Résumé

So, Bitcoin is great, right? But why can't I use it to buy coffee or pay taxes? Even though Bitcoin is a form of digital money, using it as everyday currency may not be an ideal solution. This use will probably be offered by another type of digital asset: central bank digital currencies (CBDC).

Most countries are only exploring the idea of ​​a fully digital currency, while others are already testing implementations. But what makes CBDCs different from other digital assets? Let's see it together.

Introduction

The technology behind the transfer of money in traditional finance has not really kept pace with technological developments. Although it's little more than sending data from one location to another, sending money can be expensive and take more time than is desirable.

Many governments are actively developing a new type of digital currency. The main benefits would be to increase the efficiency of payment systems and reduce costs for all parties involved. We could think of CBDCs as a digital fiat currency built on a new technological layer inspired by the advances made by blockchain.

It is likely that many countries will adopt these digital currencies in the next decade. So how do they work?

What is a central bank digital currency (CBDC)?

A central bank digital currency is a digital form of fiat currency. As such, it is money in the legal sense established by the government.

The approach to designing a CBDC will likely vary greatly depending on the issuing country. Some implementations will likely be based on blockchain or another type of distributed ledger technology (DLT), while others might make do with a centralized database. Those that are blockchain-based will use a token to represent the digital form of fiat currency.

Although we can say that CBDCs are inspired by cryptocurrencies such as Bitcoin, they are quite different. CBDCs are issued by a state government and declared as legal tender.

Cryptocurrencies such as Bitcoin are borderless and are not issued by any state or centralized entity. Of course, this doesn't mean you won't be able to make cross-border payments with a CBDC, but Bitcoin doesn't even know what national borders are.

Many central banks are actively considering or experimenting with proof of concept for CBDCs.

China has been working since 2014 on a project called DC/EP (Digital Currency/Electronic Payments). An active trial of the digital yuan has already been implemented in several cities. The European Central Bank (ECB) published a report in October 2020 that proposed a digital euro and assessed the benefits of such a digital currency.

Understanding Central Bank Digital Currencies (CBDCs)

From a technological perspective, a CBDC is essentially a database managed and controlled by the government (or possibly approved entities in the private sector). This is why a CBDC is a database with access control, because only approved actors have the ability to transact on the network.

As such, the centralized entity that controls the database also has the ability to prevent transactions from going through, cancel transactions, "freeze" funds, or blacklist addresses .

Many CBDCs will likely run on their own blockchains. However, some of them can be issued on public blockchains. This way, authorized assets are installed on a base layer without authorization. This solution could offer the best of both worlds, as the access-controlled layer could provide the necessary control for central banks, while the permissionless layer could provide the strongest security guarantees.

However, this probably won't be the norm. Currently, no public blockchain has the technological means or has stood the test of time long enough to be able to securely take on such an important task.

Other than that, it is somewhat difficult to generally describe how a CBDC works, as each country has a different approach. They will probably all adapt the technology to their specific needs.

Benefits of Central Bank Digital Currencies (CBDCs)

You may have already heard the expression “banking the unbanked” in relation to cryptocurrencies. While the idea has some appeal, CBDCs could likely achieve this goal better than decentralized cryptocurrencies like Bitcoin. Any legal citizen with easy access to a low-cost bank account can increase financial inclusion.

Another advantage is the technological progress that the overhaul of the monetary system can bring. Although much of the money is essentially numbered in a database, most of the infrastructure is quite old. Sending an email on a Sunday afternoon takes seconds, as it should. However, due to the alembic nature of today's financial system, sending money can take several days.

During the economic responses to the COVID pandemic, we have seen that central banks must act more quickly than ever. CBDCs can enable central banks and financial institutions to implement monetary policy changes more directly than ever before. This has the potential to reshape how central banking works.

A CBDC also makes it easier for governments and central banks to track illicit activities.

Comparison of CBDCs and stablecoins

This all sounds an awful lot like a stablecoin, right? Functionally, they are somewhat similar: they both represent fiat currency in the form of a digital token. However, under the hood, they are very different.

The issuance of stablecoins is usually managed by a private entity and is essentially a representation of fiat currency or another asset. They can be exchanged for the value they represent, but they are not fiat currency. On the other hand, CBDCs are issued by the government as fiat currency.

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Comparison of CBDCs and cryptocurrencies

As we mentioned previously, CBDCs are different from cryptocurrencies. CBDCs are issued by a state government and declared as legal tender. You could think of a CBDC like banknotes: it is a unit of account, a means of payment and a store of value.

Real cryptocurrencies such as Bitcoin are quite different. They are not issued by a government and do not really concern themselves with national borders. They are permissionless, trustless, and censorship-resistant. Additionally, no centralized entity controls the network. No one can blacklist your Bitcoin address from sending a transaction to another Bitcoin address.

So which one is better? It depends on the use case. The fact that Alice can send bitcoins to Bob without any intermediary or anyone being able to censor the transaction is a powerful idea. At the same time, it has its drawbacks. What happens if a lot of money is stolen? What if Alice accidentally sent her savings to the wrong address?

Sometimes it can be useful for an entity to be able to reverse transactions or blacklist addresses. Other times, it is more useful to take advantage of the benefits that a decentralized network like Bitcoin can offer the world.

To conclude

In short, we can say that central bank digital currencies are a digital form of fiat money. Many CBDC implementations will likely use blockchain technology and provide a smoother way for anyone to make digital payments.

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