How Decentralized is Central Bank Digital Currency?

A central bank digital currency (CBDC) is the digital form of a country’s fiat currency, such as the dollar, euro, pound or yuan. It is issued by the central bank and has the same value and legal status as the physical currency. CBDCs are different from cryptocurrencies, which are not backed by any government or central authority and have volatile prices.

One of the main questions about CBDCs is how decentralized they are, or how much control the central bank has over them. Decentralization is often seen as a desirable feature of digital currencies, as it can enhance privacy, security, innovation and resilience. However, decentralization also comes with trade-offs, such as scalability, efficiency, regulation and governance.

Decentralization is a term that describes the degree of control and influence that different entities have over a system or a network. In the context of digital currencies, decentralization can refer to several aspects, such as:

– The governance of the currency: who decides the rules and parameters of the currency, such as its supply, distribution, and interest rate?
– The issuance of the currency: who creates new units of the currency and how?
– The validation of the transactions: who verifies and records the transactions on the ledger and how?
– The access to the currency: who can use the currency and how?

Cryptocurrencies are generally considered to be highly decentralized, as they rely on distributed networks of nodes that operate according to a consensus protocol, without the need for a central authority or intermediary. Anyone can join the network, create new units of the currency (through mining or staking), validate transactions (through proof-of-work or proof-of-stake), and access the currency (through wallets and exchanges). However, decentralization is not absolute or uniform across different cryptocurrencies, and there may be trade-offs between decentralization and other features, such as scalability, security, and usability.

CBDCs, on the other hand, are inherently centralized, as they are issued and controlled by a single entity: the central bank. The central bank decides the rules and parameters of the currency, creates new units of the currency (through monetary policy), validates transactions (through a centralized ledger or a permissioned blockchain), and regulates access to the currency (through identity verification and eligibility criteria). However, centralization does not necessarily imply uniformity or rigidity across different CBDCs, and there may be variations in design and implementation that affect the degree of decentralization.

The anonymity of cryptocurrency transactions has left it susceptible to crimes and scams over the last decade — but there has also been a growing business of companies tracking that down, The New York Times reports. Chainalysis is one of the companies involved in deciphering blockchain records, drawing in tens of millions of dollars in contracts with federal agencies to monitor crypto transactions. But with privacy concerns on the rise these days, other companies such as Cake Wallet are trying to make crypto transactions less traceable again, making it harder to determine who is sending and receiving money. (LinkedIn News)

For example, some CBDCs may adopt a two-tier model, where the central bank delegates some functions to intermediaries, such as commercial banks or payment service providers. These intermediaries may provide retail services to end-users, such as account opening, transaction processing, and customer support. This may increase efficiency and competition in the payment system, but also introduce some degree of decentralization and fragmentation.

Another example is that some CBDCs may use a hybrid blockchain architecture, where the central bank maintains a master ledger that records the aggregate balances of intermediaries or users, while allowing for sub-ledgers that operate on different platforms or protocols. These sub-ledgers may enable faster and cheaper transactions among participants within a network or a community. This may enhance innovation and inclusion in the payment system, but also create some degree of decentralization and interoperability.

Therefore, CBDCs are not necessarily monolithic or homogeneous in terms of decentralization. They may exhibit different degrees of decentralization depending on their design choices and objectives. However, CBDCs are unlikely to match cryptocurrencies in terms of decentralization, as they still rely on a central authority that has ultimate control over the currency. This may limit some of the advantages that cryptocurrencies offer, such as censorship-resistance, anonymity, and permissionlessness. However, it may also mitigate some of the risks that cryptocurrencies pose, such as volatility, fraud, and illicit activity.

The degree of decentralization of a CBDC depends on its design choices and implementation. There are many possible ways to design a CBDC, such as:

– Who can access and use it? Is it available to everyone (retail CBDC) or only to financial institutions (wholesale CBDC)?
– How is it issued and distributed? Is it directly from the central bank or through intermediaries such as commercial banks or payment platforms?
– How is it stored and transferred? Is it based on a centralized ledger or a distributed ledger technology (DLT) such as blockchain?
– How is it validated and secured? Is it based on a permissioned or permissionless system, where different actors have different roles and responsibilities?
– How is it governed and regulated? Is it subject to existing laws and regulations or does it require new ones?

Depending on these design choices, a CBDC can be more or less decentralized. For example, a retail CBDC that is issued directly by the central bank and based on a centralized ledger would be more centralized than a wholesale CBDC that is distributed through intermediaries and based on a DLT. However, there is no clear-cut answer to how decentralized a CBDC should be, as different levels of decentralization may suit different purposes and contexts.

The benefits and risks of decentralization for CBDCs are still being explored by researchers, policymakers and practitioners. Some potential benefits include:

– Enhancing privacy and anonymity for users, by reducing the need for intermediaries and third-party verification
– Improving security and resilience for the system, by reducing single points of failure and cyberattacks
– Fostering innovation and competition for the market, by enabling new entrants and business models
– Increasing financial inclusion and access for the public, by lowering barriers and costs of participation

Some potential risks include:

– Reducing efficiency and scalability for the system, by increasing complexity and latency
– Complicating regulation and oversight for the authorities, by creating new challenges for compliance and enforcement
– Eroding trust and stability for the economy, by undermining the role and credibility of the central bank
– Exposing users to new risks such as fraud, theft or loss of funds

In conclusion, CBDCs are not inherently centralized or decentralized, but rather reflect a spectrum of possible design choices that have different implications for their performance and impact. The optimal degree of decentralization for a CBDC depends on its objectives, functions and context. Therefore, each central bank needs to carefully weigh the benefits and risks of decentralization for its own CBDC project.