Brief content
So Bitcoin is great right? But why can't I use it to buy coffee or pay taxes? Although Bitcoin is a form of digital money, using it as an everyday currency may not be the best option. This use will likely be served by another type of digital asset: Central Bank Digital Currencies (CBDCs).
Most countries are just exploring the idea of a fully digital currency, while others are already testing its implementation. But what makes CBDC different from other digital assets? Let's find out.
Introduction
The technologies behind the movement of money in traditional finance are not really keeping up with the pace of change in the rest of the world. While it's little more than sending bits from one place to another, sending money can be expensive and take longer than ideal.
Many governments are actively developing a new type of digital currency. The main advantages are increasing the efficiency of payment systems and reducing costs for all participants. You can think of CBDC as digital fiat money developed at a new technological level, inspired by the advancements of blockchain.
It is likely that many countries will adopt these digital currencies within the next decade. So how do they work?
What is Central Bank Digital Currency (CBDC)?
A central bank digital currency (CBDC) is a digital form of fiat currency. They are established as money by the state regulator.
The approach to CBDC development is likely to vary greatly depending on the issuing country. Some implementations will likely be based on a blockchain or some other type of distributed ledger technology (DLT), while others may likely simply be a centralized database. Those based on blockchain will use a token to represent a digital form of fiat currency.
Although we can argue that CBDCs are inspired by cryptocurrencies like Bitcoin, they are completely different. CBDCs are issued by the government and declared legal tender by the government.
Cryptocurrencies like Bitcoin have no borders and are not issued by any government or centralized organization. Of course, this doesn't mean you won't be able to make cross-border payments using CBDC, but Bitcoin doesn't even know what national borders are.
Many central banks are considering or even actively experimenting with CBDC concept testing.
China, which has been behind digital currencies/electronic payments since 2014, is working on a project called DC/EP. Active trials of the digital yuan have already taken place in various 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 perhaps by approved organizations in the private sector). This is why the CBDC is a permissioned database, as only approved entities are able to transact on the network.
Thus, the centralized entity that controls the database also has the ability to prevent transactions from going through, cancel transactions, freeze funds, or add addresses to a blacklist.
Many CBDCs will likely run on their own blockchains. However, some of them may be released on public blockchains. As such, they would allow permitted assets to be placed on top of a "no-permission" baseline. This can provide the best of both worlds, as the permissioned layer can provide the necessary controls for central banks, while the "permissionless" layer can provide the most robust security guarantees.
However, this is unlikely to be the norm. Currently, no public blockchain has the technological means and has stood the test of time to safely handle such an important task.
In addition, it is quite difficult to describe in general terms how CBDC works, since each country will have its own approach. Most likely, they all adapt the technology to their specific needs.
Advantages of Central Bank Digital Currencies (CBDCs)
You may have heard the phrase "bank without banking" before as it relates to cryptocurrencies. While the idea has some appeal, CBDCs could probably 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 can bring an overhaul to the monetary system. While much of fiat money is essentially numbers in a database, much of the infrastructure is outdated. It takes seconds to send an email on a Sunday afternoon. However, due to the complex financial system at the moment, it may take several days for the money to be sent.
During the economic response to the COVID pandemic, we have seen that central banks must act faster than ever. CBDCs can allow central banks and financial institutions to make changes to monetary policy more directly than ever before. This can completely change the way the central bank works.
CBDC also makes it easier for governments and central banks to track illegal activity.
CBDC vs Stablecoins
So, this all sounds pretty stablecoin-like, right? Functionally, they are somewhat similar: both represent fiat money in the form of a digital token. However, they are completely different inside.
Stablecoins are usually issued by a private organization and are basically fiat money or any other asset. They can be exchanged for the value they represent, but they are not fiat money. CBDCs, on the other hand, are issued by the government as fiat money.
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CBDC vs Cryptocurrencies
As we mentioned earlier, CBDCs are different from cryptocurrencies. CBDCs are issued by a central bank and the government issues legal tender. CBDC can be thought of as banknotes, it is a unit of account, a means of payment and a means of saving.
Real cryptocurrencies like Bitcoin are completely different. They are not issued by the government and do not particularly care about national borders. They are "permissionless", have insufficient credibility and are resistant to censorship. In addition, there is no centralized authority that controls the network. No one can blacklist your Bitcoin address to send a transaction to another Bitcoin address.
So which is better? It depends on the use case. The fact that Alice can send Bitcoin to Bob without intermediaries or anyone having the ability to view the transaction is a powerful idea. At the same time, it has its drawbacks. What if most of the money is stolen? What if Alice accidentally sends her savings to the wrong address?
Sometimes it may be useful for an organization to be able to cancel transactions or blacklist addresses. In other cases, it is more beneficial to take advantage of a decentralized network such as Bitcoin.
Final thoughts
In short, central bank digital currencies are a digital form of fiat money. Many of the CBDC implementations will likely use blockchain technology and provide a more convenient way for anyone to make digital payments.