Most of the world’s economies are considering issuing a central bank digital currency (CBDC). In this article, we explain what CBDCs are, how they differ from cryptocurrencies, and what the most advanced central bank digital currency projects are for crypto investors and traders of Immediate Edge systems.
What are central bank digital currencies?
Central bank digital currencies (CBDCs) are digital-only versions of fiat currencies issued by various central banks. They operate with networked ledgers, which record transactions. CBDCs are centralized: they are issued solely by the central bank of the country or region and do not rely on a network of miners, unlike Bitcoin (BTC), for example.
Just like “traditional” fiat currencies, central bank digital currencies will be backed by monetary reserves, such as gold or foreign exchange reserves. This is an equivalent of paper money, except that a CBDC exists only digitally.
A CBDC is a digital asset issued and guaranteed by the central bank, exchanged at par with banknotes and coins, available permanently and in peer-to-peer transactions, and circulating on digital media at least partly different from those used today. It is a kind of digital note.
China and a few smaller countries are experimenting with such a currency, and most central banks around the world are considering it. Digital currency should not be confused with electronic currency: the latter corresponds to commercial currency, a sum of money stored in electronic form (prepaid card, electronic wallet, etc.) in exchange for a remittance of funds to the issuer. A digital currency should also not be confused with a crypto asset such as bitcoin, which is not a currency.
Most major fiat currencies are of course already digital, but the difference is that CBDCs are meant to exist on their own, beyond the banking networks that we commonly use. This also raises questions about the role of banks, which could see their role reduced. Some even believe that it is CBDCs, and not cryptocurrencies, that represent the greatest danger for commercial banks. Most CBDCs were in the project stage in 2021. That is, research is being done by central banks, and proofs of concept are being published, but very few countries have a working version of their digital currency at this stage. It is also noted that there is a great diversity in the projects, with different levels of centralization and anonymity for central bank digital currencies.
Types of CBDC
The so-called “interbank” CBDC, is used exclusively by the central bank and commercial banks or specific financial institutions, for financial transactions between them. This digital central currency could be created via a distributed ledger technology, such as blockchain. Already tested by different central banks, this technology makes it possible to carry out financial transactions of large amounts in a faster, more transparent, and secure manner, and at a lower cost than using traditional technology.
A so-called “retail” CBDC, usable by the general public. The public could use this central digital currency either in a form stored in a physical medium (a card, a mobile phone, etc.) or via an account opened in central digital currency.
The aim is not for this retail digital currency to replace coins and notes. Rather, it would be to offer an alternative that would provide the public with choice and support changes in payment behavior.
The benefits of a retail CBDC
It is a central bank currency, benefiting from the same advantages as cash, namely that it is a perfectly liquid and secure payment instrument, but which can be exchanged remotely since it is digitalized. It can make payment systems more robust, more efficient, and less expensive, particularly cross-border operations, such as those of foreign tourists or transfers of funds from migrants.
It is a public and risk-free alternative to private or foreign digital solutions that can create problems of sovereignty and effectiveness of monetary policy as well as risks in terms of control of operations, laundering of dirty money, even financing of terrorism, and more generally financial instability.
How does a retail CBDC circulate?
Either in the form of a token, i.e. the digital currency units are stored on a physical medium, dedicated or not (for example, mobile phone, hard drive, payment card, etc.). The holder of the physical medium is the only one who can pay with the units stored on this medium, the exchange terms being carried out electronically from medium to medium; for the user, the use would be similar to that of an electronic note wallet guaranteed by the central bank.
Either in the form of an account accessible online or associated with their holder. In this case, payments would be made from account to account and both the sender and the beneficiary would therefore have to have an account denominated in digital currency. For the user, the operation would be similar to that of private solutions such as PayPal, i.e. online accounts operating in pre-funding mode, but with a currency as secure as banknotes.
To distribute this retail CBDC, most central banks exclude the so-called direct model, where they ensure, without an intermediary, the provision of the digital currency to end users. They prefer the so-called intermediated model because they rely on intermediaries to ensure this provision to end users. In the euro area, the choice naturally falls on banks, which already ensure the distribution of banknotes and with which the Eurosystem interacts directly via its infrastructures; a more extensive vision can include payment service providers, insurers, agents/brokers, exchange offices, post offices, etc.
CBDCs: varying uses
There are two broad categories of central bank digital currencies. On the one hand, there are consumer CBDCs, which will be held by a country’s citizens or businesses. They are intended to circulate freely, just like cash. On the other hand, there are CBDC projects intended for internal use by financial institutions and banks. The latter are used to settle transactions quickly and securely.
When it comes to central bank digital currency, however, it is often the first use case that is implied, because it is the one that could fundamentally transform the way people in a country exchange money.
The advantages of CBDC
A digitized central currency should provide many benefits:
- Increased monetary sovereignty for States: many countries have already launched feasibility studies (Bank of France and European Central Bank on a study of a digital euro ) and for some, full-scale tests have even begun (Chinese Central Bank).
- Faster and more secure transactions: while a traditional transfer takes a few days to be visible on the bank account, the CBDC allows almost instantaneous exchanges. The data is recorded in an ultra-secure decentralized register.
- A currency adapted to the changing behavior of societies and consumers: according to numerous reports, only 28% of payments made in stores are still made with cash.
- Lower costs: the virtual currency is stored in a digital wallet. There is no longer any need for a bank account. Consumers therefore save on management costs. Since a computer or smartphone is sufficient to use the CBDC, people who do not have a bank account also have access to it.
The possible dangers of CBDC
Digital currency raises several questions and fears about possible abuses:
- The monopoly of monetary authorities who could decide monetary conditions (e.g. purchase quotas, transaction limits, an expiration date, a savings ceiling, etc.)
- a profound change in the financial infrastructure since the central bank would have supremacy over the banks which would no longer serve as intermediaries as they currently
- a threat to individual liberties because the central bank will monitor transactions where cash allows completely anonymous use
- dependency in the event of a hack or major power outage
- a widening digital divide: some rural areas still do not have access to a fast and efficient internet network
- The central bank digital currency is currently a hypothesis but one that is likely to be imposed on citizens in the more or less long term. It is difficult to predict to what extent the public will accept this new monetary mode.
Are CBDCs cryptocurrencies?
As we have seen, CBDCs are therefore offered in an exclusively digital manner, thanks to a shared register. We can therefore ask ourselves whether they are cryptocurrencies or not. Here too, the answer varies depending on the project. Several countries have carried out tests with blockchains: this is the case, for example, of Australia, which has chosen to conduct research with ConsenSys and Ethereum. The Bank of England would also carry out tests with Tezos (XTZ) and Ethereum (ETH). In these cases, CBDCs could approach cryptocurrencies, from a technical point of view.
However, their level of decentralization must also be taken into account. According to some commentators, a centralized currency cannot by nature be a cryptocurrency, since this goes against one of the founding elements of the blockchain. Bitcoin was created specifically with the ambition of getting rid of fiat currencies and central banks. This is why the two types of digital currency are often seen as a contrast.
Blockchain or not blockchain?
However, the digitization of a fiat currency does not necessarily involve a blockchain. It would seem that China’s “digital yuan” does not use this technology, although it is not yet certain. It should be noted, however, that blockchain remains very widely used: more than 88% of CBDC projects are based on this technology, according to a PwC report from April 2021.
The report highlights several advantages of blockchain, including its high security, the programmability of smart contracts, and its transparency. The possibilities in terms of confidentiality were also highlighted, which would bring CBDCs closer to cash, which is historically difficult to trace. This is why central banks seem to favor this option.
Some CBDCs in development in the world
In January 2021, a survey by the Bank for International Settlements (BIS) revealed that 86% of central banks were working on digital currencies. However, not all are at the same stage, as shown by the CBDC Tracker map, which lists central bank digital currency projects.
China: The most advanced central bank digital currency
China is the most advanced economy in terms of issuing a digital currency – by far. The government is banking on its digital yuan to compete with the dollar, and it has accelerated the development of its CBDC since 2020. The digital yuan was tested in several retail outlets in early 2021, and the wallet dedicated to the asset was opened to 47 million Chinese people at the same time. Since then, salaries have started to be paid in digital yuan, and more than 3,000 dedicated ATMs have been deployed in Beijing.
China is therefore well and truly the leader in the race for central bank digital currencies. It is a safe bet that when its CBDC is offered to the general public, it will give a new boost to other global projects, which do not want to be left behind by the Chinese economic behemoth.
Turkey – A CBDC as a lifeline
Turkey’s digital lira is also among the most advanced projects. At the end of December 2020, the governor of Turkey’s central bank announced that the conceptual phase of the digital currency project had been completed, and the testing phase began in the second half of 2021. The country is expected to offer a full-fledged CBDC within the next two years. Turkey is motivated by two factors, with, on the one hand, the growing adoption of cryptocurrencies in the country. The territory is indeed one of the most dynamic global markets. The second reason is the fall of the Turkish lira (TRY), whose rate has been plummeting for years. Ankara hopes to revalue its fiat currency. Very little information is available about this digital lira, but it seems that the country’s central bank has focused on blockchain to begin this testing phase.
Bank of Sweden: one of the most advanced in Europe
The Swedish central bank is among the most advanced in Europe. As early as December 2019, it launched a test environment for its “e-krona”, with experiments that could be repeated for several years. From a political point of view, the issuance of a central bank digital currency has not been officially confirmed, but the project is moving forward.
Riskbank recently explained that it has moved to phase 1 of its pilot project. This will measure the effects that a CBDC could have on the Swedish economy. The e-krona will also start to be tested from a technical point of view during 2021.
The United States: Between Distrust and Opportunity
The United States has been distinguished by a great deal of distrust of central bank digital currencies. However, at the end of 2019, it was learned that the Federal Reserve (Fed) had begun experimenting with a digital dollar. However information is scarce, and statements from institutions do not seem to prioritize this project. In 2020, the Democratic Party proposed a digital dollar for the US economic recovery plan, but it was not included in the final bill.
The US Federal Reserve is still working in tandem with MIT to develop a technology platform that could lead to an “e-dollar.” But US central bank Chairman Jerome Powell recently confirmed that the institution is deliberately adopting an extremely cautious approach.
Things are therefore slipping for the American digital dollar, to the point that private initiatives have developed to bring about a change. In May 2021, the non-profit organization Digital Dollar Project announced the launch of five pilot programs to test the potential use cases of an American CBDC. For its part, the “Fed” released a research note during the summer of 2021.
Digital euro: slow development at the European level
At the European level, there is also great caution. The Central Bank’s digital currency project is well and truly on track, but its release is expected to take many years. Decisions have been slow to be made, and Christine Lagarde, the European Central Bank (ECB) president, believes that we will not see the issuance of the digital euro before at least 2025.It must be said that the impact of the digital euro could be considerable. According to Morgan Stanley, it could drain up to 8% of the euro reserves banks hold. Little is known about the digital euro at the moment, but digital wallets will likely have a deposit limit, which could be set at 3,000 euros per person. It should also be noted that the Banque de France is heavily involved in this project, and is working on developing the interbank specificities of the digital euro.
Major CBDC Adoption Obstacles
The road to a central bank digital currency would have its share of obstacles that need to be considered. For example, people might decide to keep a large portion of their money in this form rather than in a regular bank account. This digital variant of the traditional nest egg would even be easier to build.
But if people decided to knit themselves a “digital nest egg,” it could decrease the amount of money available to borrow, raise borrowing rates, or both. Why? Because the money that banks lend comes partly from customer deposits. This could make it harder to get credit – including mortgages and business loans. If this were to lead to less investment by businesses, productivity and innovation could suffer. This is because to create new products and services, and to innovate more generally, businesses often need to borrow.
In other words, money kept in cash is a safe asset, but not very productive. There are ways to reduce this risk. For example, central banks could make their digital currencies interest-free, just like banknotes held in a wallet. In normal times, this would make them less attractive to hold in large quantities. But in tough times, central bank digital currencies could still be considered a safe asset, like cash.
Other risks
There is another problem, however. A central bank digital currency could increase the risk of a “bank run.” This occurs when people withdraw money en masse from all their accounts at commercial banks because they are not sure which banks are healthy and which are failing.
However, banks only hold a fraction of the total value of deposits made by their customers in cash. So, most of the time, they are unable to repay everyone at once. With a central bank digital currency, it would be easier and faster to withdraw money from commercial banks. In theory, systemic bank runs could therefore be both faster and more frequent. This could lead to a situation where a central bank’s digital currency, instead of making the financial system more stable, would make it less stable. Fortunately, bank runs are extremely rare these days. There has never been one in many countries round the world.
What are the challenges facing CBDCs?
Technological challenges
Central bank digital currencies also face significant technological challenges. Blockchain is complex and can be difficult to understand and manipulate, which can pose problems for uninformed users.
Additionally, there is still a lot of research underway on how blockchain can be improved to support international trade and other applications.
Regulatory challenges
Another major challenge that CBDCs face is their regulation. Governments around the world are seeking to implement effective regulations to ensure the legitimate use of these digital currencies while addressing the risks associated with their use, including money laundering, fraud, and terrorist financing.
Many countries are therefore working on coherent legal frameworks that will enable the wider adoption of digital currencies.
In conclusion, central bank digital currencies are a form of decentralized money that can offer various benefits to users, including improved efficiency in international transfers and an increased level of security thanks to blockchain technology. Many commercial projects are underway around the world to promote the use of these digital currencies and solve the technological and regulatory challenges that prevent their widespread adoption.
The digital Euro project
In July 2021, the European Central Bank decided to launch a 2-year investigation phase on the retail digital euro. At the end of this phase, if it is deemed convincing, a second 3-year implementation phase will open. Thus, the digital euro could see the light of day in 2026.
By introducing a digital euro, the ECB would protect its “monetary sovereignty” because it would help ensure that the euro remains the sole and unique unit of account used within the eurozone. This would notably limit the risk of resorting to foreign CBDCs, or to private assets such as stablecoins, which the news of 2022 has shown are not secure means of payment.
With its digital currency, the ECB could also contribute to the strategic autonomy of the European continent in terms of payments. Today, payments in the eurozone are heavily dependent on large American companies such as Visa and Mastercard, but also on digital giants such as Google or Apple. By proposing a new European payment offer, the ECB could stimulate competition in the payments industry within the European continent and thus ensure its resilience in this area.
The challenge of CBDCs for the banking system
Many of us already use electronic means of payment. But the transactions we carry out in this way go through the banking system: everything is linked to our accounts opened with private financial institutions. This is a fundamental difference with coins and notes which, once issued by the authorities, can circulate freely, outside the banking system.
Central bank electronic currency (CBDC) would have the particularity of allowing electronic transactions to be carried out without going through the banking system. Consumers and merchants would hold a digital wallet directly with the central bank.
For the latter, it would be very interesting because it could make monetary policy more effective: varying an official interest rate applicable to these digital assets would directly influence economic actors, without having to rely on a transmission of this monetary policy by the banks.
But for them, the risk is that they will face banking disintermediation: people would no longer need to go through banks to save or invest, which would hamper lending activities, which depend on deposits.
This explains why monetary authorities generally consider setting a maximum limit on the amount of their (future) digital currency that can be held. In the eurozone, the ECB (European Central Bank) has already mentioned a possible maximum amount of 3,000 euros per person.
Conclusion
Central bank digital currency projects are therefore mostly in the approach and testing phases. It is however notable that the vast majority of financial institutions wish to digitize their fiat currencies, and that they rely on blockchain technologies for this.
By its very nature, however, such a change will take a long time, which leaves an opportunity for private digital currencies and cryptocurrencies to develop. We are thinking in particular of stablecoins, for example, Tether (USDT) or USD Coin (USDC) for the dollar. With technologies advancing very quickly, it is, in any case, likely that the landscape will be very different in 2025 than it is today
