CBDC - central bank digital currency

CBDC – the next chapter in the quest for digital money

Central bank digital currency, or CBDC for brevity, has slowly been gaining traction over the past few years. The concept has been a somewhat controversial one, with blockchain purists claiming that it runs contrary to the core tenet of distributed ledger technology and traditional finance questioning whether such instruments are even needed. Yet, central banks around the world keep pushing forward with efforts to make CBDC a reality.

So what motivates the monetary policymakers for some of the world’s biggest economies to pursue a concept that has so far only inspired a lukewarm reception. Well, to get the full picture, we first need to talk about

Stablecoins

The idea of stablecoins was born out of the need to solve a particular problem with cryptocurrencies – price volatility. This problem plagues the industry even today and while more and more people are starting to accept crypto as a viable asset type and a potential store of value, many agree that the price volatility associated with even the most liquid of crypto assets (Bitcoin, Ether) prevent crypto from fulfilling its initial promise – to be a viable medium of exchange and fuel a new type of online payment system.

As the name suggests, stablecoins are crypto assets designed to resist price volatility. They are typically pegged to a particular fiat currency or a basket of currencies and collateralized by physical fiat holdings. Stablecoins can also be tied to physical assets (gold, silver, etc.) and even other crypto assets. Nowadays, there are also non-collateralized stablecoins that use algorithms to keep their prices fixed.

The stablecoin space has seen its fair share of controversies. Tether, an early leader in the space whose UDST token is tied to the US dollar, has been accused of minting new tokens to prop up the price of Bitcoin during market downturns. Additionally, there have been doubts over whether UDST is fully collateralized.

Undeterred by the early stumbles, a significant number of high-profile stablecoin projects have entered the space over the past few years. Those include the USD Coin by the largest US crypto exchange, Coinbase, and the JPM Coin, a stablecoin developed and operated by US banking giant J.P. Morgan Chase.

Playing defense

So it seems that stablecoin operators have a lot in common with central banks when it comes to handling their assets. And indeed, central banks employ similar mechanisms in governing fiat currencies. Firstly, they hold foreign exchange reserves that give them, among other things, the ability to influence the exchange rate of their own cryptocurrencies. They also have the ability to print money, which also influences exchange rates. In addition, some fiat currencies are tied to other currencies, much like stablecoins.

So if operating sovereign currencies is, at least in principle, so similar to operating stablecoins, then launching digital versions of fiat money should be a no brainer, right? The question is why do it?

Well, one reason for that stems directly from the parallels discussed above. Ever since cryptocurrencies started gaining popularity among the general public, they have been closely monitored by financial regulators and central banks, which have repeatedly cautioned about the risks associated with these new assets. For the most part, however, regulators have focused on crypto’s role as an alternative investment and have maintained that crypto assets are unlikely to pose greater economic risks, at least for the foreseeable future.

Stablecoins, however, are a different story. Having been designed as a bridge between traditional cryptocurrencies and fiat money, they could have an impact on the wider economy. After all, stablecoins are, in a way, an early proof of concept for CBDCs, but one that affords control to private entities.

This last part, in particular, has raised significant concerns among central bankers. Last year, the Financial Stability Board, an international body that monitors the global financial system, issued a statement, warning about the potential risks that “global stablecoin (GSC) arrangements” could pose to the global economy.

“So-called “stablecoins” are a specific category of crypto-assets which have the potential to enhance the efficiency of the provision of financial services, but may also generate risks to financial stability, particularly if they are adopted at a significant scale,” the FSB said in the statement.

“[A] widely adopted stablecoin with a potential reach and use across multiple jurisdictions (a so-called “global stablecoin” or GSC) could become systemically important in and across one or many jurisdictions, including as a means of making payments,” the watchdog also said, adding that the emergence of GSCs might hinder regulators’ ability to oversee the economy.

It is no coincidence that R&D efforts regarding CBDCs have ramped up considerably following the announcement of Facebook’s stablecoin project Diem in 2019. The project, originally called Libra, has faced significant regulatory pushback, including two congressional hearings in the US.

CBDCs are a way for central banks to fend off the threat posed by global stablecoins, as they are instruments that offer similar functionality to stablecoins, but remain under regulatory control. Another potential benefit of central bank digital currencies is that they would allow for fiat currencies to be relevant in the rapidly growing sector of decentralized finance (DeFi), which currently relies on stablecoins and other crypto assets. Speaking of that, it’s time to take a closer look at

CBDC as digital money

When it comes to CBDC media coverage and the broader discussion on the topic, there is a tendency to refer to such projects as digital money, for example digital euro, digital yuan, etc. This might be somewhat confusing – after all we’ve been using digital money online for years, haven’t we? Well, not quite. The money that we’re using to make online payments are the result of a complex game of balancing various bank accounts against transaction information  and digital reserves. In most cases, no physical money ever changes hands as a result of an online transaction.

CBDCs make it possible to have actual units of account in the form of tokens that act as the digital representations of their respective fiat currencies. But tokens, some might argue, are not physical, they are, too, just digital information. So, if everything comes down to a bunch of 0s and 1s, anyway, why bother tokenizing digital money in the first place?

Well, think of it this way. Light is an electromagnetic wave, but it can also be quantized into tiny discrete packages we call photons. In general, it’s good enough to be aware that some light has been shone upon you, but there is also value in knowing how many photons bounce off you at any given time (and I’m sure physicists would agree that this analogy holds up to scrutiny!).

Having a traceable unit of account makes the concept of digital money more tangible. In addition, with central bank digital currency tokens at their disposal, central banks will be able to interact with end customers directly.

“Central banks currently rely on commercial banks to roll out their monetary policies among the general population,” LimeChain’s lead blockchain architect Daniel Ivanov said in our recent piece about the blockchain sector in 2021. “In CBDCs, central banks will have tools to directly interact with the end consumer. These instruments will also enable central banks to quickly allocate funds, for example, financial aid for the most vulnerable or badly hurt during a crisis.

Some central banks, including the European Central Bank (ECB) and Bank of Japan, are also interested in whether CBDCs are capable of providing a low-cost and low-risk alternative to cash.

Tokens? What tokens?

It’s important to note that token-based CBDCs are not the only game in town. Another possible approach is to build an account-based system that verifies the identities of all account holders. This arguably resembles the way digital transactions are done now, but such a system could potentially offer greater security and transaction speeds, with central banks handling transaction settlement. Realizing this model would require the central bank to create accounts for the users and implement a digital identity system, which could limit the CBDC’s reach.

CBDC for cross-border payments

Another area that could benefit greatly from CBDCs is cross-border payments and remittance. The sector today relies primarily on the Society for Worldwide Interbank Financial Telecommunications (SWIFT), a vast messaging network that handles the transfer of information between member banks. Processing transactions across borders in this way is a cumbersome task that can take up to several business days. With the right infrastructure built around, a central bank digital currency could provide a better alternative to the existing methods.

Strengthening the case for blockchain

One of the fortunate consequences of CBDC development is that it increases the interest in blockchain on a state level. Technically, you don’t need blockchain to build a CBDC system – you could, for example, realize the account-based model using other technologies – but blockchain seems too well suited for the job to be overlooked. In this way, central bank digital currency projects help legitimize the use and utility of blockchain technology.

It’s telling that some of the most advanced research on CBDC is being done in regions that also have strong blockchain aspirations. The People’s Bank of China (PBoC), for example, already conducted a pilot for its digital yuan project in several major cities. As mentioned above, the ECB is also considering the idea of a digital euro.

Here to stay

PBoC and ECB are far from the only ones interested in CBDCs. The Bank for International Settlements (BIS), reported in October that 80% of the world’s central banks had started to conceptualize and research the potential of CBDCs, with 40% building proof-of-concepts and 10% deploying pilot projects.

Also in October, seven central banks and the BIS released a joint report, in which they outlined foundational principles and core features on a CBDC project. The three foundational principles included; coexistence with cash and other types of money “in a flexible and innovative payment system”; central bank digital currency introductions “should support wider policy objectives and do no harm to monetary and financial stability” and “features should promote innovation and efficiency”.

With all this in mind, it seems fair to say that there’s enough interest in CBDC to fuel more research and development in the field. And while still early to say whether these efforts will produce tangible results, it is reasonable to expect that the central bank digital currency will be a big part of the blockchain debate for years to come.

 

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ABOUT THE AUTHOR

Dimitar Bogdanov