The concepts of Blockchain and cryptocurrencies have become increasingly widespread over the last few years. Ever since Bitcoin’s significant rally in 2017, there has been a lot of projects and solid infrastructure built around the entire ecosystem to enhance financial inclusion.
Cryptocurrencies are already disrupting the traditional financial system, even with the ever-expanding DeFi sector providing a catalog of financial services void of any third-party. Bitcoin for example permits an almost immediate transfer of funds across borders at the fraction of the cost of the traditional system. A couple of international businesses in Africa experienced this innovation for the first time during the thick of the Covid-19 clampdown as USD became increasingly scarce. Traders had to resort to bitcoin to pay for their goods and have never looked back.
It is becoming increasingly likely that banks would become redundant, considering the level of innovation Blockchain has brought us. However, it is noteworthy that banks aren’t sitting out on this innovation. Central banks are waking up to the advantages offered by cryptocurrencies and are instead exploring Central Bank Digital Currencies (CBDC) in order to stay relevant.
What is a CBDC?
A central bank digital currency is a digital representation of fiat currency. They are blockchain-based digital currencies issued by the government, with monetary policies formed by the central bank. This makes it heavily centralized.
Talks about CBDCs have been ongoing for years as several governments have been exploring ways to establish digital equivalents to their traditional currencies. While decentralized cryptocurrencies like Bitcoin and Ethereum have become very popular across the world, they are still not yet recognized as legal tender. Central bank digital currencies (CBDC) on the other hand would be by virtue of its definition.
The notion of “banking the unbanked” – as is the case for decentralized finance is to a large extent, the same for CBDCs. Adoption of CBDC will make transactions faster and more secure, just like cryptocurrencies have done. However, it will be much easier for governments to regulate CBDCs.
A brief look at Money
To better understand CBDCs, it’s important to understand Money for what it is. By definition, money is an economic unit that generally functions as a recognized medium of exchange.
We’ve seen money evolve from seashells, precious metals, and all sorts of commodities overtime. If this tells us one thing, it’s that there are no specific forms in which money should come. Even with paper money, different countries have theirs in different shapes and sizes. Money just has to be generally recognized and believed by everyone to hold value. This notion of value should also incorporate scarcity to a large extent. Without scarcity, it’s only a matter of time before people will begin to lose trust in any asset.
We’ve seen this happen over and over through the limitless printing of fiat by central banks leading to hyperinflation. Historically, all national fiat currencies have been losing value due to this default in supply cap. These factors must also be considered when exploring CBDCs.
In addition to the definition of money above, other characteristics of money such as fungibility, durability, portability, acceptability, and stability should be in place.
These features could easily be incorporated into CBDCs. For example, digital money cannot have wear and tear since it’s not physical. It’s also way better than carrying lumps of cash.
Some Pros and Cons of CBDC
Central banks see the added advantage of CBDCs over traditional fiat currencies. This is why they are actively exploring it.
Central bank digital currencies will make for a better payment system since it will effectively lower the cost of managing cash by using a distributed ledger technology (DLT). It will also boost financial inclusion in a way cryptocurrencies like Bitcoin, Ethereum are already doing. Furthermore, it will enhance the adoption of blockchain technology and bring more validation to the cryptocurrency industry.
Nevertheless, some drawbacks must be considered too. Most notable is the competition between central banks and commercial banks for customer deposits, interest, and lending. CBDCs risk suffering cyber attacks, glitches, or human error. Its centralized nature makes it suspicious to communities of decentralized cryptocurrencies that seek to eliminate third-party such as Bitcoin. It therefore creates contrasting ideologies.
Many countries have been actively exploring central bank digital currencies. Earlier in October 2020, Bahamas became one of the first countries to officially launch a CBDC “Sand Dollar”. The Lebanese central bank plans to introduce a CBDC by 2021 which will help move Lebanon to a cashless system. China’s central bank, the People’s Bank of China (PBOC), recently laid down regulatory foundations for a forthcoming CBDC, the digital yuan.
The cryptocurrency industry is growing at a very fast and threatening pace. Only time will tell how widespread and recognized central bank digital currencies could become.