CBDCs and The Future of Money: All you Need to Know About Central Bank Digital Currencies

Aiming for global asset class status, crypto or digital tokens owe their development to Satoshi Nakamoto, who introduced the world to new peer-to-peer payment methods without a central authority to oversee them in 2009 during the creation of the Bitcoin blockchain.

In recent years, and mainly since the onset of COVID-19, these tokens have evolved into an investment tool, increasing the global appetite for cryptocurrency. This is due to the advanced security, transparency, and inflation protection cryptocurrencies provide.

However, because digital currencies like Bitcoin (BTC) threaten governments’ ability to manage their economies, various central banks are currently trialing their own sovereign-backed virtual currencies known as Central Bank Digital Currencies (CBDCs) using Blockchain technology.

In their latest report, the Bank for International Settlements said that 85% of all central banks worldwide are currently studying or piloting CBDCs. So, what are CBDCs, and how might they impact the future of money? Read on to discover everything you require to know about CBDCs.

What is CBDC?

Central bank digital currency (CBDC) is a blockchain-based digital currency controlled directly by the country’s central bank and supported by national credit and government authority. Few technocrats regard the CBDC as a digital form of sovereign money in which the central bank determines the monetary policies.

In the most simple terms, CBDC is an electronic form of central bank money that can store value and make digital payments quickly and easily.

CBDCs use new payment technologies, typically a blockchain, to increase payment efficiency and lower costs, making them distinct from established currencies like the US dollar.

A centralized database makes CBDCs more efficient than other digital payment systems, like Bitcoin or Ethereum, which use a decentralized ledger.

Each country considering a CBDC has its approach. The blockchain technology and general principles used by various CBDCs are similar to those used in Bitcoin, the original cryptocurrency.

Several countries are experimenting with CBDCs based on blockchain technology. Venezuela took the lead in this area, introducing its cryptocurrency, the petro, in 2018.

However, Petro is afflicted by numerous problems, and there are very few Venezuelans who use it. Besides Venezuela, the Chinese government is probably the most advanced in creating a CBDC.

The Federal Reserve Bank of Boston is in collaboration with the highly regarded Massachusetts Institute of Technology (MIT) on a digital dollar experiment.

The European Central Bank (ECB) has also been researching the possibility of introducing a digital euro.

The development of this new type of currency is still in its infancy, so it’s hard to predict how CBDCs will be used in the future.

However, some believe that CBDCs could eventually replace cash and become the primary form of currency in a country.

The Goal of Central Bank Digital Currencies

Numerous people living in the US and other countries lack access to financial services. In the United States, 5% of adults do not have a bank account. Another 13% of US adults have bank accounts but use more expensive alternatives like money orders, payday loans, and check cashing services.

As a result, CBDCs aim to provide businesses and consumers transferability, privacy, accessibility, convenience, and financial security. Additionally, CBDCs could decrease maintenance costs, reduce cross-border transaction costs, and provide lower-cost alternatives to those using alternative money transfer methods.

Moreover, the CBDC provides a country’s central bank with tools to implement monetary policies to keep the economy stable, control growth, and keep inflation under control.

Cryptocurrencies’ value constantly fluctuates, making them highly volatile assets. This volatility may cause severe financial stress in many households and negatively affect the economy.

CBDCs could help to reduce this volatility by providing a more stable alternative. For instance, government-backed and central bank-controlled CDCs would provide households, businesses, and consumers with stable methods for exchanging digital currency.

The Common CBDC Features

CBDCs are still in their early stages, so it’s unclear what more features they’ll eventually have – assuming they’re ever rolled out.

A CBDC is a cross between Bitcoin and a government-issued currency. The resulting CBDC creature incorporates characteristics from each, and specific features may include the following:

Distributed Ledger Technology

The world we live in is exceedingly digital, and our money is digital for the most part. Using our smartphones, we can peek at our balances or use our credit cards to make a payment. So, how is CBDC different?

The CBSC is digital, but its technological makeup is different. The idea is to reengineer money from scratch, with many borrowing from Bitcoin’s underlying technology with distributed ledger technology (DLT).

A bank’s ledger stores financial records to track records, such as how much money a person has and what transactions they’ve made. As opposed to a single database that holds all the financial records of an individual, the distributed ledger technology consists of multiple copies of these transactions, each managed and stored by a separate financial institution, usually by the country’s central bank.

We call this a permissioned blockchain because only a few select entities can access or alter it. Additionally, central entities control who has access to the blockchain and what they can do with it.

In contrast, a permissionless blockchain, such as Bitcoin, allows anyone to run the software and participate in sending transactions on the network.

Lower Costs

With a CBDC, there would theoretically be no or meager transaction costs. Advocates claim that they could reduce the cost of transferring money due to the structured hood of CBDC. The idea is that with a CBDC, all financial entities are more connected, ensuring a smoother flow of funds.

For context, the current system often involves an intermediary – think PayPal or a bank – to process transactions. With a CBDC in place, users would no longer require this middleman, as the CBDC would act as the intermediary. This could theoretically reduce or remove transaction fees.

Faster Transactions

Another potential benefit of a CBDC is that it would enable faster transactions. When you make a bank transfer in our current system, the receiving bank must wait for the funds to clear. With a CBDC, this wouldn’t be an issue because the settlement would happen in real-time.

This is because a CBDC is built on a blockchain, which would allow for the near-instantaneous processing of transactions.

Tracking Payments

DLTs provide a complete record of all transactions. Those governments known for their extensive surveillance apparatus may want to use this information to keep close tabs on their citizens.

It could have both positive and negative applications. How? It would allow the government to track down and prevent crime. On the other hand, the government could use it to infringe on the privacy of individuals.

Different governments have different policies in this regard. The Federal Reserve, for example, seems more interested in protecting the privacy of US citizens if it adopts a CBDC.

Centralized Control

Perhaps the most controversial aspect of a CBDC is under centralized control. But, there is a reason CBDCs use this permissioned blockchain. Many governments choose DLT technology because it allows them to maintain control over certain aspects, such as:

  • The Supply– Bitcoin has a built-in limit of 21 million bitcoins, which is extremely difficult, if not impossible, to change. On the other hand, governments each have a central bank in charge of the country’s money supply. These powerful banks decide when to remove or add money to the supply, such as stimulating the economy in difficult times, and setting national interest rates.
  • Who’s in Charge– It will be up to a central entity to decide which financial institutions participate in the distributed ledger. In other words, the government will be in charge of who can and cannot access the network.
  • What Transactions are Allowed– Governments maintain control by deciding which transactions are valid and invalid. For example, most governments banned cryptocurrency for certain activities, such as financing terrorist activities.

In short, a CBDC gives the government more power, not less. They can control the money supply and track financial activity more than with fiat currency.

This centralized control is one of the main reasons some people are against CBDCs. They argue that it takes away the freedom of decentralized cryptocurrencies, such as Bitcoin.

The Future of CBDCs

The finance world is in a new chapter of the history of money. And most countries seek to preserve key aspects of their old monetary and financial systems while experimenting with new digital forms of money.

For those experiments to succeed, policymakers must grapple with many open questions, technical obstacles, and tradeoffs.

Despite the challenges, over 100 countries are actively researching and testing CBDCs. For instance, more than a year has been since the Bahamas issued its currency, the Sand Dollar, known as the local CBDC.

China is leading the way among the biggest economies in trialing Central Bank Digital Currency (CBDC). There are more than a hundred million individual users and billions of transactions in China’s digital renminbi [called e-CNY].

The US is also looking into CBDC. In February, the Federal Reserve released a report stating that a CBDC could fundamentally alter the US financial system.

All eyes are now on Jamaica since it’s set to roll out its national digital currency in the coming months. This is after pilot-testing the project in 2021, issuing 230 million Jamaican dollars (US$1.5 million) of digital money.

The list goes on. It is clear that central banks are taking the idea of a CBDC seriously and are actively researching and testing them.