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Mar 09, 2021

Decentralization and CBDCs

By: Andrea Civelli

In this blog post we elaborate on one of the principles of designing a successful Central Bank Digital Currency (CBDC) introduced in our first post about CBDCs: the importance of a decentralized system.


Why Does Decentralization Matter?

The payment system would benefit from decentralization in numerous ways. We can identify at least five major areas where the advantages of a blockchain based decentralized CBDC for the payment system would be large. 

  1. The first area is network stability. Every day, American banks use the Federal Reserve payment services, such as FedWire or FedACH, to electronically settle transactions for more than $3 trillion. All of the sudden, on February 23rd 2021 an operational glitch made the entire Federal Reserve payment system unavailable for a few hours. Important payment deadlines for that day were negatively impacted by the crash of the system.
    An efficient and secure payment system has become paramount in our modern economies. FedACH, for example, is used for paychecks, tax refunds, and other critical payments and transfers for hundreds of millions of people who rely on the system. This failure of the Fed payment system, albeit temporary, reminds us that centralized systems based on legacy technology are subject to single point of failure issues regardless of their level of efficiency.
    A CBDC based on a decentralized blockchain system, on the contrary, would rely on modern cryptography to solve the single point of failure problem and guarantee the level of stability a modernized payment infrastructure would require. Having a lower threshold for the hardware supporting the network, for example, a decentralized infrastructure ensures diversity in machines upholding the network and therefore mitigates the impact of any individual targeted vulnerability from taking down the whole system.
  2. The second area is security. One of the main characteristics of distributed ledgers is tamper resistance. The consensus protocol adds new blocks to the blockchain in a sequential way that creates an immutable, tamper proof record of transactions. By contrast, entries on centralized ledgers can be manipulated if the ledger’s database is hacked or otherwise compromised.
  3. The third is operational costs. The lighter structure requirements of the network, the simplified regulatory and managing requirements of the system, and lower entry costs for developers compared to a centralized system allow a decentralized payment system to reduce operational costs as well as the technology maintenance and updating costs.
  4. The fourth, and related to the previous point, is innovation. A system based on distributed ledger technology can accommodate new users and use cases with more flexibility than a centralized legacy system. This fosters competition and innovation among payment providers, keeping costs further down for final users as well.
  5. The last area is transparency and monitoring functionalities for Central Banks. The ledger’s transparent nature makes it much easier for Central Banks, for example, to use data analytics to detect irregularities and fraud than with cash. This has an important policy impact since a Central Bank can extensively search the blockchain transaction history and use this information to sharpen its own policies and regulations.

Hurdles to Full Decentralization

However, despite the benefits to decentralization, CBDC implementations on decentralized systems encounter two challenges: 

  1. Having transaction finality
  2. Scalability to meet the needs of an entire economy

Having Transaction Finality

When it comes to finality, transacting in cash has immediate settlement finality, but is an expensive and centralized payment infrastructure. A digital currency must have immediate settlement finality if it has to compete with and improve on cash. Otherwise, the instrument would carry counterparty risk, undoing the benefits of introducing a CBDC. Early generation blockchains have been beset by the threat of forks, which force users to wait long periods of  time to be fully sure no other competing branch of the blockchain prevails. The uncertainty associated with the risk of forking makes CBDC projects unfeasible. In order to be successful and ensure the transaction finality required, a decentralized CBDC must select the most advanced next-gen blockchain technology, which can prevent the system from forking, bringing the security and resilience of a truly decentralized system.

Scalability to Meet the Needs of an Entire Economy

Scalability issues and insufficient throughput (number of transactions per second) have plagued  most blockchains to date, particularly those based on a proof-of-work algorithm. To reliably handle the transaction volume required for a larger country’s entire economy, many early generation blockchains are not feasible for this.  For example, in the case of a country with about 50 million CBDC users transacting a couple of times per day, the CBDC system would have to handle on average 1,500 transactions per second. This is a factor of one hundred more than the standard proof-of-work blockchains process today.

Scalability is key for a seamless user experience, which, in turn, is key for the adoption and acceptance of the new payment instrument. If users have to wait several seconds even for low-value transactions to clear, many essential use cases for cash will be inaccessible for a CBDC. For CBDCs to move from experimentation to real world implementation, advanced technology is required that can scale to meet the needs of global adoption.

Algorand Blockchain Can Ensure Performance and Security of a Fully Decentralized CBDC System

The retail CBDC model we propose is inspired by the characteristics of both what we see required for the future of finance as well as the unique capabilities of the Algorand blockchain. For people, organizations, and governments to be successful in the future of finance and payments, the underpinnings of a CBDC must

  • Be decentralized by design
  • Inclusive and open for participation by all 
  • Enable the frictionless exchange of value across the economy
  • Have next generation security with immediate transaction finality.

Algorand is uniquely positioned to empower strong CBDC implementations. 

Decentralization is a function of the number of participants in the consensus protocol, hardware requirements, topography, and the number of people who own a stake in the consensus protocol itself. Algorand, unlike other platforms, has decided that to run critical infrastructure, enabling decentralization at every level is key to avoiding single points of failure. Algorand’s  valuable experience designing systems that are both fully decentralized and highly scalable will allow Central Banks to deploy a decentralized CBDC system that guarantees stability and security, without compromising finality of transactions and performance of the network.

While most blockchains do not have immediate settlement finality—and some do not have settlement finality at all—Algorand’s Pure Proof-of-Stake consensus protocol implements this natively. Algorand blockchain is mathematically proven to never fork, and will also be secure against quantum computing technology.

Algorand is designed to be highly scalable as well, even on a globally decentralized level. It easily achieves several thousand transactions per second (TPS), with our block finalization time projected to shrink to 2.5 seconds and our TPS projected to grow up to 46,000 in 2021 (thanks to a truthful approach to block pipelining).

Conclusion

The Algorand CBDC model has been designed by a multidisciplinary team that includes cryptographers, economists, technology and policy experts, which embodies Algorand’s commitment to finding the most innovative and effective solutions for a frictionless economy.

As our experience here at Algorand has grown with national digital currencies projects (Algorand, for example, is the infrastructure behind the SOV - the Marshall Islands’ new digital currency), we have developed the original and thorough model of CBDC which we have discussed in a series of recent posts.

If you are interested in learning more about the Algorand CBDC model, download the full “Issuing CBDC using Algorand” report below.

Download: Issuing CBDC using Algorand Report

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