Summary

Bitcoin is awesome, right? But why can’t I use it to buy coffee or pay my taxes? While Bitcoin is a digital currency, using it as an everyday currency may not be ideal. Another type of digital asset: central bank digital currency (CBDC) could serve this purpose.

Most countries are still exploring the idea of ​​a fully digital currency, while others are already testing implementation. But what makes CBDC different from other digital assets? Let's find out.

Introduction

The technology behind money transfers in traditional finance has not really kept pace with changes in the rest of the world. While it's only slightly more complicated than sending binary numbers from one place to another, sending money can be costly and take longer than ideal.

Many governments are actively developing a new digital currency. The main benefit is to increase the efficiency of the payment system and reduce costs for each participant. You can think of CBDC as a digital fiat currency built on a new layer of technology inspired by blockchain advancements.

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

What is a Central Bank Digital Currency (CBDC)?

Central Bank Digital Currency (CBDC) is a digital form of fiat currency. Therefore, it serves as currency according to government regulations.

The way a CBDC is designed can vary significantly depending on the country or region of issuance. Some implementations may be based on blockchain or other types of distributed ledger technology (DLT), while others may simply be a centralized database. Blockchain-based CBDC uses tokens to represent fiat currency in digital form.

Although we can say that CBDC is inspired by cryptocurrencies such as Bitcoin, the two are very different. CBDC is issued by the state and declared as legal tender by the government.

Cryptocurrencies such as Bitcoin are borderless and are not issued by any country or central entity. Of course, this is not to say that you cannot use CBDC for cross-border payments, but that Bitcoin does not even have the concept of national borders.

Many central banks are considering and even actively experimenting with CBDC proof-of-concepts.

Since 2014, China has been working on a project called DC/EP (Digital Currency/Electronic Payment). Active trials of digital renminbi have already begun in several cities. The European Central Bank (ECB) released a report in October 2020 proposing a digital euro and assessing the merits of such a digital currency.

Understanding Central Bank Digital Currencies (CBDC)

From a technical perspective, a CBDC is essentially a database run and controlled by a government (or possibly an approved private sector entity). Because of this, CBDC is a permissioned database, as only approved participants can conduct transactions on the network.

Therefore, the central entity that controls this database is also able to prevent transactions from going through, restore transactions, "freeze" funds or blacklist addresses.

Many CBDCs may run on their own blockchains. However, some of them may be issued on public blockchains. In this way, they place permissioned assets on top of a permissionless base layer. This gives you the best of both worlds: the permissioned layer provides the central bank with the control it needs, while the permissionless layer provides the strongest security guarantees.

But this may not become the norm. None of the current public blockchains have sufficient technical means, nor have they stood the test of time, to prove that they can safely handle such an important task.

Beyond that, outlining how a CBDC would work is not easy as each country or region has a different approach. They may be customized to suit their specific needs.

Benefits of Central Bank Digital Currency (CBDC)

You may have heard the expression “banking the unbanked” before in the cryptocurrency space. Although this idea is indeed some attractive, CBDC can better achieve this goal than decentralized cryptocurrencies (such as Bitcoin). Any legal citizen can easily use low -cost bank accounts to improve financial inclusiveness.

Another benefit would be the technological advances that would come from overhauling the monetary system. While a large portion of fiat currency is essentially a string of numbers in a database, most of the infrastructure is quite old. It only takes a few seconds to send an email on a Sunday afternoon – it’s a given. However, due to the current complex financial system, transferring a fund can take several days.

In the economic response to the COVID-19 pandemic, we are seeing the need for central banks to act faster than before. CBDC can allow central banks and financial institutions to implement changes in monetary policy in an unprecedented direct way. This has the potential to revolutionize the way central banks operate.

CBDC also makes it easier for governments and central banks to track illegal activity.

CBDC and stablecoins

So, these features mentioned above all sound very much like stablecoins, right? Functionally, the two are indeed somewhat similar - they both represent legal tender in the form of digital tokens. However, the two are fundamentally different.

The issuance of stablecoins is typically handled by private entities, and they essentially represent fiat currencies or other assets. Their value can be redeemed, but they are not legal tender. CBDC, on the other hand, is issued by the government as a legal currency.

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CBDC and cryptocurrencies

As we mentioned earlier, CBDC is different from cryptocurrencies. CBDC is issued by the central bank and is a legal currency issued by the government. You can think of CBDC as money - it's a unit of account, a means of payment and a store of value.

Real cryptocurrencies (such as Bitcoin) are very different. They are not issued by governments, have no “borders,” and are permissionless, trustless, and censorship-resistant. Furthermore, the network it sits on is not controlled by a central entity. No one can blacklist your Bitcoin address or ban you from sending transactions to other Bitcoin addresses.

Which one is better? It depends on the use case. Alice can send Bitcoin to Bob without any middleman or anyone with the ability to review the transaction, which is a very powerful feature. At the same time, it also has its flaws. What if a large amount of money is stolen? What if Alice accidentally sent her life savings to the wrong address?

Sometimes it is useful to have an entity that can restore transactions or blacklist addresses. Other times, it’s more useful to take full advantage of what decentralized networks like Bitcoin bring to the world.

Summarize

In short, we can say that a central bank digital currency is a digital form of legal tender. Many implementations of CBDC may use blockchain technology and provide smoother digital payments for any individual.

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