Carefully! Lots of text.

Bitcoin is very convenient, right? But why can’t you use it to pay for coffee or bills? Even though Bitcoin is a form of digital money, it is not entirely suitable for everyday payments. Other digital assets used for these purposes are central bank digital currencies (CBDCs).

Most countries are just exploring the idea of ​​switching to a fully digital currency, but some are already actively using it. What makes CBDC different from other digital assets? Let's find out.

Introduction

The technology that keeps money moving in traditional finance hasn't kept pace with changes in other aspects of our lives. While it's little more than sending money from one place to another, it can be costly and slow.

Many governments are actively developing new types of digital currencies. Their main advantage is increasing the efficiency of payment systems and reducing overall costs. CBDCs can be thought of as blockchain-inspired digital versions of fiat money at a new technological level.

It is likely that even more countries will switch to digital currencies in the next ten years. How are these currencies structured?

What is a central bank digital currency (CBDC)?

Central bank digital currency (CBDC) is a digital version of fiat currency. It can be used like regular money according to government regulations.

The approach to developing a CBDC will vary greatly depending on the issuing country. Some are based on blockchain or other distributed ledger storage (DLT), some may simply be a centralized database. In blockchain-based currencies, digital versions of fiat currency are represented in the form of tokens.

Despite the fact that CBDCs can be considered to be “inspired by” cryptocurrencies, such as Bitcoin, there is a significant difference between them. CBDCs are issued by the government and are considered legal tender.

Cryptocurrencies such as Bitcoin are not issued by a government or centralized organization. Of course, using CBDC you can also make payments abroad, but for Bitcoin there are no national borders at all.

Many central banks are considering or even actively experimenting with the concept of a CBDC.

Since 2014, the DC/EP (digital currency/electronic payments) project has been under development in China. A trial version of the digital yuan has already begun to be used in several cities. In October 2020, the European Central Bank (ECB) published a report assessing the merits of a digital euro.

The essence of central bank digital currencies (CBDCs)

From a technological point of view, a CBDC is a database managed and controlled by the government (or approved organizations in the private sector). Therefore, a CBDC is a database-controlled entity, meaning only approved entities are able to transact on the network.

That is, the centralized entity that controls the database also has the ability to prohibit and cancel transactions, freeze funds, or add addresses to a blacklist.

Many CBDCs will likely run on their own blockchains. However, some of them can be created on the basis of public blockchains. This way they could place controlled assets on top of a publicly available base layer. The controlled layer maintains the influence of central banks, while the public layer guarantees reliability and security.

However, this is unlikely to become the norm. Until now, not a single public blockchain has yet stood the test of time, and the necessary technological conditions have not been created.

Additionally, each country will have its own approach to implementing a CBDC, technologically tailored to its specific needs.

Benefits of Central Bank Digital Currency (CBDC)

You've probably heard that cryptocurrencies are bringing people into the banking system. Maybe you are right. But CBDCs will still be more effective in achieving this goal than decentralized cryptocurrencies such as Bitcoin. Any citizen with access to an affordable bank account can increase their financial inclusion.

Another advantage is technological progress, which can change the entire financial system. Although much of fiat money is essentially numbers in a database, much of this infrastructure is noticeably outdated. It takes a few seconds to send an email, but due to the instability of the financial system, sending money may take several days.

During the COVID pandemic, central banks have had to respond faster than ever. With the help of CBDC, central banks and financial institutions can make changes to monetary policy. And this can completely change the way the central bank operates.

CBDCs also make it easier for governments and central banks to track illegal activities.

CBDC and stablecoins

CBDCs are a bit like stablecoins, aren’t they? In terms of functionality, they are indeed similar: both are fiat money in the form of a digital token. However, in reality they are very different.

Stablecoins are usually created by individuals and represent fiat money or other assets. They can be exchanged for the amount they represent, but they are not fiat money. In turn, CBDCs are issued by the government as a version of fiat money.

➟ Thinking about where to start working with cryptocurrencies? Buy Bitcoin (BTC) on Binance!

CBDC and cryptocurrencies

As we said, CBDCs are different from cryptocurrencies. CBDCs are issued by the government and are considered legal tender. Like banknotes, they are both a unit of account, a means of payment, and a store of value.

True cryptocurrencies such as Bitcoin are fundamentally different from CBDCs. They are not issued by a government or controlled by a single country. They are publicly available, run on a trustless system, and are censorship resistant. In addition, they are not controlled by a centralized authority. No one will be able to blacklist your Bitcoin address and prevent you from sending transactions to another address.

So what should you choose? It depends on your goals. The ability to exchange bitcoins without intermediaries or the risk of transaction bans is extremely important and attractive to many users. However, this option also has its disadvantages. What if your money is stolen? What if you accidentally send them to the wrong address?

Sometimes an organization needs to reverse a transaction or blacklist a specific address. And in some cases, it will be more profitable to take advantage of a decentralized network such as Bitcoin.

Summary

In general, we can say that central bank digital currencies are an electronic version of fiat money. Many CBDC implementations will likely use blockchain technology and allow users to easily make digital payments.

➟ Still have questions about digital assets? Go to Ask Academy!