Clearing misinformation around CBDCs - Central Bank Digital Currency
Updated: Apr 15, 2021
There seems to be a lot of misinformation about Central Bank Digital Currencies (CBDCs). The perception is that it is somewhat similar to Bitcoin and other cryptocurrencies. It certainly is NOT. At a basic level, CBDC is the digital version of the country's currency. but this statement glosses over the details.
The difficulty in explaining CBDC is that there are no set standards for it yet. Experts are still trying to figure out what a CBDC ought to be, and eventually, America's CBDC might be very different from China's CBDC which could be very different from Japan's CBDC.
The best way to convey what it is, therefore is to describe- What has happened so far in the space? What can we do with CBDCs that we cannot do with the current form of currency? What are the motivations of the parties involved? And how does CBDC compare to bitcoin?
The story so far!
When Facebook announced plans of launching Libra- a digital currency pegged to a basket to fiat currencies, it scared us all. We were already fearful of the growing power of Big Tech with its ability to manipulate minds, take away our privacy, and even subverts elections. Now they wanted to take over the global financial system as well? America wasn’t going to let that happen.
But then... China announced its Digital Yuan project- Digital Currency/Economic Payment (DC/EP). America wasn’t thrilled about giving all that financial power to Facebook but letting China take the lead on digital currency could threaten the dominance of the US Dollar and its (unfair) hold on global money flows.
=> Net-net- The US’ taking Digital Dollars seriously appears to be motivated by fears of China’s Digital Yuan dominating global finance. China’s Digital Yuan project appears to be motivated by fears of Bitcoin dominating global finance.
Let’s talk about Libra first. What is Libra?
Libra is designed to be a single currency stablecoin controlled by the Libra Association, a Switzerland-based non-profit, governed by ~30 corporates in tech, finance, and non-profit. Every stablecoin will be backed by actual reserves (LibraUSD backed by USD, LibraGBP backed by GBP, LibraJPY backed by JPY). It will function on a permissioned Byzantine Fault Tolerant Blockchain and will be fully auditable by regulators, law enforcement, and the public.
=> Technical details described above are currently irrelevant given the absolute distrust in Facebook. No one is keen to give the keys to the financial kingdom to an Organization with a history of subverting security and betraying privacy.
What is Digital Yuan or Digital Currency/Electronic Payment (DC/EP)?
China has been working on its CBDC project since 2014 but has been fairly tight-lipped about it till recently. It conducted closed pilot tests in Apr’2020 and a public trial in Shenzhen in Oct’2020 where it distributed RMB200 each through a lottery to 50,000 winners to be spent at one of 3,000 retail outlets.
What should be emphasized about DCEP is that it has nothing to do with blockchain technology. Rather, it is simply an evolution of the payment systems built by Alipay and WeChat Pay.
DCEP is envisioned to be a replacement for cash. It will get distributed like cash i.e. from PBOC to Commercial Banks and from Commercial Banks to final users. It will earn interest if it is deposited in a bank and not if it stays in your wallet.
Unlike cash, it will offer only “controlled anonymity” i.e. it will provide anonymity at the user level (I can’t see what my neighbor is earning or spending on). However, PBOC and financial institutions can de-anonymize any transaction. Bid Adieu to privacy!
Yes, Digital Yuan is not in line with the philosophy of Bitcoin. Satoshi Nakamoto must consider this a bastardization of his creation:
Bitcoin is all about decentralization and not concentrating power in the hands of a centralized authority that can misuse it. Digital Yuan is about further centralizing power with the government.
Bitcoin promotes privacy. Digital Yuan does not. Every time you transact with a digital yuan, it’ll be possible to trace it to you. The government however has said that it’ll protect user privacy. One can argue that since in China, money is already digital, DCEP may actually give no additional benefit but subject the residents to further surveillance.
While China has been busy with its trials, 2 countries have already launched their CBDCs:
Bahamas - became the first country with a functioning CBDC when it launched the Sand Dollar on 20 Oct’2020. Its 393,000 residents can use the Sand Dollar for payment to all merchants through a government-approved e-wallet on their mobile devices. The Sand Dollar is pegged to the Bahama Dollar which is pegged to the US Dollar. Unlike the Chinese CBDC, Sand Dollar is blockchain-based.
Cambodia - launched its Blockchain-based payment system called Bakong on 28 Oct’2020. Bakong is not a digital native but rather a tokenized version of bank deposits. It is hosted on the HyperLedger Iroha protocol developed by the Japanese Blockchain firm, Soramitsu.
Other countries - Australia is considering a wholesale CBDC designed for use by financial institutions. European Central Bank (ECB) has invited public comments implying a potential retail CBDC which can be used by individuals households and corporations. South Korea is done with Phase 1 of its pilot aimed at designing and checking the technology.
So we’ve established that many countries are working on CBDCs. But why?
There are many reasons for Central Banks to introduce CBDCs. Some good, some questionable, and some outright dangerous:
Embracing Digitization - It is time for paper money to go the same way as paper letter writing.
Fighting crime - Trackable digital payments are an effective way to fight crime like money laundering or terrorist funding or tax evasion. This of course is a double-edged sword. CBDCs give direct control over your finances to the government that can freeze your account or empty it of its contents or reverse previous transactions if they deem it fit.
=> A word of advice- Try to be in the good graces of your government in a CBDC world!
Cost - Cash is expensive to store, sort, and distribute. In the Bahamas (the 1st country to issue CBDCs) moving cash between 700 islands spread across 500,000 square km of ocean for only 393,000 residents is economically unviable. This makes a digital currency all the more relevant there.
Financial Inclusion - Combodia has over 100% mobile penetration but only 22% of people over the age of 15 have bank accounts. CBDCs therefore provide banking to the unbanked.
Data based policies - A panoramic view of all transaction data (without any lag) would help a government make correct policies. Of course, this would also lay the foundation for a “nanny state” deciding what is best for you. The best the citizens can hope for is a benevolent dictator functioning for their benefit.
Effective Policy implementation - During Covid-19, governments have given much-needed subsidies to business owners to be used for paying employee salaries. Some business owners have used these subsidies for activities other than salaries. It would have been far easier to ensure that the money was used for the intended purpose with a CBDC type currency. Or in the past when banks were issued money to lend to Small and Medium Enterprises (SMEs), it was possible to divert those funds to other uses. With CBDCs programmed to be activated only when they reach SME bank accounts, that would no longer be possible.
Effective Monetary control - One of the ways to encourage spending in a slowing economy is to apply negative interest rates on bank deposits. Negative interest rates are ineffective in the current physical cash system and will result in a bank run with everyone rushing to withdraw their bank deposits. With CBDCs, negative interest rates might be effective as a monetary policy. This would still be a politically unpopular move though.
Which is superior between CBDCs and Bitcoin?
* CBDCs have the backing of governments. Any government can declare cryptocurrencies illegal but CBDCs will always have value. Having said that, any government that declares cryptocurrencies illegal runs the risk of appearing anti-innovation which serves to drive away investment and commerce.
* Bitcoin continues to be an anti-inflationary, scarce, and apolitical currency protected from government incompetence and fraud.
=> Net-net- Bitcoin may end up as a store of value and CBDCs as a mode of payment
Where does America stand in all this?
One of the real reasons for China’s DCEP is apparently to challenge the US Dollar hegemony as the world reserve currency. The threat though may be overstated. In 2019, USD constituted 60% of global forex reserves, and yuan constituted 2%. RMB won't become the leading world currency just because it is digital. That depends on a willingness to open the Chinese economy.
Whether or not the US Dollar loses its status as a global forex reserve currency, the US does seem to be behind as far as progress on CBDC is concerned. While there is pressure to not let China overtake it on CBDCs, Jerome Powell of the US Fed has said that the US is more concerned with getting it right rather than being the first. They’d rather learn from the technical, legal, and political challenges early adopters face.
They have a point. An ill-designed CBDC could have long-term repercussions for monetary stability, privacy, financial freedom, etc. It’s important to decide on the best design that balances privacy and traceability, has the ideal level of centralization, the ideal choice between wholesale or retail CBDC, etc.
And finally a word on stablecoins
We must remember that China has banned RMB pegged stablecoins and US has not banned US$ pegged stablecoins. Tokenized US$ is already thriving in the DeFi (Decentralized Finance) space through USDC, Tether, GUSD etc, and the traditional banking space has recently seen the introduction of JPM Coin. They don’t have government backing but are backed by credible teams (except Tether).