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What CBDC?

[Recommend my two-volume book for more reading]:

BIT & COIN:  Merging Digitality and Physicality

Under the influence of buzzwords such as CBDC, crypto and blockchain, some people think that CBDC is a trivial technical problem, and only a matter of ‘incentivizing’ people’s adoption.

While ‘incentivizing’ is a big part in adoption, CBDC does not have a trivial technical problem. It only seems to be so for superficial reasons.

Good CBDC must be a genuine digital cash that has at least the following strong features:

(1) extremely high scalability;
(2) extremely low cost of transaction;
(3) cash-like bearer instrument;
(4) law-abiding traceability without losing privacy.

These features constitute the core of the technical problem, and they are not easy.

In fact, it is so hard that, of the hundreds of blockchains, only one solves those problems. It is so hard that it took Satoshi 30 years (15 years before the release of Bitcoin, and 15 more years after). It is so hard that even after Satoshi has provided the solution, the vast majority of the world still do not understand it.

I challenge people to find out. (I’ll give you a hint: Satoshi’s solution is the original Bitcoin blockchain, not BTC.)

To the extent that a government recognizes the right technology, it would indeed be technically easy to do CBDC.

But the existence of hundreds of other blockchains makes it hard.

Because the signal is buried under the noise.

With an extremely low signal/noise ratio, the space is overloaded with misinformation, making it hard for government bureaucrats to understand these issues and be able to recognize the right technology from the numerous so-called blockchains that were created and promoted for coins speculations but not suited for real utility as a currency.

It is therefore a hard problem. It is socially, politically and intellectually hard.

But it is a worthy problem to solve. More people start to recognize the real problem and the real solution.

CBDC is a currency, not money

At the same time, CBDC in and of itself cannot change a nation’s monetary policy. CBDC is only a technology, not the underlying money itself. Both proponents and opponents of CBDC often fail to realize this distinction and either criticize or support CBDC on basis of properties that are not of a currency but of the underlying money. In this regard, CBDC does not deserve that kind of support nor criticism.

CBDC is a currency for transmitting money.

The money could be any fiat or a real commodity money such as gold (if the government so chooses, but that’s a huge if).

There is a difference between currency and money. See: Gold is superior money, and tokenized gold a superior currency.

While innovating currency is an immediate goal of technology, innovating money is political and social in nature, a much harder thing to do.

For example, the genuine Bitcoin as envisioned by Satoshi aims to be a currency first and gradually earn its right to become money by becoming a commodity that has utility.

In contrast, BTC decided to promote itself as money without first becoming a commodity that has utility. BTC thus violates regression theorem of money (Mises). The digital gold theorists behind BTC narratives never talk about regression theorem of money. They simply assume that BTC can be wished into money by psychic power, or can be elevated into the throne of money using a Ponzi scheme.

Further discussions

A while ago, Alexander Besant, Senior News Editor at LinkedIn, posted the following question:

Digital currency as legal tender? The U.S. Federal Reserve said it was releasing a paper this summer exploring the idea of a government-backed digital currency, likely to the chagrin of banks that make a lot of money with online transactions.

But what does this mean for cryptocurrency? What does it mean for digital transactions if the U.S. goes through with the idea?

I post my answers below:

We should define the framework before productive dialogues can be engaged in.

CBDC is not an accurate term, perhaps even a misnomer. All major currencies including the US dollars are largely digital already. Let’s make sure that when we say digital currency, we actually mean a digital currency based on some kind of blockchain technology or decentralized ledger technology (DLT). I will use the term “digital currency” or CBDC in the sense.

Thus defined, there should not even be a debate over “whether the US should have a CBDC”, but rather what kind of CBDC. 

The US must have a CBDC. Don’t kid ourselves. The world is moving toward that direction, not because currencies should be digitized (they are already), but because the entire accounting and transaction settlement concept is being transformed using blockchain/DLT, for the better by a large margin. The instant settlement versus the inefficient banking system is a total revolution for the benefit of the society. Any nation that fails to see this will be left behind. In addition, once other nations start to do this, a network is formed, so countries that don’t do it will not just be left behind, there will be left *out*.

What kind of CBDC then? 

There are two basic choices at the central bank level:

centralized, or decentralized.

This is a big question from which confusion arises. To answer this question, don’t first assume that if the central bank chooses a centralized CBDC, it would mean that it is going to necessarily contradict to or even destroy the private sector decentralized solutions.

A prerequisite question to the question of what kind of CBDC is:

The “decentralization” of what? 

Even from a very rigorous point of view, there are multiple legitimate definitions of decentralization, each representing a different aspect of the concept.

Every definition of decentralization has to do with an object that is being decentralized. In the context of central banks, there are at least three separate types of decentralization that need to be differentiated and not confused together.

The first is the decentralization of the source of money itself, which we may call the decentralization of money.

The second is the decentralization of value transactions (i.e., peer-to-peer transactions), which we may call the decentralization of transactions.

The third is the decentralization of blockchain consensus (among validators such as blockchain nodes), which we may call decentralization of validation.

1. Decentralization of Money

With regard to the first, the decentralization of money, I do not see how CBDC can be decentralized. 

I’m a believer of decentralized private money and currencies, especially in the context of using a decentralized public blockchain, but I don’t believe that the central bank can do the same. It’s hard to imagine that any sovereign central banks, especially that of the major powers, would actually choose to decentralize its fiat money issuance.  I wish they could, but they won’t.

The very definition of a central bank has its own raison d’etre and mandates. Unless we are ready to completely give up the concept and system of central banks altogether (which I personally think would actually be a good thing, but don’t see happening), central banks will do central bank things.

2. Decentralization of Transactions

With regard to the second, having transaction decentralization (peer-to-peer) would make a great system, and we would be seeing the demise of the traditional banking functions as we know them. 

But will that happen? Government would have legitimate reasons to exert control over financial transactions through a banking system that maintains regulatory compliance. So the key question is, can a peer-to-peer transaction system be compliant with financial regulations such as KYC and AML? 

That would be a focus of the policy studies.

3. Decentralization of Validators

With regard to the third, the decentralization of validators (blockchain nodes), this could become a focal point of the debate, but I do not have much confidence in the technical competence of such debate at a bureaucratic level, so the outcome may easily be a wrong one, regardless of the effort.

Note that the central bank can choose a true decentralized blockchain without giving up its centralized control over its fiat money. That is, the blockchain node decentralization does not necessarily contradict with monetary centralization.

Note that China has promptly chosen a centralized blockchain (what an oxymoron, but here it is). They probably did not even debate about it before they made the choice, because the alternative is unthinkable to them given the characteristics of its political system. For China, it was a natural choice.

But that doesn’t mean that the US should do the same as what China did. Conceptually, there may be four major levels for the US central bank to choose on the decentralization.

4. Decentralization of the system protocol

This is the most hidden aspect of the decentralization. BTC Core rejected (or did not understand) the following important truth:

that at the base level, it is a fixed protocol that makes Bitcoin decentralized, not an appearance of machine autonomy (‘the code is law’) devoid of human leadership and creativity.

A fixed protocol does not mean there is no further development. The protocol is at the base level must be fixed, but the software implementation of the protocol and applications based on the protocol may see continuous development and improvement. In fact, such development may prosper not in spite of but because of the fixed protocol, because the developers and users have a predictable standard to rely upon.

This is exactly why Internet has thrived as a decentralized system. Its TCP/IP protocol has remained unchanged for decades to allow unlimited and steady Internet development.

The levels of decentralization

The level of decentralization may be classified as follows.

Level I is the China model – centralized digital money running on a centralized network. Completely centralized. Unapologetically centralized.

Level II is a “federal model” – centralized money running on a quasi-decentralized blockchain. For example, let each state be an node. If the PoW consensus is used, separate the block hashing function from transaction processing, and distribute the block hashing function among the hashing nodes, each of which is a state government, but leave the transaction processing to private enterprises and let the market competition take the burden and decide the effect. Alternatively, if states don’t participate, a federated model based on selected entities that have a degree of independence from the central bank can be formed.

Level III is a “hybrid model” – centralized money running on a true decentralized public blockchain. For example, the US central bank may purchase a large block of the tokens on an existing proven blockchain, and “re-color” the tokens into various US dollar denominations. For more technical details of this solution, see the article: Bitcoin is “land” on which economies are being built.

Level IV is a truly decentralized model – decentralized money running on a true decentralized public blockchain.

Note that above Level IV is what many people assume: the central bank would choose one of the existing cryptocurrencies (among which bitcoin is the top candidate) as money (CBDC). But I believe this is unlikely to happen even if the central bank is forced to choose a deflationary or non-inflationary money. Unfortunately, even the above Level III is unlikely to happen with the political system that is technologically inapt.

It is important to note that central bank’s choosing a certain blockchain technology (e.g., Bitcoin blockchain) to run CBDC is not the same as choosing a particular native coin of the blockchain as the CBDC. For example, if the central bank chooses above Level III solution on bitcoin blockchain technology, it does not need to also choose bitcoin as its CBDC. It only needs to lock up a certain number of satoshi tokens on the blockchain and redefine (recolor) them as currency denominations. For more detail, see the article: Bitcoin is “land” on which economies are being built.

Personally, I would rather see the above Level IV implemented, but I see almost zero chance for that to happen. I don’t even have much hope that the right solution at Level III can successfully pass the bureaucratic barriers. But if not, Level II may be a more preferred solution than Level I, especially given the federal system of the United States.

Ecosystem and interoperability of CBDC

Assuming that CBDC is going to be implemented, the next question is, how much interoperability is the CBDC going to allow private currencies to integrate, or even compete?

First I should note that the answer to this question cannot be separate from the answer to the previous question on the choice of the blockchain. The choice of the blockchain infrastructure would determine the feasibility and operability of many blockchain features on a technological basis, whether permitted by the policies or not.

This is nevertheless a meaningful separate question, because it has to do with the ultimate functionality of CBDC.

Brief answer: the US should have a clear policy that cuts with a double edged sword: use a CBDC that allows interoperability with genuinely decentralized cryptocurrencies to integrate or even compete, and supports a value transfer ecosystem that allows real utility tokens and tokenization of real assets, but at the same time, out-law tokens that pretend to be utility tokens but really are predatory, taking advantage of people’s ignorance and greed.

Choosing wisely, the US CBDC would have an opportunity to compete strongly against the Chinese counterpart, because China simply cannot make the above choices even if it wants to. On this point, see my article: Why China’s CBDC will succeed, and why it will not.

The government must govern, and CBDC is part of the government, people should expect that. However, the government must allow free market competition which is the basis of recursive systemic learning, which in turn is the basis of growth.

When countries start to use their own CBDC’s, there must be at least one cryptocurrency that functions as a bridge and liquidity layer to connect the multiple CBDC’s. I believe the “bridging” currency must be a private solution that is truly globally decentralized, proven to be secure, vastly scalable, maximally low cost, and enabling instant cross-border settlement. Let the market choose. Let the market find truth based on merits. But the government has an opportunity to act objectively, scientifically and wisely such that the truth is not suppressed and lies not artificially augmented.

[Recommend my two-volume book for more reading]:

BIT & COIN:  Merging Digitality and Physicality