Cryptocurrencies versus Central Bank Digital Currencies (CBDC)
This might go over the head for baby boomers, but do you remember when the Blackberry phone was the king of smartphones? Do you remember what happened to Blackberry after Apple introduced the first smartphone with no buttons and they refused to evolve? Physical cash appears to be quickly going the way of physical buttons on phones.
A quick snapshot of the number of digital transactions globally and the increasing number of digital currencies and fintech companies battling for a share of the free market pie provides irrefutable proof. According to www.zippia.com, as of February 2021, there were 68.42 million cryptocurrency wallets worldwide up from 3.16 million in 2015. By July 2022 there were more than 20,000 cryptocurrencies and Bitcoin alone contributes to about 400,000 transactions every day.
Although digital currencies are not new, the last decade has especially seen a tremendous leap forward in fintech thanks to smartphone technology and global internet penetration. This initiated a demand for robust online systems and structures that were safe, provided data security, and could literally manage the load of billions of global transactions every day.
Side note: So, as I was writing the intro Amazon kept coming to mind. I don’t have the data to prove this yet, but I’m sure someone needs to shake Mr. Bezos’ hand for his company’s contribution to global financial transactions. You could also include Alibaba here.
What are cryptocurrencies?
The key feature of cryptocurrencies is their decentralized nature. They are not governed by a single entity or a central government/bank. According to Investopedia, the surge of cryptocurrencies can be attributed to the following factors.
- Cryptocurrencies represent a new, decentralized paradigm for money. In this system, centralized intermediaries, such as banks and monetary institutions, are not necessary to enforce trust and police transactions between two parties. Thus, a system with cryptocurrencies eliminates the possibility of a single point of failure, such as a large bank, setting off a cascade of crises around the world, such as the one that was triggered in 2008 by the failure of institutions in the United States.
- Cryptocurrencies promise to make it easier to transfer funds directly between two parties without the need for a trusted third party like a bank or a credit card company.
- Because they do not use third-party intermediaries, cryptocurrency transfers between two transacting parties are faster as compared to standard money transfers. Flash loans in decentralized finance are a good example of such decentralized transfers. These loans, which are processed without backing collateral, can be executed within seconds and are used in trading.
- Cryptocurrency investments can generate profits. Cryptocurrency markets have skyrocketed in value over the past decade, at one point reaching almost 2 trillion dollars. As of May 2022, Bitcoin was valued at more than $550 billion in the crypto markets.
- The remittance economy is testing one of cryptocurrency's most prominent use cases. Currently, cryptocurrencies such as Bitcoin serve as intermediate currencies to streamline money transfers across borders. Thus, a fiat currency is converted to Bitcoin (or another cryptocurrency), transferred across borders, and, subsequently, converted to the destination fiat currency. This method streamlines the money transfer process and makes it cheaper.
Cryptocurrencies also have their disadvantages. Like with any new technology there are some tradeoffs in utilizing cryptocurrencies. But if the statistics are anything to go by, these disadvantages do not seem to be an impediment to the utilization of digital currencies. However, in the last decade, we have seen two significant weaknesses in cryptocurrencies – their role in the rise of cybercrime and the volatility of their value(s). These seem to be focal points of discourse when debating the validity of cryptocurrencies.
- Cryptocurrencies have become a tool for criminals in perpetuating illegal activities such as money laundering and illicit purchases. Hackers also often use them for ransomware activities.
- On the aspect of volatility, Bitcoin has experienced rapid surges and crashes in its value, climbing to as high as $17,738 in December 2017 before dropping to $7,575 in the following months. Some economists, therefore, consider cryptocurrencies to be a short-lived fad.
These weaknesses have been a major concern for world governments. Curtailing cybercrime perpetuated by cryptocurrencies and stabilizing their values is almost impossible because most cryptocurrencies and blockchain technologies still operate outside of the jurisdiction and oversight of any government.
So what are governments to do? Well, if you can’t beat them?
Enter the dawn of the Central Bank Digital Currency (CBDC)
“A CBDC or Central Bank Digital Currency is a virtual form of a country’s fiat currency. They are a store of value and can be used to make digital payments for goods and services. They are issued and controlled by the central bank of a nation. CBDCs use blockchain technology to verify and store transaction data. However, they operate on a private, permissioned network. This means that the general populace won’t be able to take part in the verification process, and the transactional data will not be disclosed to them. Instead, nodes are chosen by the central bank to participate in the verification process. These nodes will most likely be banks and other financial institutions that facilitate transactions in the system.”
Implementation of e-money has existed for a while now – see Avant from Finland and Q by the government of Czech. The present concept of CBDCs is primarily inspired by their crypto-siblings such as Bitcoin and use the same blockchain technology to operate. By April 2021, there were at least 80 central banks around the world that were doing research or proof-of-concept on digital currencies.
The idea of CBDCs is relatively simple. Central banks are keen to install oversight on digital currencies used by the general population. In theory, this will reduce the influence of cryptocurrencies on cybercrime and since its operations will be centralized and be a one-to-one equivalent to physical money, the government will guarantee the stability of its value.
But, this is just a theory. There is the issue of local governments and policies, geopolitics and more importantly convincing millions of cryptocurrency users, many of whom are anti-CBDC, to make the switch.
Here are the benefits of CBDCs according to www.pintu.co.id
- Improve financial access. Digital currency can be distributed on mobile devices, increasing access and usability for citizens who are far from bank branches and cannot access physical cash.
- Encouraging digital innovation. The CBDC platform-based software model lowers entry barriers for startups in the payments sector, encourages competition and innovation, and pushes financial institutions towards service globalization.
- Improve monetary policy. CBDC gives the central bank direct influence over the money supply, simplifies the distribution of government benefits to individuals, and increases control over transactions for tax control.
Notice how the first two benefits can also be attributes of cryptocurrencies?
Privacy concerns of CBDCs
Generally, people, especially those who are actively using cryptocurrencies, seem to be jittery about allowing their personal transaction data to be in the hands of government. (Please cue here all the media exposes and online conspiracies on how governments use personal data to spy on and profile their citizens illegally.) Here is a direct response from the United States Federal Reserve.
“Any CBDC would need to strike an appropriate balance between safeguarding the privacy rights of consumers and affording the transparency necessary to deter criminal activity. Protecting consumer privacy is critical. As noted in ‘Money and Payments: The U.S. Dollar in the Age of Digital Transformation, analysis to date suggests that a potential CBDC should be intermediated. Under an intermediated model, the private sector would offer accounts or digital wallets to facilitate the management of CBDC holdings and payments. An intermediated model would facilitate the use of the private sector's existing privacy and identity-management frameworks.
Financial institutions in the United States are subject to robust rules that are designed to combat money laundering and the financing of terrorism. A CBDC would need to be designed to comply with these rules. In practice, this would mean that a CBDC intermediary would need to verify the identity of a person accessing CBDC, just as banks and other financial institutions currently verify the identities of their customers.” – From www.federalreserve.gov
So, now that we understand what cryptocurrencies and CBDCs are, what are their similarities and differences?
Similarities
Broadly, they have two similarities.
- They are both digital currencies. This means they exist on an online infrastructure and transactions and payments are done without the use of physical cash.
- The two utilize basic blockchain technology. Blockchain runs every operation, from data storage to transaction verification.
Differences
Although we could refer to the two currencies as siblings, they also could not be any more different.
- Decentralization is probably the key difference between the two currencies. While CBDC uses the transparency and security that blockchain platforms provide, a central bank has oversight (almost entirely) on value exchange and transactions. So CBDCs are not decentralized and function under a central bank. Cryptocurrencies can be viewed as private monies while CBDCs are government-backed forms of money.
- The other key difference is data privacy and anonymity. Users of cryptocurrency have anonymity when they make transactions on the network. However, with CBDCs users have to provide personal identification data to be able to utilize the currency.
- With cryptocurrency, most decisions are made by consensus (such consensus is normally done by Decentralized Autonomous Organizations or DOAs.) They have to agree to make any policy or structural changes to the platform. The government makes decisions regarding changes with CBDCs.
- Cryptocurrencies can also be used to hold value for speculative goods or items. For example, fine art and paintings can be represented in value by cryptocurrencies. CBDCs are only used to exchange value and make monetary transactions.
- The value of cryptocurrencies is extremely volatile and depends on market activity while CBDCs are more stable, and more or less usually represent the official currency of the country.
A basic example of how crypto volatility may affect a free market and fair trade
By definition, a free market is a self-regulated economy that runs on the laws of supply and demand. By removing or minimizing regulations, the nature of the free market forces businesses to provide superior products and services that address consumers’ needs. A free market economic system also helps sellers to create affordable prices for everyone. There are however a few regulatory technicalities that govern a free market and the utilization of currencies to exchange values and make transactions and payments. The only one that matters in this context is a stable and predictable medium of exchanging value. That medium is currency.
For a true free market with fair trade to exist, either locally, in a region, or globally, the currency used has to be stabilized. Yes, that is a fact. It’s just the reality of trade in a free market. The currency, whether digital or physical, has to be stable and hold its value consistently for fair trade to occur. In a free market, goods and services are supposed to have a predictable and consistent value and this can only be actualized by stable currencies. For the most part, the volatility of cryptocurrencies contradicts this.
Reading the comments and content of most cryptocurrency proponents online, you will start getting a sense that their view or definition of the free market has ‘evolved’. To most of them, the free market should also include a free currency that no government or any single entity has oversight of. While this is the basic principle of cryptocurrencies, ideally this view of an unregulated currency is skewed and goes against the basic logic of a free market and free trade.
For example, the new iPhone 14 costs $800. This value will not change no matter where in the world I buy an iPhone from (shipping costs and local taxes not considered.) This is because the dollar is a standardized currency and can hold its value against other currencies globally. Unless an existential financial crisis occurs, an iPhone consumer expects the value of the smartphone to be more or less consistent over a long period of time.
The same cannot be said for cryptocurrencies. Tesla’s CEO, Elon Musk literally manipulated the value of Dogecoin through his tweets. Matt Williams’s contribution about cryptocurrencies on www.business2community.com suggests that the 48-hour crash of Terra (LUNA) currency value from $120 to $0.02 in May 2022 is, “A warning on crypto price volatility.”
Looking at these cases and building on the iPhone example, a smartphone may cost $800 equivalent today and cost $20,000 equivalent next week. It could be $100 equivalent the following week – and I know we all would certainly jump at the opportunity of purchasing a $100 iPhone, but that would be catastrophic to Apple and iPhone production.
Countries currently utilizing CBDCs
In October 2022, India was the latest country to roll out its own CBDC called the e-rupee. Other countries include the Bahamas which launched the Sand Dollar in October 2020. Nigeria launched the eNaira in October 2021. At about the same time, China also launched the E-CNY or Digital Yuan.
Final thoughts.
The focus of fintech companies and governments should be on creating global solutions to make seamless payments and transactions. In 2022, a set of policies, regulations, and online structures that can ensure that any digital currency can trade and conduct business should at least be in the research or testing stage. The idea of governments creating CBDCs for their own states or countries can bring more problems than solutions. There is a possibility of policy fatigue and a lot of red tape for international trade to run seamlessly with CBDCs.
Currencies, whether digital or physical, need to be regulated and have an oversight body for value stability and fair trade. So CBDCs are, at least in principle, a great idea and can improve on the genius of blockchain technology and cryptocurrencies.
I can with a degree of certainty say that a global cashless transaction platform is the next human frontier.
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