The ABCs of CBDCs

The institutional response to a surge in global cryptocurrency adoption has been the development of central bank digital currencies (CBDCs). Official communications from governments around the world have described the move as a software update of sorts to the payments system, which would bring the current one into the digital age. The question though, is whether there’s room enough in the system for cryptocurrencies and CBDCs?

First, a peek under the fiat hood

We’re missing bits of crucial information when simply referring to all money as fiat money, says Dr Co-pierre Georg, who holds the South African Reserve Bank Chair in Financial Stability Studies at the University of Cape Town.

The money in circulation today is made up of central bank money, bank money, and non-bank money.

Central bank money includes bank notes issued by the central bank and digital cash held by commercial banks at the central bank. Traditionally, this type of money is considered the safest as there’s virtually no chance that a central bank will go bankrupt.

Commercial bank money is digital currency held in accounts at commercial banks. It’s a bit more risky than cash issued by central bank money as banks have gone under in the past, but still, highly unlikely.

Non-bank money is digital currency held at non-bank financial service providers such as Paypal. This form of money carries the most risk, as companies are most susceptible to going bust.

What is a CBDC?

A CBDC is the modern, digital version of central bank money. “It combines the security of bank notes and the functionality of digital payments,” says Georg. These central bank-issued digital currencies are as secure as the central bank backing it. For example, a CBDC backed by the Fed in the US would be infinitely safer and more stable than one issued by Zimbabwe, a country whose legal tender is virtually worthless due to the government’s monetary policy and spiralling inflation.

To clarify, CBDCs are not cryptocurrencies. A CBDC controlled by a central bank with power over the blockchain nodes is a centralised technology with blockchain-afforded capabilities.

Cryptocurrencies are designed to function on a peer-to-peer network that runs on hundreds or thousands of independent nodes, which gives these virtual assets unique traits: There’s no need for an intermediary and it makes activity on the blockchain tamper-proof.

There are downsides to decentralised cryptocurrencies, too. A decentralised cryptocurrency still in its infancy is more exposed to financial crime and price volatility in the markets, and the scaling of these technologies continues to be a thorny issue for even the most established among them. CBDCs can offer users respite from these issues but with that comes concerns of privacy and other issues related to traditional fiat money, including worries around inflation.

It’s the classic cryptocurrency trilemma at work, says Wiehann Olivier, partner and digital asset lead at Mazars, an audit, tax and advisory firm. Scalability, security and decentralisation are almost impossible to maintain on the same level. To put weight behind one element, something’s got to give on other fronts.

Government-issued digital currencies may in future simply be a matter of preference over a stablecoin like Tether or USDC. “Not everyone is ready for the current volatility issues that come with cryptocurrency transactions or the trust issues related to some stablecoins,” says Olivier.

What can a CBDC do?

“A CBDC will be a formidable tool for financial inclusion,” says Jerome Ajdenbaum, VP of Digital Currencies at IDEMIA. “Remember that 1.7 billion people are still unbanked, and the technology behind CBDC allows to lower the costs of operations and reach some populations the traditional payment system was not able to,” he says. “It used to be unreliable and costly to send an SMS abroad, now with the apps on smartphones it is instant and free. This is a good illustration of what technology can do, of what a CBDC can do in payments,” he explains.

For now, it remains unclear how CBDCs will tie into the global payments system. The Bank of International Settlements (BIS) said that government-appointed teams will have to collaborate to ensure that digital currencies speak the same language and are interoperable.

The BIS highlighted three likely models for what a CBDC could look like.

• Compatible CBDC system
• Interlinked CBDC system
• Single system for multi-CBDC arrangements

China has given us a glimpse of what a CBDC may look like, as it’s the first of the global superpowers to pilot a working CBDC, called e-CNY, which it launched in February this year. The e-CNY is connected internationally through existing retail and wholesale payment systems but at the moment it’s mainly geared for domestic use.

Ajdenbaum says researchers are currently testing the merits of a centralised framework for a CBDC versus that of a blockchain, in terms of security, throughput and resilience.

“The volume of transactions and the speed at which transactions happen will greatly increase,” says Olivier. Many blockchains also have smart contract capabilities that could automate pension and grant payments if incorporated alongside CBDCs. “It’s programmable money,” he adds.

Once CBDCs are operational, the size of the CBDC market will make it an obvious choice for developers and entrepreneurs, says Georg. “A CBDC is a universally accessible digital currency platform,” he says. “Private crypto assets are orders of magnitude smaller in their market capitalisation and the number of users they reach.” He thinks the payments space will eventually be occupied by CBDCs and low-value, real-time payment systems like TIPS in the EU and PIX in Brazil. These systems enable fund transfers in real time and around the clock, but, for now, the services are confined to markets inside regional or country borders.

Entrepreneurs will have to consider whether they want to build a product using a CBDC and reach a huge market or target a niche market by building on private crypto assets. Georg says this is a no-brainer, provided governments get the rollout right. In five years from now CBDCs will dominate the ecosystem, he says. But there’s a niche for cryptocurrencies.

What’s next for cryptocurrencies?

Cryptocurrencies and CBDCs are part of the evolution of value exchange. As more value is created on the internet, the need for a payment system that can handle many low-value transactions continues to grow, explains Georg.

Large tech companies have the power to launch stablecoins that can reach a massive user base and become an attractive alternative payment platform to CBDCs. These types of payment platforms are of concern to governments as they can’t be regulated and threaten to disrupt the central bank-based monetary policy. “A CBDC will make it easier for governments to ensure that all companies using it comply with the relevant regulation,” Georg says.

There’s also the issue of being left out in the cold while other nations are quickly making headway with their own projects. CBDC development has reached a stage where governments can’t afford not to develop a CBDC as many others are already in the implementation phase.

Georg thinks there’s room for both cryptocurrencies and CBDCs. And Olivier says that different needs in the market will drive demand for both technologies, the same as what is currently happening in the cryptocurrency market. “Bitcoin, Ether and Ripple have different characteristics that fill different gaps in the market” Olivier says.

The outcome will depend on the interoperability of the different digital currencies. If we lived in a bubble where one set of rules and laws applied, where a CBDC directly and only competed with a stablecoin, then, yes, there could be clashes, but CBDCs have some very deep waters to cross before becoming a truly global payments solution, Olivier explains.

Bitcoin has a way to go before its price is stable enough to be considered a payments solution, says Ajdenbaum, but with increased regulation, stablecoins may become more acceptable among regulators. Between a cryptocurrency like Bitcoin, a stablecoin or CBDCs, “there will most probably not be a single winner,” he says.

Perhaps it’s not so much a question of which solution, crypto or CBDC, will come out on top, but rather whether they are playing on the same field in the first place? Not at this stage, anyway.

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