Today the Bank of Israel released a paper on the architecture of its planned central bank digital currency (CBDC), the digital shekel. It differs from other CBDCs in a few ways. One of them is the ability to pay interest. Another is the separation of the role of banks from the provision of wallets and payment services.
It’s likely the central bank will publish multiple papers this year as the target date for a design document is December 2024. The central bank still needs to make technology decisions, such as whether to use DLT, so the document covers the functional architecture.
Unbundling banks from the CBDC wallet
In most retail CBDCs, a user would have a CBDC wallet with a bank or payment provider with which they already have a relationship. The same provider helps to fund and defund the CBDC wallet directly and communicates CBDC payment instructions. In contrast, Israel’s central bank envisions an unbundled solution.
Hence, a user can open a wallet with a PSP and connect to one or more third party banks for funding or defunding via open banking APIs.
Bear in mind that funding and defunding are critical for most CBDCs. That’s because when a user makes a payment and has insufficient digital shekels, there will need to be a so-called reverse waterfall from a bank to top up the CBDC balance seamlessly so the payment can be completed. If the digital shekel balance exceeds any imposed limits, the funds will be transferred to a linked bank or PSP account.
That said, it’s entirely possible for a bank to also act as a PSP for the digital shekel.
While we can see some advantages to this approach regarding market competition, there are a couple of potential side effects. Many banks envisage CBDC as a threat. One of the few advantages to banks is their potential role in managing consumer wallets. In the Israeli model, banks lose that benefit on top of competing with a potentially interest bearing CBDC. From a consumer viewpoint, there’s a chance they will opt for existing providers for the CBDC to avoid having to go through know your customer (KYC) compliance.
A centralized CBDC database
Another novel aspect relates to a planned centralized database. The data controlled by the central bank will be split into two parts. It runs the CBDC platform that is responsible for logging all transactions. In a token based scenario, that system wouldn’t necessarily have a global view of a person’s balance. However, global account balance information is desirable for various purposes. Hence, whether the system is account or token based, the Bank of Israel wants a separate centralized database with pseudonymous account balance information.
The central bank itself would not have access to personally identifiable information, but it would probably know the identity of corporate balances.
Current thinking is that personal data would be stored in the central database but encrypted. So, only the PSP with the client relationship would have read access to that information.
This approach might raise more privacy concerns compared to the European Central Bank’s approach, whether or not that’s justified.
Indirect CBDC distribution
Another feature considered in the architecture document was whether the central bank would have a direct or indirect relationship with banks for the purposes of funding or defunding. In other words, when consumers receive their digital shekels, would they get them directly from the central bank or from the bank the consumer paid to buy the digital shekels.
If the relationship were direct, then each time Alice or Bob topped up their CBDC wallet, their bank would pay the Bank of Israel via the RTGS. That would amount to a large volume of small transactions.
Hence, the Bank of Israel opted for an indirect method that works similarly to cash. Banks buy digital shekels from the central bank in bulk and pass them onto clients when they fund their wallets.
Some similarities exist between some of the designs considered here and another CBDC project involving the Bank of Israel and the Hong Kong Monetary Authority – Project Sela. Meanwhile, last year the Bank of Israel published papers about how to encourage CBDC network effects and which events would trigger a decision to launch a digital shekel.
