In April, the Bank of Japan entered the pilot phase of its central bank digital currency (CBDC) work. Today it published the results of its second phase of the digital yen proof of concept work that ended in March.
The central bank’s experiments targeted a wide range of topics. Two of the most interesting aspects of its work are the comparison between account-based and token-based CBDC and how to manage holding limits if a user has more than one account.
It also explored other added value applications, such as a ‘swing’ function to sweep excess balances into bank accounts as well as scheduled and batched payments. And it investigated integration with point of sale systems and DLTs for tokenized asset settlement.
The pros and cons of token-based CBDCs
Several central banks have used Bitcoin’s UTXO token model without using a distributed ledger. When a user makes a payment with a token, the result is two new tokens, one giving the payer change and the other providing the money to the recipient. The Bank of Japan said it used something similar to UTXO and analyzed its pros and cons.
During the first proof of concept (PoC), the Bank of Japan explored both account-based and token-based CBDC. In each case, it also tested combining this with the central bank managing the ledger or sharing this with intermediaries such as banks. The token-based model in the first PoC used fixed token denominations (similar to physical cash and India) with a centralized ledger. This time it used flexible value tokens similar to UTXO and shared the ledger functions with intermediaries.
The central bank liked the flexible value token model because it believes it’s easier to process multiple requests in parallel. However, it could require more technical resources than an account-based model. And it sees potential difficulties in implementing additional functions, such as holding limits while maintaining performance.
In a report last week, the ECB also noted that most payment providers deal with account-based payments, so they will incur costs to adapt to token-based.
How to impose holding limits with multiple CBDC accounts
The Bank of Japan recognizes that users will have more than one CBDC balance via different intermediaries, which presents a challenge in imposing CBDC holding limits.
It discussed the previous account-based experiment where the management of the CBDC ledger was shared with intermediaries. To check if the overall upper limit has been breached, this would involve an intermediary sharing details with other intermediaries to establish a user’s global balance. As the report notes, this is not ideal from a privacy perspective.
However, one technical solution is homomorphic encryption which enables this sort of check to happen without the intermediaries being able to see the details of the data being checked. This will increase processing time a little, and the central bank sees this potentially triggering a greater risk of data inconsistencies.
A suggested simple alternative is to avoid global limits and instead implement a per-account holding limit and a limit on the number of accounts a single user can hold. In our view, the per-account holding limit would ideally be higher for someone who has two accounts rather than three.
With the next pilot phase already in progress, the central bank will test the end-to-end process flow to uncover challenges in integrating with external systems. It is also creating a CBDC Forum to get input from the private sector.
