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What are Central Bank Digital Currencies? Can CBDCs Displace Cryptocurrencies?

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With each year, an increasing number of countries are discussing creating digital currencies for their central banks to issue. CBDCs represent the value of a state's funds, and examples include the digital yuan in China.

In practice, a central bank digital currency serves as a virtual means of payment that is issued and controlled by the state, which guarantees the stability of the currency's exchange rate based on its cash and non-cash components and regulates the circulation of the currency. 

In this article, we talk about CBDCs and whether they threaten the survival of cryptocurrencies, especially stablecoins like USDT and USDC.

Key Facts

  • A central bank digital currency (CBDC) is a country's fiat currency in digital form.
  • A CBDC is issued by a country's monetary authority, or central bank, to promote financial inclusion and make monetary and fiscal policy implementation easier.
  • Countries worldwide are examining how Central Bank Digital Currencies (CBDCs) may affect their economies, financial systems, and overall stability.

What is a CBDC?

A Central Bank Digital Currency (CBDC) is a digital form of a country's national currency issued and regulated by its central bank. Unlike traditional physical currencies, CBDC exists in electronic or digital form, and its transactions are typically recorded on a blockchain or centralized ledger.

CBDCs are considered legal tender backed by the issuing government's full faith and credit.

These digital currencies enhance financial transactions' efficiency, security, and traceability while allowing the central bank to retain control over the money supply and monetary policy.

Central Bank Digital Currencies (CBDCs): An Overview

The rapid development and popularization of crypto presents a genuine challenge to the stability of financial systems in all countries. The crypto market is seeing greater involvement, particularly from large corporations and institutions. The circulation of cryptocurrency is growing, as is its functionality.

 From the perspective of the traditional economy, the crypto market is an opaque grey area that behaves like a shadow economy. As a result, crypto poses a clear challenge to states' monopoly on the issuance of money.

Because of this, CBDCs are a perfectly logical response to the crypto market. They are an attempt to lure cryptocurrency out of the shadows, not through outright bans but by competing with it. 

Governments are attempting to offer financial participants currencies that are somewhat similar to cryptocurrencies in the hopes that they will eventually win a significant share of the crypto market or even displace cryptocurrencies.

What problems do CBDCs solve?

Besides overthrowing the unregulated crypto market, CBDCs aim to solve the problem of financial exclusion. For example, people in the United States and many other countries don't have easy access to financial services. Central Bank Digital Currencies (CBDCs) aim to address various challenges and bring about potential solutions, including:

  1. Payment efficiency: CBDCs can enhance the speed and efficiency of transactions, enabling faster and more seamless payment systems than traditional methods.
     
  2. Financial inclusion: By providing a digital form of central bank-backed currency, CBDCs have the potential to promote financial inclusion, allowing individuals without access to traditional banking services to participate in the digital economy.
     
  3. Reduced transaction costs: CBDCs could lead to lower transaction costs for individuals and businesses, especially in cross-border transactions, potentially fostering international trade.
     
  4. Monetary policy implementation: CBDCs offer central banks new tools for implementing monetary policy, providing more direct control over the money supply and facilitating the management of interest rates.
     
  5. Mitigation of counterfeiting: The digital nature of CBDCs can reduce the risk of counterfeiting, enhancing the currency's security.
     
  6. Financial stability: CBDCs may contribute to greater stability in the financial system by providing a secure and reliable form of digital currency that is not subject to the same volatility as some cryptocurrencies.
     
  7. Control over the money supply: CBDCs allow central banks to have direct control over the issuance and circulation of money, enabling more effective management of the money supply.
     
  8. Competition with cryptocurrencies: CBDCs offer a government-backed alternative to private cryptocurrencies, potentially reducing the risks associated with unregulated stablecoins.

The implementation of CBDCs involves careful consideration of various economic, technological, and regulatory factors, and the impact may vary depending on each country's specific design and policies.

What's the difference between CBDCs and cryptocurrencies? 

The main thing you need to understand about CBDCs is that they fall entirely within the scope of the traditional financial system. The concept of central bank digital currencies is technologically close to crypto but far from it in spirit. CBDCs are, first and foremost, ordinary fiat money – dollars, euros, yuan, or yen. They are issued by the central banks of various states, only digitally instead of paper.

  • Central bank digital currencies may or may not run on the blockchain, while cryptocurrencies are always on the blockchain.
     
  • CBDCs are not decentralized, as they are issued and fully controlled by central banks, while financial regulators do not have a direct influence on cryptocurrencies.
     
  • A consensus mechanism is used to validate cryptocurrency transactions, while the blockchain is not required for CBDCs to function because central banks will validate the transactions.
     
  • CBDCs are not anonymous, while crypto can be viewed as a conditionally confidential means of payment, especially for anonymous coins like Monero and Zcash.
     
  • A CBDC represents the money of the state, which can ensure that it is recognized and accepted within its jurisdiction. On the other hand, cryptocurrencies are the "thorn in the side" of governments, which are trying to suppress them.

Types of CBDCs

Central Bank Digital Currencies (CBDCs) can be categorized into different types based on their characteristics and operational features. The two main types are wholesale and retail CBDCs

Retail CBDCs

A retail CBDC is designed for the general public and is accessible to individuals and businesses. It can be used for everyday transactions, similar to physical cash or digital payment methods. Retail CBDCs are issued and distributed directly by the central bank to the public. They are widely available to the general population, promoting financial inclusion.

Wholesale CBDCs

A wholesale CBDC is intended for financial institutions, central banks, and large-scale transactions. It's primarily used for interbank transactions, settlements, and financial market operations. Distribution of wholesale CBDCs is restricted to authorized financial institutions and entities participating in the central bank's wholesale CBDC system. This type of CBDC emphasizes efficiency and security in large-scale financial transactions.

Beyond these primary distinctions, there are additional variations and features that CBDCs exhibit:

Token-based CBDCs are represented as digital tokens on a blockchain or distributed ledger. Token-based CBDCs can be transferred directly between users, enhancing peer-to-peer transactions.

Account-based CBDCs are held in digital accounts, similar to traditional bank accounts, are account-based CBDCs. This type of CBDC transfer is conducted through the central bank's ledger, ensuring regulatory oversight.

Cross-border CBDCs are designed to facilitate cross-border transactions and settlements, potentially reducing the need for intermediaries.

These types are not mutually exclusive, and central banks may choose to implement CBDCs with a combination of features based on their specific goals and the needs of their economies.

Countries that use CBDCs

CBDCs are a new concept and are not yet fully formed. There is no established methodology for creating and implementing CBDCs, and each government is developing its technology independently. Many countries are already at various stages of implementing CBDCs. According to the Atlantic Council's Central Bank Digital Currency Tracker, two-thirds of countries are working to create and enforce CBDCs.
Citizens can use CBDCs in China, the Bahamas, Nigeria, and the Eastern Caribbean Currency Union. In many countries, digital currencies are being piloted or at the stage of research and development.

Different governments are seeing different levels of success and encountering a range of issues associated with introducing these currencies.

A CBDC was introduced in the Caribbean several years ago but is used by a tiny percentage of the population. There were no significant issues in creating a legislative framework for the currency, but infrastructure problems emerged. Smartphones, QR codes, virtual cards, and established business processes are just some things needed for CBDCs to function, and all of these things are underdeveloped in the region.

The e-Naira

The problem in Nigeria is different. The financial infrastructure is in place to support the effective use of CBDCs, but the country's inflation rate is high. It is easier and more profitable for Nigerian citizens to transfer local money into cryptocurrency so that it does not depreciate.

The digital yuan (e-CNY)

The rollout of China's CBDC has been a resounding success. Over 250 million residents are already using the digital yuan (e-CNY), with transaction volumes reaching USD 14 billion by the end of summer 2022. China is now working to facilitate trade with other countries using e-CNY.

The digital dollar

Several CBDC projects are underway in the USA, with three being supervised by the Massachusetts Institute of Technology.

The USA has been in no particular rush to introduce the digital dollar. In December 2022, the US Department of the Treasury said there was no need to expedite the launch of a CBDC and that there was no need to introduce a digital dollar. The financial ministry believes that US regulators need to carefully study whether the CBDC will make online interbank payments faster and cheaper.

On March 22, 2023, the Office of Financial Research (OFR) issued a new report on the prospects of CBDC integration. According to the report, the introduction of the digital dollar will lead to a decrease in the number of bank deposits made, which may, in turn, bring small banks to the brink of liquidation.

In Europe, EU members are also proposing several initiatives in this area, though no consensus has been reached and no projects have been launched.

Australia, Japan, Georgia, and Ukraine have announced that they will pilot CBDCs in 2023.

The digital ruble

The Central Bank of the Russian Federation also piloted the digital ruble on April 1, 2023. The first stage will involve testing transactions between individuals – technically ready banking customers – and payments in the retail and service sectors. Next, the Central Bank will further scale transactions using the digital ruble. The regulator also makes provisions for operating a gold-backed digital token in international transactions. 

How to use CBDCs

The basic idea of how people will use CBDCs is more or less the same worldwide. We'll look at the digital yuan (e-CNY) as an example of how to use a CBDC.

To make a transaction using e-CNY, you must first create an online wallet. This can be done by downloading an iOS or Android app from Chinese app stores.

The app is the primary means users can access the digital yuan. The app is operated by Chinese banks that have been permitted to provide online wallet services and facilitate the public exchange of the digital yuan.

Users can set up several online wallets within the app and do the following:

  • Set daily spending limits;
  • Assign apps and services that can be paid for with e-CNY;
  • Link their bank cards to their wallets.

In addition to paying for goods and services online, users can transfer small amounts directly to each other and exchange the digital yuan even without an internet connection – the application supports NFC technology.

How will the rollout of CBDCs affect crypto?

Will CBDCs displace cryptocurrencies? Most experts don't think so. CBDCs and cryptocurrencies solve different problems, represent various forms of value, and operate in different spaces.

A CBDC is a centralized, private form of digital money with a complete lack of anonymity. Cryptocurrency is a decentralized, transparent, and anonymous means of payment.

CBDCs, like any other fiat money, are also subject to inflation. This differs from crypto, known for its halvings, token burns, and impartial smart contracts. In countries with high inflation rates, people should keep their savings in cryptocurrency and store them in a secure self-custodial cold wallet like the Tangem Wallet

Conclusion: What do CBDCs mean to crypto users?

CBDCs are nowhere near being a competitor to cryptocurrencies. Crypto exists in a parallel reality where individuals make most decisions, not the central bank, government, or state institutions.

It would be more appropriate to compare CBDCs with cash. Central bank digital currencies offer several advantages over this form of fiat.

One of the advantages for users is the ability to make transactions directly without the participation of third-party payment systems, which makes them faster and cheaper. Furthermore, non-cash money is always tied to a bank, which may decide not to issue it in unfavorable circumstances. 
 

CBDCs, on the other hand, are not dependent on banks and cannot be moved. In this sense, they can be compared to crypto or cash in your pocket.

For governments, CBDCs represent an opportunity to automate many economic processes, which require considerable bureaucracy. This includes tax payments and pension fund contributions. Unlike cash, governments also have total control over CBDC transactions, simplifying the implementation of monetary policy.

Additionally, cross-border payments using CBDCs are a faster and cheaper alternative to existing systems.

It's also worth remembering that digital currencies are 100% virtual, meaning governments don't need to purchase paper to issue the money or spend money on printing, transportation, storage, and disposal, which all present significant costs for state treasuries.

A great deal of discussion is taking place worldwide about the advantages and disadvantages of CBDCs and whether they are needed, along with many other issues. Only time will tell what happens.