Find Out If Central Bank Digital Currency (CBDC) Are Your Friend or Enemy?
Whether we like it or not, central bank digital currencies are coming.
A Bank of International Settlement survey states that 90% of central banks worldwide, including the Bank of England and US Federal Reserve, are conducting CBDC research.
When these government-controlled digital currencies launch, they will likely be the best thing that has happened to us after smartphones or our worst nightmare.
Therefore, it becomes important to learn about CBDC and prepare in advance.
This post will show you the benefits of CBDC (over cash) and the potential dangers or risks of using CBDC.
Before that, let’s discuss CBDC and how it will eventually work.
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What Are CBDCs?
CBDC stands for Central Bank Digital Currency. As the name suggests, they are digital representations of a nation’s fiat currency or banknotes, and the central bank issues them.
Fiat currency refers to money used as legal tender in a country. Examples are dollars, Euro, Pound, Chinese Yen, or Naira.
It’sIt’s important to note that the value of CBDC is pegged to the worth of the underlying fiat currency at every given point. Thus, if the Federal Reserve of the USA decides to launch a CBDC — digital dollar or E-Dollar, 1 unit of e-dollar will always be the same as 1 unit of the dollar.
It’s easy to confuse CBDC with bank deposits since both are electronic. However, the two are different in practice. Bank deposits are controlled by the commercial bank, while CBDC is solely issued and controlled by the country’s apex bank. This implies that commercial banks will be held responsible if something happens to the money in your bank account, while in most cases, the central bank will be liable for CBDC failures.
Most countries build their CBDC on a distributed ledger technology (e.g. blockchain) to maintain trust and transparency. Since cryptocurrencies are also built on the blockchain, many people compare them to each other.
Are Central Bank Digital Currency (CBDCs) The Same as Cryptocurrency?
Even though both CBDC and crypto are built on distributed ledger technologies, and both serve as legal tender, the two currencies are different in many ways.
Decentralized cryptocurrencies ( such as Bitcoin and Ethereum) are unregulated and not controlled by any central authority, while CBDC is issued and controlled by the central bank.
In addition, cryptocurrency transactions are anonymous, and users do not need to do verification to make payments. However, you need an ID verification to access central bank digital currencies.
Lastly, crypto assets are volatile and not covered by insurance, while central bank digital currencies are stable, risk-free and backed by assets in the central bank’s foreign reserves. This implies that holding cryptocurrency is risky while central bank digital currency offers cash-like security.
Will CBDC Disrupt Cryptocurrency?
There are many reasons to believe that CBDC will not pose any serious threat to cryptocurrency.
For starters, both are two different asset classes. While CBDC is controlled and regulated by the government, cryptocurrency is not regulated by any single entity. Therefore, free market and permissionless money advocates will continue using cryptocurrency.
Secondly, the efficient remittances and low-fee transactions promised by CBDC are already fulfilled by crypto. Therefore, they do not offer any exceptional value or upper advantage over crypto.
Lastly, crypto usability is not limited to value or money transfer. Programmable cryptocurrencies (e.g. Ethereum, Solana, etc.) can be used as smart contracts, governance and utility tokens, among other applications. Therefore, if we wake up to a day where CBDC becomes the preferred currency, crypto assets will continue to be relevant in other areas and will never fade into oblivion.
The above reasons show that CBDC may ccomplementcrypto in money transfers, but they will never replace cryptocurrency or threaten its adoption.
How will CBDC Work (eventually)?
What follows is an oversimplification of how CBDC may eventually work. You can check this BIS survey to explore CBDC design in detail.
According to the survey, three possible CBDC models exist based on the issuance and the role of banks in payment. These include:
- Direct CBDC
- Indirect CBDC
- Hybrid CBDC
It’s crucial to note that the central bank will always issue the CBDC in all cases, and there are going to be two to three participants in the money flow (central bank, consumer, and or intermediates)
The direct CBDC model excludes intermediaries from money flow. The central bank issues digital currency directly to the consumer and executes the other key activities. It records and updates transactions daily, handles payments, and takes care of cash to token exchange. The central bank also conducts KYC verification, although it can outsource it to third parties. Since the central bank is responsible for payment failure, the direct CBDC model provides cash-like security, but transactions tend to be slow and inefficient due to the heavy workload on one agency.
The indirect CBDC model involves two CBDCs and can be likened to the current banking system. The central bank issues wholesale CBDC to intermediaries (private institutions), who issue a retail CBDC to the final consumer. The major role of the central bank is to record wholesale CBDC transactions, while intermediaries oversee verification, compliance, messaging, dispute resolution etc. Remittance tends to be frictionless and pretty convenient. The only wrinkle is that the central bank can not interfere in dispute settlement during transaction failure since they don’t hold transaction records.
The hybrid CBDC model leverages both direct CBDC and indirect CBDC. Thus, the consumer receives banknotes directly from the central bank while the intermediaries handle record-keeping and customer management. The intermediary handles major payment settlement, identity verification and record-keeping. However, the central bank also keeps a copy of transaction records from time to time in case of dispute settlement. This implies that the users still benefit from the cash-like security of the direct CBDC model without trading off the convenience of indirect CBDC.
What Are The Benefits of CBDC (over Cash)?
CBDC can be beneficial to both the government and depositors when it’s properly designed.
Some of the benefits of central bank digital currency to the users are:
Financial Inclusion: CBDC eliminates intermediaries from money flow and enables everyone with a smartphone to access funds directly from the central bank. The exclusion of intermediaries provides financial inclusion to millions of people that don’t use banking services due to trust issues and high fees charged by commercial banks. In addition, CBDC will also make banking services available in remote regions with no commercial banks, giving financial inclusion to millions of underserved people.
Efficient Remittances: CBDC will bring about frictionless remittances by allowing users to send and receive funds locally and across borders within an eyeblink and at a very low cost. Furthermore, direct CBDC will enable people to access foreign exchange markets without going through money managers.
Better Fiscal Policy: CBDC gives the government more economic control. The direct access to consumers gives the central bank more oversight over people’s earnings, savings, and spending patterns. This data enables them to tax users directly and form better and more informed economic policies.
Fraud Detection and Protection: The digitization of money gives the government better real-time intelligence regarding money ownership and usage. This enables them to effectively detect illicit money usage and combat fraud and terrorism funding.
Economic Stability: If CBDC delivers on its promise, more people will use their local currency for local transfer and foreign exchange, thereby preserving the currency stability, establishing more trust in government and boosting the economy.
Dangers of Central Bank Digital Currency
Although the government has presented CBDC as the holy grail of money, this new digital money is not without risk and concern. The following are some of the potential disadvantages of CBDC:
Disintermediate Commercial Banks: CBDC will partially or completely diminish commercial banks’ role in money flow if the central bank decides to be the absolute issuer and distributor of money. While the disintermediation of commercial banks promotes efficient remittances, it will also lead to the loss of many jobs. Besides, it concentrates power in the hands of one agency and makes the economy a single point of failure.
Lack of Privacy: CBDC means farewell to privacy and anonymity granted by cash and cryptocurrency, respectively. Even though CBDC is built on the blockchain, people will still require ID verification to send large sums of money. Besides, the digitization of money enables the government to monitor and track money flow down to the last detail. While financial surveillance helps curb illicit money transfers, it also means the government can track how everyone uses their money, which may be a problem for non-profit and activist groups.
Inflation Risk: Another unaddressed problem of CBDCs is their susceptibility to inflation. In the present financial system, economic stability is achieved through quantitative easing and the gradual rollout of cash. However, the high velocity of central bank digital currency aids quick fund distribution. Add the high velocity of digital money to the infinite CBDC supply and an abusive government, and you’ll quickly notice that CBDC is a tool for hyperinflation in disguise.
Security Vulnerabilities: The centralization of economic power in the hand of one agency makes CBDC susceptible to hacks and bad actors.
Lending Difficulty: The ability of people to keep CBDC by themselves will lead to an all-time shortage of funds in commercial banks and private financial institutions. These institutions will turn to increase interest rates to break even on profit, thereby making loans more difficult to borrow and access.
CBDC in The Global Economy: Which Countries Are Considering CBDC Adoption?
As of March 2022, data gathered from CBDC Tracker shows that close to 75 countries and monetary institutions are working on the prospect of a CBDC. And over 80 CBDC projects are currently being investigated.
Most countries (52) are still at the research stage where they are trying to study what CBDCs are, if they want to design one, and consider the economic impact of CBDCs on their economy. The USA project Hamilton is one of the hottest CBDC research projects.
Ten (10) CBDC projects have advanced from the research stage to proof of concept ( theoretical prototype). These include the central banks of Japan, Sweden, Hong Kong and Turkey. Sweden is already one of the lowest cash-usage countries in the world. So, the e-krona is primed for massive adoption when it launches.
The Chinese e-Yuan and Uruguay e-Pesos are the hottest digital currencies at this stage. A dozen CBDC projects are in the pilot-testing stage, where the currency is tested in a real-life environment. So far, the digital Yuan trial has recorded over 9.6b Yuan in transactions, and over a 21million citizens have opened a digital yuan wallet.
The Bahamas and the Federal Republic of Nigeria are the only countries to have launched CBDC to date. The Bahamas Sand Dollar — a digital version of the Bahamas dollar launched in October 2020 to become the worlds world’s first operational retail CBDC.
Exactly one year later, the central bank of Nigeria rolled the e-Naira — a digital iteration of the Nigerian Naira ( NGN) into circulation, making e-Naira the second CBDC worldwide and the first legally-backed digital currency out of Africa.
5 CBDC projects have kissed the dust. Some proponents have gone back to intensify their efforts, with a few others giving up.
Conclusion
Depending on the design and the integrity of the central bank in question, CBDC could be a good or terrible innovation.
On the one hand, central bank digital currency will foster quick and efficient money transfer, better fiscal policy and help the government track illicit use of money.
However, on the other hand, CBDC robs us of cash-like privacy and quickly manifests into a tool the government uses to survey our finances and meddle in our lives. Let’s not start with CBDC inflationary risk, the threat to loan accessibility, and security vulnerabilities.
Lucky for us, most CBDCs are still in the works, and we have enough time to prepare for every outcome. The best way to prepare is to continue doing your little research until you form a conclusion. In addition, you can diversify your cash into physical valuables such as real estate or Gold and purchase alternative currency, e.g. crypto or stablecoin.
In the meantime, drop a comment on the CBDC project you are watching or rooting for?
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