Bitcoin was not the first digital currency, but it is the most successful to date, despite roller coaster volatility and a polarizing ethos. Regardless of bitcoin’s eventual outcome, there is no better validation of its influence than the increasing interest from central banks in issuing their own digital currencies.
Countries as diverse as the US and Nigeria are taking note of central bank digital currencies, (CBDCs), for very different reasons. Bitcoin’s popularity outside of domestic centralized control threatens the US dollar’s 75 year dominance as the preferred global currency standard.
In developing countries, the Bitcoin ecosystem unlocks economic growth as unbanked yet ambitious people sidestep restrictive commercial banking systems that shut them out from traditional credit and capital.
What is a Central Bank Digital Currency?
A quick search on TikTok for “CBDC” uncovers a lot of talking head sensationalism around the topic. Let's back up a bit. What exactly is a CBDC?
Most countries already embrace cashless transactions and deposits backed by fractional reserves within the fiat system. You might think, I hardly ever use cash anyway. What is the big deal? How are CBDCs different from Venmoing your buddy for half of the pizza delivery?
CBDCs differ from current electronic transfers of money via debit cards and electronic transactions in several ways:
- Nature of money: CBDCs are a form of money that is directly usable by individuals, while electronic transfers via debit cards and electronic transactions involve transferring claims on money held in bank accounts.
- Efficiency and cost savings: CBDCs can increase the efficiency of payments and reduce transaction costs.
- Issuance: CBDCs are issued and backed by the central bank, while electronic transfers via debit cards and electronic transactions rely on commercial banks.
- Accessibility: In theory, CBDCs are accessible to all individuals and institutions, regardless of their access to commercial banking services.
- Security: Because CBDCs use blockchain and distributed ledger technology (DLT), they offer enhanced security features, such as cryptographic protections and immutability, compared to traditional electronic transactions.
- Functionality: CBDCs have the potential to offer new functionalities like programmable money, smart contracts, and instant settlement, which are not possible with traditional electronic transfers of money.
It's important to note that most of the above benefits represent a CBDC that conforms to the theoretical model of distributed ledger technology.
The actual design and features of CBDCs are still evolving. In reality, CBDCs threaten some very powerful, entrenched systems and institutions. Specific differences between CBDCs and their utility will depend on the priorities and politics of each country.
What Are the Risks of CBDCs?
Despite the potential benefits of CBDCs, their implementation carries several risks and challenges. Here are some of the top risks that countries are facing with their CBDC plans:
- Cybersecurity risks: The short history of alternative currency is riddled with fraud, hacks and losses. CBDCs, like any other digital financial asset, are vulnerable to cyber attacks which could result in losses for individual users or the central bank itself. To the degree a government insures CBDC deposits or transactions, fraud could also increase legal exposure.
- Privacy concerns: CBDC transactions tied to specific identities could compromise the privacy of transactions and financial data. This could be a significant concern for individuals who value their financial privacy. On the other hand, all current transactions, other than cash, leave a digital trail as well.
- Monetary policy risks: CBDCs could impact central banks' ability to implement monetary policy effectively. For example, if CBDCs were to become widely used, it could affect the demand for other forms of money and the transmission of monetary policy.
- Operational risks: CBDCs could pose operational challenges, including issues related to the energy infrastructure needed to support their issuance and use.
- Disintermediation: CBDCs could displace commercial banks as intermediaries in financial transactions, reducing their role in the financial system. This could lead to a reduction in the financial system's stability as a whole since commercial banks play a crucial role in maintaining stability through their ability to manage and contain financial risks.
- Liquidity risks: CBDCs could create new liquidity risks if adopted too quickly and on a large scale. For example, if many consumers switch from holding deposits at commercial banks to holding CBDCs, this could create significant liquidity pressure on commercial banks.
- Monetary policy transmission: Introducing CBDCs could affect monetary policy transmission from central banks to the broader economy. For example, if CBDCs become a preferred means of payment, it could reduce the effectiveness of interest rate adjustments as a tool for influencing borrowing and spending
- Cybersecurity risks: CBDCs introduce new cybersecurity risks, as they are vulnerable to hacking and other cyberattacks. This could lead to financial instability if large amounts of digital currency are stolen, or the underlying infrastructure is compromised.
- Technical issues: There are also technical issues associated with implementing CBDCs that could lead to financial instability. For example, the operational requirements of CBDCs, such as the need for high computing power and security, could be difficult and expensive to meet, particularly for smaller countries.
As with any disruptive innovation, CBDCs introduce new risks and challenges that leaders must weigh against the potential benefits of increasing access to financial services, more transparency into central bank activities, and reducing costs and fees for users.
CBDCs and Cryptocurrencies: What is the Difference?
While a CBDC is a subset of digital currencies, there are some fundamental differences between cryptocurrencies like bitcoin or ether.
The value of the chart is that you can easily compare the differences between different types of payment by looking at the bottom row, first.
Let's look a bit closer.
Identity and Decentralization:
Cryptocurrencies and central banks have fundamental differences in their approach to identity and decentralization.
For governments, the ability to track user identity and financial activity is a major requirement. Governments need to know who is who to monitor tax collection, pension systems, and welfare payments. They also need to be able to track identity to fight money laundering and other illegal activities. Governments use centralized databases to track individuals and their transaction history.
Cryptocurrency in its purest form takes the opposite view. Cryptocurrency enables private transactions between individuals, across borders, with complete privacy and no third party involvement or reporting requirements. Transactions are recorded on a blockchain, a decentralized system of distributed ledgers. For obvious reasons, governments are threatened by this level of privacy and decentralized control in cryptocurrency.Cryptocurrency transactions are anonymous and transparent at the same time. How is this possible?
Cryptocurrency and tokens run on public “permissionless” blockchains. Permissionless means users do not have to be granted permission to use a blockchain protocol, DeFi platform, or related systems. In other words, no one keeps a database of approved users, for example.
Transactions are encrypted and users are identified by a unique wallet address rather than their personal information.
The blockchains are called public because anyone can view the transaction history. It is possible to trace a transaction back to its origin wallet by analyzing the blockchain data. However, being able to see the identity of the person who initiated the transaction depends on whether they have shared any information linking the wallet to their personal identity.
Cryptocurrency wallets typically do not disclose personal information. But if the person has shared their wallet address on a public platform or otherwise linked their identity to the wallet, then the transaction can be traced back to them.
In contrast, the CBDC is issued by a central authority and designed so that the government can easily verify user identity and track individual transactions.
Cryptocurrencies are entirely decentralized, meaning that there is no central control (like a central bank). They rely on the network of their users to maintain the integrity of their blockchain ledger. CBDCs, on the other hand, are issued and maintained by a central bank or government, making them much more regulated than their cryptocurrency counterparts.
CBDC transactions are processed through a centralized payment system. This control facilitates security and compliance with regulatory requirements.
However, the centralized nature of CBDC also raises concerns about privacy and security. Central banks may collect and store more personal information about users than is necessary, and there is a risk that this information could be compromised or misused. Central banks can also seize assets.
Cryptocurrencies operate using a public ledger system that records all transactions across the network in an immutable way. The public ledger lets anyone view all past transactions and balances while protecting the anonymity of the user. In traditional banking systems, all records remain private and are only accessible by authorized entities who may track transactions back to the user.
CBDCs also employ some elements of distributed ledger technology to record transactions. However, their ledgers are not open for public viewing like cryptocurrencies and are kept within the control of a central institution like a government or bank.
Furthermore, unlike cryptocurrencies that use consensus mechanisms to reach successful transactions, CBDCs utilize permissioned networks centrally managed by regulated authorities.
Finally, another critical difference between CBDCs and traditional cryptocurrencies is their respective use cases. CBDCs are only used for payments, transactions and wholesale activities. Cryptocurrencies are used for payments and investment assets.
Since regulators can track CBDCs more easily than physical currency or cryptocurrencies outside of central bank control, they could facilitate faster verification processes for financial transactions and improve efficiency within financial markets. CBDCs also help governments fight money laundering by automating monitoring of cross-border transactions.
What About Stablecoins and CBDCs?
Stablecoins are also an attempt to smooth out some of the volatility and risk in cryptocurrency trading. So what is the difference between CBDCs and stablecoins?
The two concepts have very different fundamentals. As we’ve shown, CBDCs are issued by central banks and are meant to serve as a digital representation of a country's fiat currency.
Stablecoins are a type of cryptocurrency issued by a company or organization, pegged to a specific asset or a basket of assets, such as the U.S. dollar, in an attempt to reduce price volatility.
CBDCs are aimed at the general public, while stablecoins are aimed at the cryptocurrency market and its participants.
Stablecoins so far have not been able to deliver on their promise of reducing volatility.
Why Are Central Banks Considering Issuing a Digital Currency?
Central banks are considering digital currency as an alternative to traditional fiat currencies to compete with the advantages of bitcoin, while retaining a level of control that looks more like traditional currency. CBDCs have the potential to offer faster, more efficient, and more secure payment solutions than the existing system of banks and clearing houses for third-party verification.
With a CBDC, the central banks control a fiat digital token as part of the domestic monetary system. Digitizing fiat makes payments faster and easier for consumers and businesses. Additionally, a CBDC could add greater transparency to central bank transactions, making them more accountable to the public and government.
In addition to improving payment systems, CBDCs would address high fees associated with cross-border payments, lack of access to underserved populations, low liquidity levels in some markets, and overall inefficiency in the banking sector.
In theory, central banks could also use CBDCs to manage interest rates and improve control over inflation levels than with traditional financial instruments like bonds or securities.
The Current Landscape for CBDCs
Not all monetary policy experts are convinced that a CBDC is a necessity. Barry Eichengreen, Professor of Economics at the University of California, Berkeley, is a former senior policy adviser at the International Monetary Fund. He says CBDCs are an answer looking for a problem.
Even so, many major economies worldwide are considering or implementing CBDCs, including China, Sweden, Canada, Switzerland, Japan, and Singapore.
The Atlantic Council hosts a fantastic resource for tracking the global progress of CBDCs in almost real-time, including a global map of CBDC status by country.
Current statistics include:
- The New York Federal Reserve’s wholesale CBDC experiment, Project Cedar, is moving from research into development.
- 114 countries, representing 95 percent of global GDP, are considering a CBDC.
- 11 countries have launched a digital currency
- China’s pilot, which already affects 260 million people, is on track for further expansion this year.
- Financial sanctions on Russia have prompted countries to look at payment systems that avoid the dollar.
- The number of cross-border wholesale and retail CBDC tests has nearly doubled since 2021.
- In 2023, Australia, Thailand, Brazil, India, South Korea, and Russia intend to continue or begin pilot testing. In all, over 20 countries are moving towards a CBDC pilot this year.
- 18 of the G20 countries are in the final stages of CBDC development, with 7 countries already in pilot.
Cryptocurrency is triggering the evolution of the global financial system as decision makers and governments grapple with designing CBDCs that strike a balance between retaining centralized control and preventing bad actors while opening up the system to more people.
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The above is for general info purposes only and should not be interpreted as professional advice. Please seek independent legal, financial, tax or other advice specific to your particular situation.