Thinking Rationally

Tag: DLt

  • RBI’s Concept Note on CBDC: A Review

    RBI has issued a concept note on CBDC on October 7, 2022. The stated objective for publication of this note is “to create awareness about CBDCs in general and the planned features of the digital Rupee”.  Incidentally in February 2020 RBI bulletin had published an article on Distributed Ledger Technique. This article had discussed DLT initiatives of 7 central banks. Interestingly, the concept note does not even refer to this article.

    In 2020, another article documented in detail (Opare and Kim 2020), a large number of ongoing CBDC initiatives of many central banks and classified these experiments into 3 groups based on their year of initiation. The authors have listed 10 Central banks in the Early Adopter group, each of which began their CBDC experimentation between 2015-2016.  It was, therefore, expected that RBI would evaluate the lessons learnt from these projects and come out with a more detailed feasible plan for its envisaged CBDC journey.

    It may not be out of place to note here that in April 2022, Indonesia’s central bank and the Bank for International Settlements (BIS) Innovation Hub announced launching of a global hackathon on 3 potential areas of CBDC’s uses. These areas are: use of CBDCs as a medium of exchange; use of CBDCs in a central bank’s financial inclusion initiatives; and use of CBDCs in cross-border payment system.

    Coming to the main content of RBI note, I would like to dwell on certain aspects of CBDC implementation that would be relevant in the context of India, a country of 1.38 billion people and which have been either not dealt with or dealt with perfunctorily in the concept note.

    1.  Financial Inclusion as one of the objective of CBDC (section 3.3.5 page 20 of the Note): CBDC is neither necessary nor sufficient for financial inclusion. Predominance of cash as medium of transaction is one indicator of a financial exclusion. The share of ”money in circulation “in M1 is 59% in India (end March 2022) while for USA it was only around 11% (end august 2022). For China, this figure was around 13% at the end of 2017. So financial inclusion is more of a function of formalization/ corporatization of economy and not of the form of money in circulation.

    2. [F]irst and fundamental question that needs to be answered is the choice of technology platform (section 5.1 page 31).:  Here lies the major confusion that RBI internal committee is plagued with. Once CBDC is designed as a platform based medium of payment like a bank account, it loses the main characteristics of paper money-that is instant settlement of a monetary transaction. One does not need an internet connection or a mobile connection for verification with a third party in case of a paper money mediated transaction. You should be able to make a cash payment and, therefore, payment with CBDC at the top of Everest or in a submarine at the bottom of Indian ocean.

    3. DLT could be considered for the indirect or hybrid CBDC architecture (5.2.2.2 page 32): The word “could” is somewhat equivocal.  In an “Indirect Model”, “consumers would hold their CBDC in an account/ wallet with a bank, or service provider.   …. The central bank would track only the wholesale CBDC balances of the intermediaries. ”(Section 4.3.2 page 24). It follows that the responsibility of maintaining DLT would lie with the intermediaries. It is not clear whether DLT would be blockchain based or not. If blockchain is not to be part of any solution, then the architecture of any DLT needs more clarification which is missing from the concept note. It is not clear who will bear the cost of maintaining DLT, if it is to be based on blockchain. Will it be a permissioned or permission-less?  If an intermediary issues a CBDC to its customers, can that customer use that CBDC in another place which is under the jurisdiction of another intermediary?  The concept note is silent on all these issues

    4. Further, systemic checks through third party validation should ensure that in case of a token system, only such tokens issued by the Central bank are circulating in the ecosystem. Additionally, a competent party should be able to verify identity information before a participant is allowed to join the CBDC network. (section 5.4, page 33). This requirement of RBI’s CBDC can be considered as the last nail on the coffin of RBI CBDC. RBI annual report of 2022 puts the total number of banknotes in circulation at 1305326 lac or 130.5 billion pieces. If each note participates at least one transaction in a year, at least 1 billion transactions need to be validated in one-year period. I left to the imagination of my readers about the feasibility and cost of such an exercise. Even verification of half a billion transactions will be a humongous task.  Furthermore, verification of identity information of a participant in CBDC network can be considered as a gross violation of privacy of a citizen.  The very purpose of issuance of bank notes will stand completely negated by this requirement.

    5. In offline mode, the risk of “double-spending” will exist because it will be technically possible to use a CBDC unit more than once without updating the common ledger of CBDC (5.6, page 34). I may humbly submit that I have proposed a detailed protocol by which the goal of preventing double –spending can be achieved (Nag 2021). My protocol tries to mimic all properties of paper note. The anonymity of transacting parties is largely achieved, although absolute anonymity cannot be achieved in a digital world.

    6. Indirect Model: The concept note has argued that this model is the most suitable for India. Under this model, “RBI will create and issue tokens to authorised entities called Token Service Providers (TSPs) who in turn will distribute these to end-users who take part in retail transactions.” It is like a customer of a bank withdrawing cash from ATM/bank counter and then spending it outside. In this case CBDC will be withdrawn.  But suppose the bank customer wants to pay CBDC to her maid who does not have a bank account, will it be possible?  If that bank customer withdraws the money from her account at Mumbai and wants to spend it in Kolkata, how the ledgers will get updated? If the CBDC paying wallet has been issued by a Bank A and the receiving wallet has been issued by bank B, how the shake hand will take place in the absence of internet connection?

    7.  China has started experimenting with CBDC since 2016 and has now started issuing e-CNY, which has now 260 million individual users. 

    References

    Fintech Department (October 2022).  Concept note on Central Bank Digital Currency

    https://rbidocs.rbi.org.in/rdocs/PublicationReport/Pdfs/CONCEPTNOTEACB531172E0B4DFC9A6E506C2C24FFB6.PDF

    Ashok K Nag (December 2021). A Proposed Architecture for a Central Bank Digital Currency for India. ORF Occasional Paper No. 340, Observer Research Foundation.

    https://www.orfonline.org/research/a-proposed-architecture-for-a-central-bank-digital-currency-for-india/

    Bhowmick Sayantika and S. Majumdar (February 2020).  Distributed:  Ledger Technology, Blockchain and Central Banks   RBI Bulletin

    https://rbidocs.rbi.org.in/rdocs/Bulletin/PDFs/0BUL11022020FL847E8EFB34744BAEBB2E45E91759ACCD.PDF

    Opare Edwin Ayisi and Kwangjo Kim (June 2020) A Compendium of Practices for Central Bank Digital Currencies for Multinational Financial Infrastructures in IEEE Access

    https://ieeexplore.ieee.org/stamp/stamp.jsp?arnumber=9115606

  • Block Chain – for my own understanding:

    Part1: Definitional Issues

    I am trying to understand the concept and use cases of blockchain. I plan to put up a series of blogs on this subject as I navigate through the complexity of the subject. I will be more than happy to receive any response pointing out flaws in my understanding. Please write to me at ashok.nag@gmail.com.

    Definition of Blockchain:

    Bitcoin.org: The blockchain is a shared public ledger on which the entire Bitcoin network relies. All confirmed transactions are included in the blockchain. It allows Bitcoin wallets to calculate their spendable balance so that new transactions can be verified thereby ensuring they’re actually owned by the spender. The integrity and the chronological order of the blockchain are enforced with cryptography.

    Ethereum: A blockchain is a public database that is updated and shared across many computers in a network.

    Wikipedia: A growing list of records, called blocks, that are securely linked together using cryptography. The blocks are timestamped and chained with the previous block by incorporating a cryptographic hash of the previous block.

    IBM: Blockchain is a shared, immutable ledger that facilitates the process of recording transactions and tracking assets in a business network.

    Oracle: Blockchain is defined as a ledger of decentralized data that is securely shared. Blockchain technology enables a collective group of select participants to share data. With blockchain cloud services, transactional data from multiple sources can be easily collected, integrated, and shared. Data is broken up into shared blocks that are chained together with unique identifiers in the form of cryptographic hashes.

    Our definition: Blockchain is a digital record management system with the following properties:

    1. Records are grouped into blocks with a pre-defined limit for the size of a block. The size of a block determines the number of records of a given size that a block can include. Data in blocks can only be appended and not deleted or modified.
    2. The process of creating a new block and adding it to a given chain determines the type of blockchain. There are mainly two types of blockchain, namely permissionless and permissioned. The former one is called public blockchain as access to it is open to all. The latter type restricts access to authenticated users only and is also known as a private blockchain. 
    3. Blocks are mostly stored in a key-value database. Bitcoin, Ethereum, and many other cryptocurrencies use LevelDB database of Google. Cryptographic hashes are used as identifiers for a block as well as its records. In other words, hashes are the keys and the data as the value.  
    4. The “chain” part in “Blockchain” refers to the fact that two consecutive blocks are linearly linked as a parent and a child. The block which has no parent is called the Genesis block of a particular chain.  The “chaining process” entails the incorporation of the hash value of a parent block in the header of the child block. A block’s header contains all the metadata of the block. This linking of parent and child through a hashing process ensures
    5. immutability of data of a child’s parent block and then all its ancestors up to the genesis block

    Before explaining the components of a blockchain in more detail, we need to clarify the term “distributed ledger” and its connection, if any, to the concept of “distributed database”.

    A ledger, primarily an accounting term, is a date-wise summary of all transactions of values, details of which are kept in a supporting book called “journals”. The word” ledger” was used in the blockchain context because its first use case was in the creation of a decentralized currency system. Since a ledger is also a record-keeping system, the term has persisted.  But the question remains whether a ‘distributed ledger” is conceptually and practically equivalent to a “distributed database”. The answer is a big No.

    Let us first demystify the term “distributed”. Oracle has defined a distributed database as “a set of databases stored on multiple computers that typically appears to applications as a single database. Consequently, an application can simultaneously access and modify the data in several databases in a network”. 

    Ozsu and valduriez have defined a distributed database and database management system as a “    Collection of multiple, logically interrelated databases distributed over a computer network. A distributed database management system (distributed DBMS) is then defined as the software system that permits the management of the distributed database and makes the distribution transparent to the users” (page 3). It is important to note that a distributed database system must also have an associated database management system to enable end users to access, query ,and generate user defined reports. Although a key-value database is also called a database, it provides limited support for data manipulation to discover patterns within the database and, therefore, the DBMS associated with it is very rudimentary.

    Let us now look into the ledger aspect of blockchain-based databases. What does a business ledger look like? IBM, while highlighting the deficiencies of current business ledgers, has given the following example.

    Source:     https://developer.ibm.com/tutorials/cl-blockchain-basics-intro-bluemix-trs/

    IBM states that the current business ledgers are “inefficient, costly, and subject to misuse and tampering.” If this is the “reality”, then all the balance sheets and P&L accounts of IBM itself are faulty, and cannot be trusted by investing public as well as any tax authority”. Be that as it may, it is undoubtedly true that no enterprise will maintain its transactions only in a blockchain database although the immutability property of blockchain may have its own use.

    For pedagogical purpose, let us consider the following example of an accounting database model

    Source: https://towardsdatascience.com/how-to-build-an-accounting-system-using-sqlite-2ce31f8b8652

    Obviously, a proper industry standard accounting information system (AIS) software will require a much more complex database. For our limited purpose, it suffices to note that a ledger book database cannot be a list of transactions only. A number of complex rules must be enforced on the database to create a proper double-entry accounting system.  For example, a bank reconciliation process that matches a company’s bank statement with its cashbook balances is automated in many accounting information systems(AIS).  The participants in this process must be authorized and cannot be anonymous validators. A blockchain-based database cannot be a solution for such essential requirements of an AIS, although underlying transactions can be stored in a private blockchain for future auditing requirements (see the article: Blockchain as the Database Engine in the Accounting System).

    Let us consider the information management issues in regard to the Letter of Credit (LC), the most important banking document for facilitating international trade. In general, there are 5 five parties involved in an LC-based international payment settlement process. They are- importer, exporter, issuing bank, advising bank, and confirming bank. Today, banks use the SWIFT platform’s category 7 message type for sending and receiving messages between these parties. It is eminently possible to use a permissioned blockchain platform for sending and receiving LC-related messages. But it is impossible to use a public blockchain platform for this purpose. Furthermore, such a blockchain must rest at the top of a standard relational database to enable payment settlement and recording of underlying credit flow.

    The moot point is that a blockchain-mediated database is extremely useful for record-keeping purposes and not for enabling contestable transactions involving values between a network of legally connected parties. For enforcement of any contract between two parties, the foremost requirement is the identification of the parties involved. It is immaterial whether the parties are connected in a network managed by a centralized authority or not. The anonymity of transacting parties should be considered the weakest part of a blockchain-based transaction system and not its strongest one.  As we know a chain is as strong as its weakest part.  

    References:

    References:

    Musa Aujara Shamsuddeen (April 2019) , Documentary Letter of Credit Discrepancy and Risk Management in the Nigerian: Crude Oil Export; Ph.D Thesis submitted to University of Central Lancashire

    Özsu  M. Tamer & Valduriez   Patrick (2011)  Principles of Distributed Database Systems; 3rd Edition 2011

    Tan Boon Seng , Kin Yew Low (2019) Blockchain as the Database Engine in the Accounting System in  Australian Accounting Review No. 89 Vol. 29 Issue 2