As decentralized finance (DeFi) takes the world by storm, many are wondering how the centralized multi-trillion dollar banking industry participates in Web3.
In DeFi’s aim to put power in the hands of the people rather than under the control of conglomerate entities, some believe central bank digital currencies (CBDCs) are counter-intuitive to the Web3 movement. Alternatively, CBDCs can help underdeveloped countries with poor banking infrastructure achieve fiscal progress at unprecedented rates.
This article explores all things CBDC, which includes definitions, examples, projects launched, and potential effects on the average investor.
Overview of CBDCs
CBDCs are a new form of monetary unit being tested by government agencies around the world to bring banks into the ever-expanding Web3 space.
What sets a CBDC apart from other non-cryptocurrencies seems to be that enthusiasts believe it will be able to use new technologies, such as a blockchain or digital ledgers, to improve payment efficiency and reduce costs.
Free cash and savings held by eligible financial institutions with the central bank are the two most common forms of central bank money. CBDCs are a new kind of currency that uses smart documentation or virtual tokens to represent a country’s virtual currency, and the technology is trying to be a third form of central bank money. A CBDC is generated and administered directly by the banking system and can be used by consumers, businesses and investment firms.
An important aspect to consider seems to be the type of blockchain used by CBDCs. Because commercial banks, for acceptable or unacceptable reasons, wish not to immediately post activities or other financial information on the blockchain, CBDCs are typically built on a private blockchain system.
This form of ledger, often referred to as a permissioned blockchain, is distinct from decentralized blockchains like Bitcoin, Ethereum, and Solana. The ability to monitor and conduct operations on the blockchain must be granted to peer nodes by centralized power, and this power is usually granted by centralized banks.
A large number of countries have been involved in research to enable their economies to use a CBDC. In fact, according to CBDC Tracker, over 50 countries have worked on integration. Nigeria, Bahamas and China came out early.
Given the global importance of the US dollar, the US Federal Reserve is considering operating CBDCs, but needs to verify the effectiveness and ensure that there are no political issues regarding this new initiative.
How are CBDCs different from cryptocurrencies?
To explain the inherent differences between CBDCs and cryptocurrencies, it is important to define these terms. Cryptocurrencies are decentralized digital assets built natively on permissionless blockchains. Cryptocurrencies can be used for both financial transactions and speculation. No centralized authority can regulate their use. Moreover, their offer is historically limited and cannot be adjusted without the agreement of a majority of users.
CBDCs are a centralized digital currency controlled by a central institution, whose blockchain network can only be accessed and used by a select group of financial institutions. CBDCs can only be used for payment purposes; investing is not possible because the coin is not tied to the specified dollar value, it is fiat currency itself.
Three distinct differences between CBDCs and cryptocurrencies emerge:
- Privacy: Crypto users remain anonymous while CBDC users have their names associated with the digital currency to some degree.
- Utility: Crypto can be used for investing and storing value in general, while the CBDC’s transactional value is limited and allowed only within its own system.
- State of the blockchain/centralization: Crypto users are familiar with permissionless decentralized blockchain. CBDCs use an authorized blockchain.
Countries working on central bank digital currencies
Many countries are working on integrating CBDCs, including Nigeria, the Bahamas, and China.
The CBDC of Nigeria is arguably the largest among the countries listed. The Central Bank of Nigeria (CBN) launched its CBDC, the “eNaira”, on October 25, 2021. The eNaira, like currency and silver, is an asset of the CBN. This categorization is important because Nigeria is one of two fully launched CBDC protocols, and Nigeria is much larger than the Bahamas.
eNaira is held in digital wallets and can be used for financial transactions; it can also be digitally transferred for free to anyone with an eNaira wallet anywhere in the world. However, there remain significant gaps against crypto assets. eNaira, for starters, is subject to strict limitations on central bank access rights. Second, unlike crypto assets, eNaira is a digital version of a national currency that derives its value from the real naira, to which it is pegged.
The Bahamas are in a similar situation. It was the first country to launch a CBDC. The Sand Dollar is a digital version of the Bahamian Dollar issued by the Central Bank of the Bahamas in October 2020. It is one of only two fully operational retail CBDCs in the world. The sand dollar is issued by licensed financial institutions and has the same legal status as normal currency. It can be used for a range of transactions.
China’s situation is very remarkable for many reasons. Central bank-backed digital currencies have not yet been properly launched in China. However, many financial institutions have implemented pilot programs and research initiatives to determine the feasibility and use of a CBDC in their economy. China is the country that has made the most progress in this approach, having created the framework and launched a pilot program for the introduction of a digital yuan. The digital yuan is rapidly adopted in early 2022 for use in the 2022 Beijing Olympics.
What blockchains do CBDCs use?
CBDCs use permissioned blockchains which are different from permissionless blockchains. While permissionless and permissioned blockchain technologies provide comparable value propositions, inherent qualities make each better suited for some applications and much less suited for others.
Permissionless blockchains are most often used in applications that have a large financial component or require highly decentralized blockchains.
Authorized blockchains have opened up new possibilities for applications that rely on privacy and security.
CBDC vs. Stablecoins
CBDCs and stablecoins have many differences and some similarities.
To begin with, stablecoins are a cryptocurrency and are therefore open and can be transferred to third-party services. Stablecoins are more publicly transparent than central bank digital currencies.
CBDCs are inherently different because the issuer hosts the currency, decides its use cases, and keeps the transactions private.
They both represent a 1:1 backed dollar and are easily redeemable for fiat currency.
Are central bank digital currencies decentralized?
CBDCs are not decentralized. Complete decentralization of a country’s financial system would likely be seen as challenging the inherent nature of its governance.
The crypto market is extremely bearish in January 2022. Bitcoin dropping below $40,000 and Ethereum dipping below $3,000 are potentially indicative of a downward run with over 30% decline from their historic highs.
Can you invest in CBDCs?
No, CBDCs can be held, but are not intended to be used as an investment. You can think of CBDCs in the same way as cash where they are used almost entirely for simple transactions. CBDC transactions are similar to debit cards. Additionally, if you are looking to earn interest on a token pegged to the US dollar, stablecoins offer a better option, as they are interoperable with lending programs like Aave and Curve.
CBDCs are unlikely to take the markets by storm if properly integrated. They work as a way for governments and banks to integrate with Web3.