Removing fragmentation risk from CBDCs

Interest in central bank digital currencies (CBDCs) has risen exponentially in recent years, gaining popularity as the financial community explores the untapped potential of digital currencies.

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As different countries experiment with CBDCs at varying paces with a broad range of designs and use cases, it's vital to recognise the potential risk of creating a fragmented landscape across borders.

"As different central banks develop digital currencies based on  unique technologies, protocols and procedures, there is a looming risk of fragmentation.”

Financial institutions and markets should already engage in discussions on how to seamlessly integrate CBDCs into the evolving global payments landscape, ensuring they contribute to enhanced interoperability and frictionless cross-border transactions.

Tackling fragmentation

In September the Sibos Conference was hosted in Toronto, attracting financial industry leaders to discuss emerging trends. CBDCs was a focal point of discussions, with panellists emphasising the importance of interoperability as various domestic and global platforms evolve to accommodate CBDCs. It is crucial to ensure the industry recognises the full potential of digital currencies.

However, the majority of central banks focus on the domestic use of CBDCs, potentially paving the way for a fragmented landscape. As different central banks develop digital currencies based on unique technologies, protocols and procedures, there is a looming risk of fragmentation.

This could lead to a multitude of disconnected digital islands around the world and ultimately disrupt the global economy.

Hence, CBDCs and traditional infrastructures need to find a way to coexist and collaborate as the industry explores how to integrate them with existing payment systems. Establishing common connectivity is paramount in eliminating friction and fostering interoperability between the existing financial ecosystem and digital currencies, thereby creating a unified global market.

Innovation milestones

Swift is collaborating with the financial community to address fragmentation and work toward enabling CBDCs to move seamlessly across international borders. In October 2022, Swift developed a solution allowing CBDCs to transition between distributed ledger technology (DLT)-based and fiat-based systems using existing financial infrastructure.

Swift also used sandbox testing involving 18 central and commercial banks to support the solution's continued development. This ensured a smooth exchange of CBDCs, even those built on different platforms. Swift's solution was tested across 5,000 transactions and two distinct blockchain networks and a traditional fiat currency.

Three central banks and monetary authorities are now in the beta testing phase of Swift's CBDC interlinking solution – including the Hong Kong Monetary Authority (HKMA) and the National Bank of Kazakhstan.

The sandbox testing is now entering its second phase, with 30 commercial banks, central banks and financial market infrastructures exploring additional use cases, such as trigger-based payments for digital trade platforms, foreign exchange models, liquidity-saving mechanisms and delivery versus payment.

Notably, the Reserve Bank of Australia and other national banks are among the 30 leading institutions involved in this second phase.

Collaboration Remains Essential

While testing of the CBDC integration has been successful, ongoing global collaboration and innovation is necessary. By working together, central banks can achieve their goal of developing CBDCs and ensure these digital currencies seamlessly operate on a global scale.

Sandbox testing, which invites banks from around the world to trial solutions, provides a platform for the industry to engage, collaborate and refine their approaches.

Looking ahead, financial institutions should consider incorporating various blockchain technologies in their sandbox testing and experimentation. This not only facilitates bilateral testing but also offers opportunities for customers to provide real-time feedback and contribute to the design of next-generation CBDC solutions.

CBDCs are poised for ongoing evolution and increased prominence within the financial sector. When creating platforms and solutions for these currencies, it is crucial banks remain alive to the risk of fragmentation.

Suresh Rajalingam is Head of Oceania at Swift

The views and opinions expressed in this communication are those of the author and may not necessarily state or reflect those of ANZ.

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