The rise of cryptocurrencies like Bitcoin and Ethereum was one of the most disruptive inventions in the financial sector. Satoshi Nakamoto, the Bitcoin developer, introduced the token as an alternative to fiat currencies. He wanted to create a decentralised financial system away from central financial systems controlled by central banks, the government, and other financial agencies.
So far, cryptocurrencies have been successful. Coins like Bitcoin have increasingly become the preferred medium of exchange, store of value, and investment asset.
However, the rise of digital currencies comes at the expense of fiat currencies. This means that traditional financial agencies are losing their stake in the economy. The central bank’s role in controlling the money supply diminishes, while the government loses taxes. Commercial banks also miss out on funds because most crypto transactions are through peer-to-peer platforms and decentralised exchanges.
Cryptos have become a threat to traditional finances. It is only plausible that governments can stay ahead of the crypto threat. In this case, it is the central bank digital currencies (CBDCs).
What Is A Central Bank Digital Currency (CBDC)?
A central bank digital currency (CBDC) is a digital form of currency issued by central banks to support financial services for a nation’s government and commercial banking system. Examples of central banks include the US Federal Reserve System, the Bank of Japan, the People’s Bank of China (PBOC), and Germany’s Deutsche Bundesbank.
CBDCs are distinct from stablecoins, which are private, stabilised cryptocurrencies pegged to another currency, commodity, or financial instrument to maintain a stable value over time. Unlike decentralised cryptocurrencies, CBDCs are state-issued and operated.
A CBDC would be tied to fiat reserves at a 1:1 ratio, providing citizens with a cheaper and more efficient way to manage their funds due to fewer fees and the instant nature of a digital offering. Built on blockchain technology, a CBDC could offer the benefits of cryptocurrencies, such as banking the unbanked and immediate transactions, without the drawbacks, such as potential volatility.
The main goals of CBDCs are to provide businesses and consumers with privacy, transferability, convenience, accessibility, and financial security. CBDCs could also reduce the cost of maintaining a complex financial system, lower cross-border transaction costs, and offer those who use alternative money-transfer methods with lower-cost options.
What Are Different Types Of CBDCs?
When discussing the different types of CBDCs, there are two main models to consider: retail CBDCs and wholesale CBDCs. Let’s take a closer look at each model and the variations within them.
Retail CBDC Model
The retail CBDC model is primarily focused on facilitating payments between individuals and businesses, with a low value but a high volume of transactions. This flexible model accommodates various payment instruments, including cash, cards, and online transfers. Retail payment systems worldwide generally involve three processes: clearing, settlement, and transaction.
One key difference between CBDCs in the retail model is the level of verification required for use. CBDC tokens must undergo authenticity verification, including spending history details, while CBDC deposit accounts require account holder verification through KYC procedures. The retail CBDC model has three notable variations:
- Indirect Retail CBDC is similar to existing retail payment processes and requires an intermediary layer of financial institutions to onboard businesses and individuals, manage communication, and send payment messages to financial institutions.
- Direct Retail CBDC allows businesses and individuals to hold ownership of CBDCs by leveraging central bank private accounts, eliminating the need for intermediaries. However, some direct retail CBDC model developments suggest involving intermediaries among users and central banks.
- Hybrid Retail CBDC is a blend of indirect and direct retail CBDC types. An intermediary layer of financial institutions manages onboarding and communication, while individuals and enterprises have an immediate claim to a CBDC at the central bank.
Wholesale CBDC Model
The wholesale CBDC model facilitates payments and settlement of transactions among financial institutions, offering improvements in risk management and settlement efficiency. Banks already have direct access to electronic central bank money, but wholesale CBDCs could further enhance asset transfers dealing with securities. There are two kinds of wholesale CBDCs:
- Domestic Payment Wholesale CBDCs: Most wholesale transactions today involve large values, shorter settlement times, and institutional participants. These transactions are typically routed through central banks using real-time gross settlement (RTGS) systems to execute payments. Examples of such payment systems in Europe include EURO1 and TARGET2, which use wholesale CBDCs. TARGET2, owned and controlled by the Eurosystem, processes domestic payments by receiving instructions from the originating bank and completing reconciliation, confirmation, and fund transfers between bank accounts.
- Cross-border Payment Wholesale CBDCs: Implementing wholesale CBDCs for cross-border payments is more critical than domestic transactions. Cross-border transactions rely on various intermediaries and face jurisdictional challenges, which wholesale CBDCs can solve. Three scenarios for crafting wholesale CBDCs are local wholesale CBDCs, local transferable wholesale CBDCs, and universal wholesale CBDCs. In addition to these classifications, wholesale CBDCs can be used for secure transactions and play a significant role in supporting the tokenisation and digital transformation of the security value chain.
What Is The Current State Of CBDCs?
The cryptocurrency market cap currently fluctuates around two trillion USD. With that in mind, eighty-one countries have already considered, and a growing percentage have even begun developing or piloting CBDCs. They collectively represent over 90 per cent of global GDP. The first to propose CBDCs was the Central Bank of England, yet China is currently the primary first-mover advancing the Digital Yuan.
Most governments are optimistic about the prospects of CBDCs as it is the best way to mitigate the impacts of digital currencies. China is one of the leading world economies that have embraced CBDCs. The People’s Bank of China started experimenting with CBDCs in 2019. It released over $5.3 billion as part of the preliminary trials and is now pushing for the use of the digital Yuan by the broader population.
Other Asian countries like Cambodia, Malaysia, and Japan are looking to follow in China’s footsteps as they experiment with a CBDC of their own. The Bank of Korea has already hired Ground X to help in its CBDC pilot.
European countries like Australia, Canada, and the United Kingdom also focused on researching the viability of CBDCs. A report by the Bank of Canada showed CBDCs are great for the country as they would provide non-bank deposit options for the citizens and help fight anti-competitive and monopolistic behaviours.
In Africa, Nigeria is the first country to have launched a CBDC. It launched the digital Naira to provide a controlled option for the crypto-active Nigerian community.
The possibility of CBDCs for regular use is becoming more feasible and realistic, and several countries are becoming interested. The International Monetary Fund (IMF) report shows that over 110 countries are looking into CBDCs.
However, it is still far from being a consolidated practice. There is still no standard blueprint that central banks can use to issue digital currencies. While the shift towards crypto regulation is occurring, the goal is to incorporate external financial innovation. But why wouldn’t governments want to innovate and use blockchain tech internally in the first place?
What Are The Potential Benefits Of CBDCs?
A CBDC offered by the central bank or any other government agency has the potential to revolutionise the economy. It will impact and benefit millions of the populations within the countries and, by extension, the trade partners.
The ease of accounting and reporting is the first way the CBDCs will impact the economy. CBDCs will operate on the blockchain with a public ledger like the cryptocurrencies. The ledger records all the transactions, allowing the government access to critical consumer data to plan and adjust the fund’s supply to balance the economy. The government can also use the data in case of an economic crisis.
The other benefit of a CBDC is the ease of updating by the masses. Some people are yet to take up cryptocurrencies due to the lack of education on operating and use cases. However, fiat currencies are common for almost all citizens in a country. They are already trusted and are widely used. Therefore, most people will not hesitate to take them up in the form of CBDCs.
The regulatory clarity that comes with CBDCs is an added advantage. The crypto community has struggled with the need for crypto regulatory clarity as most countries are still creating regulatory frameworks. The ever-changing crypto world, with new tokens and projects coming up every other day, makes it challenging to govern.
The CBDCs, however, are likely to use the existing fiat legal framework. They are also expected to come with the stability of the fiat currencies. Even though cryptos have become mainstream, volatility remains a concern such that some businesses find it hard to use them for payments. The reduced volatility and the government backing will appeal to more individuals and merchants to adopt CBDCs.
The corporate world is also likely to gain from the launch of the CBDCs. For example, a blockchain analytics company can easily pick transactions and analyse the associated financial statements within a given sector. It can then share the information with the industry players for proper business strategy.
Adopting CBDCs works for the whole blockchain network. It would mean the network’s legitimisation, expanding other blockchain-based applications like the NFTs, decentralised finances, and DAO.
Some financial experts have also raised concerns that CBDC would need much initial and incremental investment. However, that has proven to be an incomplete view of the product. Already, digital currencies and virtual currencies are the order of the day, with e-commerce growing by significant margins in recent years. The widely used infrastructure that supports digital currency transactions can do the same for CBDCs. Financial companies like PayPal and Visa are looking to develop or support stablecoins. It means they can support fiat currencies on blockchains.
Still, that is not to say CBDCs are foolproof and short of challenges.
What Are Some Concerns Around CBDCs?
One of the major concerns that most crypto die-hards raise is that CBDCs are not in line with crypto’s idea. Digital currencies were all about decentralisation. They were created to do away with a few people or government agencies having all the power over the economy. The centralised operations system remains in place because CBDCs are fiat currencies running on blockchains.
The other concern is the risk of inflation. The world is facing acute inflation following the economic crisis due to COVID-19. One of the reasons for the high inflation includes government measures like printing more money. With complete government control, the government can produce as many CBDCs as it wishes, irrespective of the impacts like inflation.
CBDCs could also trigger hyper-centralisation. One of Bitcoin’s and other cryptocurrencies’ main value propositions is its decentralisation. There’s good reason in government politics and finance for some level of arm’s length distance. Much like governments have a separation of powers with federal courts, parliaments, regulators and central banks separate, CBDCs may concentrate economic and social power in the hands of the issuing body. Issues that must be addressed then are:
- Cybersecurity risks of hacking being more accessible on a centralised network.
- Open-source ledgers may allow all transactions to be publicly viewed, infringing on the right to privacy. Moreso, government overreach could observe and potentially control citizens’ financial doings. (Immediate tax takes, freezing accounts, etc.)
- Launching a CBDC may cause citizens to pull their money from banks, causing a run on their capital or a financial crisis.
Implementation would be no easy feat, and governments worldwide are looking extremely closely at the implications of CBDCs.
So far, Bitcoin has almost dislodged gold as the hedge against inflation. This is primarily down to Bitcoin’s limited supply. BTC works such that the supply remains the same irrespective of demand. Without similar provisions for CBDCs, there is the risk of consumer exploitation by financial regulations.
Already, the Nigerian launch of CBDC has shown how governments can use it to control the economy without consumer interest. At the time of the launch of the digital Naira, the government was all about suppressing information. It only allowed a few media stations to launch, and no questions were allowed. At the same time, no clear information on development and supply was given. This was coming at a time when the government had already banned Bitcoin.
The same way the government can monitor bank accounts and freeze them at will, the same can happen with CBDCs.
What Do CBDCs Mean For Cryptocurrencies?
Bitcoin and other digital currencies have become mainstream financial instruments. Other than individuals and merchants using them for transactions, countries like El Salvador have declared Bitcoin a legal tender. However, they still come with concerns like costly transactions, slow transaction speeds, and environmental concerns.
CBDCs are looking to be the answer to the existing digital currencies concerns. Moreover, governments will likely introduce recovery mechanisms for those who send money to the wrong address and ID-check to recover lost wallet keys.
The clear regulatory framework and government backing of the CBDCs means it is likely to attract massive users quickly. The decentralised cryptocurrencies might directly compete with the CBDCs once launched. Since cryptos rely on massive adoption for increased value, most cryptos might struggle.
The launch of the CBDC can also impact crypto regulations. So far, most governments have backed crypto and allowed free crypto trading. However, this is likely to change once they adopt CBDCs. For example, the consensus is that the main reason for the China crypto crackdown was to pave the path for the Digital Yuan.
Most governments will likely ban the cryptos or impose regulations limiting their usage to avoid direct competition from decentralised cryptocurrencies. This will reduce the growth of cryptos and the development of new projects.
How Stakeholders Prepare For The Future Of CBDCs
Although the future of CBDCs is uncertain, various stakeholders should begin preparing for their arrival. Central banks can consider the following questions: what is the end game compared to traditional money, which constituencies will the CBDC address, what role will the central bank play, what resources and capabilities will be required, and what changes beyond payments will be needed?
In addition, other stakeholders should also prepare:
- Providers of financial-service infrastructure should optimise their design choices for interoperability with digital currencies.
- Retail banks, merchants, and payment service providers should consider the level of infrastructure investment required to implement CBDCs successfully while addressing other requirements for modernising payments.
- Chief risk officers and CFOs should monitor the impact of digital currencies on bank liquidity and capital requirements in light of potential policy changes.
- Investors in popular and speculative cryptocurrencies should anticipate how CBDCs will affect their assets, as the emergence of central-bank solutions could hinder the growth of crypto ecosystems.
- Commercial banks should learn to conduct effective KYC and anti-money-laundering monitoring of digital currencies. They may also be expected to carry the cost burden for KYC compliance if they issue CBDCs to customers.
Bottom Line
Whether CBDCs are bad or good for cryptos remains in the balance. On the one hand, embracing CBDCs by governments approves blockchain technology. It would give needed confidence to develop the various blockchain platforms like NFTs and decentralised finances, which already rely on cryptocurrencies for operations. The growth would mean the expansion of the primary tokens of the given platforms.
On the other hand, the CBDCs launch will mean direct competition between the centralised and decentralised currencies. The government looking to win can ban or limit digital currencies.
Therefore, only time will tell whether CBDCs are good or bad for cryptocurrencies.
