Central Bank Digital Currencies (CBDCs) Should be on a Public Blockchain

Exploring why and how CBDCs can be issued on a public blockchain like Solana and the path to getting there.

Yash Agarwal
14 min readJun 7, 2023

Over 80% of central banks are exploring the possibility of directly issuing digital money on decentralized ledgers, a.k.a. central bank digital currencies (CBDCs). While most CBDC initiatives are still in the research and testing phase, privately-issued stablecoins are arguably the only web3 product vertical that has found product-market fit, with over $130 billion in issuance despite drastic market downturns. Stablecoins such as USDC powered more than $8.6 trillion in cumulative on-chain transactions in 2021. In fact, ~15% of USDC transactions were wallet-to-wallet transfers, hinting at real-world economic transactions, including peer-to-peer payments, cross-border transactions, payrolls, and so on.

However, without the support of governments, stablecoins will hit a ceiling when it comes to integration with the existing financial system. CBDCs, if issued on public blockchains, marries the value proposition of cash and stablecoins. Here’s how:

  1. Cash: enables anonymity; directly issued and guaranteed by central banks.
  2. Fiat-backed stablecoins: 24/7 digital, programmable money backed by cash equivalents.

Think of CBDCs as “cash on the blockchain” or stablecoins issued directly by central banks instead of a private player like Tether Foundation, who themselves (probably) hold bank deposits or T-bills partially guaranteed by central banks. In this paper, we take the best of stablecoins and apply them to CBDCs!

Why issue CBDCs when there are already many forms of money?

Money has two major functions:

  1. Store of Value: T-Bills are one of the safest storage of value backed by the US government. Large financial institutions, such as banks, can exchange them freely with each other, but for small companies and retail individuals, such a transaction would be unwieldy.
  2. Medium of Exchange: bank deposits are a relatively liquid medium of exchange but require trusting and dealing with banks that run on fractional reserves, which we’ve seen fail many times throughout history.

Cash (paper notes) serves both purposes, but it’s far less efficient than its digital counterparts, restricted by its physical nature, and lacks programmability.

Remember the Silicon Valley Bank (SVB) crisis, how every business was rushing to store their wealth in T-bills? Although T-bills are a safer asset, they are not a ‘medium of exchange’ and can’t be transacted as easily. CBDCs as a solution combines the best of both worlds, where it’s like T-bill (directly backed by the government) in the form of bank deposits (easily able to send and receive).

But why CBDCs instead of native cryptocurrencies?

  1. While native assets like Bitcoin and Ethereum are promising forms of money, currencies issued by sovereign states remain important. Bringing them onto the blockchain could be a game-changer for the global monetary system.
  2. CBDCs can act as a way to lend more credibility to the industry and expose a broader audience to the concept of programmable money through user adoption.

CBDC Efforts Around the World are in Its Early Days

Issuing CBDCs on Solana

In this essay, we focus on Solana as the example blockchain. However, the same argument can be applied to other scalable public blockchains with smart contract capabilities, thriving ecosystems, and sufficient decentralization. (Hint: there aren’t that many at the moment.)

Reasons we are biased toward Solana👇

  • Scalability: With very low fees (<$0.001), high speeds (up to 65k transactions per second), and a 1–2 second confirmation time, Solana is one of the most performant blockchains. With the launch of a second validator client by Jump Crypto, Firedancer, the performance and reliability of the network will also increase significantly.
  • CBDCs as NFTs: Just like paper cash of different denominations, if CBDCs are given a unique identifier, NFTs are the best way to represent serialized digital cash and coins. For instance, Solana’s compressed NFT allows for minting and storing 1 billion NFTs at just ~$10k or 500 SOL, making it best suited for issuing NFT CBDCs. Compared to printing 1 billion worth of $100 dollar bills (10M bills) for $860,000 — NFTs can represent cash bills at a minimal cost.
  • Vibrant ecosystem and built-in standards: Solana already has battle-tested DeFi protocols like automated market makers (AMMs), fully on-chain order books, lending and borrowing projects, payment standards like Solana Pay, and token standards like SPL (Solana Program Library) — similar to ERC standards. Further, the upgraded Token-2022 allows for whitelisting and interest-bearing tokens, which can be used for compliance and sovereign bonds.

5 Important Properties for CBDCs:

1. Programmability

Programmability unlocks endless possibilities of conditional money movement by third parties. For instance, wholesale CBDC could be issued or redeemed based on pre-set rules such as changes in interest rates. For retail CBDC, it could allow the issuance of ‘digital vouchers’ that can only be used to pay certain merchants, with smart contract controls to determine whether payments are allowed based on certain merchant identifiers. This could thus serve as the underlying infrastructure through which the government disburses a variety of highly targeted or in-kind fiscal support (e.g., grocery vouchers for low-income families or time-limited tourism vouchers) to their citizens in a timely, safe, and cost-efficient manner.

Imagine countries using programmable money to encourage spending to increase GDP or curb spending in order to control inflation. The increased rate of monetary as well as fiscal transmission due to programmability makes it an attractive proposition for central banks.

2. Transaction Finality:

In order for transactions to be trustworthy, they cannot be reversed or tampered with. If a payment is added to a block, it is considered final and irreversible. For instance, Circle, the issuer of USDC, considers Solana as the blockchain with the fastest time to transactional finality at ~400 ms. This also enhances user experience significantly as the transactions are confirmed near-instantly without waiting minutes or hours for confirmation.

However, instant finality does not preclude issuers or payment platforms from building additional clawback or escrow features on top of CBDCs for certain use cases. For example, it is possible for cash-like transactions under a certain size to be instant, but delay the release of large corporate transactions to account for human error.

3. Inherent Interoperability:

Apart from numerous entities issuing assets on blockchains like Solana, many markets between these asset pairs have organically been developed, which can enable swaps in a single transaction using an on-chain limit order book (LOB) or automatic market maker (AMM) — already facilitating over $50 billion in volumes.

The vibrant ecosystem of private players can create identity solutions, generate liquidity, build consumer wallets, and work with central banks to ensure the best user experience. Private participation will spur innovation and competition and create a new system that truly solves the problems that exist due to siloed and disjointed payment systems. Private players can also create “synthetic CBDC” or “wrapped CBDC,” where the consumer holds the balances on these fintech platforms and makes payments. The private player, in turn, will hold CBDCs by the central bank. This will be similar to e-money wallets currently offered by FinTechs.

With a growing decentralized finance (DeFi) ecosystem, the interoperability of CBDCs can be leveraged to create financial instruments like interest-bearing CBDCs, lending and borrowing of CBDCs against other assets as collateral, and much more.

Compatibility with Traditional Financial Rails and Other Blockchains:

While assets within Solana are inherently interoperable, to ensure further interoperability:

  • Frictionless on/off-ramps are critical to ensure seamless interaction with fiat currencies.
  • CBDCs on Solana should be interoperable with CBDCs on other blockchains as well. One solution is to use cross-chain bridges, which enable the transfer of assets and generic messages.
  • On-chain representations of traditional assets denominated in CBDCs are inevitable, and we have already seen off-chain assets like private credit (Credix) and real estate (Homebase) getting represented on-chain. Robust oracles are also needed for streaming price feeds and proof of reserves.

4. Compliance and Identity:

Solana or any other public blockchains are, by default, anonymous, given their permissionless nature. However, many regulated entities like Circle, the issuer of USDC, perform KYB (Know Your Business) before allowing businesses to create a Circle account for direct minting and redemption. Countries may be more inclined to build their own identity standards out of sovereignty and privacy protection.

Central banks can maintain a database of whitelisted addresses, and only those addresses can be allowed to send or receive CBDCs. Further, SPL standards allow for a number of knobs and levers that can be turned on or off on a case-by-case basis:

  1. Freeze: Any SPL token in a wallet can be frozen and made non-transferable. This is critically important for cases like terrorist financing, where authorities can freeze illicit funds (CBDCs) in suspicious wallets. This would be essential for enforcing Anti-Money Laundering (AML) and Combating the Financing of Terrorism (CFT) activities, which are primary concerns for the anonymous nature of currencies.
  2. Clawbacks: The issuing authorities can also handle clawbacks to reclaim the assets back from a wallet in cases where the self-custodial or non-custodial wallet was compromised, or access is lost due to the sudden death of an individual.

Since all transfers are on-chain — the entire flow of illicit transactions can be tracked efficiently as opposed to traditional banking systems. Using zero-knowledge proofs, CBDC transactions can also be made private, like cash. At the same time, central banks maintain the authority to view the flow of private transactions in case of illicit transfers.

5. Secure Asset Issuance

Just like banks use centralized ledgers, blockchains like Solana are giant decentralized ledgers where authorized account holders can sign and submit transactions. For a user, it’s like moving the account balance from one account to another. These accounts are, by default, anonymous.

However, organizations like central banks that issue real-world financial assets can link their issuing accounts to verifiable credentials and identifiers to gain the trust of asset holders and prove authenticity. This way, holders of the assets can verify the issuer and terms and conditions of the asset’s supply, issuance, and redemption.

Go-To-Market — Implementation Plan on Solana:

As per the IMF, there are two ways in which CBDCs can be distributed:

  1. One-tiered model: directly to consumers.
  2. Two-tiered model: via commercial banks and regulated financial institutions.

Various central banks will have different needs. However, most jurisdictions are showing higher interest in the ‘two-tiered model,’ where the circulation of CBDC would be facilitated via a public-private partnership, which is very similar to how physical cash is issued and distributed today. This means the central bank would issue CBDC, while the private sector would handle distribution and customer-facing activities, including compliance and KYC.

  1. Account Setup and Minting: The central bank can set up its account by simply setting up its issuing wallet address and minting the fungible tokens via the SPL standard. These tokens can have a fixed or dynamic supply, and they can be minted and burned when needed. The central banks can also transfer these tokens to commercial banks, which can further distribute them to the users. Only the central bank will have the authority to mint new tokens, which can be further secured by a multi-sig that requires M out of N signatures by stakeholders such as banks.
  2. Distribution: For distribution to end users, central banks can restrict their assets to being held only in accounts they have explicitly authorized or whitelisted. This will be similar to the creation of a bank account today, where a central bank would make sure that proper KYC has been conducted before whitelisting any user’s wallet to interact with CBDCs. Currently, banks, financial institutions, fintechs, and others interact directly with end users for identity verification. Similarly, financial institutions can handle verification to make sure that no CBDC would ever be held in an account not allowed to do so.
Mock-up of Hong Kong CBDC in the HSBC mobile banking app

The user’s account can be either a custodial wallet or a non-custodial wallet.

a) The custodial wallet can be controlled by a centralized entity like a bank, which will hold CBDCs on behalf of a user, just like they do for fiat currencies. For simplicity, they can also be linked to existing bank accounts, which will result in a seamless user experience.

b) The non-custodial wallet, on the other hand, allows users to manage their own private keys. This configuration is ideal for disintermediation and leaving users with full control of their assets. Non-custodial wallets are very much analogous to cash but in digital form.

Distributing CBDC through welfare programs can be an essential mechanism for adoption. Think of this as similar to airdrops. For instance, a Chinese city paid its government employees in digital yuan to promote adoption.

  1. Monetary Policies: In the modern financial system, banks periodically deposit and withdraw fiat currencies at the central bank, which results in increased or decreased reserves. Similarly, for CBDCs, banks can simply send or withdraw CBDC to the issuer’s account, i.e., the central bank. This process is already in practice for stablecoins through minting and redemption (a.k.a. burning). This could serve as an instrument for implementing monetary policies and help in faster monetary transmission.
  2. Foreign Exchange: To allow for effective real-world exchange rates, CBDCs can be made readily fungible with bank deposits, i.e., they can be exchanged easily for traditional cash or bank balance. This would enable CBDCs to maintain the peg on-chain as well. The ease of arbitrage between the CBDC and institutional markets will also allow for lower bid-ask spreads for retail foreign exchange transactions. Hence, sound interoperability of CBDCs with existing foreign exchange markets would enable exchange rates to be reflected more directly and promptly to both individuals and businesses.

Private Deployment of CBDCs and Its Tradeoffs

In our discussions with a number of central banks, we realized that private blockchains might be an appropriate environment for piloting CBDCs in their early stages. The current financial system runs on very centralized servers and databases and for good reason. Currency is an extension of a nation’s sovereign power. It is paramount for governments to maintain control over its flow and issuance. Hence it is extremely unlikely that a large country with independent military forces and political influence would be willing to issue all its CBDCs on a public blockchain like Ethereum or Solana with distributed nodes globally.

While CBDCs can be issued on a separate blockchain that runs on a private server to maintain complete control of the asset, that would result in a closed system with similar characteristics as existing fiat currencies — a siloed and permissioned ecosystem with limited transparency. If platforms that serve use cases like foreign exchange, trade finance, and new payment methods can only be run by government-approved organizations, then it would defeat the purpose of having a CBDC as it limits access to free markets and open-source innovations. This is a major reason why private blockchains have seen far less adoption compared to public blockchains!

We suggest that central banks consider, over time, allowing a growing concentric circle of stakeholders with diminishing degrees of access authority to contribute to the growth of CBDCs. For example, CBDC v1. might only have 2 nodes run by central banks. Then big banks and exchanges can run permissioned nodes in CBDC v2., then verified organizations can run nodes for CBDC v3., and so on. Eventually, CBDCs can flow into public blockchains in a controlled fashion.

We hope that whichever blockchain configuration central banks settle on can be compatible with its public blockchain counterpart. That way, CBDCs can benefit from all the community-built dApps in that ecosystem. There will need to be some sort of “bridge” between the CBDC world and pure Web3, but it would be a pity if the two end up being completely siloed from one another.

Launching CBDCs on a Solana VM (SVM)

The two benefits of launching on VMs are:

  1. Customizability: central banks can adjust their block times, subsidize gas fees, or make it permissioned by restricting who can use their blockchain, allowing only KYC or KYB-verified entities to create CBDC wallets.
  2. Scale horizontally: central banks can spin up an execution layer, giving the power and throughput of Solana all to themselves, without interference from other applications. This leads to higher performance as they don’t have to compete with other dApps for blockspace on the same network.

SVM rollups offer a relatively more elegant solution than choosing private permissioned enterprise blockchain solutions like Hyperledger, R3 Corda, Ripple, and Quorum. Apart from composability and interoperability, the closed-source nature of permissioned blockchain has problems like:

  1. Vendor lock-in: central banks have to keep paying subscription and support fees with high switching costs.
  2. Reliability: since the code is not in the public review, there can be potential bugs that can go unnoticed by the enterprise team.
  3. Adaptation and dependency: without permission from the closed-source developer, source codes cannot be modified to include newer features — resulting in high dependency on the enterprise solution provider.

What Would it Take CBDCs to Win?

  1. Global adoption depends on major countries: While smaller countries are more likely to adopt CBDCs, however, they will likely look up to bigger countries as an example. For instance, the Bank of Israel has clearly indicated that its issuance of CBDC would depend on issuance by the EU, the US, or other major economies. We believe that, for bigger countries like the US, CBDCs could improve payments, maintain the dollar’s global dominance, and protect consumer privacy if implemented correctly.
  2. The country-wide effort combined with tailwind forces such as cash shortages: The adoption of eNaira, the digital version of the Naira (CBDC) issued by the Nigerian central bank, had a slow start early on. However, it is on the rise — jumping 12x from October 2022 to 13 million wallets in March 2023 (still ~6% of the population). This was pushed by Nigeria’s recent demonetization policy, which led to a shortage of banknotes. The central bank has been attempting to replace old bank notes with new ones in the hopes of curbing inflation and removing excess liquidity.
  3. Seamless integration with existing financial applications: On a country level, CBDCs can be integrated into the most used payments and finance applications with incentives or value-add such that it is frictionless for citizens to switch to CBDCs. CBDCs need to leverage smart contracts and programmable money to show end users why on-chain money is more efficient or better than digital money.

Overall, a strong tokenization narrative is needed in the mainstream to ensure not just CBDCs, but also the issuance of commercial bank money, T-bills, and bonds on the public chains.

Closing Thoughts

While CBDCs could be beneficial to various currencies, it’s likely that smaller countries will be more willing to replace cash with CBDCs than bigger countries due to lower switching costs. CBDCs offer governments a way to digitize and control their currency but come at the expense of the ability of banks to lend. This is because if individuals and business store their wealth in CBDCs instead of bank deposits, it might result in lesser commercial bank deposits and hence, lesser lending capacity for banks. In some places, especially where financial services infrastructure is less developed, this is a cost worth paying, and hence, we believe smaller countries would likely experiment and adopt it first.

Further, to bring central banks to experiment on public blockchains like Solana, an open-source reference CBDC implementation is needed to prove the point. A dedicated team can be formed that focuses on doing pilots and engagement with smaller countries that are actively looking to implement CBDCs. While the actual implementation of CBDC will involve rigorous evaluation from policymakers, economists, and engineers, we believe that running various experiments are the best way forward.

We believe that CBDCs in no way are meant to be replacements for any existing forms of money and will tend to complement other instruments like cash, t-bills, stablecoins, digital bank deposits, and so on. CBDCs will likely co-exist as natively programmable money backed by sovereign states. As we know, programmability is a double-edged sword; it can lead to an efficient form of money while leading to increased control and surveillance. Trade-offs indeed!

Feel free to contact Yash or Anna for any feedback or if your jurisdiction is interested in issuing a CBDC. If you find this even slightly insightful, please share it — it justifies our weeks of effort and gets us more eyeballs :)

References:

  1. Circle’s “State of USDC Economy Report”
  2. Stellar’s CBDCs Report
  3. CBDC Tracker
  4. IMF CBDC Two-tiered Model

Disclaimer: This essay is our personal perspective and doesn’t represent any organization we might be associated with. None of this is financial advice or recommendation.

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Yash Agarwal

Building & Writing in FinTech & Web3 | @yashhsm on Twitter