Drex for gringos — Part II : The Hyperledger Besu choice

After my last piece, “Drex for Gringos,” I have considered jumping into more details about Drex this time. Now we are going to address questions such as “Why did the Central Bank of Brazil (BCB, the acronym in Portuguese) chose Hyperledger Besu?” and perhaps consider if there are other solutions that could be considered in the future, along with more of those burning questions you all have.

Yeah, you could just ask Google, but that is like so boring, right? Isn’t it more fun to have all the answers right here in one spot?

But before we get started, I want to repeat an important disclaimer: the views expressed are solely mine and are based on my research and expertise. I really appreciate comments, corrections, and additional information.

If you prefer not to read the entire article, feel free to skip to the “Wrapping Up” section at the end.

So, what is Part II really about?

I want to take an in-depth look at the Drex, not only gaining a comprehensive understanding of this digital currency pilot, exploring its complexities and underlying mechanisms in great detail. This is more than a mere exploration; it is a deep dive into the future of digital currency and blockchain technology in Brazil.

Part I covers Brazil’s introduction of Drex, our own CBDC, a new programmable version of the Brazilian Real, bringing new improvements to the financial system. We discussed its significance, how it could streamline transactions, and its potential impact on the global economy. For those skipping the first, I highly recommend you reading it before you start here — Drex for gringos

Brazil as an innovation hub

Brazil’s financial system confidently stands on a robust and unique history brimming with innovation and ingenuity. Without a doubt, it has always been at the cutting edge, championing the adoption of revolutionary technologies. This go-getter spirit has really shaped up Brazil’s financial scene, making it a shining example for other nations to follow in the world of financial tech.

We can track back some of these key developments.

Early adoption of electronic banking

Brazil was one of the early adopters of electronic banking in the 1980s. The Brazilian banks started to use computer systems not only to automate their internal processes but also to provide better services to their customers. Inflation was one of the main reasons for that. By the 1990s, internet banking began to take off in Brazil, with major banks quickly establishing online platforms. This early move into digital banking positioned Brazil as a leader in financial technology.

Itaú Bankline (floppy disk, 1995)

ATMs and bank automation

Brazil’s Banco24Horas is a notable example of ATM network innovation, which started in the late 1980s. It was one of the world’s largest shared ATM networks, allowing customers from different banks to withdraw cash and perform other banking services. This network represented a significant step towards interoperability within the Brazilian banking system.

Pioneering Real-Time Gross Settlement (RTGS) — STR

The Real-time Gross Settlement Systems (RTGS, or Sistema de Transferência de Reservas – STR), launched in 2002 by the Brazilian Central Bank, is the country’s RTGS system for high-value payments. STR was a revolutionary step in ensuring that payments between banks could be made in real-time, reducing credit risk and increasing the efficiency of the financial market.

Open Finance (formerly Open Banking)

Brazil’s Central Bank officially launched its Open Banking initiative in 2021, which is now evolving into Open Finance. This framework allows the sharing of customer data between financial institutions with customer consent, fostering competition and innovation. It aims to give consumers greater control over their financial data and enable them to access a broader range of financial services.

Pix: our beloved Instant Payment System

Perhaps the most groundbreaking innovation in recent years is PIX, launched by the BCB in November 2020. PIX facilitates instant 24/7 payments and transfers at low or no cost to consumers. It represents a significant leap towards financial inclusivity and has been widely adopted by the Brazilian population.

Each of these milestones demonstrates Brazil’s commitment to leveraging technology to enhance its financial infrastructure. The country’s innovative spirit in this domain has made it a reference point for other nations looking to modernize their financial systems.

Some history about Drex

The “Real Digital” project, initiated by the Central Bank has its origins rooted in the broader context of financial innovation and the global trend towards digitizing national currencies. The project is part of a strategic agenda launched in 2016 for the Brazilian financial system, known as Agenda BC#, which aims to modernize the financial and payment landscape in Brazil.

The BCB had been studying cryptocurrencies and blockchain technology for several years before formally launching the Real Digital, Drex project.

As of my previous article, the BCB is in the process of conducting pilot projects with various financial institutions to test the functionality and impact of the Real Digital. These pilot projects are part of a broader effort to assess technical feasibility, market demand, and use cases for a Brazilian CBDC.

So, Drex’s main task is to test a digital, programmable version of the Brazilian Real. This is designed to keep up with changes in the global financial system, and using blockchain technology to meet modern financial demands.

The master plan is to create a system that works together well, interoperable and protecting privacy. It also aims to make the financial ecosystem more efficient by removing unnecessary middlemen.

Resolving this points, it is possible to build faster, more efficient banking services, including cross-border transactions. This should also help more people access financial services. By using these new technologies, Drex wants to meet market demands and go beyond traditional banking.

This fresh take is all about making Drex easy to get for everyone, while still keeping its tech accuracy and goals intact. It is like, “hey, let’s use this cool blockchain tech to totally flip traditional banking on its head!” It shows you how to mix blockchain into these services, creating a win-win for both the folks running the show and you guys using it. Plus, it shines a light on all the stuff this could mean for the future of banking — and it does it in a way that is easy to digest.

Pretty much reengineering what permissionless crypto protocols and Descentralized Finance (DeFi) brought to the game. It is a kind of effort of organizing it, using same tech layers. And that is fine, as long as innovation is not killed in the process. Both worlds can coexist.

Timeline of Drex

The Central Bank of Brazil began exploring the concept of a digital real in 2019. This exploration was part of a broader initiative to understand the implications of sovereign digital currencies and how they might fit into the Brazilian Payment System (SPB). The BCB’s focus was on the potential for a CBDC to improve domestic and cross-border transactions, enhance financial inclusion, and foster new business models.

Real Digital/DREX Roadmap — source: BCB

During the design phase of the test infrastructure, the BCB took into account the increasing trend of asset tokenization and the creation of digital assets on unregulated decentralized registries. Through the pilot or proof-of-concept, the BCB will evaluate the advantages of programmability provided by a Descentralized Ledger Technology (DLT) platform by conducting transactions with selected tokenized assets.

The assets selected for “Piloto do Real Digital” include tokenized deposits, which are digital versions of demand deposits held by financial institutions (FIs) or Payment Institutions (PIs). Notably, during the tests, these deposits will adhere to their respective regulatory frameworks regarding access and information transfer.

They will also be used to settle transactions with a tokenized Federal Government Bond issued on the platform. According to Bruno Batavia, who until recently was at the BCB’s Currency Management Department, “the inclusion of these deposits aims to safely offer the benefits of a DLT system to the end customers of the SFN and the SPB.”

Lift Challenge, 2020

The journey began with the 2020 Lift Challenge, a program that invited tech companies to develop and present innovative projects, with the goal to contribute positively to the Central Bank Digital Currency (CBDC) ecosystem. You can find extra information and all project papers at “Lift Challenge: Real Digital”.

The organizers of the Lift Challenge were particularly interested in solutions that demonstrated creativity, practicality, and the potential to be applied to a future digital version of the real. The objective was to explore how technological advancements could help in shaping the future of digital currency, and how it could possibly revolutionize our understanding of money in the digital age.

This program called upon technological innovation companies to present solutions that could potentially be applied to a CBDC model for Brazil, focusing on innovative propositions that could contribute to the development of a digital currency ecosystem.

Following the Lift Challenge, the BCB continued to explore the potential of a CBDC and its implications for Brazil’s financial system. In May 2021, the BCB created a working group to study the potential issuance of a Digital Real. The group’s focus was on evaluating the benefits and impacts of a CBDC, as well as how it could fit into Brazil’s existing payments ecosystem, which includes the recently implemented Pix system, an instant payment platform that has seen widespread adoption.

The BCB’s approach to exploring a CBDC has been cautious and thorough, emphasizing that a digital real would complement the traditional currency and not replace it. The BCB has outlined that the Drex would be used primarily for high-value transactions and could support the development of new business models based on smart contracts, the Internet of Things (IoT), and other digital innovations.

Real Digital Working Group, 2021

In May 2021, the BCB formed a dedicated working group to study the issuance of a digital real. The group’s mandate included evaluating the benefits and challenges of a CBDC, considering its impact on Brazil’s monetary policy, financial stability, and the economy at large.

Pilot’s first phase, 2022–2024

The first phase of testing for the Digital Real project, later called Drex, required a collaboration with the Brazilian National Treasury. This phase of the project involved meticulous testing designed to simulate the process of the issuance of government bonds using a CBDC.

Source: Ledger Insights

One of the big reasons we are not going after mainstream retail payments?

Brazil’s Pix is killing it. Our instant payment method that lets people and businesses transfer cash, buy stuff, and pay bills in seconds.

Real Digital pilot — the basic requirements

These were the basic requirements presented by the BCB in a press conference on March 2023:

  • Multi-asset DLT: testing of a platform based on the DTL in which predetermined assets of different natures can be registered, as well as transactions involving them.
  • Assets: deposits from Bank Reserve accounts, Settlement Accounts and the Treasury Single Account held at the BCB; demand bank deposits; IP payment accounts; and a Federal Government Bond. The criteria for accessing Bank Reserves or Settlement Accounts will follow the current legal and regulatory framework.
  • Transactions: issuance, redemption and transfer of the assets, as well as financial flows arising from their trade. Transactions will include conditional and simultaneous settlement between the registered assets to guarantee Delivery against Payment (DvP) up to the end customer level (atomic settlement). Asset registration and trade should allow for asset fractionalization , maximizing one of the potential benefits of a DLT system.

Essential functionalities — tests for three layers:

  1. Registration
  2. Settlement
  3. Protocols

As well as for the smart contracts necessary for executing the proposed transactions in the pilot. Importantly, an overdraft will not be allowed in any transaction with registered assets.

Applications

Contrary to cryptocurrencies, which operate on a basis of demand and supply causing their prices to be highly volatile and unpredictable, Drex is designed to have a fixed value directly tied to the Brazilian real. In this structure, every 1 Drex will be equivalent to 1 BRL, establishing a stable and reliable digital currency.

This stability is further reinforced by the backing of the Central Bank, a level of governmental guarantee that cryptocurrencies typically lack. While cryptocurrencies operate in a decentralized manner without any direct regulation from a monetary authority, Drex is firmly rooted in an established financial institution, providing an extra layer of security and trust for its users.

Drex will function similarly to Pix in practice but with different purposes and value scales. While Pix is mainly used for commercial transactions and obeys security limits, Drex can buy real estate, vehicles, and even government bonds.

Stablecoins, such as Drex, have the potential to rival fiat currencies as the dominant form of payment. Stablecoins’ value is relatively stable and they can be sent instantly without the transaction fees associated with credit cards or international remittance services such as Western Union. Moreover, because stablecoins can be used by anyone with a smartphone, they represent an opportunity to bring millions of people who lack traditional bank accounts into the financial system.

The primary objective of this first phase is to gain a deep and thorough understanding of how a digital real, in a new form of programmable currency, could potentially improve and streamline the process of government bond sales. By doing so, it may hold the potential to significantly reduce the costs associated with such complex securities transactions. This phase is integral to the project due to its potential implications for the future of financial transactions and the broader economy.

Privacy Solutions

Another critical aspect of the first phase is testing privacy solutions. This is the phase BCB is at now and we expect to be concluded around May 2024.

The BCB is examining how to ensure transaction privacy while complying with regulatory requirements, such as anti-money laundering (AML) and combating the financing of terrorism (CFT) laws. The goal is to find a balance between maintaining user privacy and enabling necessary transparency for oversight bodies.

Again, Drex is still in its pilot stage, with this first phase of initial tests being done to build the foundation for subsequent development phases. The outcomes of this first phase will significantly influence the design and functionality of Brazil’s future CBDC.

As mentioned in the first part of “Drex for Gringos”, each selected consortium is working on a strategic model to address privacy issues, seeking a solution for this matter.

Three solutions are being tested:

The use case currently being applied is the transaction of a tokenized federal public security between different entities. We will deep dive in some of them later in this article.

The Central Bank’s concern is precisely this: which technology to choose, which model to use to comply with both the LGPD (General Data Protection Law) and the law that deals with the secrecy of financial transactions.

The ecosystem

Often, discussions about Drex or any other CBDC pilot may suggest that these initiatives are being conducted by a select group of companies and institutions, excluding others from the benefits of what is being evaluated and implemented. However, this is not the case. In the case of Brazil, the leaders of the consortiums are financial institutions regulated by the CBDC and that already have access to National Financial System Network (RSFN).

Perhaps it is because in a pilot or sandbox, options need to be narrowed down to the primary focus group. At Drex, we often see a large number of fintechs, exchanges, and solution providers among the participants.

Our current ecosystem in the crypto economy is not very complex at this stage. We can divide it into a few categories to provide a clearer understanding of the types of businesses and institutions involved in these changes. The main divisions are:

  • Financial Institutions — Regulated, traditional market institutions such as banks and credit card companies.
  • Exchanges — Cryptocurrency trading platforms or crypto exchanges. They may also offer services beyond trading, such as custody of clients’ private keys or staking.
  • Tokenization Enablers — Can be marketplaces that issue tokens (e.g., token-as-a-service), including stablecoins, utility tokens, tokenized securities, and others.
  • Infrastructure — Companies that provide blockchain/DLT infrastructure to other businesses, including software houses, custom-built development, Stablecoin solutions, cloud services, and more.
  • Custody — Solutions and services that store and protect the private keys of crypto asset wallets for individuals and institutions.
  • Asset Management — This involves the professional management of crypto assets and portfolios containing cryptos and related products, including investment funds and ETFs.
  • Education and Information Providers — Entities that produce, organize, supply, and/or disseminate information about crypto assets and decentralized finance, such as news websites and courses.
  • Other Services — These services facilitate various financial services using crypto assets and blockchain for players in the financial market, as well as for other industries.

In the context of the new economy we are discussing, it is important to note that all these companies play a significant role. Each one of them contributes in its own unique way, bringing various strengths and innovative ideas to the table.

They may operate in different sectors, cater to different markets, or use different business models, but they all share the common objective of pushing boundaries and driving the new economy forward. They are all integral parts of this economic shift, each piece forming a part of the larger puzzle. Without one, the picture would not be complete.

Thus, it is fair to say that while each has its own unique contribution, all are necessary and vital to the functioning and growth of this new economy.

Hyperledger Besu: Drex’s chosen one

The Brazilian Central Bank picking Hyperledger Besu for its CBDC is like going for a tailor-made suit instead of a one-size-fits-all. Just like a suit cut and stitched to your exact measurements and style, Hyperledger Besu is an Ethereum client that is all about customization. It has been tweaked to fit the needs of both the public and private sectors.

Hyperledger Besu is an open-source Ethereum client that offers a solid platform designed to fit your specific needs.

This approach means it can be used for all sorts of things, whether that is within a private network or on the public Ethereum network. Perfect for someone like the BCB, who needs a solution that can be sculpted to fit their unique needs.

When it comes to a CBDC, choosing Hyperledger Besu might be a sign that the BCB is after a platform that is customizable, secure, and efficient. Just like a tailor-made suit, Hyperledger Besu can be altered to meet the BCB’s specific needs, providing a solution that’s made just for them. This could show that the BCB is all about checking out new tech, but also wants a solution that can be shaped to their specific needs.

Plus, picking Hyperledger Besu could suggest that the BCB is committed to transparency and privacy. As an Ethereum client, Besu is based on a platform known for its solidity and transparency, something super important for a CBDC. But at the same time, it can work within a private network, letting the BCB keep some privacy and control over what they are doing — pretty important in the world of finance.

Source: Banco Central do Brasil/GitHub

But why Besu?

Among the known reasons for this choice, are the facts that it is open source and compatible with Ethereum Virtual Machine (EVM) on a permissioned network. Additionally, it supports transaction privacy and the ability to incorporate additional modules. The solution also has a wide range of technology providers both within and outside Brazil, which impacts the development of the Drex. An EVM setup could make it “expandable” and more affordable for other financial institutions.

For starters, BESU is part of the Hyperledger greenhouse, which is like a Silicon Valley for blockchain projects. It has got a rep for being robust, versatile, and it has got the smart contract smarts — these are its self-executing contracts that cut out the middleman and could streamline everything from loans to property sales. You can find more about at Hyperledger Foundation website.

EVM or non-EVM?

Being an Ethereum client designed for corporate use, we may find some performance challenges in the future, similar to those faced by other blockchain platforms.

Like other numerous solutions, it could potentially face challenges related to scalability. This issue becomes particularly evident when the volume of transactions being processed on the network is high. The consequence of this elevated transaction volume is that the network can become congested, which can cause a number of difficulties.

One of these is an increase in transaction costs. As the network becomes more clogged with transactions, the cost associated with processing each transaction can rise. This can make it more expensive for users to carry out transactions (as infrastructure costs will go higher), potentially discouraging the use of the network.

Another issue that comes to mind is network congestion, resulting in slower confirmation times. When there are a lot of transactions being processed simultaneously, it can take longer for each individual transaction to be confirmed. This can result in delays, which can be inconvenient for users who are expecting their transactions to be processed swiftly.

The transaction throughput of Hyperledger Besu, which is the number of transactions the network can process per second, the famous and usually miscalculated TPS, could be limited compared to centralized systems. This could be a factor when considering its use for high-frequency trading platforms or large-scale enterprise applications.

While it offers privacy features, ensuring the confidentiality of transactions on a distributed ledger is complex and requires constant updates to stay ahead of potential security vulnerabilities. Open source world for the newbies can be dangerous.

As blockchain ecosystems evolve, the ability to interact seamlessly with other platforms and protocols becomes crucial. Any limitations in Besu’s interoperability with other systems could pose risks for users requiring cross-chain transactions.

Since it is compatible with EVM, it inherits the risks associated with smart contract deployment. Smart contracts are immutable once deployed, and any bugs or vulnerabilities can be exploited if not thoroughly audited. Personally, smart contract auditing services is one of the biggest business opportunities in the coming years.

In permissioned networks, there’s a risk of node centralization where a small number of nodes control the majority of the processing power, leading to potential security and governance issues, and changes in regulatory frameworks could impact the deployment and operation of Besu-based applications, especially in different jurisdictions.

To mitigate these risks, it is essential that companies using Hyperledger Besu conduct rigorous testing, implement robust security protocols, engage in continuous monitoring for anomalous behavior, and stay updated with the latest developments in blockchain technology and regulations.

But wait, were there other fishes in the sea?

The BCB has not aired their laundry list of DLT contenders, but let’s play matchmaker and think about who else could have been in the running.

There is Corda, which is like the discreet banker who values privacy above all else. It is big on interbank communication and keeping things on the down-low from the public eye. But lack of EVM compatibility can be an issue.

Consider Quorum, that is like the gatekeeper of a sophisticated gathering, maintaining an Ethereum-based environment. But recently, many Quorum implementations have been migrating to Besu.

And let’s not forget, they could’ve gone with a custom-built solution from scratch, to fit like Cinderella’s slipper.

Comparing the contenders

When we pit these options against each other, we are looking at how they handle performance under pressure, how tight their security is, and their privacy features.

But it’s not just about being tough and secretive; it’s also about how well they can coexist with other financial systems.

Hyperledger Besu is flexible and has that Ethereum core, but Corda is built for finance from the ground up despite their high prices and EVM incompatibility, and Quorum adds an extra layer of privacy to Ethereum’s world. Each has its own superpower in the world of CBDCs.

So, did BCB hit the bullseye with Besu? It is hard to say without peeking behind their decision-making curtain. But here is where you come in — what is your take on this? Could another DLT have danced the samba better with Brazil is economic rhythms? Comments very welcome!

For those who want to dig into the nitty-gritty of Hyperledger Besu, check out their official documentation. To understand how Corda is carving out its niche in finance, their website offers a wealth of information. And for the curious minds wondering about Quorum, its features and use cases are well-detailed online.

In this tech tango, every step counts. Let’s keep the conversation going and explore which blockchain platform could lead Brazil to a future where digital reals make the financial music everyone dances to.

So, Drex is currently using a permissioned network for its pilot testing, there is an intention to explore interoperability and potential integration with public blockchains like Ethereum in the future (more about it below). The use of Hyperledger Besu as an EVM indicates a strategic move towards ensuring compatibility with a wide range of blockchain environments and assets.

Drex and “permissionless” blockchains

“Integration with Ethereum and other public blockchains is a top priority for the DREX platform in 2024,” stated Fabio Araujo, Drex’s project lead at BCB, during the event Blockchain Finance Brazil hosted by Blocknews in collaboration with Cantarino Brasileiro in October 2023.

Blockchain Finance Brazil

By the way, you can watch Araujo’s presentation on Youtube with English subtitles and read an article about the seminar on Blocknews website.

This seminar was actually a masterclass on how digital assets will be a hot topic in 2024. Regarding Araujo’s presentation, he stated that Drex’s mission is to promote the link between Open Finance and Interoperability in payment and settlement systems. He clarified the differences between Pix and Drex; while the former is focused on payment services, Drex is focused on financial services.

By the way, before Pix, people would withdraw funds to make payments, lacking a digital channel for communication with service providers. This model is being replicated in multiple countries, proving once again, that Brazil has been leading the innovation in Financial Markets for a while. The widespread adoption of Pix in Brazil has created new opportunities for incumbents and small market participants.

Araujo also mentions that tokenization will play a crucial role in the Central Bank’s activities in the coming years and that BCB is planning to invite new test cases on Drex in the second half of 2024.

The debate concerning the potential risks and challenges of expanding Drex usage and developing a CBDC in crypto markets is up for discussion. The importance of developing communication channels between different blockchains is highlighted. However, the current lack of standardization and structure in the crypto market necessitates regulations. The regulated nature of Drex could potentially promote clearer communication within the market. Again, worth watching.

One of the cool parts about working in Brazil right now?

All the awesome seminars and events, like the Blockchain Festival in Rio and São Paulo. And you’ve got innovation hubs and acceleration programs like Next from Fenasbac, who are always pushing these initiatives and helping everyone get in the know.

An interoperable and safe place

So, back to our chat, what’s the dream set up for blending and getting permissionless public blockchains to work nicely with permissioned ecosystems and those super regulated, centralized DLTs/private networks?

Trying to mix public blockchains, permissioned ecosystems, and private DLT networks in super strict and centralized places like Brazil’s financial markets can be a real headache. But, don’t worry, we have got a few tricks up our sleeve to make them all play nice together and keep things private.

Here are some potential (options) or solutions:

Bridges

Bridges serve as vital mechanisms in the blockchain landscape, acting as conduits for the transfer of assets and information between different blockchains, irrespective of whether these blockchains are public or private. Given the diverse nature of blockchains, the use of a bridge can provide a seamless connection between them.

For example, a bridge can create interoperability between Drex and public blockchains such as Ethereum or Polygon, or even a non-EVM chain.

Interoperability is crucial in the blockchain ecosystem as it facilitates secure transactions and the seamless movement of digital assets across different networks. The utility of bridges extends beyond transactions and asset movement; they essentially unify various blockchain networks, creating a more integrated and efficient blockchain ecosystem.

One ongoing initiatives exploring the use of bridge solutions in CBDC pilot projects is mBridge. The BIS mBridge or Project mBridge is a multi-CBDC platform developed by central banks. It is designed for real-time, peer-to-peer, cross-border payments and foreign exchange transactions using CBDCs, with a focus on international trade. The platform utilizes a new blockchain, the mBridge Ledger.

Recently, a pilot involved twenty banks from Hong Kong SAR, Thailand, mainland China, and the United Arab Emirates. They completed 164 payment and foreign exchange transactions totaling over U$22 million. This pilot represents a significant step in multi-CBDC experimentation, allowing for the settlement of real value directly on the platform.

The experimental platform employs a purpose-developed permissioned DLT called the mBridge Ledger, or mBL. The mBL supports instant peer-to-peer and atomic cross-border payments and foreign exchange transactions using wCBDCs. Being EVM-compatible, the mBL enhances interoperability with other blockchain systems. More information can be found here.

mBridge is seen as a potential alternative to traditional cross-border payment systems like Swift. It’s expected to launch a minimum viable product in mid-2024, involving the BIS and the central banks of China, Hong Kong, Thailand, and the UAE.

The Polygon Supernet is another possible solution. It is a customizable blockchain stack that allows the creation of dedicated blockchain networks tailored to specific needs. It is a modular framework designed to support various scaling and infrastructure solutions, including sovereign and enterprise EVM chains and Layer 2 solutions. It enables developers to customize various aspects of their blockchain, including consensus mechanisms, block times, and transaction fees. Works with a modular framework, allowing developers to pick and choose the components they need for their specific use cases.

Polygon Supernet

EVM chains, which means it can run smart contracts just like the Ethereum mainnet and Networks built on Polygon Edge can interoperate with other blockchains in the Polygon ecosystem, leveraging the security and network effects of the main Polygon network.

Integrating Polygon Supernet with a CBDC pilot project like Drex could create a tailored blockchain, meeting BCB’s specific regulatory requirements and ensuring local financial law compliance.

Being EVM-compatible, Polygon Edge allows Drex to facilitate interoperability with Ethereum and other similar blockchains. This enables secure transactions and digital asset movement across networks. And a high scalability could allow Drex to manage a large transaction volume, a key aspect for a CBDC. Security could be enhanced using additional layers from the main Polygon network while keeping a customized, permissioned network.

What about the gas fees? I am not a specialist in Polygon Supernet or Edge, but maybe it would depend on the network operators’ specific configurations. This is actually a concern related to all permissionless blockchain. We cover a bit more about the “gas problem” below in this article.

Since Polygon Edge allows custom blockchain creation, these networks could have unique fee structures and consensus mechanisms, potentially influencing transaction costs. For example, Proof of Stake (PoS) or other consensus algorithms might be used to decrease costs compared to Proof of Work (PoW), which is more energy-intensive and usually has higher fees.

Other alternative would be use of subsidized transactions. The organization or consortium running the public blockchain nodes could choose to subsidize transaction costs to encourage usage or during the initial phase to attract adoption. Or other “fee mechanisms”, like a gas stations, to allow more flexible transaction fee structures, where users might not always pay for gas themselves.

The problem is, the more we dig, the more we find. And more complex it gets. This tech is evolving quick and today’s decision can become your tomorrow’s nightmare.

CCIP

The Cross-Chain Interoperability Protocol — CCIP by Chainlink is designed to facilitate secure and decentralized messaging and token transfers across different blockchains. So let’s explore how this protocol (or solution) could theoretically assist in a CBDC environment like Drex.

CCIP could enable the Drex platform to securely transfer its CBDC or other digital assets across various blockchains, including private and public networks. This could be vital for cross-border transactions involving Brazil’s digital currency. Its decentralized inter-chain messaging system could allow Drex to send and receive information across different blockchain networks, which is essential for executing smart contracts that rely on external data or need to communicate with other chains.

Given the significance of security for CBDCs, the multiple layers of protection provided by the CCIP, including the Risk Management Network, could offer the robust security infrastructure needed for the digital currency platform. Furthermore, its interoperability with “Bank Chains” could enable connections between blockchains and “Bank Chains”. These connections could potentially be used to link Drex with other banking and financial institutions’ blockchains, thereby enhancing interoperability within the financial ecosystem.

I wrote about CCIP in the past, in case you are interested, please check here.

Interledger Protocols

Protocols such as Interledger facilitate communication between different payment systems, encompassing both blockchains and traditional networks. This could enable Drex to interact with numerous financial systems without the necessity for multiple point-to-point integrations.

The Interledger Protocol is a creation of Ripple Labs and Introduced in 2015, ILP’s goal was to address the core issue of interoperability among various blockchain networks. The existing isolated nature of blockchains was hindering their full potential by restricting the smooth transfer of value and data across platforms.

You can learn more about ILP here and here.

Hybrid smart contracts

Developing smart contracts that operate on DLTs but can interact with contracts on public blockchains allows regulated transactions to occur within a controlled environment while still benefiting from the advantages of public networks.

Ok, but how? One option is using platforms like Hyperledger Besu, which is EVM and allows a private network to execute standard Ethereum smart contracts to interact with other EVM-compatible networks.

Another option that comes to mind is creating a Regulated DeFi Zone, a zone within the Drex ecosystem where DeFi products could operate under specific regulations. This could be achieved through a regulatory sandbox for financial innovation, allowing entities to test new products and services in a controlled environment.

Zero Knowledge Protocols

Zero-Knowledge Proofs (ZKPs) were first introduced in a 1985 paper called “The knowledge complexity of interactive proof-systems” by Sbafi Goldwasser, Silvio Micali, Charles Rackoff.

In this paper, they’re diving into a complexity theory that is all about the ‘knowledge’ you get from a proof, calling these ‘zero-knowledge proofs’. These proofs don’t give you any extra info, just that the thing you are proving is right. They also give some examples of zero-knowledge proof systems for stuff like quadratic residuosity and quadratic non-residuosity. These are the first examples of zero-knowledge proofs for stuff we cannot recognize efficiently. Pretty nice, and I suggest you to read the paper in case you are interested in this topic.

These proofs allow for the verification of knowledge without exposing that knowledge. The classic example often used to explain ZKPs is the “Ali Baba cave” analogy, where one person proves to another that they know the secret word to open a magical door in a cave without revealing the word itself.

In the context of blockchain, ZK protocols are particularly powerful for enhancing privacy and scalability. Basically, ZKPs can be used to verify transactions without revealing sensitive data. For instance, in a financial transaction, ZKPs could validate that a payment was made and that the payer had sufficient funds without revealing the payer’s balance or other transaction details.

ZKPs can also be used to create “succinct” proofs for blockchain scalability solutions. One example is ZK-Rollups, which bundle hundreds of off-chain transactions into a single transaction and generate a cryptographic proof — a ZK-SNARK (Zero-Knowledge Succinct Non-Interactive Argument of Knowledge) — that all transactions are valid. This single proof can be quickly verified by the blockchain, significantly reducing the data that needs to be stored and processed on-chain.

But ZKPs are not an easy topic, and as everything, brings some challenges and risks. The creation and verification of ZKPs require complex mathematical computations, which can be resource-intensive.

Security of ZKPs relies on specific assumptions and cryptographic primitives. If these underlying components are flawed, it could compromise the entire protocol.

The technical complexity of ZKPs makes them difficult to implement and use, potentially limiting their adoption now.

Also, integrating ZKPs with existing systems and ensuring they work across different platforms is an ongoing challenge.

For those interested in learning more about the technical aspects of ZK protocols, foundational papers and resources from the cryptographic community are essential. This original paper is a cornerstone in this field. I’ve wrote a bit about it on the past, as this is a topic that catches my attention. You can find more at my medium articles:

ZK’s are Awesome But…

Zero-knowledge or Optimistic Rollups for CBDCs — Why not?

But maybe, the solution is just right there, being tested now by the BCB. It’s called Parchain, from Parfin.

Parfin’s Parchain

Parchain is an EVM-compatible system designed to provide complete privacy, scalability and interoperability to permissioned blockchains, and has been designed to support each of the Principles for Financial Market Infrastructure.

It complements new and existing blockchain networks with a set of unique components:

  1. Privacy Ledgers
  2. Bridges
  3. Commit Chain

These parts work together to form independently-governed Value Exchange Networks (VENs) that can be connected into a multi-ledger ecosystem. This design ensures consistent tokens and free-flowing currency across the ecosystem, all while keeping each VEN decentralized.

Transactions are confidently initiated by a single Privacy Ledger, governed by an institution. Through a Bridge mechanism, this ledger relays encrypted transaction data and node updates to the Commit Chain.

This Commit Chain, in its authoritative role, dispatches updates to every other Privacy Ledger in the VEN via additional Bridges, ensuring transaction information reaches its intended destination.

It is important to note that while the VEN remains informed of all events, only the parties involved in a given transaction possess full access to its details.

Privacy Ledger

A Privacy Ledger is a scalable, single-node EVM ledger integrated with a MongoDB database. Privacy Ledgers are based on the Geth execution client, modified to fit the Parchain system.

Privacy Ledgers utilize an enterprise-grade database (MongoDB) focusing on high availability, horizontal scaling, data querying, disaster recovery and API integrations to traditional financial systems, the famous “Legacy”.

This component also provides private, EVM-compatible blockchain ledgers for internal operations as well as interoperability with other members of a VEN. By integrating MongoDB with Ethereum Virtual Machine, Allowing financial institutions to maintain sole authority of token issuance, to control tokens issued by them within their own Privacy Ledger, to establish adaptable, flexible platforms and to ensure conformity to regulatory standards from participants

By design, each Privacy Ledger is its own component. This ensures that private data stays inside an existing IT structure, keeping it exclusive to the financial institution.

Bridges

A Bridge is a mechanism that allows Privacy Ledgers to communicate with one another. They ensure complete transaction privacy between financial institutions, even when the issuer isn’t present.

These bridges use Zero Knowledge Proofs (ZKPs) and homomorphic commitments to enable:

  • Fully encrypted, peer-to-peer data and token transactions
  • Quantum-secure on-chain privacy
  • Cryptographic proof of original token legitimacy across networks
  • Auditor view to confirm transaction and circulation validity
  • Cryptographic proof of correctness for state updates

Here is a link just in case you wanna learn a little bit more about Homomorphic encryption.

All cross-chain transfers occur on Bridges between two Privacy Ledgers and the Commit Chain, using a smart contract on each Privacy Ledger to deal with the transaction, while the transaction is coordinated through the Commit Chain.

Since smart contracts cannot automatically pull or push data to external sources, a Bridge communicates transaction events from one blockchain to another.

All events are encrypted and submitted with cryptographic proofs to ensure correctness. Operationally, this enables competing banks to participate in a network and exchange value with their peers without revealing transaction data to third-party participants.

Parchain bridges’ support the ISO 20022 standard. Each Bridge can be configured to issue and receive requests that conform to a specified messaging standard, and can be extended to support additional messaging standards as required by an institution’s use cases.

Commit Chain

A Commit Chain is a shared blockchain ledger used to validate and record transactions between Privacy Ledgers. Parchain allows for new and existing blockchains to deploy any EVM-compatible ledger to serve as the system’s Commit Chain.

Parfin recommends using Hyperledger Besu as the platform for new projects, as it is open-source, private, permissioned, and EVM-based. However, other EVMs can be used.

The Commit Chain coordinates transactions between Privacy Ledgers and receives updates from each one, providing an immutable record of state updates and transactions. Commit Chains also store public information from participants, accepted tokens on the network, issuers, and the mappings that allow for this level of intercommunication.

Communications between Privacy Ledgers consist of an originator and a recipient. The originator retrieves the recipient’s public key from the Commit Chain and sends a message to the Bridge. Transactions are coordinated cryptographically through Bridges and the Commit Chain, ensuring privacy and validity without causing transactional redundancy (or “double spend”).

All Privacy Ledgers within a Value Exchange Network must register their public keys to the Commit Chain. Each Privacy Ledger must send state updates to the Commit Chain before communicating with other Privacy Ledgers. State updates are published every 10 second by default, and provide proofs of transactions, states, and token values for validation by the Network Operator.

The VEN — Value Exchange Network

A Value Exchange Network (VEN) is a functional network of permissioned institutions that record their transactions through a shared Commit Chain. Institutions can become members of a VEN after obtaining permission from a Network Operator.

Diagram of a Value Exchange Network. Privacy Ledgers have Bridges between each other and the Commit Chain.

According to Parfin, connecting to a VEN is as simple as connecting a Privacy Ledger to a Commit Chain. Once the connection is established and governance policies are agreed to, the Privacy Ledger can begin synchronizing state updates and downloading token smart contracts.

Institutions can join multiple VENs without compromising sensitive data between networks. The Bridges and Commit Chain of each VEN encrypt transaction information and provide proof of legitimacy back to the original issuing authority.

Núclea in Brazil, is one of the financial institutions using Parfin’s solution for its core network.

The VEN also is very similar approach as the RLN, Regulated Liability Networks.

The Gas problem

Addressing the issue of high gas fees on public/permissionless blockchains is a critical concern, especially when it comes to CBDCs, where it is vital to ensure the stability and predictability of transaction costs.

This is because CBDCs are designed to function as a stable, digital form of a country’s fiat currency, and high or unpredictable transaction costs could undermine this stability and deter widespread adoption.

I believe several strategies may need to be employed, each of which may approach the problem from a different angle, but all with the common goal of reducing gas fees and thereby enhancing the feasibility and appeal of using public blockchains for CBDCs.

But let’s exercise the possibilities, because we look for solutions here.

If we want to take some of the weight off the main blockchain network, one option is to think about using these things called Layer 2 Scaling solutions like rollups or state channels.

They are pretty cool because they could bring down gas fees a lot, and we all know those are a big pain in the blockchain world. Basically, these solutions do their magic by handling transactions off the main blockchain, in a separate layer, which means the main blockchain doesn’t have to work as hard.

It is kind of like they only jot down the final results of these transactions on the main chain, not every single transaction. So by shifting most of the transactions off-chain, we can make the blockchain scale better, speed up transactions, and cut down on those pesky gas fees.

Using Sidechains that run parallel to the main blockchain can offer a cheaper and faster alternative for processing transactions. Sidechains can have their own fee structure, independent of the main chain’s token price fluctuations.

Other alternative, is to use Fixed Fee Mechanisms. Designing CBDC systems with a fixed fee structure can shield users from the volatility of network fees. This might involve the central bank or governing body absorbing variable costs to maintain fixed transaction fees.

Optimizing Consensus Mechanisms by using more efficient consensus mechanisms like Proof of Stake (PoS) can reduce the cost associated with transaction validation, as they require less computational power than Proof of Work (PoW).

Implementing a Quota System where users receive a certain number of free or discounted transactions per day or month could help mitigate the impact of high gas fees.

Hybrid Solutions by combining public and private blockchains where high-volume, low-risk transactions are processed on a low-cost private ledger, while final settlements occur on the more secure public blockchain.

Pre-Paid Gas Tokens that can be pre-purchased at a stable price can help users manage and predict transaction costs more effectively.

Using Dynamic Fee Structures by developing algorithms that adjust fees based on network congestion and token price could help in smoothing out fee volatility.

And finally, Interoperability Protocols. Using interoperability protocols to switch between different blockchains can allow transactions to occur on whichever chain is cheapest at the time.

But each of these strategies has its own trade-offs and would need to be carefully considered in the design of a CBDC to ensure it meets the needs of all stakeholders, including users, regulators, and financial institutions. I’m just brainstorming here, so what else would you do? Please comment.

Next Steps

BCB is in the process of testing a range of privacy solutions like mentioned on part I and up here. The testing process is a comprehensive one, designed to evaluate the effectiveness and applicability of these solutions in real-world scenarios.

With the timeline that has been put in place, we can expect these tests to be concluded by May 2024. Following the conclusion of these tests in May, June promises to be a month of revelations where we will gain more insight into the future of Drex, an integral part of this entire process.

The second half of 2024 brings with it expectations, among which is the anticipation that BCB will begin testing new protocols and features. This aligns with their commitment to continuous improvement and adaptation to the ever-evolving financial landscape.

From BCB’s DREX meeting Dec 2023, Brasília DF Brazil

You can also watch the full DREX 2023 annual meeting with english subtitles.

Wrapping up…finally

Writing is a mental exercise for me. But, sometimes things get out of control 🙂 The DREX for gringos — Part II was getting too long, so I have decided to split it and write the Drex for gringos — Part III, which is coming out soon! Stay tuned…

The evolution from barter to digital currency

From bartering goods to the invention of paper currency, and now to digital currencies, we’ve constantly evolved our financial systems. This journey shows our ongoing pursuit of financial innovation, adapting to better meet our needs in economics and trade.

Embracing the digital shift

We are on the verge of major digital transformation. The future of commerce depends on our shared vision for programmable money. The use of technologies like Hyperledger Besu on the Drex pilot is not just a technical decision. It shows our commitment to privacy, interoperability, and community-led development.

Values beyond technology

The debate over the ideal digital currency transcends technicalities, touching on our societal values, priorities, and the type of future we aim to build. Whether we opt for a blockchain-based approach or an entirely new technology, our transactional methods must resonate with our aspirations for an equitable, efficient, and inclusive financial system.

Technology as a tool for transformation

As we explore the vast ocean of possibilities that technology offers, we must remember that technology itself is just a tool — a means to an end. It’s our collective vision for a more inclusive and opportunity-rich future that will steer the evolution of programmable money.

Programmable money: a visionary shift

The essence of programmable money is not in its code or algorithms, but in its capacity to revolutionize society and the economy. In this new era, it is crucial to question the status quo, challenge norms, and approach our options with an open mind.

The dialogue on programmable money

The speech on programmable money is not just significant — it is imperative. This conversation demands our active participation and deliberate actions. The choices we make now will sculpt the financial terrain of the future.

The role of DeFi and addressing core challenges

Incorporating a comparison with DeFi could illuminate how programmable money might evolve. DeFi has set precedents in composability and privacy — the very challenges DREX aims to tackle. Understanding how these elements coexist within DeFi can shed light on their integration into DREX’s infrastructure.

Composability and privacy: The twin pillars

Composability and privacy are the twin pillars Drex must reconcile to thrive. Exploring how these two objectives can coexist in the ecosystem we’re building is essential.

How will Drex maintain privacy while ensuring components can interoperate seamlessly?

Engaging with the ecosystem

I invite feedbacks on this exploration. Your comments, corrections, and insights are invaluable as we navigate this collaborative ecosystem. It’s through our joint efforts that we’ll shape a financial future that is not only innovative but also aligned with our shared vision. I am not an expert on Drex, just a curious guy.

Extras

Here are some additional resources, YouTube channels, Podcasts, Newsletters and articles that can help you gather more information about all that:

Fintrender newsletter and blog posts. Watch Real Digital with Fabio Araújo, BCB @Fintrender’s youtube channel and Real Digital needed and inevitable by Gustavo Cunha.

Blockdrops, the number one podcast in my opinion, hosted byMauricio Magaldi. Great source about Crypto economy in Brazil and around the world, with weekly episodes.

Brazil Crypto Report with Aaron Stanley, is a publication devoted to exploring Latin America’s largest (and the world’s 9th largest) crypto market. It provides English-language news analysis and business intelligence coverage of the market through a weekly newsletter, and interviews with key stakeholders and local players through a podcast and YouTube series. It also provides coverage of other markets in the region through its Latam Crypto Report sister publication.

highlight of the episode — Inside DREX with Fabio Araújo

Blocknews — one of my preferred source of news about Brazilian Crypto and CeFi scene.

Special thanks

Collaboration is crucial in this market. I would like to express my special thanks to Claudia Mancini (Blocknews), Gustavo Cunha (Fintrender), Aaron Stanley (Brazil Crypto Report) and Robson Junior (Pods Finance) for their reviews, corrections, and insights.

Your thoughts really matter in this chat we are having. Let’s keep shaping the future of finance together, shall we? Hope you enjoyed.

Feel free to reach me on Linkedin.

*Leandro Pereira (Sciammarella) is Blockchain Head at Núclea.

This article was originally published at Leandro Pereira’s profile at Medium

Compartilhe agora

Deixe um comentário

O seu endereço de e-mail não será publicado. Campos obrigatórios são marcados com *