The Components of a Functioning CBDC – XRP As the Global Bridge?

Advocates of Central Bank Digital Currencies (CBDCs) assert they are a mechanism for good; allowing for greater financial inclusion and more pro-active monetary policy. Others think the prospect may lead us closer to a dystopian nightmare; eroding boundaries between the state and the individual by giving governments control through “programmable money”.

Whatever your opinion on CBDCs, it looks increasingly inevitable that they’ll be implemented in most countries in the near future, in one form or another. At the time of writing, 87 central banks are actively exploring CBDCs. Some central banks are further along than others. Seven countries in the Caribbean have already launched a CBDC. Nigeria also recently launched its eNaria. China has been working on its digital currency since 2014. Other countries, like the United Kingdom, are just starting to discuss the architecture for its version of a CBDC.

Last year, Ripple, the architect of the XRP Ledger, released a white paper setting out its vision for “the future of CBDCs”. Ripple is one of the more prominent cryptocurrency companies that has been cooperating with central banks in designing and implementing CBDCs. Recently it was announced that both Bhutan and the Republic of Palau would leverage a private version of the XRP Ledger for their national digital currencies. As well as this, Ripple is one of the members of the Digital Pound Foundation.

In their whitepaper, Ripple discusses some of the challenges involved in designing and implementing a successful global network of CBDCs.

What are the Keys to overcoming the challenges of CBDCs, according to Ripple?

Interoperability

The development of CBDCs so far has been a patchwork of differing approaches. Some countries, such as Jamaica, are relying on more conventional tech infrastructure, while others are using various forms of distributed ledger technology (DLT). There are also countries that are using a combination of conventional tech and DLT.

At this point in time, no two CBDC projects look 100% alike. In order to enable these separate systems to work together, it’s imperative to have proper cross-border functionality. Any CBDC also needs to be able to interact with other domestic and international payment systems.

Ripple suggests that central banks could start to do this by creating common standards in respect of :

• Transaction-level operations, such as escrow and hash time-locks
• Identity and addressing schemes
• Flexible routing to determine most efficient ways of transmission.

Public and Private Partnerships

CBDCs will not immediately replace the existing financial architecture and therefore Ripple suggests that the best way forward is to take a layered approach and build new systems on top of the existing infrastructure

So far, some Central Banks have employed the expertise of firms and leveraged private or permissioned versions of blockchains to build their sovereign digital currencies. Algorand, Ripple, and Ethereum are examples of blockchains that have been leveraged to build CBDC infrastructure. (Permissioned ledgers would allow only trusted parties to act as validators on the CBDC network).

Neutral Bridge Currencies

Even if CBDC networks are interoperable with each other and the rest of the financial system, other issues still remain in respect of cross-border payments, namely costly settlement, and liquidity issues. Using a neutral bridge currency would eliminate the need for pre-funding, thereby freeing up capital for other more useful purposes.

A neutral bridge asset can support healthy, alternative liquidity markets that will allow for frictionless and cost-effective value movement between various CBDCs in real-time. It would also enable the exchange of less liquid CBDC pairs and increase global competition by lowering entry barriers to new and smaller market participants.

Ripple

RippleNet’s On-Demand Liquidity allows financial institutions to transact in real-time across multiple global markets, using XRP as a bridge currency. 

At present, a host of financial institutions use Ripple’s ODL to settle cross-border transactions. Institutions convert fiat to XRP, then convert XRP into the destination currency. This allows banks to free up capital, which would otherwise be held in foreign currency reserves. Ripple suggests that central banks could leverage XRP in a similar way to these private institutions.

Other Prototypes in the Pipeline

Ripple’s XRP is not the only bridging solution, however. For example, in the latter half of 2021, the Bank of International Settlements (BIS), along with four other central banks, announced that they had developed and successfully tested a DLT-based “multi-CBDC bridge”. According to the BIS, this prototype platform is capable of completing international transfers and foreign exchange transactions in seconds, as well as cutting the cost of this process “in half”. Note that the prototype was built by ConsenSys on Hyperledger Besu, which is a permissioned Enterprise Ethereum blockchain. You can read the full report on this prototype here.

The Way Forward

CBDCs will most likely be based on a variety of technologies. At present we are in the testing phase, and some technologies may prove to be streets ahead in terms of speed, energy efficiency, and cost-effectiveness. However national CBDCs are built, it will be imperative to find a way to effectively transfer value between these “walled gardens”.