cohorts. These include payment service giants Alipay and WeChat Pay, which together control approximately 90% of China's payments market.
Without the two-tier system, integration of these two fintech firms may have involved some element of financial disintermediation, curbing the control of the PBoC. This, along with ensuring fewer bottlenecks and the ability to stretch resources between one or more institutions, is just a few of the advantages of using a two-tier system.
The two-tier infrastructure allows interoperability on a domestic scale. The system provides for collaborative development between the PBoC and commercial banks, granting access to the latter's research and development teams, talent reserve, IT equipment, and other resources. By fostering collaboration, the PBoC and the commercial banks can assure against bottlenecking DC/EP and avoid financial disintermediation that single-tier infrastructure could be prone to.
A CBDC operating within a single-tier – a system in which the central bank distributes to citizens directly – can become stunted as there is less of an onus on joint development. Meanwhile, under the much more collaborative multi-tiered approach, developmental and operational risks are minimised as the workload can be shared among institutions.
No CBDC Is an Island
On a larger scale, however, for DECP to fulfil its goal of cross-border adoption and global establishment, it needs to extrapolate its intrinsic interoperability and foster fully-fledged cross-chain compatibility; in fact, all CBDCs do.
CBDCs aren't compatible by design. This renders several drawbacks, not least being the inability to interact with another CBDC cross border. CBDC transfers of this nature will require a unified system, or custom-designed infrastructure, deliberated upon by either end of the trade. While this works for nations in good standing with one another, it's hardly practical for the rest of the world and could well end up capping the potential of CBDCs.
What instead is required is a uniform global solution, not unlike SWIFT – but, of course, entirely removed from the legacy system. A third-party mediator between two distinct CBDCs, or even digital currencies, could validate cross-chain transfers via a joint consensus mechanism – guaranteeing that transaction data is constant with information on either side of the transfer and avoids the double-spend issue.
A system like this would also settle disparities in compliance with state transfer rules, including anti-money laundering regulations and sovereign monetary policies.
Central banks and governments must heed the benefits of cross-chain compatibility before it's too late. Fail to do so, and CBDCs may be doomed to serve as little more than a facsimile of traditional currency.
- 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.