CBDCs and Cryptocurrencies: When Worlds Collide
Bitcoin and stablecoins have fixed cross-border settlements. So how do central bank digital currencies fit in?
We are entering the age of digital money. Much like commodity or representative money in the past, digital money is emerging in response to changes in society and technology.
This is what Fabio Panetta, Member of the Executive Board of the European Central Bank (ECB), said in an official announcement on July 14th.
Now that central banks are pushing ahead with central bank digital currencies (CBDCs), are the days of cryptocurrencies numbered? Can Bitcoin and CBDCs co-exist? And what does all that mean for security tokens?
The Rise of CBDCs
Central bankers tend to be a conservative bunch. But even they are now starting to take Bitcoin seriously. While a blockchain-based CBDC may be a bridge too far, central bankers have been inspired by other aspects of Bitcoin. For example: its popularity, which also has them feeling a little uncertain. Let’s see what they’ve been up to.
A 2021 Bank of International Settlements (BIS) survey found that 86 percent of central banks are now researching the potential of CBDCs, 60 percent are already experimenting with one, and 14 percent have launched pilot projects.
Among those developments:
The Bahamas launched the first-ever nationwide CBDC in October 2020 after completing a pilot project in 2019.
The ECB started the investigation phase for its digital euro project on July 14th; the next 24 months will be used to address key issues related to its CBDC’s design and distribution.
The Bank of England issued a discussion paper on CBDCs in March 2020 and on April 19th this year announced a task force to explore the potential for a UK CBDC. It also released a discussion paper on digital currencies in June.
The central bank of the Netherlands issued a discussion paper on a digital euro in April 2020 and has indicated its willingness to develop a CBDC for the EU. The ECB published the results of a public consultation on a digital euro on April 14th this year.
In December 2020, the BIS, Swiss National Bank, and Swiss financial infrastructure provider SIX released the results of a successful experiment showing the settlement of wholesale payments with a tokenized CBDC.
France has been conducting several similar settlement experiments with BNP Paribas and Euroclear.
China, which has banned the use of cryptocurrencies, is already trialing the use of its CBDC (the e-CNY) for applications such as subway tickets.
Jamaica will begin a pilot roll-out of its CBDC in August.
The National Bank of Ukraine has built a prototype on the Stellar blockchain, and the Ukrainian parliament recently passed a law to give a CBDC the same status as legal tender.
In June, Russia announced a pilot project for the digital ruble with 12 banks.
Japan has also begun experimenting with the idea of a digital Yen.
What Is a CBDC?
But what exactly is a CBDC? A central bank digital currency, or CBDC for short, is a new electronic form of money that is issued and regulated by a country’s central bank. It differs from commercial bank deposits in that it is backed by the central bank.
But unlike existing central bank money used by banks for settlement in payment and settlement systems, it’s available to be used by everyone and for all types of transactions.
The success of Bitcoin and its use of a blockchain to settle transactions has helped spark interest in CBDCs, which is why many often compare the two. However, many, if not most CBDCs are most likely not going to be issued on a blockchain — they therefore have pretty much nothing in common with Bitcoin or other cryptocurrencies.
What Are the Benefits of CBDCs?
Like cryptocurrencies and bank deposits, CBDCs facilitate electronic transactions and thereby fit well into our increasingly digital economy. Possibly one of the main benefits of a CBDC may be the potential to make cross-border payments a lot faster — and a lot cheaper. If you’ve ever made an overseas wire transfer, you’re well aware of the high fees and outrageous wait times involved. This is the case as your money goes through multiple banks on the way to its destination. Depending on their design, CBDCs could skip many of those middlemen. Previously, central banks have shown limited interest in tackling cross-border payment issues. It will be interesting to watch if they change their strategy now that the world is more connected than ever.
Notably, stablecoins like USD Tether (USDt) already fulfill many of the same use cases as CBDCs seek to. The difference? The regulatory status. Stablecoins are usually not issued by public bodies, whereas CBDCs will be issued by central banks themselves.
CBDCs may also enable faster settlement of the cash leg of security transactions like stocks and bonds. But not as fast as a cryptocurrencies or stablecoins, which offer the promise of near-instant (“atomic”) settlement when paired with a crypto exchange on the same blockchain.
Depending on the technology used, they could also be programmable and carry a record of ownership and payment information. This traceability is a boon to policymakers, economists, and taxation departments. Imagine a world in which governments could target stimulus to specific groups in society and then track exactly how each dollar is spent — it’s a treasury official’s fantasy!
How Do CBDCs Differ From Cryptocurrencies?
CBDCs don’t meet the basic characteristics of a cryptocurrency.
Cryptocurrencies like Bitcoin or Ether are tokens recorded on distributed and decentralized ledgers (blockchains). Issuance (or mining) is also decentralized and independent.
CBDCs are centralized by design: they are issued and regulated by a central bank. Central banks will either maintain a central ledger or structure their distribution over a limited number of authorized service providers — therefore CBDCs won’t in any way approximate the decentralized and distributed nature of cryptocurrencies.
Bitcoin has a fixed supply, making it a perfect alternative instrument and inflation hedge. Meanwhile, CBDCs are simply another representation of today’s fiat money. The rails it moves on may change, but the policy mandate and economic conditions stay the same.
CBDCs will be guaranteed by their respective central bank, meaning they. can be exchanged for cash (at least as long as cash is still around). Cryptocurrencies aren’t backed by a central bank; they’re backed by their decentralized network.
Can CBDCs and Cryptocurrencies Coexist?
For its early proponents and true believers, Bitcoin is the key to a new financial system. A decentralized system that empowers private individuals to transact and move their money without the influence of the established banking system and governments.
These true believers would see CBDCs as the antithesis of the original intent of Bitcoin. It is the government and status quo taking control again.
With that in mind, does the rise of CBDCs spell the demise of cryptocurrencies? The answer to this can be found if we consider two questions. First, is there still a use case for cryptocurrencies after the introduction of CBDCs? And second, is the backing of central banks a game-changer in terms of the relative reputation of cryptocurrencies?
Bitcoin can be used in most of the same ways as current electronic money, as is demonstrated by El Salvador making it legal tender. But its main uses are as a store of value (or speculation), instant transfers, and its ability for pseudo-anonymous cross-border transactions.
Gold has long been a traditional store of value particularly during times of economic uncertainty and high inflation. High net-worth Individuals and even investment banks are now turning to Bitcoin for the same reason.
Critics of Bitcoin as a store of value argue that it is too volatile to be a good store of value. Instead, they argue that investors are being lured by the promise of future prodigious returns. Most investors would likely admit that they are having a two-way bet on inflation and the future rise of Bitcoin.
CBDCs are unlikely to eat into this crypto niche. After all, most CBDCs will just be fiat money in another form. No one switches their stock investments or cash into bank deposits because they think the electronic form of money is somehow a better store of value or a better inflation hedge.
Another current advantage of Bitcoin and a couple other cryptocurrencies is their instant transferability. Domestic payment systems have been fighting hard to go near-instant, and cross-border payment systems still have too many cooks in the kitchen, meaning there’s too many steps — and too many fees. One of the reasons El Salvador adopted Bitcoin, and why Bitcoin is popular across the developing world, is because of its clear advantages in remittance payments. When you are sending vital money back home, you want it to be quick and not eaten up by fees.
As for clandestine transactions, cryptocurrencies will retain their use case here. CBDCs will be transparent and traceable by design, even more so than traditional money. This is one of their main attractions for governments and central banks.
Governments will try to crack down on crypto transactions related to crime, as the recovery of $2.3 million worth of bitcoins in the recent Colonial pipeline ransomware attack demonstrates. But they will struggle to control cryptos completely where they are fully decentralized, can be held in non-custodial wallets, and can be exchanged peer-to-peer.
As for CBDCs being backed by central banks, this may initially provide CBDCs with greater legitimacy in the public eye than cryptocurrencies; yet many would argue that cryptocurrencies with a limited supply are more legitimate than any CBDC whose supply is controlled by its central bank and can be easily manipulated by a government.
Final Thoughts
CBDCs will have a major impact on society. They will streamline cross-border and ecommerce payments and likely cut costs in many parts of our financial lives. They will also give governments a sharper tool for monetary and fiscal policies. But the decentralized nature of certain cryptocurrencies, paired with their limited supply (in most cases), will ensure a growing role going into the future.
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