A Take on Recent BIS CBDC Article

Jul 21, 2023

Introduction

In the rapidly evolving world of digital finance, new concepts frequently emerge that have the potential to redefine our understanding of money and its function within society. Recently, the Bank of International Settlements (BIS) proposed such an idea, suggesting a new model where commercial banks’ tokenized customer deposits would coexist alongside Central Bank Digital Currencies (CBDCs) on a unified ledger. By all appearances, this is a groundbreaking proposal; one with the potential to revolutionize the world financial system. However, it warrants a thorough examination before we can gauge its true merits and implications.

Bearer and Non-Bearer Instrument Models

In the report, BIS distinguishes between bearer and non-bearer instrument models. The bearer instrument model is akin to stable coins we’re familiar with (i.e., USDT/USDC). The document states:

“In the digital bearer instrument model, private money tokens represent a transferrable claim on the issuer. Their movement transfers the issuer’s liability from one holder to another. There is no need to update the issuer’s balance sheet when these tokens are transferred. It is only when a holder wishes to redeem a token for cash or a conventional deposit that off-platform balance sheets are updated. An archetypal example of a digital bearer instrument is an asset-backed stablecoin.”

Essentially, the value of a stable coin can diverge from the value of the underlying fiat currency due to a multitude of factors, and the KYC bracket exists outside of the issuer’s platforms. Money can change hands without the issuer (i.e., Circle for USDC) necessarily having KYC on any current set of holders.

In contrast to this, we have the non-bearer instrument model. The report explains:

“In the non-bearer instrument model, tokens that represent an issuer’s liability are not directly transferable to individuals who are outside the KYC boundary of the issuer. Instead, the payment process mimics the practice in the current two-tier monetary system of debiting the account of the sender and crediting the account of the receiver, together with settlement on the central bank’s balance sheet. Specifically, the payment is put into effect by reducing the sender’s token balance at their issuing institution and creating a new tokenized liability for the receiver that is issued by their institution. Meanwhile, there is a concurrent transfer of central bank money using a wholesale CBDC.”

In simple terms, all settlements happen in central bank money. This ostensibly means that there is no risk other than sovereign credit risk, thus the exchange rate of such an asset will always be strictly equal to that of the underlying fiat.

Projects Helvetia, Jura, Dunbar, mBridge, and Mariana are practical implementations of the aforementioned models. In the digital bearer instrument model, a transfer of the token from Alice to Bob transfers Alice’s claim on issuer 1 to Bob. Bob now holds liabilities of both issuer 1 and issuer 2 even though he is a customer of only issuer 2.

Tokenization

Bank of International Settlements’ Proposal

The crux of the BIS’ proposal is the tokenization of bank deposits and their placement on the same ledger as CBDCs. The proposal argues that tokenization would be more solidly grounded if based on central bank money, which carries the trust and reliability associated (for some) with a central bank’s guarantee. The BIS contends that compared to unstable and loosely regulated cryptocurrencies, central bank money offers a much more dependable foundation for tokenization and for moving value across blockchains.

The concept of a ‘unified ledger’ in the BIS’s proposal refers specifically to a model resembling a network of networks, wherein multiple ledgers — each serving a unique purpose — could coexist. These ledgers, according to the BIS, could be interconnected using APIs, and allow for potential new functions or mergers as their scopes overlap.

While some elements of the BIS’ proposal align with Galactica Network’s vision, the proposal’s tendency towards centralized power structures and potential infringements on privacy rights necessitates a critical examination. We argue that Web3 builders should focus on fostering balanced innovation, while prioritizing the principles of decentralization, privacy, and meritocracy to ensure a future financial infrastructure that works in favor of the common people, rather than the consolidation of power behind a few powerfully centralized entities.

The rise of tokenization and its potential has been frequently recognized by traditional financial institutions and industry thought leaders. As Larry Fink, CEO of BlackRock, observed in his annual letter to investors, “the tokenization of asset classes is expected to augment capital market efficiencies, streamline value chains, and optimize cost and accessibility for investors.”

He goes on to mention that industry forerunners like BlackRock are examining the digital assets ecosystem, with a specific focus on areas like permissioned blockchains and the tokenization of stocks and bonds. There have been numerous recent advances in TradFi, including the launch of EDX Markets, a crypto exchange backed by firms such as Citadel Securities, Fidelity Digital Assets, and Charles Schwab Corp. Meanwhile, BlackRock’s plans to create a Bitcoin exchange-traded fund (ETF) helped Bitcoin reach more than a one-year high in recent weeks. Bitcoin’s value increased by nearly 25%, and Ethereum rose by more than 16%.

This perspective is assuredly shared by BIS, which emphasizes the exploration of tokenization use cases by commercial banks and private sector groups, with JPMorgan being a notable example. The BIS also proposes the idea of a “unified ledger,” which would combine tokenized forms of central bank digital currency (CBDC) with tokenized bank deposits and other tokenized claims, potentially signaling a new era in the joint development of the monetary system and the economy.

In Perspective

They are not alone. The World Economic Forum (WEF) and Citi have both released reports acknowledging the potential value of tokenized traditional market assets. The WEF’s report suggests that almost all traditional market assets, worth an estimated $866.9 trillion, could eventually be tokenized. This projection includes various types of markets such as equity markets, debt markets, securitized products, derivatives, securities financing, and asset management/fund administration. However, it also notes that there is no agreed-upon path for market-wide adoption and that market participants are far from adopting at scale.

Likewise, a recent report from Citi states that the future of financial markets could be significantly influenced by the tokenization of physical and financial assets, given advances in technology, market infrastructure, and regulation. It states that the potential value of tokenized assets and liabilities could amount to $24 trillion by 2030. According to the report, the tokenization of assets is still in its early stages, but rapid growth is expected, with up to 10% of global GDP potentially being on-chain by the end of this decade.

Opportunities and Challenges

But their way is not the only way. By applying some of the same principles of tokenization, Galactica Network offers benefits such as reduced friction and transaction costs, increased standardization and functional interoperability, improved auditability, and transparency of transactions. The following table highlights the opportunities and challenges of implementing a compliant middle ground between traditional finance (TradFi) and Web3. But to obtain these goals, we must encourage the development of platforms which bring people closer to the ideals and methodologies of Web3, rather than focus on emboldening silos of controlled power structures, as the BIS suggests.

Balancing Centralization and Decentralization

One critical concern with the BIS’ proposal for a unified ledger is the potential centralization of power that it may entail. With tokenized customer deposits coexisting alongside CBDCs on a unified ledger, the control of financial transactions and their associated data is likely to become consolidated in the hands of a small number of centralized entities. This would have far-reaching implications for individual privacy rights and the principles of decentralization that are at the heart of Web3 technology.

The report prioritizes operational efficiencies while ignoring the impairments it could yield to personal privacy. The centralized structures it advances would grant controlling entities access to a vast amount of data about individuals’ financial transactions. This is an inarguable point of concern. We must not infringe on the right to financial privacy. It is a cornerstone of personal liberty and a crucial aspect of economic freedom.

The BIS concept also stands to further entrench existing power structures with foreseeably disastrous effect. The proliferation of centralized control would be stifling to innovation, and is likely to further exclude those who are already marginalized from traditional financial systems. This is an abhorrent contradiction to the original vision of blockchain technology and Web3, which seeks to decentralize power, democratize finance, and — importantly — enable peer-to-peer interactions without the need for intermediaries.

In contrast, the Galactica Network intends to uphold the principles of decentralization, privacy, and meritocracy. Our decentralized governance model ensures that power is distributed among the network’s participants, rather than being concentrated in the hands of a few. It allows individual actors to participate in decision-making processes, fostering a more democratic and inclusive financial ecosystem. Galactica Network’s approach aligns with the fundamental ethos of Web3, where platforms are designed to reduce centralized control and increase user sovereignty.

To do otherwise is tantamount to the betrayal of the common man, and perpetuates the imbalances and inequities of the traditional financial system.

Privacy and Compliance

A unified ledger system, despite its efficiency, prompts serious questions concerning privacy and compliance. Blockchain transactions can often be traced back to their originators, particularly under the vigilant surveillance of central and commercial banks. BlackRock, one of the world’s largest asset management firms, recognizes the need for oversight in the financial industry. Joseph Chalom, one of the company’s executives, recently stated, “I think it’s going to be hard for large, regulated institutions, no matter what liquidity is available, to participate […] All I know is, we go to jail if we don’t know who we’re trading with.”

Galactica Network takes a different approach. By leveraging zero-knowledge cryptography, we are able to offer full compliance on-chain while keeping user privacy central to the network’s design. Zero-knowledge proofs allow users to prove the validity of their transactions and interactions without revealing sensitive information. This ensures that privacy is maintained while still meeting regulatory requirements.

Arthur Hayes, the co-founder of BitMEX, once referred to CBDCs as “pure evil,” saying that these kinds of centralized mechanisms “represent a full-frontal assault on our ability to have sovereignty over honest transactions between ourselves.” He noted pessimism in the centralized model, warning that it could one day be implemented in all major economies.

Galactica Network’s decentralized governance model and commitment to privacy and compliance stand in stark contrast to the autocratic design inherent in such centralized unified ledgers.

A Call for Balanced Innovation

As we navigate the path of financial innovation, it is crucial to respect the principles that have brought us to this point. While the BIS’ proposal for a unified ledger system may offer certain advantages, it also carries the risk of leading the financial infrastructure in a direction that neglects the core values of Web3.

Eric Hughes’s Cypherpunk manifesto, written in the early days of the internet, emphasized the importance of privacy as a fundamental right. The manifesto serves as a reminder that privacy is not a luxury, but a necessary component of a free and open society.

In light of these considerations, we advocate for a balanced approach to financial innovation. It is essential to prioritize privacy, decentralization, and meritocracy in the design of future financial systems. Instead of pursuing autocratic goals, we should embrace permissionless innovation and empower individuals to have control over their financial lives.

We echo a16z’s stance on sustainable innovation, emphasizing the need to expand compliant privacy concepts. By incorporating privacy-preserving technologies and adhering to regulatory standards, we can achieve transparency and user privacy simultaneously.

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