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Apr 01, 2021

The Governance of the CBDC System

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 governance of the CBDC system.

Governance, Control, and Monitoring of the CBDC

In our previous post we discussed the numerous advantages of adopting a decentralized model for the CBDC system in terms of stability and security of the network, cost reduction, and innovation. A common question, however, that people have when decentralization is proposed for a CBDC is: Isn’t decentralization going to put Central Banks’ control of their digital currencies at risk? 

The answer to this question is no, if the correct design choices of the CBDC governance are put in place. The thing is, only advanced next-gen blockchain technology can support these design features. Under these conditions, the case can be made that the control of the CBDC system, the monitoring capabilities of a Central Bank, as well as the flexibility of policy implementation are even increased by a blockchain based approach.

Let’s take a closer look at the desirable design characteristics of CBDC governance:

  1. A Central Bank must retain full control of the CBDC network: A good CBDC model should be built on an open-source, but not an open-access, system. Openness is fundamental to foster innovation in payment services, but Central Banks must be able to control the conditions under which individuals join the network, create a CBDC account, and participate in CBDC activities. 
    A successful CBDC system must provide Central Banks with a set of programmable controls and tools to easily achieve their governance objectives and guarantee the security of the system for their citizens. Central Banks must also be able to set the degree of decentralization of the CBDC governance based on their policy goals and the structural characteristics of a nation, for example awarding a service provider the operational authorizations to act as validating node of the CBDC blockchain or delegating AML functions to a specific agency.
  2. A Central Bank must retain full control of all CBDC policies: Central banks must maintain full control of the issuing and management processes of the digital currency by interfacing directly with the CBDC blockchain. CBDC transactions between end-users occur directly on the CBDC blockchain, but Central banks must be the only entity with the authority to issue a legal tender, and to expand or contract the supply of CBDC. Central banks can delegate some functions to other authorized service providers or private banks, such as onboarding or KYC operations, but these activities must be exclusively regulated by the policy making authority.
    Programmable controls and smart contracts directly embedded in the CBDC structure will facilitate policy implementations and the management of the CBDC. For instance, users who do not satisfy a given AML requirement may be programmatically prevented from participating in transactions over a certain threshold. Similarly, a Central Bank may programmatically require a quorum of users to act in concert for particularly sensitive or powerful actions such as the minting of new currency or the forced movement of currency to revert an illegal transaction.
  3. A CBDC system must enhance Central Banks’ monitoring and regulatory capabilities: A blockchain based CBDC must provide central banks with custom analytics and tools to inspect the disposition of CBDC balances and to impose limits and rules on individual wallets by integration with the programmable CBDC controls. All transactions and balances on the CBDC blockchain must be visible to the central bank and other authorized entities. Central  Banks must be able to easily explore and search the full blockchain transaction history. The information obtained from the monitoring activity of the blockchain may be used to inform policy decisions and design differentiated policies, such as modulated interest rates or different maximum holdings per wallet, based on the amount of CBDC held in each wallet or on the level of AML clearance of an individual. 
    A CBDC must conform to all applicable regulatory and legal frameworks. Users granted access to the CBDC blockchain authenticate their transaction using the matching cryptographic Private Key for the Public Key of a particular account. If strong real world identity is required for certain operations, then a Licensed Trust Provider can certify a Public key with additional identity information once the user has passed through KYC/AML processes. Moreover,  while in traditional distributed ledgers only the token holder is authorized to move tokens in their account, a successful CBDC must also allow for remediation by the Central Bank under exceptional circumstances, such as errors or transactions that violate laws.
  4. A CBDC must be a liability exclusively of the Central Bank: The central bank must be the only entity able to issue the CBDC, so it cannot be a liability of private banks or any other licensed service provider (LSP). From an accounting perspective, the CBDC must be treated exactly as any other type of central bank money, i.e., the same as central bank reserves and cash. A two-tier CBDC system in which the distribution of CBDC exclusively occurs through authorized RTGS settling counterparties further guarantees this principle. In this approach, CBDC is “passed” by the central bank to LSPs (including, but not limited to banks), which will be involved in managing individual users’ accounts and in distributing the CBDC to service providers without access to the existing RTGS system and end-users.

The alternative scenario to a two-tier system is a synthetic CBDC in which private banks and LSPs act as issuing authorities. This solution may limit the risk of disintermediation of the bank sector by involving the banks more directly in the creation of the CBDC, but it would make ensuring the effectiveness of monetary policy decisions more difficult for the Central Bank because the control of the CBDC supply would be subject to banks’ behavior. In some sense, it would be similar to a system in which banks issue private bank currency within the parameters specified by the central bank by using bank deposits to collateralize the issuance of CBDC.

Algorand Blockchain Can Ensure Flexibility in Governance and Full Control of a Decentralized CBDC System

While Algorand’s consensus protocol facilitates the spontaneous formation of trust in a new CBDC instrument by guaranteeing immediate settlement finality, Algorand is also uniquely positioned to empower strong CBDC implementations by providing Central Banks with full flexibility in CDBC governance and full control of the CBDC system.

Algorand's proposed model leverages four main features to achieve the above properties:

  1. The Algorand Layer-1 Smart Contracts (ASC1) 
  2. The control functionalities of the Algorand Standard Assets (ASA) 
  3. The hybrid, two-tier architecture of the Algorand CBDC system
  4. The deployment of the CBDC on a private, permissioned instance of the public Algorand blockchain

ASC1 are elemental programs directly operating on Layer-1 of the Algorand blockchain, which can be used to programmatically create more advanced operations and processes. For example, relying on ASC1, Central Banks can programmatically implement rules to prevent transfers to a wallet exceeding a desired limit or not complying with specific AML requirements.

ASA are standardized, Layer-1 features used to represent any type of asset on the Algorand blockchain. ASA include Role-Based Access Control (RBAC) functions, flexible asset controls used to issue and manage ASA requirements. Since RBAC are going to be embedded in CBDCs issued on the Algorand blockchain, they can be used by Central Banks, for example, to program minting activities or to endow appropriate agencies and users in the system with specific supervisory powers. 

ASC1 and ASA together will support any governance model and policy objective set by the Central Bank issuing the CBDC in a fully programmatic and simplified fashion.

Our hybrid, two-tier approach allows for a partitioned system where transfer of CBDC from the central bank to end-users is handled separately from CBDC interactions between end-users, providing Central Banks with a protected and independent CBDC distribution mechanism. This mechanism is independently designed and administered by the Central Bank, and requires the Central Bank to grant access to the national RTGS. For example, distribution could initially rely only on banks and gradually extended to other LSPs if desired. 

Moreover, the entire supply of tokens is generated during the instantiation period of the CBDC and locked in a vault under the sole control of the Central Bank, which can issue and recall tokens from circulation in function of its monetary policy decisions. As such, the Algorand CBDC model is neutral to the monetary policy stance of the central bank. 

Finally, building a CBDC system on a private, permissioned instance of the public Algorand blockchain ensures Central Banks would be able to independently choose all the aspects of the governance of their CBDC network, setting roles and rules for service providers and end-users who want to take part in the CBDC system.

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 the Future of Finance (FutureFi) 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, please download the full “Issuing CBDC using Algorand” report below.

Download: Issuing CBDC using Algorand Report

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