February 17, 2023 - 8 min read
As digital transactions continue to grow, central banks around the world are exploring the possibility of issuing their own blockchain-based digital central bank digital currencies, or CBDCs. CBDCs have gained significant appeal among governments due to the need for a safer and more efficient payment system, and while inspired by the rise of crypto, CBDCs are actually quite different in nature. In fact, one could argue that CBDCs, due to their centralized nature, are actually the polar opposite of cryptocurrencies– as they increase government control over financial systems, instead of promoting economic decentralization.
While CBDCs have become increasingly controversial, they do offer a variety of potential benefits for central banks, including making it easier to regulate individuals and institutions, providing them advanced tracking and monitoring capabilities, allowing for the quick implementation of monetary policy, as well as giving them the ability to counter the growing dominance of fintech and financial institutions. Additionally, CBDCs can reduce inefficiencies related to printing and transferring physical money, saving banks time and resources.
In their most basic form, CBDCs are simply a digital version of fiat currency– and each unit of digital currency is fully linked to the value of a fiat currency, such as the U.S. dollar or the Euro. In contrast to decentralized cryptocurrencies like Bitcoin, CBDCs are subject to regulation and control by central banks. Like all fiat currency currently circulating, CBDCs are not tied to or backed by any physical commodities such as gold or silver.
A major reason why central banks may prefer CBDCs to traditional currencies is that CBDCs may be able to provide more efficient and secure electronic funds transfers between individuals and businesses, all while preserving the central bank’s stability and control over the currency supply.
While most CBDCs are currently in their testing stages, CBDC transfers are considered to be far more secure than fiat electronic money transfers (and less susceptible to hacking and fraud) due to the immutable nature of blockchain technology. This is reinforced by the fact that CBDCs establish a highly reliable public record of transactions.
In addition, CBDCs can also enable seamless cross-border payments, eliminating expensive and ineffiecnet payment processors. With CBDCs, central banks will, in theory, also have more control over the money supply, improving their ability to enact monetary policy.
Currently, there are two main categories of CBDCs: retail and wholesale. The general public is the target market for retail CBDCs, which lets users store digital currency in electronic wallets and make payments with it.
In contrast, wholesale CBDCs are explicitly created by banks and other financial organizations, enabling faster money transfers and transaction settlements. Ideally, these wholesale CBDCs will greatly increase the efficiency of international payments, such as inter-bank money transfers. Since wholesale transactions are recorded on a public digital ledger, wholesale CBDC transactions could also prevent counterfeiting.
However, there are many potential downsides to CBDCs. One potential negative is that central banks could use CBDCs to prevent or manipulate business transactions that they don’t approve of, causing economic disruption and infringing on individuals’ economic rights. In addition, the widespread adoption of CBDCs may decrease demand for bank deposits, a significant source of funding for banks, resulting in liquidity problems and potential financial instability. CBDCs also present significant privacy and security concerns, and, even if implemented in a well-intentioned manner, would provide governments and banks unprecedented levels of information on– and financial control over– ordinary citizens.
Just as with business transactions, many fear that CBDCs could be used to prevent people from making purchases that the government doesn’t approve of– even if these transactions are fully legal. For instance, some commentators fear that CBDCs could be used to enforce draconian environmental regulations on individuals, limiting the amount of meat they purchase or gasoline they buy.
In today’s economy, retail consumers have a variety of digital payment options to choose from, including physical credit cards and debit cards, mobile wallets, and, in some situations, cryptocurrencies. Consumers’ may weigh several factors when deciding which payment method to use. For example, credit cards– whether physical or digital– may offer bonus points and cash back rewards. Some also consider credit cards to be safer than debit cards, since it may be harder to cancel a debit card transaction when compared to a credit card transaction. Mobile wallets, pre-loaded with credit card, debit card, or bank account information, are extremely efficient, but some consumers may be worried about hacking, and might consider mobile wallets to be less secure than physical cards. In general, many consumers feel that cryptocurrency offers the greatest level of transaction privacy, so, when possible, they may opt to pay in crypto for more private purchases.
Although certain vendors do accept cryptocurrency payments, most cryptocurrencies experience significant price volatility. In general, this makes them unsuitable to use as instruments for frequent payments. Unlike crypto, fiat-denominated transactions using CBDCs or credit cards do not involve the same price volatility.
However, it should be noted that there are a wide variety of privately-issued stablecoins that individuals can pay with, including many, such as USDC, that are fully, 1:1 backed by the U.S. dollar. However, even these fiat-backed stablecoins can experience temporary price fluctuations during periods of market turmoil, meaning that they temporarily “de-peg” from the U.S. dollar. Decentralized and crypto-backed stablecoins are another potential payment method, but they are generally more volatile than fiat-backed stablecoins.
As previously mentioned, consumers can experience several benefits by using credit cards, including liability protection for fraud and cashback rewards. Many credit cards provide cash back rewards of 1%, which can add up significantly over time. Bonus cashback rewards may also be available in specific spending categories, such as gas, groceries, or travel.
While credit cards place liability on commercial banks and other authorized financial institutions, CBDCs place direct liability on the central bank as the main issuer of the currency. While many merchants and vendors accept credit cards, they also risk incurring late fees, interest charges, foreign transaction fees, and other associated fees. However, credit cards are still relatively secure, making them a good choice for both consumers and businesses in many situations.
As we touched on before, privacy is again, a major concern when it comes to CBDCs. CBDCs may provide some degree of privacy for users, but the level of anonymity can vary depending on the specific design choices made by central banks and policymakers. However, most believe that CBDCs are far less private than traditional fiat transactions, and even less private than cryptocurrencies– and, unlike credit cards, your central bank will not be providing a 1% cash back offer on everything you spend.
When using a credit card, individuals still give up a certain level of privacy to the retailer or vendor– which could sell their information to a third party– or, as more usually happens, consumer information may be exposed in a cybersecurity breach. This can allow hackers to steal credit card data and use it to rack up fraudulent transactions on a credit card. On the other hand, cryptocurrency transactions eliminate this risk, as they go directly from the sender’s wallet to the recipient without intermediaries. Moreover, crypto transactions are irreversible and can only be refunded by the receiving party, whereas credit card transactions can be canceled.
Both credit cards and cryptocurrency are secure payment methods that offer users discretion over their transactions. In contrast, CBDCs are produced and governed by governments and, as a result, are under their authority. This implies that users of CBDCs might have less flexibility to transact than they would with credit cards or cryptocurrency. Ultimately, consumers will continue to choose payment methods that best align with their individual needs and preferences.
In the eyes of central banks and government regulators, CBDCs could offer a solution that combines the convenience of credit cards or cryptocurrencies with the privacy of cash. In theory, CBDCs can be designed to ensure privacy and confidentiality– though in practice, this may be very difficult to achieve.
In an ideal scenario, CBDCs transactions would not be linked to personal identity data, providing greater anonymity than credit cards or cryptocurrencies. In general, legal experts consider financial privacy and the idea of freedom to transact to be essential human rights- as people should be allowed to make financial transactions without worrying that their personal information will be misused by corporations and governments.
In theory, a government would need to have a warrant– or some other type of valid legal reason, in order to mine an individual’s personal information from a CBDC ledger. However, some commentators believe that governments cannot be trusted to avoid spying on their citizens, and, much like the myriad of scandals involving the U.S. NSA, in practice, there might be little to prevent governments from using information from CBDC transactions for a variety of purposes.
In fact, public concern about CBDC privacy has grown so great that, in late March 2023, Florida governor Ron DeSantis announced legislation to ban CBDCs in the state, due to fears of increased government surveillance and the negative impact that CBDCs would have on local and regional banks.
However, CBDCs would still have some benefits, such as cutting out intermediaries like banks and credit card companies. This, in turn, could reduce transaction costs for businesses and consumers. Additionally, CBDCs could provide a means for central banks to stimulate the economy through monetary policy directly, such as by providing direct, digital payments to citizens. This could cut down on the types of fraud and inefficiency that were commonly seen during the process of giving stimulus checks to individuals during the height of the COVID-19 pandemic.
Overall, CBDCs could be far more useful for large, enterprise transactions, such as bank-to-bank transactions and short-term inter-bank lending facilities, rather than for consumer purposes. Plus, these types of enterprise transactions wouldn’t put individual citizens’ privacy at risk. CBDCs might also be useful for international remittances, in which individuals that have immigrated to a new country send money to their families back home. Remittance fees are incredibly high– often as high as 7%, and CBDCs could eliminate these costs.
Despite some potential benefits, the implementation of CBDCs would require centralization that could amplify existing cyber vulnerabilities and increase the risk of cyber attacks on central banks. This would transfer the risk from individual banks to central banks, which could erode the credibility of the financial system. In addition, due to privacy concerns, consumers may actively attempt to avoid CBDCs by using physical cash or cryptocurrency in an attempt to avoid government surveillance.
Before CBDCs are rolled out to the general public and adopted by the financial services industry, a number of serious considerations must be taken into account. Even though they may be able to offer greater “transactional freedom” than credit cards or cryptocurrencies, issues still abound, including how CBDCs affect privacy, interoperability, consumer protection, and financial stability.
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