Technical note
5 minute read

Modernizing banking with central bank digital currencies

The financial industry and its banking sector are undergoing a significant transformation, with a growing trend of tokenizing digital (and physical) financial assets — including national currencies. This transformation has political and business implications, alongside technological enablement barriers.

What is a Central Bank Digital Currency and what are its benefits and expected impact?

One of the most prominent trends in the industry is nations creating Central Bank Digital Currencies (CBDC) for use in both retail and wholesale contexts. A retail CBDC refers to a digital currency with the direct liability of a country’s central bank that can serve as legal tender for payments and storage of value. A “wholesale CBDC” refers to wholesale transfers of currency and is typically associated with the digital representations and exchange of other financial assets (such as bonds and securities), between commercial banks and central banks.

Wholesale CBDCs are expected to bring higher degrees of transparency and efficiency in wholesale settlements. Retail CBDCs, on the other hand, represent a way for central banks to respond to the reduced use of cash and increasing investments in digital payments and cryptocurrencies in recent years. The evolution of Web3 decentralized finance (DeFi) services and investors’ attraction to these options are yet another accelerator for governments to introduce CBDCs. Typical Web3 DeFi services are still mostly unregulated and have resulted in the past in massive investor losses.

Retail CBDCs are expected to impact the global financial system both from an overall business model standpoint, and from the perspective of stakeholders. Many individuals could potentially reconsider their use of traditional central bank currencies for their payments, given that new digital variants could offer an increased range of applications.

Where do central banks stand in adopting CBDCs?

As such, traditional financial institutions have been actively exploring appropriate legal and technology frameworks for CBDCs and digital assets more generally. According to the CBDC Tracker of the Atlantic Council, more than 110 central banks (whose corresponding countries representing over 95% of the global GDP) are exploring CBDCs. A few G20 countries are now in the advanced stages of CBDC development or have fully launched a digital currency. In Europe, a Digital Euro frontend pilot is underway, with the European Central Bank, the Swedish Riksbank, and the Bank of England having announced calls for market research on CBDCs. In the US, the White House issued an executive order in March 2022 to ensure the responsible development and implementation of digital assets, including the development of a US CBDC. In Asia, the Reserve Bank of India has undertaken several experimentations already, and China’s digital yuan pilot — which already reaches 260 million people — is set to expand to most of the country in 2023.

What are the technical challenges?

From a technology standpoint, the management of regulated digital assets, whether fungible or non-fungible, comes with challenges in such areas as transactor privacy, compliance, scalability, performance, and interoperation. Resilience requirements of digital asset systems have changed from the crash-fault tolerance of traditional Financial Services infrastructure to compromise resiliency. This brings to the surface the need and relevance of distributed consensus and transparency mechanisms. Meeting all these requirements in a system that is practical from both a transaction latency and a throughput perspective requires:

  1. A careful investigation of the use cases to be supported and their threat models (including who are the system actors, who can be trusted today, who tomorrow and in what ways)
  2. Full-technology-stack optimization for the needs of these use cases, including cryptographic libraries, distributed consensus systems, distributed ledger technologies (DLTs), and the use of dedicated hardware at the infrastructure layer of the stack

However, it is important to note that these optimizations are not intended to substitute, but rather to complement and strengthen the security, resilience, and availability provisions of dedicated infrastructure services, such as those of z/OS systems for on-premises or multi-cloud deployment. Evidently, a recent call for market research by the European Central Bank proposed the use of a multi-cloud deployment for a digital Euro system, while the EU Digital Operation Resilience Act (DORA) is also compatible with this approach. 

How does IBM Research work address these challenges?

The Decentralized Trust team at IBM Research is working to offer the next generation of critical digital asset infrastructure. The team’s scientific work was driven initially by researchers’ interest in accomplishing asset transfer capabilities that meet the needs of enterprises for privacy, accountability, transparency, audit support, and interoperability. That work was validated by the research team’s involvement in two CBDC projects, which were part of the Banque de France’s call for experimentation in March 2020. In both projects, the use of DLTs was recommended as a way to increase the resilience and transparency of the overall CBDC system, lowering the risk, and the system’s operational cost. At the same time, advanced cryptographic protocols were developed and implemented by the team to amortize the need for accountability in a highly privacy-preserving setup.

The first experiment was conducted with a consortium of financial actors led by Euroclear on the tokenization of government bonds and their distribution in a primary and secondary market using a CDBC. Several secondary market processes were fully automated during the experiment using the smart contracts capability of the blockchain, including auto-collateralization, on-flow, and coupon payments. This experiment was concluded successfully after the consortium was able to replay a complex scenario covering several days of bond trading.

The blockchain platform used for the experiment, called DL3S, is a platform based on Hyperledger Fabric that embeds an asset derived by IBM Research called Token SDK, a Hyperledger Labs project that enables unique privacy and audit support features.

Token SDK offers a platform-agnostic token exchange capability with configurable privacy levels via dedicated modules called drivers. The “Zero Knowledge Asset Transfer” (ZKAT) driver supports enterprise privacy features, where the transactions remain anonymous and their transactional data confidential, unless a requirement for them to be audited is on the table. In the latter case, authorized auditors could access the otherwise confidential data of that individual. The actual ZKAT capability is based on Zero Knowledge Proofs, the details of which were published in a scientific conference in 2020.

The second experiment was conducted with HSBC. The objective was to demonstrate the interoperability between the DL3S platform that was used in two wholesale CBDC networks and the HSBC secondary market network based on R3 Corda. A corporate bond issuance, distribution, and coupon payment was implemented as the use case, with a particularity on the coupon payment operation which triggered an foreign exchange transaction to pay in a different CBDC currency from the bondholders. At the heart of this experiment, another asset produced by IBM Research was used through the Weaver Interoperability Framework, a cutting-edge interoperability toolkit for DLTs. The Weaver Interoperability Framework accommodates a variety of threat models, without imposing changes to the communicating network infrastructures.

The IBM Research team continues to work with central banks on cutting-edge technology for CBDCs. In particular, we’re continuing to collaborate on performance and scalability fronts with several central banks. By introducing changes to the many layers of a CBDC technology stack and underlying DLT, we aim to demonstrate that the use of DLTs is one of the most suitable technology choices for both wholesale and retail CBDCs.