Zou Chuanwei: Exploring the Application of Multilateral Central Bank Digital Currency Bridges in Cross-Border Payments

This article is from ChainNews, author: Zou Chuanwei.

On February 23, 2021, the Hong Kong Monetary Authority, the Bank of Thailand, the Central Bank of the UAE, and the Digital Currency Research Institute of the People's Bank of China announced the joint launch of the Multi-CBDC Bridge research project, aimed at exploring the application of central bank digital currencies in cross-border payments. The project is supported by the Hong Kong Innovation Hub of the Bank for International Settlements (BIS). During the BIS Innovation Summit from March 22 to 25, the Multi-CBDC Bridge received significant attention. So, what is the Multi-CBDC Bridge? How is it applied in cross-border payments? What impact does it have on the global central bank digital currency ecosystem?

This article aims to discuss these questions, divided into four parts. The first part discusses the path selection for the application of digital currencies in cross-border payments. The second part discusses the design of the Multi-CBDC Bridge and its application in cross-border payments. The third part discusses the impact of multi-central bank digital currencies on the global central bank digital currency ecosystem. The fourth part summarizes the article.

Path Selection for Digital Currency Application in Cross-Border Payments

Since the release of the first version of the Libra (now renamed Diem) white paper in June 2019, the application prospects of digital currencies in cross-border payments have received widespread attention and have entered the G20 agenda. In July 2020, the Committee on Payments and Market Infrastructures (CPMI) of the Bank for International Settlements outlined 19 tasks in its report to the G20 on improving cross-border payments, among which tasks 18 and 19 relate to new payment infrastructures and arrangements: enhancing the robustness of global stablecoin arrangements and incorporating international dimensions into the design of central bank digital currencies. In October 2020, the Financial Stability Board (FSB) proposed a roadmap for improving cross-border payments based on the CPMI report and released its final recommendations for the regulation of global stablecoins. In March 2021, the Bank for International Settlements published a working paper titled "The Future of Multi-CBDC Arrangements and Cross-Border Payments."

In theory, digital currencies that can be used for cross-border payments include single-currency stablecoins, basket-currency stablecoins, wholesale central bank digital currencies, and retail central bank digital currencies. From the practice of the Libra/Diem project, basket-currency stablecoins face many challenges in terms of price stability mechanisms, reserve asset management, user habit cultivation, and protection of monetary sovereignty, making their launch very difficult. Single-currency stablecoins, if circulated globally, would constitute a global stablecoin as defined by the Financial Stability Board, and would be subject to strict regulation in areas such as governance frameworks, reserve asset management, operational resilience, cybersecurity, anti-money laundering, counter-terrorism financing, and privacy protection. Retail central bank digital currencies can have overseas individual and institutional users, but acquiring overseas users while respecting the monetary sovereignty of other countries is not easy, and the M0 (cash in circulation) positioning will also limit the application of retail central bank digital currencies in cross-border payments.

From the discussions at the BIS Innovation Summit from March 22 to 25, the central banking community tends to improve cross-border payments using wholesale central bank digital currencies, while the Multi-CBDC Bridge will become an important mechanism for interaction between different countries' wholesale central bank digital currencies and support cross-border simultaneous settlement (PvP). Cross-border simultaneous settlement is a fundamental requirement for cross-border payments, primarily aimed at improving settlement efficiency and preventing settlement risks. Technically, different countries' wholesale central bank digital currencies generally use different distributed ledgers (DLT), and the core issue of cross-border simultaneous settlement is cross-chain interoperability. Various solutions have been attempted in practice to address this issue.

The Monetary Authority of Singapore's Ubin project collaborated with the Bank of Canada’s Jasper project in the fourth phase to conduct synchronized cross-border settlement experiments, where the Singapore central bank digital currency is based on the Quorum platform, and the Canadian dollar central bank digital currency is based on the R3 Corda platform. They focused on testing intermediary solutions, where the intermediary is typically a commercial bank that participates in both the Quorum and R3 Corda platforms and implements synchronized cross-border settlement through Hash Time-Locked Contracts (HTLC). The tests found that in most cases, HTLCs are reliable, and the "intermediary solution + HTLC" can help both parties in a transaction implement synchronized cross-border transfers without trusting the intermediary. They also proposed two other conceptual designs: one where the paying Singapore bank and the receiving Canadian bank both participate in the Quorum and R3 Corda platforms and hold both countries' central bank digital currencies; the other where the same distributed ledger supports both countries' central bank digital currencies.

The Stella project, a collaboration between the European Central Bank and the Bank of Japan, also tested cross-border simultaneous settlement based on intermediary solutions in its third phase, with no specific restrictions on the types of ledgers used by the paying bank, receiving bank, and intermediary, which can be either centralized or distributed ledgers. Cross-ledger transfers utilized five methods: Trust Lines, On-Ledger Escrow with HTLC, Simple Payment Channels, Conditional Payment Channels with HTLC, and Third Party Escrow. Among these, the first four methods are derived from Hash Time-Locked Contracts.

The aforementioned tests indicate that the mainstream cross-chain technology currently used by central banks is Hash Time-Locked Contracts. HTLCs are the basis for conditional payments in decentralized and trustless environments. Besides the application of cryptography, the core of HTLCs is sequential games. Due to the lack of perfect game design, HTLCs may fail under certain conditions, resulting in undesirable game equilibrium outcomes. However, this drawback of HTLCs has not yet been resolved.

The concept of the Multi-CBDC Bridge primarily comes from the Inthanon-LionRock project, a collaboration between the Hong Kong Monetary Authority and the Bank of Thailand. Essentially, it maps two central bank digital currencies onto the same distributed ledger, issuing deposit receipts based on central bank digital currencies on a "corridor network," allowing the same distributed ledger to support multiple central bank digital currencies. The benefits of the Multi-CBDC Bridge include: first, transactions between two central bank digital currencies occur on a single ledger, avoiding cross-chain operations, making it easier to implement cross-border simultaneous settlement through smart contracts; second, it can accommodate different central bank digital currency systems and designs, providing good scalability; third, it alleviates the impact of central bank digital currencies circulating abroad on the monetary sovereignty of other countries. However, the Multi-CBDC Bridge may create governance issues involving multiple central banks, as well as new issues related to the circulation of digital currencies.

Design of the Multi-CBDC Bridge and Its Application in Cross-Border Payments

Design of the Multi-CBDC Bridge

From the Inthanon-LionRock project, the core components of the Multi-CBDC Bridge include: the "corridor network," deposit receipts, cross-border transfers, liquidity management, regulatory compliance, and multilateral governance.

Corridor Network

The core of the Multi-CBDC Bridge is a "corridor network" that connects the digital currency systems of multiple central banks. For each participating country, the central bank and several commercial banks connect to the "corridor network," but foreign central banks and commercial banks are not allowed to access that country's central bank digital currency system or hold that country's central bank digital currency. In other words, the central bank digital currency systems of various countries are "physically isolated," but interconnected through the "corridor network."

Deposit Receipts

For each central bank digital currency, there is a corresponding deposit receipt on the "corridor network," issued by the respective central bank and responsible for redemption.

For each participating country, if a commercial bank in that country requests to destroy one unit of its central bank digital currency, the central bank will issue one unit of the deposit receipt for that central bank digital currency to the commercial bank on the "corridor network." Conversely, if the commercial bank requests to destroy one unit of the deposit receipt on the "corridor network," the central bank will issue one unit of the central bank digital currency to the commercial bank.

In other words, central banks are responsible for the 1:1 two-way exchange between their central bank digital currency and the deposit receipts on the "corridor network," ensuring that the number of deposit receipts issued on the "corridor network" always equals the number of central bank digital currencies destroyed.

Although a country's central bank digital currency cannot be held by foreign commercial banks, the corresponding deposit receipts can be held by foreign commercial banks on the "corridor network."

Cross-Border Transfers

Cross-border transfers are conducted through deposit receipts on the "corridor network." Any pair of commercial banks from different countries on the "corridor network" can conduct real-time transactions using their respective central bank digital currency deposit receipts, eliminating the need for a complex network of correspondent banks for cross-border transfers. The exchange rates between different deposit receipts can refer to the rates in the foreign exchange market. If the trading volume of deposit receipts on the "corridor network" is sufficiently large, it will become an important component of the foreign exchange market.

Although different deposit receipts are issued by different central banks based on different central bank digital currencies, transactions between them can occur around the clock due to reliance on the same distributed ledger, achieving atomicity of payments (i.e., a payment instruction is either fully executed or not executed at all, with no partial execution) and finality of settlement.

Liquidity Management

Transactions of deposit receipts on the "corridor network" are settled in real-time and in full, reducing settlement risks but requiring high liquidity. The "corridor network" will provide liquidity management functions, including queuing mechanisms and trading congestion solutions related to liquidity-saving mechanisms (LSM). Liquidity providers for deposit receipts can also be introduced on the "corridor network" to help commercial banks on the "corridor network" smooth their liquidity needs.

Regulatory Compliance

On the "corridor network," central banks monitor wallets and transactions related to their central bank digital currency deposit receipts in real-time to implement regulations against money laundering, terrorist financing, and tax evasion.

Given that foreign commercial banks can indirectly hold a country's currency through deposit receipts, and that the currency can circulate among foreign commercial banks in the form of deposit receipts, central banks may need to limit the time and quantity that foreign commercial banks can hold deposit receipts of their central bank digital currency.

Multilateral Governance

The "corridor network" is jointly owned, built, operated, and managed by the central banks participating in the Multi-CBDC Bridge. This raises governance issues involving multiple central banks, including:

• Which central bank digital currencies can access the "corridor network"? What decision-making procedures should be followed to add new central bank digital currencies supported by the "corridor network"?
• The admission conditions and procedures for commercial banks participating in the "corridor network."
• How to ensure that the number of deposit receipts issued by central banks on the "corridor network" always equals the number of central bank digital currencies destroyed in their respective central bank digital currency systems?
• Issues related to the storage, consensus accounting, upgrades, error management, and dispute resolution of the distributed ledger of the "corridor network."

Analysis of the Multi-CBDC Bridge

The Bank for International Settlements, in its working paper "The Future of Multi-CBDC Arrangements and Cross-Border Payments," compares 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 techniques, data requirements, and user interfaces. Second, the central bank digital currencies of different countries are interconnected at the system level, including shared technical interfaces and the same clearing mechanisms. Third, a single multi-currency payment system is established. The Multi-CBDC Bridge falls under the third method.

In the Multi-CBDC Bridge, any pair of commercial banks from different countries can conduct point-to-point real-time transactions. This is a fundamental goal for the application of digital currencies in cross-border payments, as it constitutes an improvement over the existing correspondent banking model. Representative schemes include:

• Commercial banks from different countries using a super-sovereign digital currency for cross-border payments, such as the Libra/Diem basket of stablecoins. However, this depends on the market acceptance of the super-sovereign digital currency and its ability to fulfill basic monetary functions, raising issues of monetary sovereignty.

• Commercial banks from different countries using a dominant central bank digital currency or stablecoin for cross-border payments, such as a digital dollar or a dollar stablecoin. However, this could lead to the issue of strong currencies replacing weak currencies.

• Different countries issuing central bank digital currencies on their respective distributed ledgers and using smart contracts for cross-ledger interactions to achieve cross-border simultaneous settlement. However, this is constrained by the immaturity of cross-chain technology.

• The Multi-CBDC Bridge.

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

• Opening the central bank's real-time gross settlement (RTGS) system to foreign commercial banks. However, due to issues of monetary jurisdiction, this is currently only a theoretical possibility.

• Establishing interbank accounts between commercial banks from different countries. However, as the number of commercial banks increases, the implementation costs will rise significantly.

In summary, if improvements to cross-border payments follow the principles outlined above, the Multi-CBDC Bridge should be the best choice at present:

• Use digital currency technology rather than banking account systems.

• Respect the monetary sovereignty of each country and alleviate the issue of strong currencies replacing weak currencies.

• Avoid reliance on complex or immature cross-chain technologies.

• Accommodate the differences in currencies and payment systems (including central bank digital currencies) of various countries.

• Achieve high economic efficiency and good scalability.

Finally, two points need to be clarified. First, the Multi-CBDC Bridge can be compatible with central banks' real-time gross settlement systems. In other words, even if a country has not launched a central bank digital currency, its central bank and commercial banks can improve cross-border payments by accessing the Multi-CBDC Bridge. Second, from the current discussions and practices regarding central bank digital currencies, it can be seen that although some important consensus is gradually emerging, there is still significant flexibility in both the monetary economics design and technical solutions of central bank digital currencies. In the foreseeable future, central bank digital currencies from various countries are unlikely to converge to a single standard. These two points will enhance the importance of the Multi-CBDC Bridge.

Impact of the Multi-CBDC Bridge on the Global Central Bank Digital Currency Ecosystem

Although there is significant flexibility in the monetary economics design and technical solutions of central bank digital currencies, the Multi-CBDC Bridge enables the interconnectivity of different countries' central bank digital currencies, which is crucial for improving global central bank digital currency standards. The governance issues involving multiple central banks in the Multi-CBDC Bridge will promote cooperation among central banks on central bank digital currencies.

From the research and practice of central bank digital currencies in major countries and regions, some prioritize wholesale models while others focus on retail models. Currently, representative wholesale central bank digital currency projects are gradually completing trials, while retail central bank digital currencies, due to their involvement in complex monetary and financial issues, have become a research hotspot. If focusing on domestic payments, retail central bank digital currencies are undoubtedly the focus. However, as previously pointed out, relying solely on retail central bank digital currencies for cross-border payments is insufficient; they must be complemented by wholesale central bank digital currencies. Therefore, it is necessary to reassess the relationship between wholesale and retail central bank digital currencies in the context of cross-border payment scenarios.

Currently, central bank digital currencies generally follow a "central bank-commercial bank" dual model (also known as a two-tier operating model). Retail central bank digital currencies also include a wholesale segment, but the wholesale segment only pertains to the issuance and redemption of digital currencies, not their application in securities transactions and cross-border transfers. In the Multi-CBDC Bridge, wholesale and retail central bank digital currencies will form an organic whole.

Consider two countries, A and B. Alice, a resident of country A, opens an account at bank a in country A, while Bob, a resident of country B, opens an account at 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, 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 directly transfers funds to bank b through the Multi-CBDC Bridge, which then increases Bob's deposit balance or digital currency wallet balance accordingly. The advantage of "wholesale central bank digital currency + Multi-CBDC Bridge" over directly using retail central bank digital currency lies in its better support for large transactions and its lesser impact on the monetary sovereignty of other countries or the issue of currency substitution.

Conclusion

The Multi-CBDC Bridge has the following important significance, which deserves attention.

First, the Multi-CBDC Bridge will promote cooperation among central banks of different countries and the interconnectivity of central bank digital currencies, helping to form global central bank digital currency standards.

Second, the Multi-CBDC Bridge, in the context of cross-border payments, helps integrate retail and wholesale central bank digital currencies and supports cross-border simultaneous settlement.

Third, the Multi-CBDC Bridge accommodates the differences in currencies and payment systems (including central bank digital currencies) of various countries, respects the monetary sovereignty of each country, and alleviates the issue of strong currencies replacing weak currencies.

Fourth, the Multi-CBDC Bridge achieves high economic efficiency and good scalability, without relying on complex or immature cross-chain technologies.

Fifth, under the Multi-CBDC Bridge, a country's currency can circulate among foreign commercial banks in the form of deposit receipts, leading to new issues in the management of digital currency circulation.

Sixth, the "corridor network" is jointly owned, built, operated, and managed by the central banks, which will raise governance issues involving multiple central banks.