CBDC’s — What they are & How They Work

https://www.youtube.com/watch?v=xYBXSTHik5g

Central Bank Digital Currencies are coming. As decentralized digital currencies like bitcoin have become more popular the world’s central banks are beginning to realize they need to get in the game or let the evolution of money pass them by. Backed by a government’s central bank, which means they hold the liability, not your private bank. CBDC’s are set to change the way in which monetary policy is set, and enforced. I discuss how they work, and how they might effect our future.

A CBDC you say? What is that?

Thats a great place to start!

A Central Bank Digital Currency or CBDC is a countries fiat currency, but in digital form. So, what this means is that instead of a countries central bank printing new physical money, the central bank would instead issue electronic coins.

Importantly, CBDCs are the liability of the countries central bank. This is an important fact to remember, because it means that the government of that country must maintain reserves and deposits to back it up.

So — its a crypto currency?

Yes, it is a crypto, in the fact that there would not be a physical version of the currency, however it also is different to most other crypto’s as we know them today. This is because CBDCs are not decentralised. This means that although there are already thousands of crypto’s, most of these, such as bitcoin, are decentralised. CBDCs by contrast are not decentralised and are instead run via a central hub.

Why do governments want their own crypto currencies?

Well, there may be a number of reasons why a country would want its own virtual or crypto currency.

Firstly, the expense of managing and transferring physical fiat cash is high, and by making it virtual, these related costs can be reduced.

Secondly is financial inclusion. This means that those people who do not currently bank are able to get easier and safer access to money, for example on their phones or mobile devices.

Thirdly is fluidity. Having a crypto currency allows governments to react more quickly in its own monetary policy in a way that would not be possible with physical currency.

We assess however, that the main motivations for a country to pursue a CBDC is the potential to improve both the speed and cost efficiency of money payments and transfers. A CBDC can also potentially help to overcome the limitations of existing systems, especially in system security and resilience.

Ok — so what’s the downside? Are there risks?

According to analysts, one of the key risks is the worry that a CBDC would facilitate bank runs, or large numbers of customers withdrawing their money in an emergency whenever that are concerned about the future of a financial institution.This could potentially cause great shocks in a countries financial stability.

So is this likely to happen? Are CBDCs going to be a reality?

Perhaps, although this new type of crypto is still early in its development, and only a few countries have developed a CBDC to a significant degree. Examples include the USA, which is developing a digital dollar, and a couple of other countries, such as China that has developed its digital yuan, and South Korea — both of which are conducting a pilot of the technology behind the currency. Despite this progress, no country has yet deployed a CBDC to a significant scale.

How are CBDCs different from cryptocurrencies?

The most basic difference is the goal, which is different to those of other cryptos.

As we know traditional crypto currencies such as Bitcoin are unique in that no central entity or group of entities is in charge. That will not be the case with a CBDC, as governments will want to continue to control a number of aspects.

A CBDC will allow governments to continue to control the supply of its currency, allowing its central banks to remove or add money to the supply as needed in order to stimulate the economy in troubled times, and set national interest rates.

The other difference is who actually runs it. Unlike say Bitcoin, which allows anyone to run the software without any need for permission, in the case of a CBDC, a central entity, the government or central bank, will choose which financial entities participate in managing the distributed ledger.

Will CBDCs replace physical money?

Although we don’t know for sure, as the development of CBDCs is still in its infancy, I’d guess that they will eventually replace hard fiat currency, and in the meantime most countries will use CBDCs as a supplementary form of money alongside physical cash. A cashless society, although potentially tyrannical, has many benefits to it.

  • Increased technology adoption rate

What impact will CBDCs have?

Given the fact that CBDCs are still early on in their journey, we can’t say for sure. However, experts and researchers speculate that CBDCs may increase the international ramifications of monetary shocks.

Research conducted by the European Central bank modeled various scenarios with two open economies in which there were financial shocks, both with and without CBDCs. It found that in the absence of a CBDC, there was increased movement of assets into foreign currency bonds when there are shocks to an economy.

The researchers also explored everyday monetary policy and found that issuing a domestic CBDC will impact the autonomy of the foreign country’s monetary policy.

Summary

Governments and central banks have a challenge of how to meet the demand and trend of cashless payments. A CBDC is a way of doing that, but it also raises the question about the role of central bank money in the economy, access to central bank liabilities and structure of financial intermediaries.

For people to have trust in a CBDC, it must be safe and accessible and like cash, give respect to importance of anonymity and data protection. There is unlikely to a be a one size fits all solution, and the benefits of a move to a CBDC will need to be analysed for each country and the associated trade-offs have to be identified.

What is clear however is that central banks and governments are clearly responding to the rise of cryptocurrencies and by developing their own central bank digital currencies, they are looking to get in on the crypto act. Whilst they, on the surface, look very similar to other cryptos like bitcoin or ethereum, and can potentially even some architecture with other cryptocurrencies, we do not consider CBDCs a crypto currency, or a threat to more established coins, due to the technical differences and because of the centralised nature of them. Although the decentralised nature of real crypto currencies means that they will continue to have a place, the supplementary opportunities presented by CBDCs is exciting, and we look forward to seeing their ongoing development. I imagine stablecoins will no longer be required once CBDC’s are in full effect.

I’d be really interested to find out what you think about the subject, and if you have any questions that I haven’t answered, or simply want to share your thoughts, then please do let me know in the comments section down below.

Tech entrepreneur, music producer and DJ. Founder of PYRO音乐, an early adopter of blockchain technologies and a mining enthusiast. Living in Shanghai!