Central banks across the globe are exploring and testing Distributed Ledger Technology (DLT) to provision Central Bank Digital Currencies (CBDC). In this blog, Arjeh van Oijen, Head of Product Management, and Atul Verma, Senior Payments Architect at Icon Solutions, explore how DLT overcomes the restrictions of existing financial infrastructures, to provide a viable digital alternative to physical coins and banknotes.
The changing face of money
Money as we know it, also known as fiat currency, has taken many guises. For centuries, ‘money’ meant coins and banknotes. Yet nowadays, the majority of fiat money is registered in commercial bank accounts, and payments take place through a digital transfer between two bank accounts.
Over the years, interest in cryptocurrencies has exploded to become a multi-trillion-dollar business. This is remarkable considering cryptocurrencies and their underlying platforms are not regulated and run by a central (governmental) body, but by ‘communities of independent parties’. Their value is completely determined by supply and demand. As a result, cryptocurrencies have proven to be very volatile. This has made them interesting for speculation but less suited for today’s financial system, where it is essential for the acceptance of a currency that its value remains stable and can be redeemed with the issuer at any moment of time in the future.
While crypto maximalists would disagree, fiat money – which is government-issued currency controlled and regulated by central banks – is much more stable. Central banks are responsible for ensuring the value of fiat currency remains secure, and have multiple instruments at their disposal to help keep inflation (or deflation) within required boundaries.
What are the advantages of DLT platforms for financial infrastructures?
In the slipstream of cryptocurrency’s growing popularity, interest in the underlying technology has also increased in recent years. This technology, known as blockchain or DLT (the latter is considered more adequate), makes it possible to create highly secure and reliable platforms to transfer assets and perform business transactions. The Bank for International Settlements (BIS) reports that as of 2021, 60% of central banks were experimenting and conducting their own proof of concepts with DLT technology to enable a Central Bank Digital Currency (CBDC). A CBDC is a fiat currency issued by a central bank and made available on a DLT platform to facilitate the processing and settlement of financial transactions between financial institutions and/or end users.
A key driver of central banks’ strong interest in DLT is the fact that it can be used to overcome the restrictions of existing financial (market) infrastructures. DLT makes it possible to create highly secure and reliable platforms to transfer assets and perform business transactions, without the need to rely on one centralised infrastructure. DLT-based CBDCs can be used to settle payments and other financial transactions in real time, 24×7, and with a high availability, and is much less vulnerable to disruptions (including cyber-attacks) than existing infrastructures. DLT also meets the highest security requirements in the market from both a reliability as well as a data confidentiality perspective.
CBDC as an enabler of financial inclusion?
Besides the settlement of financial transactions between financial institutions, digital currency platforms built on DLT could deliver affordable and scalable solutions, and the data transparency and security required to help boost financial inclusion.
A significant portion of the global population still has no access to basic banking services. DLT offers lower transaction costs, which provides an incentive for financial service providers to expand their operations to reach communities in underserved economies. It would also enable unbanked populations to open an account in fiat currency and use this account to receive funds and perform payments. What’s more, with DLT technology it is even possible to issue digital currencies for a specific purpose, such as fees for education.
As the BIS notes: “A trusted and widely usable retail CBDC must be secure and accessible, offer cash-like convenience and safeguard privacy.” This is where DLT stands to deliver some significant advantages over conventional digital currency bank architecture, and a growing number of central banks are considering it for their next-generation payment platforms. India’s central bank, for example, has just revealed its plan for a blockchain-based rupee by 2023 and at Icon we expect more to follow.
As momentum for digital currencies continues to build, DLTs present wide-ranging strategic opportunities for central banks to expand their fiscal armoury, modernise payment systems, support economic stability, and promote financial inclusion.