How Central Bank Digital Currencies (CBDC) Can Transform Money and Finance

Today, I am going to write a blog post about a very interesting and important topic: central bank digital currencies (CBDCs). CBDCs are a new form of money that central banks can create and use in the digital world. They are different from the traditional money that we use every day, such as cash, bank deposits, or credit cards. CBDCs have some unique features and benefits that can make the financial system more efficient, innovative, and inclusive. But they also have some challenges and risks that need to be carefully considered and addressed.

In this blog post, I will use a publication from BIS titled "A step toward new financial market infrastructure: infrastructure: Bank of Korea’s initiative" as my main source of information. The Bank of Korea is the central bank of South Korea, and it has recently launched a pilot project to explore the possibility of issuing a wholesale CBDC. A wholesale CBDC is a type of CBDC that is used only by financial institutions, such as banks, for large-value transactions and settlements. It is different from a retail CBDC, which is a type of CBDC that is used by the general public for everyday payments and transfers.

The publication explains the design and architecture of the CBDC network that The Bank of Korea is testing, as well as the objectives and considerations of their project. It is a very technical and detailed document, but don’t worry, I will try to explain it in a simple and engaging way. I will also use some imaginary examples to help you understand better. By the end of this blog post, you will learn:

• What are CBDCs and why are they important?
• What are the main features and benefits of the CBDC network that the Bank of Korea is testing?
• What are the main challenges and risks of the CBDC network that the Bank of Korea is testing?
• How does the CBDC network work in practice?
• What are the main takeaways from the Bank of Korea’s pilot project?

Are you ready? Let’s get started!

Read my other posts here: Conventional Finance - FinFormed, Islamic Finance - FinFormed, Takaful - FinFormed, Career - FinFormed and Randow Writings - FinFormed

What are CBDCs and why are they important?

Money is something that we use every day to buy goods and services, to save for the future, or to exchange with other people. Money has three main functions: it is a store of value, a unit of account, and a medium of exchange. A store of value means that money can keep its purchasing power over time. A unit of account means that money can measure the value of different goods and services. A medium of exchange means that money can facilitate transactions between buyers and sellers.

Money can take different forms, such as physical cash, bank deposits, or electronic payments. Each form of money has its own advantages and disadvantages. For example, cash is easy to use and widely accepted, but it can be lost or stolen, or become dirty or damaged. Bank deposits are safe and convenient, but they require intermediaries, such as banks or payment service providers, to process transactions, which can incur fees or delays. Electronic payments are fast and convenient, but they require internet access and digital devices, which may not be available or affordable for everyone.

CBDCs are a new form of money that central banks can create and use in the digital world. They are digital tokens that represent a claim on the central bank. They are issued by the central bank and backed by its reserves. They are legal tender, which means that they have to be accepted as a valid form of payment by law.

CBDCs have some unique features and benefits that can make the financial system more efficient, innovative, and inclusive. Some of these features and benefits are:

• CBDCs can be programmable, which means that they can have smart contracts embedded in them. Smart contracts are self-executing agreements that can automatically perform certain actions when certain conditions are met. For example, a smart contract can automatically pay interest on a loan when it is due, or automatically transfer funds to a charity when a donation goal is reached.
• CBDCs can be interoperable, which means that they can work seamlessly with other digital platforms and assets. For example, CBDCs can be used to pay for tokenised assets, such as securities or artworks, on distributed ledger platforms. Tokenised assets are digital representations of real-world assets that can be easily traded or transferred on digital platforms.
• CBDCs can be inclusive, which means that they can provide access to financial services for everyone who has a digital device and an internet connection. For example, CBDCs can enable people who do not have bank accounts or credit cards to participate in the digital economy and benefit from lower costs and higher convenience.

However, CBDCs also have some challenges and risks that need to be carefully considered and addressed. Some of these challenges and risks are:

• CBDCs can pose legal and regulatory issues, such as how to define their legal status, how to protect their users’ privacy and data rights, how to prevent money laundering and terrorist financing, and how to coordinate with other jurisdictions and international standards.
• CBDCs can have economic and financial implications, such as how to manage their supply and demand, how to ensure their price stability and convertibility, how to balance their innovation and competition with their safety and security, and how to avoid negative effects on the existing monetary system and financial intermediation.
• CBDCs can require technical and operational solutions, such as how to design and implement their architecture and infrastructure, how to ensure their scalability and performance, how to enhance their resilience and reliability, and how to deal with cyberattacks and fraud.

Therefore, CBDCs are not a simple or straightforward solution. They require a lot of research and experimentation, as well as collaboration and consultation among various stakeholders, such as central banks, regulators, financial institutions, technology providers, academics, and the public. Different countries may have different needs and preferences for CBDCs, depending on their economic, financial, social, and cultural contexts. There is no one-size-fits-all approach for CBDCs.

What are the main features and benefits of the CBDC network that the Bank of Korea is testing?

The Bank of Korea is one of the central banks that is exploring the possibility of issuing a CBDC. It has recently launched a pilot project to test a wholesale CBDC network. A wholesale CBDC network is a network that allows financial institutions, such as banks, to issue and use digital currencies for large-value transactions and settlements. It is different from a retail CBDC network, which is a network that allows the general public to use digital currencies for everyday payments and transfers.

The Bank of Korea’s pilot project has four main objectives:

• To redirect the public’s interest in cryptoassets toward more innovative, constructive, and responsible channels. The Bank of Korea wants to encourage the private sector to use its infrastructure to develop new payment and financial services that are based on digital currencies, rather than on unregulated and risky cryptoassets.
• To support the integration of the emerging concept of tokenisation into the realm of assets. The Bank of Korea wants to facilitate the growth of the tokenised asset market by enabling seamless payment and settlement for tokenised assets using digital currencies.
• To explore and assess a means to significantly enhance payment system efficiency by introducing programmable digital currencies issued by banks. The Bank of Korea wants to evaluate the potential of programmable digital currencies to offer innovative and convenient payment services that are not possible with conventional payment methods.
• To realise the unified ledger concept proposed by the BIS. The Bank of Korea wants to prevent the fragmentation or siloing of the financial infrastructure by ensuring interoperability among diverse programmable platforms using CBDC as an anchor.

The Bank of Korea’s pilot project has a unique design and architecture for its CBDC network. The CBDC network consists of two main parts: the CBDC system and the connected outside systems.

The CBDC system is a permissioned programmable platform that is operated by the Bank of Korea and participated by commercial banks. The CBDC system allows three types of digital currencies to be issued and circulated:

• CBDC: This is a digital currency that is issued by the Bank of Korea and backed by its reserves. It serves as a settlement asset for interbank funds transfers and as collateral for issuing other digital currencies.
• DC-I: This is a tokenised deposit that is issued by commercial banks based on fractional reserve banking. It resembles traditional bank deposits in structure, but it uses blockchain technology in form factor.
• DC-II: This is a tokenised e-money that is issued by commercial banks based on full reserve banking. It resembles current e-money in function, but it uses blockchain technology in form factor.

The CBDC system ensures that all three types of digital currencies can be exchanged at par using CBDC as an anchor. For example, if a user wants to exchange DC-I issued by Bank A with DC-II issued by Bank B, they can do so through an automatic conversion process using CBDC as an intermediary.

The connected outside systems are platforms that are tailored for specific purposes or use cases, such as carbon credit exchange or security token trading. They are interlinked with the CBDC system through bridges or gateways that allow assets or money to be transferred across different networks. The connected outside systems allow another type of digital currency to be issued:

• DC-III: This is a specialised payment instrument that is issued by commercial banks on the connected outside systems. It is backed by DC-II held in the CBDC system as collateral. It is used only for paying for tokenised assets on the same platform.

The connected outside systems enable delivery-versus-payment (DvP) for transactions involving tokenised assets using DC-III as a payment token. For example, if a user wants to buy carbon credits from another user on a carbon credit exchange platform, they can do so using DC-III issued by their bank on the same platform.

The Bank of Korea’s pilot project has several features and benefits that can make its CBDC network more efficient, innovative, and inclusive. Some of these features and benefits are:

• The CBDC network is programmable, which means that it can have smart contracts embedded in it. Smart contracts can automatically perform certain actions when certain conditions are met. For example, a smart contract can automatically pay interest on a loan when it is due, or automatically transfer funds to a charity when a donation goal is reached.
• The CBDC network is interoperable, which means that it can work seamlessly with other digital platforms and assets. For example, the CBDC network can be used to pay for tokenised assets, such as securities or artworks, on distributed ledger platforms. Tokenised assets are digital representations of real-world assets that can be easily traded or transferred on digital platforms.
• The CBDC network is inclusive, which means that it can provide access to financial services for everyone who has a digital device and an internet connection. For example, the CBDC network can enable people who do not have bank accounts or credit cards to participate in the digital economy and benefit from lower costs and higher convenience.

However, the CBDC network also has some challenges and risks that need to be carefully considered and addressed. Some of these challenges and risks are:

• The CBDC network can pose legal and regulatory issues, such as how to define its legal status, how to protect its users’ privacy and data rights, how to prevent money laundering and terrorist financing, and how to coordinate with other jurisdictions and international standards.
• The CBDC network can have economic and financial implications, such as how to manage its supply and demand, how to ensure its price stability and convertibility, how to balance its innovation and competition with its safety and security, and how to avoid negative effects on the existing monetary system and financial intermediation.
• The CBDC network can require technical and operational solutions, such as how to design and implement its architecture and infrastructure, how to ensure its scalability and performance, how to enhance its resilience and reliability, and how to deal with cyberattacks and fraud.

Therefore, the Bank of Korea’s pilot project is not just about testing a new technology or product. It is about exploring a new paradigm for money and finance in the digital age. It is about understanding the opportunities and challenges of this new paradigm, learning from the experiences of other countries and sectors, listening to the voices of different stakeholders, adapting to the changes in the environment, innovating in response to the needs of the society, and contributing to the development of the global community.

How does the CBDC network work in practice?

Let’s imagine a scenario where Alice wants to buy a tokenised artwork from Bob on a distributed ledger platform using DC-III issued by her bank.

Firstly, Alice needs to deposit some money into her bank account. Her bank will then issue DC-I based on her deposit. DC-I is like a digital version of her bank deposit. It represents her claim on her bank.

Secondly, Alice’s bank will use some of its reserves at the Bank of Korea to buy an equivalent amount of CBDC. The Bank of Korea will then issue CBDC based on these reserves. CBDC is like a digital version of cash. It represents Alice’s bank’s claim on the Bank of Korea.

Thirdly, Alice’s bank will use this CBDC as collateral to issue DC-II on the CBDC system. DC-II is like a digital version of e-money. It represents Alice’s claim on her bank’s reserves at the Bank of Korea.

Fourthly, Alice’s bank will use this DC-II as collateral to issue DC-III on the distributed ledger platform where Alice wants to buy the tokenised artwork from Bob. DC-III is like a digital version of payment tokens. It represents Alice’s claim on her bank’s DC-II at the CBDC system.

Finally, Alice can use this DC-III to pay Bob for his tokenised artwork. Bob can then redeem this DC-III for DC-II at Alice’s bank on the CBDC system. Bob can also redeem this DC-II for CBDC at Alice’s bank on the CBDC system. Bob can also redeem this CBDC for cash at his own bank.

This process may seem complicated at first glance, but it actually mirrors what happens in traditional payment systems. The main difference is that everything happens digitally and automatically using blockchain technology.

What are the main takeaways from the Bank of Korea’s pilot project?

The Bank of Korea’s pilot project provides valuable insights into how central banks can design and implement their own CBDC networks. Here are five main takeaways:

1. CBDCs are not just about technology: They are about money and finance in the digital age. They require a deep understanding of economics, law, sociology, psychology, politics, ethics, history, culture, etc.
2. CBDCs are not just about central banks: They involve various stakeholders such as commercial banks, technology providers, regulators, academics, consumers etc.
3. CBDCs are not just about domestic issues: They have global implications such as cross-border payments or international standards.
4. CBDCs are not just about risks: They offer opportunities such as efficiency, innovation, inclusion etc.
5. CBDCs are not just about the present: They shape the future of money and finance.

In conclusion, CBDCs are a fascinating and complex topic that deserves our attention and study. They represent a new frontier for central banks and society as a whole. They challenge our traditional concepts and practices of money and finance. They open up new possibilities and dilemmas for our digital age. They call for our collective wisdom and action to navigate this uncharted territory.

Disclaimer: The views expressed in this blog post are those of the author and do not necessarily reflect the views of any institution or organization. The information provided in this blog post is for educational purposes only and should not be used as financial advice or investment recommendation.

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