Paper banknotes and coins may be a thing of the past due to a new financial instrument, the Digital Central Bank Currencies (CBDC). As of July 2020, many countries around the world, including the US and Japan, are researching technologies in this field. China, in turn, is preparing to launch the first payment system with the national cryptocurrency soon. What CBDC is, what its advantages are, and how crypto assets can displace the traditional fiat? Let’s discuss these topics in this article.
What is CBDC?
Central Bank Digital Currency (CBDC) — digital currencies of central banks or so called national cryptocurrencies. They are the digital equivalent of a national currency. For example, instead of the traditional dollar, you can release its cryptographic version in CBDC format.
There are several scenarios for issuing national cryptocurrencies. The choice depends on how the CBDC will affect the country’s financial system:
- CBDC instead of cash. Users are offered to switch from traditional money to their more convenient digital version. The emergence of such crypto money will have almost no impact on the country’s monetary policy;
- CBDC instead of payment systems. It will become more convenient and easier to pay for goods and services, but at the same time the role of CBDC in the payment systems market will increase dramatically. National cryptocurrency will directly compete with payment systems, which will lead to significant changes in monetary policy;
- CBDC instead of deposits. In this case, deep changes are expected in monetary policy. In addition, the role of commercial banks will change.
The central bank may issue cryptocurrencies for individuals or for financial institutions. In this case, the scenarios for the use and application of the new type of money will be very different. The choice of direction depends on how much market participants need an alternative to fiat money and what problem the regulator plans to solve with CBDC.
CBDC vs. regular currency
The CBDC issuer, as in the case of the regular (fiat) currency, is the Central Bank of the country. As a result, the national cryptocurrency becomes a centralized financial instrument, which is controlled by a single authority. However, in contrast to fiat money, all transactions with a crypto asset can be digitized.
Advantages of CBDC over fiat currencies:
- Improved quality of payment systems by automating the process.
- Availability to the public without any restrictions and legality as a means of payment within the country;
- May take various forms depending on the existing payment;
- Legally recognized form of payment and represents funds from the Central Bank and the State;
- The Central Bank directly guarantees the convertibility of the CBDC at face value into cash or reserves;
- The CBDC may decide to pay the interest rate on CBDC obligations in accordance with the interest rate structure of other government obligations and the broader monetary policy of the Central Bank and the goal of financial stability;
- Acts as a means of final regulation of taxes, fees, penalties and private obligations;
- Safer for transactions and deposits than transactions of commercial banks;
- Improves the efficiency and security of both retail and large payment systems. In retail, the focus is on how digital currency can improve payment efficiency, for example at POS, online and peer-to-peer (P2P) outlets.
CBDC will allow regulators to control the circulation of funds and monitor cash flows, including government spending. As a result, the authorities will receive the necessary tools to combat theft, fraud, money laundering and other illegal activities.
However, in trying to understand the macroeconomic implications of the adoption of the CBDC, central banks are faced with a lack of historical experience.
Central banks fear that if the use of paper money is significantly reduced, the central bank’s monetary policy will depend on an e-money issuer policy that could seriously weaken the transfer of monetary policy, as well as limit the central bank’s ability to act as lender of last resort.
The issuance of digital government currency by the central bank may prevent such competition if it is meant to be a perfect replacement for private e-money.
The risk of error is significant, so most central banks have to be cautious about everything. Depending on the CBDC model, central banks risk either excluding commercial banks, which are a vital source of funding for the real economy, or assuming the direct risks and complications associated with servicing the masses. Problems in managing a new business for them can undermine the public trust that central banks count on, allowing them to take unpopular actions from time to time, such as raising interest rates.
How CBDCs differ from decentralised cryptocurrencies
CBDC issuer is the Central Bank of the country. It has the tools to regulate operations with the national cryptocurrency. Work with the CBDC is built on the principle of centralization, which implies a single supervisory authority.
Decentralized cryptocurrencies, for example — Bitcoin, are outside of the direct pressure of financial and other regulators. Central banks in countries are unable to control the issue, distribution and use of digital assets of this format.
CBDC safety and security
CBDC is considered safer than fiat money as it is more difficult to forge or use it with impunity in financial fraud. However, much depends on the technical realization of an asset. If it is based on a blockchain — the degree of protection is high enough. Fully centralized coins are more vulnerable, including hacker attacks.
For example, some experts believe that the transition to a national cryptocurrency will not save the Central Bank from the attention of attackers. Moreover, a safe transition to CBDC is possible only in countries with well-established financial institutions.
On the other hand, digital money is much safer in terms of infection spread. This topic has become particularly relevant in the context of the coronavirus pandemic. According to the Bank for International Settlements (BIS), people are more likely to look for information on the level of security of banknotes in the epidemic. Experts are confident that COVID-19 will accelerate the production of national cryptocurrencies.
Which countries are developing CBDC
According to the media, at least 18 countries were working on a national cryptocurrency at the beginning of 2020. About 60 central banks all over the world were engaged in the study of CBDC capabilities.
The list of countries working on digital alternative to fiat includes France, China, Thailand and others. Some central banks have already launched pilot crypto versions of their currencies. For example, in Venezuela there is El Petro coin, provided with oil reserves of the country. However, its viability raises questions among researchers.
Europe is actively exploring the possibility of issuing CBDC. Some European countries have already offered their infrastructure to test the financial instrument. Thus, on April 21, 2020, the Central Bank of the Netherlands expressed its desire to lead the development of national cryptocurrencies and take part in testing the CBDC of the European Central Bank.
For the first time, the possibility of issuing a digital alternative to the euro became known in the autumn of 2019, when German Finance Minister Olaf Scholz proposed to study the possibility of creating a crypto version of fiat.
Testing of digital euro is scheduled for the first half of 2020 at the Central Bank of France. At the end of March 2020, the website of the regulator published information that citizens of the country will be able to take part in the initiative. Everyone should submit an application by May 15. Selection of participants was scheduled for July 10, 2020.
In parallel with the work on creating a digital alternative to fiat, the European Union has introduced a ban on interaction with private companies. National cryptocurrencies do not fall under this category. At the same time, the ban applies to the crypto project of Facebook, private controlled Libra stablecoin.
As of the end of July 2020, China is the closest to a full-scale launch of CBDC. The Chinese project is named DCEP (Digital Currency Electronic Payment).
The Chinese cryptocurrency may be launched before November 2020. Such information was shared by Edith Cheung, investor and partner of the Proof of Capital venture fund, during her interview at East Tech West.
According to China Daily, work on a digital version of the yuan has accelerated amid a coronavirus outbreak in the country. In mid-April 2020, China Star Market reported that in May China will start paying part of the subsidies in the cryptocurrency. The first recipients of the digital yuan will be officials of Suzhou City. Earlier Chinese news channels also reported that three more cities will be included in the testing program: Shenzhen, Xun’an and Chengdu.
Tunisia’s initiative was promoted directly by the Government. Digital tokens based on DLT “e-Dinar” (digital version of the Tunisian dinar) were launched in 2015 with the support of a Swiss company and local fintechs. This is so far the first successful case of a digital coin issue by a government agency or the Central Bank in the world. The digital tokens are now listed in the global crypto exchange of assets and can be used in Tunisia to transfer funds, pay for goods and services online, pay salaries and bills.
Another Government-led initiative is in the Marshall Islands, where the United States dollar has been the official currency as legal tender since 1982 and there is no central bank. In 2018, the Government proposed to introduce its own public crypto asset, the “sovereign” (SOV), which is the second legal tender to supplement the dollar.
Parliament passed the Sovereign Currency Act in February 2018 to permit the issuance. The main motivation for this initiative is to prepare for the planned reduction in grants under the Compact Trust Fund established by the US Government to compensate Marshallese citizens affected by nuclear testing near the country after 2023 and to acquire new sources of income.
If central banks can overcome technical difficulties, government digital currencies can provide faster and cheaper transfers across borders and improve access to legal tender in countries where cash supplies are declining.
One of the documents from the World Economic Forum pointed out that new currencies could offer retail investors safer places to save if they could create accounts with their central bank and could reduce the price barriers that currently leave about 1.7 billion people without banking services.
Some economists even argue that they could make monetary policy more effective by allowing direct interest rate transfers. For China, the digital currency offers a possible way to keep up with and control the rapidly growing economy. On the other hand, it could also provide the government with an additional instrument of control.
After all, central banks can take responsibility for conducting proper customer checks, meeting anti-money laundering and counter terrorism financing requirements, and providing tax information.
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