Collaboration is paramount for CBDC development

Larry Li July 04, 2023 09:10

The emergence of Central Bank Digital Currency (CBDC) has been exponential over the recent couple of years. While the merits of CBDCs are still widely debated, central and commercial banks are exploring the use of CBDCs in local markets. The Hong Kong Monetary Authority (HKMA) is one of the first central banking institutes in Asia-Pacific to set out a policy stance on retail CBDCs, outlining the next steps in its formation through the “Fintech 2025” strategy and eventual integration with existing financial systems.

Adopting a phased approach

HKMA joins many central banks worldwide that are introducing or considering introducing their own virtual currencies. Mainland China has already rolled out several pilot schemes for its digital yuan, the e-CNY, with India and Australia also in their own respective stages of development and pilot schemes for local digital currencies. China, Singapore, and Hong Kong have all been frontrunners globally due to their relatively mature private sector digital payment platforms and technological advantages. Given both their unique roles and backgrounds as hubs for international finance, Singapore and Hong Kong initiated CBDC projects in 2016 and 2017 respectively, both for retail and wholesale applications.

Supporters of CBDCs believe that an e-HKD has the potential to create a more effective and robust payment system that will support an increasingly digital economy. While CBDCs will offer many opportunities for private and public institutions, challenges will inevitably arise surrounding adoption, privacy protection, legal considerations, and use cases. HKMA has taken a three-rail approach with the first rail aiming to lay the legal and technological foundation for the implementation of the e-HKD. Rail 2 will run concurrently, with the HKMA taking deep dives into use cases, applications, and implementations through pilot projects like simulations of tokenised deposit transactions. The third and final rail will focus on the actual launch of e-HKD, based on the consolidated outcomes of Rail 1 and Rail 2 as well as the pace of adoption and development in local and international markets.

Cross-border potential of wholesale CBDCs

The motivation for the development of wholesale CBDCs focuses on creating an enhanced payment system that is both efficient and secure, particularly for cross-border transactions while reducing their inherent transaction costs. CBDCs offer many opportunities for the financial industry but will face significant hurdles stemming from the proliferation of multiple CBDC platforms in development, parallel to existing financial systems. Although CBDCs are new forms of fiat currencies that have the potential for new payment capabilities, they are not necessarily a replacement for payment infrastructures and processes. As development progresses based on varying central bank arrangements and their parameters for different CBDC projects, CBDCs and entrenched infrastructures will need to find ways to co-exist and reach a middle ground as the industry moves towards trials and system integration.

Addressing the risk of fragmentation

As numerous central banks develop digital currencies based on different technologies, protocols, and procedures, and also in parallel to existing traditional payment methods, the risk of fragmentation can arise if left unaddressed.

Largely differing frameworks, systems, and processes, including regulation could lead to a range of digital islands for CBDCs globally. Therefore, the need to develop a process for transactions to flow between different CBDC platforms will become critical. A multilateral interoperability solution will be needed to connect CBDC networks and existing payment systems globally, and thus enable seamless CBDC transactions to flow across borders.

Fortunately, integrating CBDC connectors into existing cross-border payment systems will not require a reinvention of new practices to ensure security, compliance, authentication, and tracking. Leveraging industry-standardised approaches such as ISO 20022 will ensure that CBDC transactions carry rich standardised payment data. Establishing a solution to bring interoperability to CBDCs will be a long process, but continuous industry collaboration, innovation, and experimentation will pave the way to a frictionless future for digital currencies. It is also important for solutions to allow banks to easily integrate their domestic CBDC flows with their cross-border payments system.

Connecting digital islands: Swift’s experimental CBDC connector

In October, Swift announced that it had developed a solution that enabled CBDCs to move between DLT-based and fiat-based systems using the existing financial infrastructure. The test was set up so that central and commercial banks could experiment with and validate the effectiveness of the solution and share insight to guide its continual development. The solution was then tested in a sandbox environment with 18 central and commercial banks.

During the 12-week testing period, almost 5,000 transactions were simulated between two different blockchain networks and existing fiat-based payment systems. Central and commercial bank participants expressed strong support for the solution’s continued development, noting that it enabled a seamless exchange of CBDCs, even those built on different platforms. Many of the participants expressed a clear desire for continued collaboration and interoperability – crucial for the financial industry as it continues to evolve.

CBDCs will only continue to evolve and become fixtures in the financial industry. It will be paramount to keep the vision of a frictionless CBDC future in mind when developing platforms and solutions for the currencies to operate on. Globally, so much potential can be harnessed from CBDCs for payments, and ensuring interoperability and collaboration are at the forefront of all developments will lead to CBDCs being connected across global markets, in the future.

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Larry Li

Head of North Asia at Swift