So, Bitcoin is great, huh? But why can’t I use it to buy coffee or pay taxes? While Bitcoin is a form of digital money, using it as a day-to-day currency maybe isn’t the most ideal. This use will likely be served by another type of digital asset: central bank digital currencies (CBDC).
Most countries are only exploring the idea of a fully digital currency, while others are already testing out implementations. But what makes CBDCs different from other digital assets? Let’s find out.
The technology behind moving money around in traditional finance hasn’t really been keeping up with the pace of change in the rest of the world. While it’s only a little more than sending bits from one place to another, sending money can be costly and take more time than it would be ideal.
It’s likely that many countries will adopt these digital currencies in the next decade. So how do they work?
What is a central bank digital currency (CBDC)?
A central bank digital currency (CBDC) is a digital form of fiat currency. As such, it’s established as money by government regulation.
Cryptocurrencies such as Bitcoin are borderless and aren’t issued by any state or centralized entity. Of course, that’s not to say that you won’t be able to make cross-border payments with a CBDC, but Bitcoin doesn’t even know what national borders are.
Many central banks are considering or even actively experimenting with a proof-of-concept for CBDCs.
China has been working on a project called DC/EP, standing for Digital Currency/Electronic Payments, since 2014. An active trial for the digital yuan has already been rolled across various cities. The European Central Bank (ECB) has issued a report in October 2020 that proposed a digital euro and assessed the merits of such a digital currency.
Understanding central bank digital currencies (CBDC)
As such, the centralized entity controlling the database also has the ability to prevent transactions from going through, revert transactions, “freeze” funds, or blacklist addresses.
This, however, likely won’t be the norm. At present, no public blockchain has the technological means nor stood the test of time long enough to safely be able to handle such an important task.
Other than that, it’s somewhat difficult to generally outline how a CBDC works, as each country will have a different approach. They will all most likely tailor the technology to their specific needs.
Benefits of central bank digital currencies (CBDCs)
You may have heard the phrase “banking the unbanked” in relation to cryptocurrencies before. While the idea does have some appeal, CBDCs could likely achieve this goal better than decentralized cryptocurrencies like Bitcoin. Any legal citizen having easy access to a low-cost bank account can increase financial inclusion.
Another benefit is the technological advancements that overhauling the money system can bring. While a good portion of fiat money is essentially numbers in a database, most of the infrastructure is quite dated. Sending an email on a Sunday afternoon takes a few seconds – as it should. However, thanks to the currently convoluted financial system, sending money can take multiple days.
During the economic responses to the COVID pandemic, we’ve seen that central banks need to act faster than ever. CBDCs may enable central banks and financial institutions to implement changes in monetary policy more directly than ever before. This has the potential to overhaul how central banking works.
A CBDC also makes it easier for governments and central banks to track illicit activity.
CBDCs vs stablecoins
CBDCs vs cryptocurrencies
So, which one is better? It depends on the use case. The fact that Alice can send Bitcoin to Bob without any middlemen or anyone having the ability to censor the transaction is a powerful idea. At the same time, it does have its downsides. What if a huge chunk of the money is stolen? What if Alice accidentally sends her life savings to the wrong address?
Sometimes, it can be useful for an entity to have the power to revert transactions or blacklist addresses. Other times, it’s more useful to reap the benefits that a decentralized network like Bitcoin can offer the world.
In short, we can say that central bank digital currencies are a digital form of fiat money. Many of the implementations of CBDCs will likely use blockchain technology and provide a more frictionless way for anyone to make digital payments.