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Central Bank Digital Currencies

What Are Central Bank Digital Currencies (CBDCs)?

Discover how central bank digital currencies, or CBDCs, work and how they could solve significant crypto challenges.

Tether ($USDT) is the third-largest cryptocurrency in the world with a market capitalization of more than $200 million. As a stablecoin that mirrors the price of the U.S. dollar, many cryptocurrency exchanges settle trades in USDT rather than U.S. dollars, and investors use it as a cash alternative to generate yield through lending opportunities.

While stablecoins act as a de facto digital replacement for fiat currency, you don’t have to look very far to find potential problems. TerraUSD, an algorithmic stablecoin pegged to $1.00, experienced a run on its currency that resulted in a fall to just $0.01. And many regulators are concerned about the assets backing other stablecoins’ peg to the dollar.

Let’s look at how Central Bank Digital Currencies, or CBDCs, could address these problems by providing a state-backed alternative.

CBDCs could radically transform how payments operate and help stabilize the crypto ecosystem – here’s how they might work.

What Are CBDCs?

CBDCs are cryptocurrency-like tokens issued by a central bank. Like a stablecoin, the value of CBDCs is pegged to the country’s fiat currency. But unlike a stablecoin, CBDCs are a liability of the central bank rather than a commercial entity. As a result, it can guarantee a peg to a fiat currency.

These pegs are particularly important for the decentralized finance, or DeFi, ecosystem. Since transactions must be settled with a stable value, investors have historically had to choose between off-platform fiat currency or potentially-risky stablecoins. CBDCs could provide a compelling alternative with guaranteed stability in fiat terms.

There are two types of CBDCs:

  • Wholesale – Wholesale CBDCs support interbank transfers and other wholesale transactions. For example, two financial institutions may use them to settle payments. While many of these settlements are already electronic, CBDCs could enable new forms of conditionality on the payments.
  • Retail – Retail CBDCs provide consumers and businesses with a digital currency without intermediary risk. Rather than using the current two-tier system where central banks only interact with payment service providers (PSPs), retail CBDCs would make central bank digital currency directly available to the public.

Retail CBDCs could be further divided into anonymous token-based CBDCs that the public could access with public/private keys or account-based CBDCs that would require identification. The latter could help governments monitor for illicit activity while still preserving privacy by shielding transactions from commercial entities.

The exact architecture of CBDC schemes depends on each government’s priorities and capabilities. For example, some governments may choose to provide CBDCs and handle retail payments, while others may provide them to intermediaries that handle retail payments. Similarly, some may use anonymous tokens while others may require identification.

Pros

  • They reduce the systemic risks posed by stablecoins by replacing them with a guaranteed alternative in mission-critical use cases. For example, crypto investors don’t need to worry about Tether’s reserves or an algorithmic stablecoin’s viability.
  • They could enable governments to more easily monitor illicit activities across the cryptocurrency ecosystem. By simplifying know-your-customer requirements, the technology could help reduce risk for payment providers.
  • They could help target subsidies to specific households by providing them with variable interest rates. For example, account-based CBDCs could enable governments to offer higher interest rates to low-income households.

Cons

  • They could decrease anonymity by enabling governments to track transactions made on exchanges or even retail transactions. As a result, the IRS could have more power when it comes to tracking tax obligations and enforcing them.
  • They could introduce a much larger systemic risk if governments don’t properly secure their blockchains. For instance, a breach in the U.S. CBDC could spark a global financial crisis whereas a failure of a smaller stablecoin would not.

What Countries Have CBDCs?

The Bahamas was the first country to issue a CBDC – the Sand Dollar – in October 2020. As a direct liability of the central bank, the Sand Dollar is backed by foreign reserves. The non-anonymous digital currency and the central bank-provided app are also interoperable with new and existing payment services, including point-of-sale retail transactions.

As of early 2022, there are 10 countries and territories with CBDCs and more than 100 others with projects in development. Most of the active CBDCs are located in the Caribbean, including Jamaica, Antigua and Barbuda, Saint Lucia, Dominica, St. Kitts and Nevis. But other active CBDCs include Nigeria – Africa’s largest economy.

Central Bank Digital Currencies
A map of current CBDC projects and their status around the world. Source: Atlantic Council

Nearly all of the G20 countries are exploring CBDCs, with 16 already in development or pilot stages. Of the G7 economies, the U.S. and U.K. are the furthest behind the curve. South Korea, Japan, India, and Russia have all made significant progress, and the European Central Bank plans to deliver a digital euro by 2025.

U.S. Plans to Develop a CBDC

Biden’s March 2022 executive order directed the government to assess the technological infrastructure and capacity needs for a potential CBDC. In addition, the order encouraged the Federal Reserve to continue its research, development, and assessment efforts for a CBDC, including potential plans for the government to assist in its work.

Prior to the executive order, in January 2022, the Federal Reserve issued its own whitepaper examining the pros and cons of a CBDC and how it could improve the safe and efficient domestic payments system. The paper did not favor any particular policy outcome and sought comments from the public to help objectively evaluate the opportunity.

Since the U.S. dollar is a major reserve currency worldwide, the introduction of a CBDC could have a widespread impact on the global financial ecosystem. For example, CBDCs would likely become a safe haven during times of financial stress, and the ability to convert deposits into CBDCs could make runs on banks more likely or severe.

Finally, Biden’s executive order stresses the importance of multi-country coordination in the development of a CBDC. Given the U.S. dollar’s integration into foreign markets, any CBDC would have to be compatible with other CBDCs, making international standards essential.

The Bottom Line

Central bank digital currencies, or CBDCs, are cryptocurrency-like digital tokens issued by a central bank. Unlike stablecoins or other cryptocurrencies, these tokens are backed by central banks, eliminating any de-pegging risk. As a result, they could help stabilize the crypto ecosystem and provide a range of other benefits.

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Justin Kuepper

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