With cryptocurrencies exposing the inefficiencies of traditional payment systems, central banks have begun to explore the concept of central bank-issued digital currencies.
Read on as we discuss how CBDCs differ from cryptocurrencies, their opportunities and risks, and the controversy behind them.
This is partner content sourced from Laura Shin’s Unchained and published by CoinDesk.
What is a central bank digital currency?
A central bank digital currency (CBDC) is a blockchain-based digital form of fiat currency issued and managed by a central bank.
Since CBDCs are essentially a blockchain-powered version of a country’s national currency, CBDCs are automatically considered legal tender and can be used for payments. The primary idea behind CBDCs is to offer a government-sanctioned digital payment system that addresses payment inefficiencies within a country.
How is CBDC different from cryptocurrency?
CBDCs only draw inspiration from cryptocurrencies, but they are significantly different from them. Cryptocurrencies’ key feature is the decentralized aspect. Decentralized digital currencies like Bitcoin are borderless, permissionless and censorship resistant. Peer-to-peer transactions take place on public blockchains, and no one can tell a user what they can or cannot do with their digital money.
For CBDCs, the central bank controls the digital currency and oversees transactions, potentially allowing it to take actions such as freezing funds, blacklisting digital wallet addresses, and directly prompting individuals to spend their money (as opposed to saving it), especially if the CBDC is programmable.
Since most CBDCs are in the conceptual stages, we will have to wait and see how they will actually function (especially outside national borders), and the level of control that central banks will have.
Types of CBDCs
There are two main types of CBDCs: wholesale and retail.
The classification depends on the intended users: one is for financial institutions, and the other is for the general public.
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Wholesale CBDCs target financial institutions, which can use them for interbank transactions.
The intended users of retail CBDCs are the public for everyday transactions, such as buying goods and services and sending money. Ideally, retail CBDCs will complement traditional bank accounts and cash. However, it is still too early in the concept and implementation stage to determine the impact on traditional financial systems.
Opportunities and Risks of CBDCs
CBDCs could potentially change the financial landscape. However, it is still too early to determine whether the net change will be positive or negative for society. Here’s a look at the opportunities and risks it presents.
Advantages
Third-party risk elimination: The system relies on the central bank’s stability, unlike in traditional finance, where commercial banks are the counterparties.
Cost reduction: Central banks will deal directly with the public and remove the current expensive banking infrastructure. This has the potential to lower transaction costs.
Financial Inclusivity: CBDCs can potentially provide a financial structure that facilitates access to financial services.
Disadvantages
Complete lack of privacy: CBDCs will require a healthy dose of personal information. The issuing central banks are responsible for monitoring fraud and determining the legality of transactions. The government will have access to financial information without having to go through third parties to access it.
Government control over consumer behavior: CBDCs run the risk of being tools that the government uses to encourage certain practices in line with its policies. For example, a government can only program its CBDC to be used to buy certain goods and services, but not others.
Centralization risk: With CBDCs, central banks are likely to be the sole entity in control of the digital currency, creating a single point of failure that hackers can exploit, which could have crippling effects on the economy if a hack occurs.
Why are CBDCs considered controversial?
A key issue with traditional finance is the control that third parties such as banks have over transactions. CBDCs will take further control and give the government direct access to everyone’s financial information.
Furthermore, if a CBDC is programmable, it would allow the government to actively encourage or discourage certain behaviors by its population. For example, it can directly prevent citizens from buying things like alcohol or cigarettes, if the government wants to actively discourage consumption. Clearly, there is potential for abuse of such access and control.
In a world where people resent the lack of privacy from government hacking and surveillance, CBDCs will only serve to exacerbate the problem.
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