Last updated on November 17th, 2022 at 12:50 pm
A Central Bank Digital Currency (CBDC) is the digital form of a fiat currency. It is released by a government to represent the digital token of their official currency. This type of virtual token is different from cryptocurrencies, as they are issued by the government, regulated by it, and may not be as transparent. Privacy may also not be possible with CBDCs, as has been seen with Nigeria’s e-Naira, where potential users are requested to provide their bank identification number.
As a government-issued token, residents of a country would trust it because they are issued by the authorities, just like cash. Different governments may use CBDCs as a way of influencing their economic policy. Several countries are working on their CBDCs and only a few have released a functioning prototype.
CBDCs may be retail or wholesale variants. For the retail CBDCs, it allows the central bank to transfer the currency directly to the citizens, without the need to use commercial banks as intermediaries.
Wholesale CBDCs are based on the usual interbank transaction channels of commercial banks. It would involve the transfer of digital currency between multiple banks.
Do CBDCs Have Implications For The Crypto Industry?
Depending on the country in question, some governments are creating their CBDCs as a way of diverting the attention of their citizens from the unregulated and private crypto market to the regulated version of digital token, CBDCs. For example, in Nigeria (one of the first countries in the world to issue a CBDC), its Central Bank banned commercial banks from allowing payments to crypto platforms. This was several months before the e-Naira, Nigeria’s CBDC was launched.
Some countries are trying to replace crypto with CBDC because of the anonymity that the former offers its users. Claims of cryptocurrencies being used to launder money, finance terrorism, and carry out other illegal activities have fueled the discourse of swapping crypto for a regulated government-issued token.
Using Nigerian e-Naira as an example, the release did not reduce the crypto trading volume of citizens. As of the time of writing this, hundreds of thousands of people had downloaded the e-Naira wallet from Google PlayStore, but there were complaints from people about the app’s functionality, especially the difficulty in signing up.
To further buttress the possible implications that this government-issued virtual token may have on its citizens, it is crucial to examine the advantages and disadvantages.
Advantages
- Government policy implementation
As their physical fiat currency counterparts, CBDC is a tool that can be used by the government to implement monetary policy. In the case of inflation, the regulatory authorities tend to reduce the money supply, and vice versa. As the digital version of the fiat currency, the government can use CBDCs to control inflation, deflation, and other economic scenarios.
- Curbing illegal activities
Several articles and reports have been published about the potentiality of using cryptocurrencies for illegal activities because of their anonymity feature (i.e. pose similar risks to cash). CBDC can be used as a tool by the government that allows them to track the financial activities of their citizens.
- Government distribution of benefit
In a typical CBDC wallet, a potential user is expected to input their national identification number and verify their identity. This allows the government to know the identities of those transacting with the currency. In a similar light, authorities can seamlessly distribute benefits and collect taxes from their citizens.
- A bridge between the Central Bank and the populace
CBDCs allow the central bank of a country to create a relationship with its citizens. It reduces the cost of infrastructure necessary to offer financial services to the unbanked.
Disadvantages
- Lack of privacy
Privacy is non-existent in digital fiat currencies, as the government requests that users must verify their identity. Every transaction done is linked not only to an address but to identity. In the crypto market, there are private coins and non-KYC-focused exchanges that allow people to enjoy financial transactions in anonymity, but this will not be available in CBDCs.
In addition, cash allows anonymity whereas CBDCs do not, despite both being issued by a central bank. There are real concerns about the possibility for governments to monitor transactions by citizens and to be able to cut people off from their own money in a manner that would be difficult with cash. The potential for governments to abuse their power, and act oppressively to their citizens, this respect cannot be overemphasized.
- Centralization
In the design of a cryptocurrency or decentralized finance platform, a key feature that is integrated is decentralization. This element is crucial to the extent that it is part of the blockchain trilemma. People crave a payment ecosystem that is not controlled by a centralized organization and that is one of the numerous reasons cryptocurrencies are favoured by their users. CBDCs, on the other hand, are issued by a centralized body, regulated by it, and monitored by it. The government can decide what happens and has the power to freeze any address with the funds in it based on its discretion. Aside from abuse of power, another key risk from centralization is the single ‘point of failure’ problem. A central authority is an obvious target for hackers, fraudsters, and other criminals.
- Uncertainty
As a new development, there is uncertainty surrounding its implementation, usage, and benefits. The government’s role in managing this type of currency is also uncertain, as well as the regulatory needs.
With CBDCs still in their infancy globally, it may be difficult to state if people will migrate from cryptos to digital fiat currencies. The core reason people became interested in cryptocurrency was because it was decentralized and free from the control of the government. CBDCs do not have this key element, which means that they have a lot to offer before a successful competition can occur with cryptocurrencies. It is also not clear if CBDCs will be capable of programmability and other innovative features of crypto.
Do CBDCs require blockchain technology?
CBDCs are different from cryptocurrencies, hence, it is not compulsory that they need to be built on blockchain technology. This type of digital currency can be developed on other forms of databases. And even if a CBDC uses blockchain technology, it will very likely be private and permissioned which again marks a departure from the popular cryptocurrencies which are public, open, and permissionless.
As a centrally-controlled ecosystem, a blockchain is not necessary to develop a CBDC, as there are several centralized database options available.
What might CBDCs mean for Stablecoins?
Stablecoins are similar to CBDCs except that the former is not issued by the government and does not enjoy the direct backing of the authorities. Both are dependent on the value of a physical fiat currency. For instance, USDT, TUSD, USDC, and BUSD are popular stablecoins that derive their value from the USD. They are pegged against the USD at a ratio of 1:1.
It is too early to adequately predict the implications of CBDCs for stablecoins but stablecoins are likely to be more innovative than CBDCs by offering the programmable features of cryptocurrencies whilst enjoying the relative stability of fiat currency valuations. Stablecoins can be used for cross-border payment, and it is possible that some CBDCs may not offer this feature. Whilst USDC is centrally controlled by Circle, some newer stablecoins like TUSD (from Terra) are decentralized, meaning that there is no centralized authority to decide what happens or to freeze accounts. On the other hand, CBDCs are controlled by the government, and user accounts can be frozen at will.
With the uncertainties still present in the development of government-issued tokens, it is quite early to forecast the effects they may have on stablecoins.
Will CBDCs Lead to a Ban on Cryptocurrencies?
Some countries appear to be motivated to build their CBDCs as a way of replacing cryptocurrencies in their country, while others are creating them to work alongside their unregulated counterparts.
China, for example, has banned the usage of crypto and penalized those that flouted the order. In June 2021, the authorities arrested over one thousand people involved in the activity. According to US News, “Police in China arrested over 1,100 people suspected of using cryptocurrencies to launder illegal proceeds from telephone and Internet scams in a recent crackdown.”
Its CBDC, which will be the virtual version of the yuan, is being developed by the authorities to replace cryptocurrency.
Countries like Nigeria have taken a softer approach in driving the adoption of its CBDC. In its case, the authorities banned commercial banks from allowing their clients to utilize banking channels to purchase or sell cryptocurrencies. This means that exchanges are banned from paying funds to the bank accounts of their clients. People are no longer allowed to purchase crypto with their bank cards on exchanges, forcing them to use peer-to-peer trading options.
The third category includes countries that may have no intention of banning cryptocurrencies in any way to replace them with CBDCs. Such countries may regulate the usage of cryptocurrencies while promoting their own CBDCs. An example of a country that may fall under this category is the United States. Though the authorities are still debating the merits of developing a CBDC, they are currently regulating the crypto market through different strategies, especially taxation. Note that the U.S. central bank, the Federal Reserve, recently published a discussion paper that examines the pros and cons of a potential U.S. CBDC.
In Conclusion,
- CBDCs are issued, regulated, and owned by the government.
- They are pegged to the fiat currency.
- CBDCs remove the privacy element of a digital currency.
- Some countries want CBDCs to replace cryptocurrencies.
- CBDCs need not be built on a blockchain.
- There is uncertainty surrounding the effects of CBDCs on payment solutions, especially since only a few countries have released a CBDC so far.
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