Advances in cryptocurrency technology have forced central bankers around the world to begin exploring the opportunities and risks to the monetary system from adopting such technologies. A recent survey of Central Bankers across the world on Central Bank Digital Currency (CBDC) by the Bank of International Settlements (BIS) showed that 86% of central banks are exploring the pros/cons of CBDCs, and 60% are conducting experiments or proofs-of-concept on them. Facebook’s announcement to introduce a digital currency inside its platform – the Libra/Diem project – has perked up central bankers. However, these technologies are not as simple as the printing press or double-entry bookkeeping and require wide consultation and strong stakeholder buy-in. China’s central bank has been among the leading institutions to introduce a hybrid CBDC into an already formidable digital payments ecosystem. The European Union is exploring a digital Euro. Surprisingly, The Bahamas with its small population spread across hundreds of islands has recently introduced its own CDBC, the Sand Dollar, as has the Cambodian Central Bank. What then can the Nepal Rastra Bank (NRB) do, and what considerations does it need to make before introducing its own digital currency, a Green Rupee perhaps? The NRB needs to identify benefits, explore design choices and trade-offs, and identify how a CBDC scheme can be implemented.
Government-backed digital currencies have been gaining popularity over the past 5 years, and central bankers are starting to appreciate the benefits. For Nepal, CBDCs can be different from the rupees in our existing electronic payment systems because they can be a direct liability on the NRB’s balance sheet, like the paper notes we carry in our pockets. CBDC holders will, thus, have no counterparty risks like they do in today’s accounts-based electronic payments, which require multiple layers of identity and transaction verifications across the payment value chain. Today, only commercial banks can hold electronic central bank money in the form of reserves at the NRB. A CBDC can significantly open the payments system, increase competition, reduce costs, and spur innovation.
CBDCs potential to build a more resilient payment infrastructure can be a strong motivation for the NRB. As Nepali people shift from cash to electronic payments, the payment ecosystem will need diversity for resilience. Electronic payments in Nepal still rely on bank settlements at the back end, which are fragile given our poor physical infrastructure, nascent IT infrastructure, and poor cybersecurity baselines. And even among those using electronic payments (cards or e-wallets), cash is still contingently in the back pocket. A CBDC designed to be settled atomically, principally in the same way we make settlements with cash in exchange for goods/services, provides an alternative to the current payment landscape increasingly building up concentration risk with a few systemically important organizations. For a disaster-prone country like Nepal, greater resilience coming from an alternative payment option – one with a smaller infrastructural/operational footprint – may be the most important raison d’être. More efficient and faster payment will be additional benefits.
Secondly, a CBDC could promote greater financial inclusion than what current forms of electronic payment solutions might deliver. Especially in Nepal, where approximately 50% of the population is still unbanked or underbanked, a basic account and payment system through the central bank would make a significant difference. Cash still has many benefits – with universal acceptance and privacy – which would be lost as people shift to electronic payments. A CBDC can provide cash-like benefits in transactions; and even those without bank accounts may be able to use it.
CBDCs could also protect Nepal’s financial sector from anti-money laundering and criminal activities. CBDC users and transactions will be known to some authority/organization in the network, depending on the scheme’s design. That data can be shared with a monitoring agency, either within the NRB or externally, to monitor for irregularities. Personal data of users kept in the core NRB ledger could be pseudonyms, while the actual identity of users can only be linked to a Payment Service Provider (PSP), for example. Therefore, NRB would not hold granular personal data on anyone, while anti-money laundering (AML) requirements would be off-loaded to a private payment processor.
A Green Rupee can directly promote three of NRB’s four core objectives: improved payments system, supervising banking and financing system, and enhanced public trust. It can indirectly promote price stability through more targeted policy implementation.
Building a CBDC scheme will rely on specific technologies that the NRB will have to adopt. Decisions on these technologies must reflect the benefits the NRB wishes to bring to the Nepali population. Three key technologies that cryptocurrencies have brought over the past decade is what the NRB will have to deliberate on for their own CBDC:
Consensus protocols: Consensus protocols in computer science are algorithms employed to reach agreement among a set of participants. It has been used extensively to manage datacenters, and until bitcoin emerged, only internally in a single organization. These were permissioned consensus, where participants voted to establish consensus. Bitcoin introduced a permission-less protocol – the Nakamoto consensus – that did not require knowing a priori who would be participating to maintain the ledger and allowed anyone to participate. This new consensus was based on proof-of-work: demonstrating that a participant could computationally mine a cryptographic sequence. Newer protocols such as federated consensus, where participants just need to know a partial set of other participants to obtain voting power, proof-of-stake protocols, and others are being explored to find options that require less computing and mining resources than protocols used by Bitcoin. Importantly, these new systems should allow new people/entities to join and participate and allow participants to validate and verify the system’s operation. NRB’s choice of which protocol to use, if any, will have trade-offs regarding security, stability, and scale.
Programmable money: CBDC’s, especially if built on a blockchain, can be programmed to facilitate other generalized programs on top of simple transfers of value. Introducing ‘smart contract’ elements into a CBDC can expand its functionality. A transaction between currencies on two different blockchain provides an example: when two participants decide to swap digital assets, there is a risk to whomever trades first. A trusted third party may be used as a temporary custodian for both assets. However, a CBDC may be programmed such that if one party executes a transfer, so must the other to validate the first leg of the transaction. The assets are partially escrowed, but not by a third party. Such programmability may be built in for settlement between a CBDC and other digital assets. Benefits from such types of atomic settlement are vital for replicating the universal acceptance feature of cash in a CBDC. But building in more functionalities induces more complexity and can undermine security.
Cryptographic techniques: If the NRB holds personal data on CBDC users and their transactions, then mines that data, the CBDC will fail. It is important, therefore, to embed privacy features in the currency itself, rather than rely on institutions to maintain moral compasses. Cryptographic techniques can allow the NRB to maintain privacy settings in the CBDC scheme while enforcing their policy to maintain oversight of the financial and monetary system, curb illicit activity, and enhance public trust. Third-party auditors can correctly verify information about users, transactions, reserves, etc., without any revealing of transaction content or metadata. These techniques are known as zero-knowledge proofs. For example, if a verifier needs to know if a CBDC user is above the age of 18 before buying an online product, the user can present a password that satisfies the verifier without revealing any personal or transaction details to the verifier or the government department that issued the ID. However, these technologies are still very much in its early stage; the NRB may have to rely on a combination of PSPs, PSOs or FIs in the system to vet transactions and users.
Design and implementation
A CBDC should be a continuation of Nepal’s efforts to develop its digital payments system. Making CBDC technology choices about a consensus protocol, settlement, and privacy, therefore, will depend on the current payment architecture and how the NRB co-opts existing incumbents – notably banks and established technology companies – and upstart technology companies. Uncovering how other countries are experimenting with CBDCs can help provide clues on how the NRB can begin conversations about its own Green Rupee:
The first foundational design choice for the NRB will be that of the architecture: what operational role will NRB take vis-a-vis private intermediaries? A CBDC could be operated directly: the CBDC is a direct claim on NRB and NRB maintains the ledger of all transactions and executes retail payments. Alternatively, a CBDC could be intermediated through private institutions, where the NRB would only maintain a wholesale ledger rather than a central ledger of all retail transactions. The CBDC would still be a direct liability for the NRB, yet private intermediaries would handle and execute retail payments. A synthetic CBDC is another alternative; private intermediaries issue a currency and manage all retail transactions. Retail clients would have claims on the private intermediaries, while the private intermediaries would need to have corresponding reserves at the NRB for back-up.
The NRB then must decide on the infrastructure for the CBDC. This could be based on a conventional centralized database or a distributed ledger (DLT). A conventional database is what exists today and is already tried and tested. A full DLT infrastructure can be highly secure and have utmost resilience, but it can be operationally complex depending on the consensus protocol used. Many central banks currently experimenting with DLT use permissioned protocols, where the operator decides who is admitted to the CBDC network. No central bank is experimenting with permissionless DLT technology, which is used by Bitcoin and other private cryptocurrencies. China and Canada’s central banks are building a hybrid system with a centralized database but with the options to issue a CBDC using DLT for retail use.
Next, the NRB must consider how consumers will access the Green Rupee. Account-based CBDC access would build upon current trends towards e-payments; access is granted to whomever has a bank account or verifiable documents to meet KYC standards. However, for the unbanked and those who rely heavily on cash, accounts based CBDC might not add value. Access based on digital tokens would be radical. This option would allow for value-based payment options that match the qualities of cash such as being inclusive, crisis-proof, and anonymous. The EU and Sweden are experimenting with both types of access, while Brazil and South Africa are experimenting with token-based access.
Finally, the NRB needs to consider cross-border payment options for the CBDC, which relies on interlinkages to the retail or wholesale payment ecosystems. A CBDC scheme linked to the wholesale payment ecosystem can connect to the real time gross settlement (RTGS) system and other wholesale payment services, thereby allowing cross-border payments. For retail use, a token based CBDC would allow tourists and foreigners to make transactions in the domestic market.
CBDC schemes could have profound implications for the development and resilience of Nepal’s payments ecosystem, financial inclusion, and anti-money laundering efforts. And CBDCs are not only for developed countries; The Bahamas recently launched its Sand Dollar, as did the National Bank of Cambodia with the Bakong! The NRB should begin exploring the benefits of a digital rupee and set further ambitious goals for the development of Nepal’s payments ecosystem.
By Ashraya Dixit
Senior Fellow & Technical Lead at Center for Digital Transformation, Nepal Economic Forum.