What is CBDC?

CBDC stands for Central Bank Digital Currency, and represents the digital form of a nation’s fiat money (currency backed by trust or faith in the regulating government). As such, it is controlled directly by the country’s central bank, and is backed by national credit and government power. 

Despite being influenced by decentralized cryptocurrencies like Bitcoin, CBDC is more of a reaction to than an embrace of cryptocurrency, which central banks see more as a threat to be managed.

With the immense popularity of Bitcoin and the announcement of the launch of Facebook’s Libra last year, governments are beginning to realize the importance of protecting against these threats to the existing banking and finance industry.

One of the major recent motivations for the creation of CBDC was, as mentioned, the planned development of the Facebook-backed currency and blockchain, Libra, which would essentially position Facebook, a private company with 2 billion users, to wield enough power to challenge the central bank.

The government has long been wary of cryptocurrencies since Bitcoin’s inception due to its ability to circumvent capital controls, and the possibility of its being used for illicit purposes like money laundering. Central banks are also worried that cryptocurrencies could undermine the authority and control of central banks, as there is currently no government-controlled reserve of currencies like bitcoin, and they would have difficulty regulating such anonymous and decentralized systems.

To maintain control over the production and supply of money, and to prepare in advance for the seemingly inevitable cashless society, countries are now launching experiments to test the workings of CBDC.

Although governments and banks may be wary of currencies like Bitcoin, they are very interested in the underlying blockchain technology, which can increase financial security and government oversight of the economy, and reduce criminal activities like money laundering, tax evasion, and the production of counterfeit money.

Wholesale and Retail CBDC

CBDC has two “types”: wholesale and retail, which have different purposes.

Wholesale CBDC can be exchanged between private banks and the central bank to streamline payments between such financial institutions, as well as cross-border transactions, and to reduce liquidity risks. It essentially replaces banks’ reserve deposits (held in the central bank) with digital tokens, circumventing the traditional credit and debit system. Governments are hopeful that wholesale CBDC will make the current system cheaper, faster, and safer.

Retail CBDC is the digital money that average people would use to conduct transactions in day-to-day life. Retail CBDC could render cash obsolete, and would greatly increase the efficiency of payments between accounts without requiring a third party (as trust is guaranteed). It would also be totally traceable, thereby mitigating various criminal activities.

The Underlying Technology

Several countries, including the UK, Sweden, China, Venezuela, and Cambodia are already launching proof of concept experiments to test the design and implementation of CBDC, which may or may not include blockchain technology.

One of the key distinctions between a CBDC system and a decentralized cryptocurrency blockchain is the fact that it is centralized. Therefore, it is likely that the ledger of transactions (whether it is distributed among nodes or not) will be centralized and regulated in some degree by the government.

A record of all transactions by every entity will likely be kept on the centralized database, utilizing cryptographic technology for security and privacy.

The Impact

CBDC will cause significant impacts to existing monetary policies, and will fundamentally change the way governments, banks, businesses, and people use money. However, there are positives and negatives to this system.

Some of the positives include:

1)   Greater technological efficiency allowing for real-time money transfers and payments without requiring any intermediary.

2)   Broader financial inclusion. Central banks can open low-cost accounts under the name of every legal citizen.

3)   Helps prevent criminal activity such as money laundering, tax evasion or avoidance, and other activities by tracking and observing the flow of money.

4)   Eliminates the need to print and handle physical money.

5)   Optimizes monetary policy, and allows for greater stability and management of national interest rates. CBDC may also eliminate the fractional banking system.

There are some negative points as well (depending on where you stand), mostly relating to the impact CBDC would have on the traditional banking industry. There is some fear that it would lead to bank runs, and would reduce funding for commercial banks. This has led to a lot of ambivalence within the private banking industry where large banks currently control a monopoly.

By allowing people to open bank accounts directly with the central bank or with smaller competitors offering their own unique advantages, CBDC puts pressure on the banking giants. To adapt to this competition, the large banks would therefore have to offer greater incentives, such as remuneration packages, rewards, or higher interest rates on deposits.

Conclusion

CBDC would lead to some big changes in the way money is stored, allocated, and spent, and would shake up the financial industry and the functioning of governments.

While it (in theory) has some promising features, those who are concerned about centralization, especially libertarian proponents of decentralized currencies in the cryptocurrency space, should be wary of a central authority having so much power.