Blockchains in Central Banking: an Update from the Front Lines

Jun 22, 2018 Articles Blockchains in Central Banking: an Update from the Front Lines

Crying wolf without learning its eating and sleeping habits won’t help protect the sheep. The all-to-frequent regulatory reaction to blockchain initiatives and cryptocurrencies is to cry wolf and occasionally even shoot at them with fines or lawsuits. It is understandable given that more than a few lambs have been slaughtered on the altar of financial innovation and democratization. When it was unfortunately only personal gain being promoted at the expense of believers in revolutionary but eventually hollow promises. The already demonstrated potential should though not be ignored, let alone suffocated.

What better way to understand the threats and opportunities of a new technology than to experiment with it in a safe environment? This was the reason that motivated the #BankOfLithuania to organize a hackathon for the launch of a digital collector coin. The mission: create a prototype for the first blockchain-powered digital collector coin along with its selling platform.

The formal requirements reflect the technical and legal constraints faced by the issuer. Given the nature of the coin, it must be unique, counterfeit-proof and easily identifiable as a digital collector coin. Unlike a cryptocurrency, holders of the token would need to be identified to conform with AML regulations. A specific requirement was that the coin be issued using blockchain or an equivalent technology.

Perhaps awkward for some digital natives but traditional collectors enjoy the smooth edges and careful and intricate design of a physical coin. All coins evoke an important event or personality, something which creates an indistinguishable emotional connection with the buyer. In this case, the coin commemorates 100 years from the restoration of Lithuania’s statehood. The coin, through its innovative design, recalls the struggle for independence and bridges the present to a tech-inspired future.

What would attract the traditional and crypto community alike? The limited issue. Appealing to the crypto-enthusiasts as well as traditional buyers, the digital coin shadowed by a physical one, is expected to have a secondary market for each type of token. Participation in the market must not require special equipment or knowledge. Ease of acquisition and sale are important elements which insure the success of the concept. Speed of transactions was raised only as a secondary aspect. These requirements needed to be explicitly specified as technology enthusiasts sometimes disregard that mass adoption depends on mass appeal. Complicated terminology and 12 words long passwords are acting as an insurmountable obstacle for many potential users.

Seems straightforward but there is a twist: the digital collector coin must be linked to a physical coin. A necessary element of centralization is introduced to track the ownership relationship between the physical and the digital token. The owner may possess only one of the coin representations at any time. Digital or physical trades can nevertheless be conducted without any link to the bank.

A tedious list of necessary platform requirements was also presented. Mobile-compatibility, support for multilingual interfaces, possibility to limit the number of coins purchased per person and ability to easily trace the start and end time of a purchase session were some of the technical requirements. Security is of primordial importance for storing order, payment and customer information (possibility to identify buyers, payments, track orders). Automatic transfer of the digital collector coin after payment confirmation was also requested to limit the need for operator input. Ironically, it is the incumbent specifying what needs to be disrupted and how to be successful in this effort.

The business model innovation of selling collector coins relies on two main ingredients: insuring fast and almost costless online verification of the coin authenticity and ownership status and bridging heterogeneous consumer groups by offering the physical-digital counterparties. The first is a textbook application of a decentralized cryptographically secured blockchain. Whether buyers value this bundle of features remains to be seen.

Eight teams participated in the competition. Most prototypes relied on the #Ethereum ERC-721 standard for the token design. Hybrid solutions were proposed ranging from a complex combination of inhouse private blockchain connecting to public chains, to a more traditional database architecture for confidential user data with an Ethereum connection for the token. One application combined a traditional database setup with a Bitcoin colored coin.

A strong gamification component was present in most proposals. The map of Lithuania could be assembled given a certain number of tokens had been gathered. Some solutions proposed one coin-to-one token relationship. Some others instead thought about a setting with one coin-to-many tokens. The later allowed for more flexibility in the gamification strategy.

Remember the twist? Creating a physical-digital connection with ownership of only one of the coin representations requires at this stage a rather archaic solution. Swapping a digital token purchased online for the physical counterparty would cost you a trip to the bank. This is due to the legal status of the collector coin and the implied constraints a central bank needs to satisfy in relation to issuing such coins.

Reliance on a public infrastructure brings with it fundamental challenges. The need for security, predictability and responsibility in case of failure have been well emphasized during the event. Value overflow incidents, unexpected forks or frozen wallets may be considered unwanted but normal occurrences of implementing a new technology. But lack of legal responsibility and the absence of an identified accountable party are eventually the reasons preventing a faster integration of public chains in the practice of traditional intuitions.

The event stirred the curiosity of actors across the entire spectrum. Freshly minted ICO issuers and regulators interacted for 2 days to find a way to leverage the technology and find usefulness beyond the hype but within the legal boundaries. The event showed that a carefully designed experiment may produce valuable insights for regulators and new business avenues for crypto developers. Some elements may be recombined, further developed and, within a different setting, potentially used to tokenize central bank cash or other assets issued by a central authority.

At the end, we shouldn’t allow the ingrained fears from Aesop’s fable make us forget the ecological role wolves play in keeping our ecosystems healthy. Same should hold true for blockchain startups and cryptoassets.

Posted on Jun 22, 2018 by

Mihnea Constantinescu

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