The Best of the Centralized and Decentralized Worlds

There is a perception that decentralized finance (DeFi) and central banks are worlds apart. However, these two worlds should explore common ground that can unlock the best possible solution for the end-consumer – the transparency and efficiency of the DeFi space paired with safe and reliable liquidity and reduced compliance burden provided by central banks. After all, it should be about working towards one common goal – to provide the safest, most efficient, and reliable user experience in payments.

A lot of existing and prospective initiatives are looking into enabling faster, cheaper, more transparent and more inclusive cross-border payment services, while maintaining their safety and security. Improved cross-border payments translate into widespread benefits such as supporting economic growth, international trade, global development and financial inclusion. Cross-border payments are particularly relevant for emerging and developing economies given the central role of remittances and the large number of unbanked citizens in these countries.

The emergence of distributed ledger technology (DLT) has added new momentum to efforts to improve cross-border payments initiated both by the private and public sector. While the private sector has focused on developing decentralized peer-to-peer (P2P) solutions in the retail domain, the public sector has aimed at enabling direct exchanges between participating financial institutions through centrally operated DLT-based networks in the wholesale domain.

For the private sector, the use of DLT eliminates the need for trusted third parties and intermediaries like commercial banks for processing, clearing and settlement. DLT has spurred the growth of DeFi that recreates traditional functions of financial systems using smart contracts in place of middlemen. DeFi operates via decentralized, permissionless DLT-enabled applications called DApps. Currently, the primary DeFi platform is Ethereum, but in principle these ideas can be implemented on any smart contract platform. The main building blocks of DeFi are fiat currency-pegged stablecoins that can be exchanged seamlessly and most DApps are designed to fully interoperate with each other.

Public sector activity in the cross-border domain has focused on exploring DLT-enabled private permissioned wholesale CBDC networks as an alternative to existing real-time gross settlement (RTGS) systems. The broadcast of transactions in real-time across the network of participants eliminates the need for reconciliation or intermediation, allowing designated financial institutions to transact directly without relying on correspondent banks. The Inthanon-LionRock research project carried out in collaboration between the Hong-Kong Monetary Authority and the Bank of Thailand in 2019 created a Thai Bhat and Hong-Kong Dollar cross-border corridor network prototype, which allowed participating banks in Hong Kong and Thailand to conduct funds transfers and foreign exchange transactions on a P2P basis reducing settlement layers.

At a first glance, these two types of initiatives appear worlds apart. But the potential convergence holds promises for the best of two worlds in cross-border payments – a robust solution leveraging the competitive advantage of both. For example, DeFi relies on liquidity pools to meet its liquidity needs. Liquidity pools are crypto-assets that facilitate trading on decentralized exchanges. The tokens are locked into smart contracts and serve to provide liquidity in decentralized exchanges. Those exchange typically make use of an automatic market maker, which obviates the need for an order book and a counterparty in the traditional sense. For the buyer to compete a transaction, there does not need to be an available seller, only sufficient liquidity in the pool against which the trade is executed.

However, these pools can put the deposited funds at serious risk such as impermanent losses, smart contract exploits or malicious actions by pool administrators. Given their decentralized nature, there is no recourse when funds or data is lost as the counterparty is not easily identifiable. Instead of relying on crypto-assets in the liquidity pool, stablecoin providers could purchase central bank reserves issued “on-chain”. These reserves can be used to back the issuance of their coins in different currencies. Another advantage of linking up with central banks is that it could ease the regulatory and compliance burden of DeFi providers and participants which can be particularly heavy when working across different sectors and jurisdictions. Central banks, on the other hand, would have more regulatory oversight over DeFi providers holding their reserves.

Also, rather than having to venture out in the retail space to operate and manage their own networks, which can be time and resource intensive, central banks could benefit from the continuous enhancements of decentralized public networks. In addition, central banks would not need to run consumer-facing operations, like hosting wallets, handling consumer complaints, maintaining superior user experience and integrating with other functional applications beyond payments, which are traditionally outside their mandates. Plus, central banks would have real-time insights into how DeFi providers are using these on-chain reserves and whether they are achieving desired policy goals.

The oracle middleware of decentralized data systems provides a unique opportunity for central banks (or international regulatory and standard setting bodies) to impose technical and regulatory standards that govern the interaction with external DeFi providers. Oracles are third-party services that enable data and transaction sharing between disparate environments in a secure and authoritative manner. Information shared by oracles is digitally signed and hence is considered non‑repudiable (assurance that the signature cannot be denied by the party who signed it). For example, only parties that have completed required financial integrity checks would be authorized to purchase the central bank liability discussed above. Oracles can transmit real-time exchange rate data for DeFi cross-border payments systems and continuously validate and monitor data usage in the downstream applications. Oracles can also be used to achieve interoperability with private enterprise blockchain networks and existing legacy payment systems.

The marriage of the decentralized P2P solutions and centrally governed and organized networks can catalyze mutual benefits beyond cross-border payments. Linking central platforms with decentralized marketplaces would allow for a better integration of the retail and wholesale domains thereby unlocking a variety of use cases for DeFi providers that could be aligned with a country’s strategic policy objectives such as expanding financial inclusion. At the same time, central banks can rely on the continuous improvement of the public networks underlying DeFi while ensuring access to liquidity and regulatory compliance.

Blockchain Service Network – Key to Digital Currency Interoperability?

As central banks advance their work on central bank digital currency (CBDC), they are faced with questions on how to ensure interoperability with other digital assets. To unravel the interoperability conundrum and provide a robust digital ecosystem for the economy, China has launched the Blockchain Service Network (BSN). Although in its early stages, the BSN remains a unique attempt to build a global interoperability network that connects digital assets both across borders and networks.

Many central banks are exploring central bank digital currency (CBDC), but China is at the cutting edge of exploring interoperating their e-CNY with other digital currencies and payment systems. The Blockchain Service Network (BSN) is a government-backed infrastructure network that bridges various distributed ledger technology-based networks. It was founded in April 2020 by Red Date Technology, a Beijing-based software company, and six other private and public sector agencies, including China UnionPay, China Mobile and the State Information Center. For regulatory compliance purposes, the governance of the BSN was split up into BSN China (for private permissioned blockchains) and BSN International (for public permissionless networks) while preserving a certain level of interoperability.

BSN International is expected to launch a Universal Digital Payment Network (UDPN) and integrate CBDCs and stablecoins from various countries in collaboration with international banks and technology companies in 2021. The payment network is supposed to introduce a standardized digital currency transfer method and payment procedure for various information systems. Ultimately, banking and insurance mobile applications will be able to initiate digital currency transaction payment processes using UDPN.

BSN China is expected to serve as a domestic public infrastructure network that will facilitate the development, deployment, operations, maintenance, and regulation of low-cost consortium blockchain applications. (Consortium blockchains grant assess only to selected participants, whereas private blockchains keep write permissions to one entity, although read permissions may be more open, whereas with public blockchains, access and interaction with the network is unrestricted and the identity of its participants is semi-anonymous.)

Rather than starting from scratch, developers can leverage the BSN to build their applications efficiently by choosing desired components from a broad menu of integrated systems. Developers would be able to deploy their distributed applications (dapps) with a single private key across different networks, while servers running on the BSN are designed to be compatible with the blockchains of any participating member.

A network of public city nodes that are linked via the internet form a nationwide (and in the future, worldwide) physical city node blockchain service network. In effect, public city nodes serve as BSN data servers that developers can deploy their applications to using a dedicated channel for transaction processing, data communication, and storage. These disparate channels are supposed to ensure “absolute privacy” of each application while allowing data allocations across multiple channels. Participants and end-users can access those applications at no cost. Currently, the BSN spans various cloud environments and portals, including 108 public city nodes, connecting over 80 cities across mainland China and eight public city nodes in other countries around the world.

The BSN has been integrating public blockchains into the network based on unique capabilities they offer with a focus on building ecosystems with strong use cases. Several public blockchains such as Ethereum, EOSIO, Tezos, Neo, Nervos, IrisNet, and most recently Consensys Quorum have already been onboarded there. The BSN aims to integrate with 30 to 40 public blockchain networks by June 2021. Collaboration with interchain protocols COSMOS and Polkadot are focused on developing an Interchain Communications Hub.

Through the hub users can tap into data generated by outside applications while getting cross-chain services between blockchains adapted in the network. For example, an Ethereum-based dapp would be authorized to access real-time logistics data generated by a dapp built on Hyperledger and processed through the Interchain Hub. The BSN envisions this becoming a standard protocol for dapps from different blockchains, allowing them to call each other with just a few lines of code.

This aim of this collaboration was to provide developers outside China with a standardized development environment to build and run dapps on public blockchains. The public blockchains are supposed to be adapted to the Chinese market with public blockchain nodes that are installed on top of the BSN, so that Chinese developers can access all nodes from all public blockchains via one gateway and one simple monthly plan.

In the localized version for the Chinese market, the network will convert the decentralized public blockchains into permissioned ones, while replacing their native tokens with direct payment by the Chinese currency renminbi to cover transaction fees on these blockchains. This is considered to be the most direct and effective way to ensure regulatory and supervisory compliance and encourage adoption among users within China. Unlike the localized version, the global version of the BSN will allow public decentralized blockchains.

According to industry experts, the BSN is supposed to serve as the backbone of China’s Digital Silk Road ambitions. Others argue that the BSN will encourage the development of digital currencies, stimulate internationalization of digital assets, and expand Chinese developers’ access to the global crypto industry. Regardless of the underlying motivation, thus far, the BSN is the only large-scale network that aims for seamless interoperability between international digital assets and applications across public and private blockchain networks.