Zou Chuanwei: Explore the application of multilateral central bank digital currency bridges in cross-border payments

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Multilateral central bank digital currency bridges help to integrate retail and wholesale central bank digital currencies in cross-border payment scenarios, and support simultaneous cross-border settlement.

Author: Zou Chuanwei, Chief Economist of Wanxiang Blockchain

On February 23, 2021, the Hong Kong Monetary Authority, the Bank of Thailand, the UAE Central Bank and the People’s Bank of China Digital Currency Research Institute announced the joint launch of the Multi-CBDC Bridge Research Project (Multi-CBDC Bridge), which aims to explore the role of central bank digital currency in cross-border Application in payment. The project was supported by the Hong Kong Innovation Center of the Bank for International Settlements (BIS). At the Bank for International Settlements Innovation Summit on March 22-25, the multilateral central bank digital currency bridge received a lot of attention. So, what is a multilateral central bank digital currency bridge? How is it applied in cross-border payments? What impact does it have on the digital currency ecology of global central banks?

This article is devoted to discussing these issues and is divided into four parts. The first part discusses the path selection of digital currency applied to cross-border payment. The second part discusses the design of multilateral central bank digital currency bridge and its application in cross-border payment. The third part discusses the impact of multilateral central bank digital currencies on the global central bank digital currency ecology. The fourth part summarizes the full text.

The path selection of digital currency applied to cross-border payment

Since the release of the first white paper of Libra (now renamed Diem) in June 2019, the application prospects of digital currencies in cross-border payments have received widespread attention and have entered the G20 vision. In July 2020, the Committee on Payments and Market Infrastructure (CPMI) of the Bank for International Settlements (CPMI) in its report to the G20 on improving cross-border payments, sorted out a total of 19 work in 5 areas, of which the 18th and 19th are related to the new payment infrastructure It has to do with the arrangement: improve the robustness of the global stable currency arrangement, and incorporate the international dimension into the central bank’s digital currency design. In October 2020, the Financial Stability Board (FSB) proposed a roadmap for improving cross-border payments on the basis of the report of the Payment and Market Infrastructure Committee, and issued a final recommendation report on the regulation of global stablecoins. In March 2021, the Bank for International Settlements released a working paper “The Future of Multilateral Central Bank Digital Currency Arrangements and Cross-border Payments”.

In theory, digital currencies that can be used for cross-border payments include single currency stablecoins, a basket of currency stablecoins, wholesale central bank digital currencies, and retail central bank digital currencies. Judging from the practice of the Libra/Diem project, a basket of currency stablecoins faces many challenges in terms of price stabilization mechanism, reserve asset management, user habits training, and currency sovereignty protection, and it is very difficult to launch. If a single currency stable currency circulates on a global scale, it will constitute a global stable currency defined by the Financial Stability Board. It will be subject to governance frameworks, reserve asset management, operational flexibility, network security, anti-money laundering, combating terrorism, and privacy protection. Strict supervision. The retail central bank digital currency can have foreign individual and institutional users, but it is not easy to obtain overseas users under the premise of respecting the monetary sovereignty of other countries, and the M0 (current cash) positioning will also restrict the retail central bank digital currency to make cross-border payments In the application.

Judging from the discussions at the Bank for International Settlements Innovation Summit on March 22-25, 2021, the central banking community tends to use wholesale central bank digital currencies to improve cross-border payments, and the multilateral central bank digital currency bridge will become a wholesale central bank in different countries. An important mechanism for interaction between digital currencies and supporting cross-border synchronous delivery (PvP). Cross-border simultaneous settlement is the basic requirement of cross-border payment, mainly to improve settlement efficiency and prevent settlement risks. From a technical point of view, the wholesale central bank digital currencies of different countries generally use different distributed ledgers (DLT), and the core problem of cross-border synchronous settlement is cross-chain. To this problem, various solutions have been tried in practice.

The fourth phase of the Ubin project of the Monetary Authority of Singapore and the Jasper project of the Central Bank of Canada carried out a simultaneous cross-border settlement experiment. The central bank of Singapore digital currency is based on the Quorum platform and the central bank of Canadian dollar digital currency is based on the R3 Corda platform. They focus on testing the middleman scheme. The middleman is usually a commercial bank, participates in Quorum and R3 Corda platforms at the same time, and implements synchronous cross-border settlement through the Hash Time Lock Contract (HTLC). The test found that in most cases, the hash time lock contract is reliable. The “middleman solution + hash time lock contract” can help both parties to implement synchronous cross-border transfers without trusting the middleman. They also proposed two other conceptual designs: one is that the Singapore bank that pays and the Canadian bank that receives the money participates in the Quorum and R3 Corda platforms at the same time, and holds the central bank digital currencies of the two countries at the same time; the second is that the same distributed ledger supports both at the same time. The country’s central bank digital currency.

In the third phase, the Stella project of the European Central Bank and the Bank of Japan also tested cross-border synchronous settlement based on the intermediary program. There are no specific restrictions on the type of ledger used by the paying bank, receiving bank, and intermediary. It can be a centralized ledger. It can also be a distributed ledger. Cross-ledger transfers use five methods: Trust Lines, On-Ledger Escrow with HTLC, Simple Payment Channels, Conditional Payment Channels with HTLC, and third-party escrow (Third Party Escrow). Among them, the first four methods are all derived from the hash time lock contract.

The above test shows that the current mainstream cross-chain technology used by the central bank is the hash time lock contract. The hash time lock contract is the basis for conditional payment in a decentralized and trustless environment. In addition to the application of cryptography, the core of the hash time lock contract is a sequential game. Because there is no perfect game design, the hash time lock contract may fail under certain conditions, resulting in undesirable game equilibrium results. But this shortcoming of the hash time lock contract has not been solved so far.

The concept of the multilateral central bank digital currency bridge mainly comes from the Inthanon-LionRock project, which is a cooperation between the Hong Kong Monetary Authority and the Bank of Thailand. It essentially “maps” two central bank digital currencies to the same distributed ledger, that is, based on the central bank digital currency in the “corridor network” The issuance of depositary receipts on the Internet enables the same distributed ledger to support multiple central bank digital currencies. The advantages of the multilateral central bank digital currency bridge are: first, the transaction between the two central bank digital currencies occurs on a single ledger, does not involve cross-chain operations, and is easy to implement cross-border synchronous settlement through smart contracts; second, it can be compatible with different central banks The digital currency system and design have good scalability; the third is to alleviate the influence of the central bank’s digital currency circulation overseas on the currency sovereignty of other countries. However, the multilateral central bank digital currency bridge will cause governance issues involving multiple central banks and new digital currency circulation issues.

The design of multilateral central bank digital currency bridge and its application in cross-border payment

Design of Multilateral Central Bank Digital Currency Bridge

From the perspective of the Inthanon-LionRock project, the core components of the multilateral central bank digital currency bridge include: “corridor network”, depository receipts, cross-border transfers, liquidity management, regulatory compliance, and multilateral governance.

Corridor network

The core of the multilateral central bank digital currency bridge is a “corridor network” connecting the digital currency systems of multiple central banks. For each participating country, the central bank of that country and several commercial banks are connected to the “corridor network”, but neither foreign central banks nor commercial banks are allowed to access the digital currency system of the country’s central bank or hold the digital currency of the country’s central bank. In other words, the digital currency systems of central banks in various countries are “physically isolated”, but they are interconnected through a “corridor network.”

Depositary receipt

For each central bank’s digital currency, there is a corresponding depository receipt on the “corridor network”, which is issued and redeemed by the corresponding central bank.

For each participating country, if the country’s commercial bank proposes to the national central bank to destroy a unit of the national central bank’s digital currency, then the national central bank will issue a depository of one unit of the national central bank’s digital currency to the commercial bank on the “corridor network” certificate. Conversely, if the commercial bank proposes to destroy a unit of depository receipt to the national central bank on the “corridor network”, then the national central bank will issue a unit of national central bank digital currency to the commercial bank.

In other words, the central bank of each country is responsible for the 1:1 two-way exchange between the digital currency of the national central bank and the depository receipts on the “corridor network” to ensure that the number of depositary receipts issued on the “corridor network” is always equal to the central bank digital currency destroyed quantity.

Although a country’s central bank digital currency cannot be held by overseas commercial banks, the corresponding depository receipts can be held by overseas commercial banks on the “corridor network”.

Cross-border transfer

Cross-border transfers are made through depository receipts on the “corridor network”. Any pair of commercial banks from different countries on the “corridor network” can use the depositary receipts of the central bank’s digital currency for point-to-point real-time transactions, so that there is no need to carry out cross-border transfers through a complicated network of correspondent banks. The exchange rate between different depository receipts can refer to the exchange rate in the foreign exchange market. If the scale of depository receipt transactions on the “corridor network” is large enough, it will become an important part of the foreign exchange market.

Although different depository receipts are issued by different central banks based on different central bank digital currencies, because they rely on the same distributed ledger, transactions between them can be carried out around the clock, and the payment can be atomic (that is, a payment instruction Either all or no execution, there is no partial execution) and finality of settlement.

Liquidity management

Depository receipt transactions on the “corridor network” adopt real-time full settlement, which reduces settlement risk, but requires higher liquidity. The “corridor network” will provide liquidity management functions, including queuing mechanisms and transaction congestion solutions related to the Liquidity Saving Mechanism (LSM). The “corridor network” can also introduce liquidity providers for depository receipts to help commercial banks on the “corridor network” smooth their liquidity requirements.

Regulatory compliance

On the “corridor network”, central banks of various countries monitor the wallets and transactions related to the depositary receipts of their central banks’ digital currencies in real time to implement anti-money laundering, anti-terrorist financing, and anti-tax evasion regulations.

In view of the fact that foreign commercial banks can indirectly hold domestic currency through depository receipts, and that domestic currency can circulate among foreign commercial banks in the form of depository receipts, central banks may need to restrict foreign commercial banks from holding depository receipts of their own central bank digital currency Time and quantity.

Multilateral governance

The “corridor network” is jointly owned, constructed, operated and managed by central banks participating in the multilateral central bank digital currency bridge. This has created governance issues involving multiple central banks, including:

  • Which central bank digital currencies can be connected to the “corridor network”? If the central bank digital currency supported by the “corridor network” is to be increased, what decision-making process should be adopted?
  • The access conditions and procedures for commercial banks to participate in the “corridor network”.
  • How to supervise that the number of depositary receipts issued by the central bank on the “corridor network” is always equal to the number of central bank digital currencies destroyed on the central bank’s digital currency system?
  • “Corridor network” distributed ledger storage, consensus accounting, upgrades, error management and dispute handling, etc.

Analysis of Multilateral Central Bank Digital Currency Bridge

In its working paper “Multilateral Central Bank Digital Currency Arrangements and the Future of Cross-border Payments”, the Bank for International Settlements compared three different ways to achieve cross-border and cross-currency interoperability based on central bank digital currencies. First, the central bank digital currencies of different countries are compatible in standards, including similar regulatory frameworks, market practices, message formats, cryptographic technologies, data requirements, and user interfaces. The second is that the digital currencies of central banks of different countries are interconnected on the system, including shared technical interfaces and the same clearing mechanism. The third is to establish a single multi-currency payment system. Multilateral central bank digital currency bridges belong to the third method.

In the multilateral central bank digital currency bridge, any pair of commercial banks from different countries can conduct peer-to-peer real-time transactions. This is a basic goal to be achieved when digital currency is applied to cross-border payments, because only in this way can it constitute an improvement to the existing agency bank model. Representative programs include:

  • Commercial banks in different countries use a super-sovereign digital currency for cross-border payments, such as the Libra/Diem basket of stable currencies. But this depends on the market acceptance of super-sovereign digital currencies and the ability to perform basic monetary functions, and will cause monetary sovereignty issues.

  • Commercial banks in different countries use a leading central bank digital currency or stable currency for cross-border payments, such as digital dollars or US dollar stable currencies. But this will cause the problem of a strong currency replacing a weak currency.

  • Different countries issue central bank digital currencies on their own distributed ledgers, and interact across ledgers through smart contracts to achieve cross-border synchronous settlement. But this is subject to the immaturity of cross-chain technology.

  • Multilateral central bank digital currency bridge.

This basic goal can also be achieved through innovations in the bank account system, such as:

  • The central bank’s real-time full payment system (RTGS) is open to overseas commercial banks. But because of currency jurisdiction, this is currently only a theoretical possibility.

  • Commercial banks in different countries open interbank current accounts. However, as the number of commercial banks increases, implementation costs will rise significantly.

In summary, if the improvement of cross-border payments follows the following principles, the multilateral central bank digital currency bridge should be the best choice at present:

  • Use digital currency technology instead of a bank account system.

  • Respect the currency sovereignty of various countries and alleviate the problem of replacing weak currencies with strong currencies.

  • Does not rely on complex or immature cross-chain technology.

  • Compatible with the differences of national currencies and payment systems (including central bank digital currencies).

  • High economic efficiency and good scalability.

Finally, two points need to be explained. First, the multilateral central bank digital currency bridge can be compatible with the central bank’s real-time full settlement system. In other words, even if a country does not launch a central bank digital currency, the country’s central bank and commercial banks can also improve cross-border payments by connecting to the multilateral central bank digital currency bridge. Second, from the current discussion and practice on central bank digital currency, it can be seen that although some important consensus has gradually emerged, the central bank’s digital currency has great flexibility in terms of monetary economics design and technical solutions. In the foreseeable future, central bank digital currencies will not converge to the same standard. Both of these points will increase the importance of multilateral central bank digital currency bridges.

The impact of the multilateral central bank digital currency bridge on the global central bank digital currency ecology

Although central bank digital currency has great flexibility in monetary economics design and technical solutions, the multilateral central bank digital currency bridge allows central bank digital currencies of different countries to be interconnected, which is of great significance for improving global central bank digital currency standards. The multilateral central bank digital currency bridge involves the governance issues of multiple central banks, which will promote the cooperation of central banks on central bank digital currencies.

Judging from the research and practice of central bank digital currencies in major countries and regions, some of them are wholesale-oriented, and some are retail-oriented. At present, the representative wholesale central bank digital currency project is gradually completing the experiment, and the retail central bank digital currency has become a research hotspot because it involves complex monetary and financial issues. If focusing on domestic payments, retail central bank digital currencies are undoubtedly the focus. However, the previous article has pointed out that for cross-border payments, it is not enough to rely on retail central bank digital currencies. It must be matched with wholesale central bank digital currencies. Therefore, it is necessary to re-understand the relationship between wholesale and retail central bank digital currencies in cross-border payment scenarios.

At present, the central bank’s digital currency generally follows the “central bank-commercial bank” binary model (also known as the two-tier business model). The retail central bank digital currency also includes a wholesale link, but the wholesale link only targets the issuance and return of digital currency, not the application of digital currency in securities transactions and cross-border transfers. In the multilateral central bank digital currency bridge, wholesale and retail central bank digital currencies will form an organic whole.

Consider two countries A and B. A resident of country A, Alice, opens an account with bank a in country A, and Bob, a resident of country B, opens an account with bank b in country B. Suppose Alice initiates a cross-border remittance to Bob, she has two options. First, if a country’s retail central bank digital currency is open to overseas users, then they can directly use this retail central bank digital currency. Second, after Alice initiates a cross-border remittance instruction to bank a, bank a deducts Alice’s deposit balance or digital currency wallet balance, and sends money directly to bank b through the multilateral central bank digital currency bridge, and bank b increases Bob’s balance by the same amount Deposit balance or digital currency wallet balance. The advantage of “wholesale central bank digital currency + multilateral central bank digital currency bridge” relative to direct use of retail central bank digital currency is that it can support large-scale transactions and will not affect other countries’ currency sovereignty or cause currency substitution problems.

to sum up

The multilateral central bank digital currency bridge has the following important meanings and deserves attention.

First, the multilateral central bank digital currency bridge will promote cooperation between central banks of different countries and the interconnection of central bank digital currencies, which will help to form a global central bank digital currency standard.

Second, the multilateral central bank digital currency bridge helps to integrate retail and wholesale central bank digital currencies in cross-border payment scenarios, and supports cross-border simultaneous settlement.

Third, the multilateral central bank digital currency bridge is compatible with the differences of national currencies and payment systems (including central bank digital currencies), respects the currency sovereignty of various countries, and alleviates the problem of strong currencies replacing weak currencies.

Fourth, the multilateral central bank digital currency bridge has high economic efficiency and good scalability, and does not rely on complex or immature cross-chain technology.

Fifth, under the digital currency bridge of multilateral central banks, a country’s currency can circulate among overseas commercial banks in the form of depository receipts, which will bring new problems in the management of digital currency circulation.

Sixth, the “corridor network” is jointly owned, constructed, operated and managed by central banks, which will cause governance issues involving multiple central banks.

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