The frothy nature of the financial markets throughout 2020 and early 2021 has put renewed focus on maintaining the safety of our financial landscape.

Dramatic stock market volatility, pandemic-related uncertainty, and a move away from physical cash have led many governments worldwide to explore alternatives to traditional reserve currencies.

Among the new mediums of exchange being explored, blockchain technology is consistently being considered, owing to its ability to launch digital currencies. But, as with any nascent technology, the path to fully digital currencies has yet to be clearly defined.

Instead of using pre-existing digital currencies, many banks are now looking to launch their own CBDCs. Here, we’re going to explore what CBDCs are and discover what they could mean for the blockchain landscape. We will also discuss why permissionless blockchains, like Cardano, could provide key benefits for CBDCs through decentralization.

What are CBDCs?

Central bank digital currencies, often abbreviated to CBDCs, are digital analogs of fiat currencies, such as the US dollar or Japanese yen, issued at a state level. CBDCs can either be issued by a central or national bank or alternatively by government agencies, and they are being explored for a number of use cases 42.

Digital forms of traditional fiat currencies could pave the way for instant and cheap cross-border payments without the need for payment processors, and also expedite the interbank securities settlement process. They could improve anti-money laundering and know-your-customer requirements compared to cash-based currency. For retail users, CBDCs could also reduce banking costs, and therefore potentially increase interest rates and banking benefits.

Multiple jurisdictions worldwide have publicly expressed their interest in launching a national CBDC. In October 2020 6, China finished its largest pilot project to date for its digital yuan, a project led by the People’s Bank of China. One of the worldwide leaders in the race for CBDCs, the People’s Bank of China rolled out their digital yuan to a focus group of 50,000 random participants.

The US Federal Reserve is also exploring the launch of a CBDC 23, assessing and analyzing the benefits of launching a digital US dollar. In Europe, the Bank of England, Sveriges Riksbank (Sweden), Swiss National Bank, and the European Central Bank are also working on CBDCs 12 for their respective fiat currencies.

In association with banks from around the world, the Bank of International Settlements (BIS), headquartered in Switzerland, laid out three key principles required from a CBDC:

• Coexistence with fiat and ‘other types of money’,
• Supportive of monetary and financial stability,
• Promoting innovation and efficiency.

The need for these features has typically led regulators and issuing banks to explore permissioned blockchains—generally seen to offer better controls over who can access data 9 through controlled membership, while still promoting innovation.

In some cases, CBDCs have sought alternatives to blockchains completely 13. But with recent permissionless blockchain developments such as scaling, sidechains, and flexible token issuance, the tide could be turning for CBDCs and public blockchains.

But first, let’s discover the difference between permissioned and permissionless blockchains.

Permissioned vs. permissionless—what’s the difference?

We often describe Cardano as a ‘permissionless’ or ‘public’ blockchain. This means that anyone, regardless of their background, affiliation, or location, can explore on-chain information and view the history of the blockchain. Public blockchains have decentralized node operators, and usually, anyone with the technical expertise and necessary hardware can run a node. On Cardano, this role is filled by stake pool operators.

On the other hand, permissioned or private blockchains only grant access to a number of participants—usually enterprise and institutional users. Permissioned blockchains have typically been used by private companies who wish to build backend infrastructure on the blockchain, but do not require a public and visible ledger of transactions.

Instead of decentralized node operators, permissioned blockchains usually reach consensus through a group of federated nodes, who agree on a version of the blockchain’s history. These federated nodes are usually operated by commercial entities or enterprises that use the blockchain, hence the term ‘permissioned’. Permissioned blockchains can still make use of open-source code, which lets enterprises verify the security of the underlying blockchain.

Some commonly used permissioned blockchains include Hyperledger by the Linux Foundation and Corda by R3. In an enterprise setting, permissioned and permissionless blockchains have their individual merits and use cases, but to date, banks have typically focused on permissioned ledgers.

Could permissionless blockchains offer benefits for CBDCs?

Permissioned blockchains may be beneficial for controlling access to the blockchain, but they do introduce issues of security. Like all relatively-centralized systems of record, they are vulnerable to attack.

According to Washington-based public policy organization Brookings, a single bulk data breach 2 of one permissioned node operator could potentially reveal the financial history and associated data of all on-chain participants.

In a discussion paper published by the Bank of England (BoE) in early 2020, BoE proposed that although a CBDC would need to remain permissioned to a certain extent by the bank, there could be benefits to pursuing greater decentralization.

The Bank of England describes the potential benefits 11 of using a public decentralized ledger as:

• Resilience: High availability and assurance of digital currency built on a public ledger,

• Programmability: The use of smart contracts and tokens for enabling ‘programmable money’,

• Reach: Data sharing via blockchain to provide access to a greater number of individuals,

• Use of cryptography: Public-key cryptography could help verify that the party sending a transaction is authorized to do so.

To use a CBDC, retail users and other participants could transact with authorized payment interface providers, who would communicate via APIs to a core ledger permissioned by the issuing bank.

As interfacing with the underlying ledger would require intermediaries, privacy-preserving steps could be taken for each user through these providers, regardless of whether the underlying blockchain was permissioned or permissionless.

Public digital currencies for all

As public blockchains mature and release new privacy-preserving features, banks exploring a CBDC launch may choose to use a decentralized and semi-permissionless solution.

At the very least, CBDCs could stand to benefit from multiple elements of decentralized technology, such as resilience to data loss and the high-availability of assets through the maintenance of a decentralized network. Similarly, a public blockchain would instil greater transparency in our global financial systems, and therefore bolster the people’s trust in banking establishments.

In the future, we may see national-level digital currencies launched on public blockchains, with certain oversight by central banking authorities to ensure their safe usage.

What are your thoughts on CBDCs? Do you think that digital assets should replace fiat currency? Do you believe that CBDCs should be built on open and transparent ledgers?

Let us know in the comments below!

Read more about blockchain’s potential here:

• Censorship on social media: how blockchain could be the new norm for unfiltered communications 59,
• How Cardano could fast-track financial inclusion in emerging economies 85,
• Tokenization in the real world—three industries that can be transformed by blockchain