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Interest in central bank digital currencies (CBDCs) has risen since the start of June, particularly after China’s ban on Bitcoin miners. Although cryptocurrencies have dominated decentralized finance (DeFi) over the years, CBDC has become the new topic of discussion in recent times. Instead of being persuaded to adopt the ever-popular cryptocurrency, countries have opted to experiment with this new form of currency. So, what are CBDCs and how important are they?
What Is A CBDC?
A CBDC is a virtual form of a country's fiat currency; effectively, it is a new type of money that governments are experimenting with to facilitate payments and reduce transactional costs. A CBDC would utilize a centralized blockchain to initiate payments and allow designated entities to hold copies of transaction history or an immutable ledger. In addition, CBDCs share parity value with the country’s fiat currency.
Countries like China, the U.S., South Korea, and Nigeria are already exploring the idea of having a digitized form of their fiat currencies. In fact, China, South Korea, and Nigeria have already completed a trial of their CBDC networks. Venezuela was the first to pioneer the idea in 2018 when it launched the Petro; however, it was plagued by issues and seldom used. Currently, CBDCs are yet to be employed on a large scale because development is still in its infancy in the majority of nations.
Features of CBDCs
CBDCs are basically a more centralized version of Bitcoin/blockchain technology, which is combined with the national government’s fiat currency. This new form of digital currency utilizes distributed ledger technology (DLT), which would exist over multiple locations, enabling the elimination of central authorities and intermediaries as well as allowing enterprises to validate their transactions.
Money has already become digital; for example, credit-card users use applications to check balances and money is moved around the world at the click of a button. Physical currency (cash) is gradually being superseded and CBDCs are the next step towards employing a different technological model. As discussed earlier, CBDCs utilize DLT. Unlike Bitcoin technology, DLT is somewhat restrictive in relation to who can access records and manage transactions, and it is composed of several copies of the transaction history that are managed by a central authority; in this case, is the country's central bank.
CBDCs vs Cryptocurrencies: What Are the Differences?
CBDCs utilize DLT, which may or may not be implemented on a blockchain and will most likely be centralized. Cryptocurrencies, on the other hand, utilize blockchain technology and aim to be decentralized in nature. One of the main reasons (beyond technological limitations) that governments have been so slow to embrace blockchain technology is because of their dependence on centralized control of their assets. This is why they prefer a DLT to run on a more centralized platform.
Supply
Bitcoin has a limit of 21 million BTCs. In the case of CBDCs, governments, and the central bank in particular, is in charge of supply. These powerful entities choose when to increase or decrease supply to stimulate the economy. In addition, supply is effectively infinite.
Control
The central bank or permissioned enterprises would manage the DLT. Conversely, in relation to Bitcoin and many other blockchains, anyone can run the software.
Advantages of CBDCs
Lower Transaction Costs
The structure of CBDCs allows for higher efficiency and lower transaction costs. CBDCs will foster cooperation amongst financial entities, paving the way for a smoother financial system.
Track Payments
Full records of transactions are held in DLTs. This allows the government to effectively monitor transactions and keep tabs on any potential terrorism-related or illegal activities.
Promote Financial Inclusion
Many people around the world have not banked their money; with CBDCs, these individuals will be financially included.
Disadvantages of CBDCs
Centralized Control
The central bank, which is referred to as the central authority, controls the CBDC and conducts transactions. It also controls the number of transactions and the data that is transferred between customers and banks.
No Privacy
Customers will have to give up some degree of privacy, since the central bank is responsible for conducting transactions, disseminating, and collecting digital identifications.
How a CBDC is Developed?
Countries partner with blockchain solutions, such as Algorand, to facilitate the development of its CBDC. This solution bridges the gap between decentralized and centralized financial models. With its L1 abilities and interoperability, countries and even organizations can leverage these elements to redefine the future of finance. The beauty of Algorand’s co-chains is that they can be designed to be as centralized or as decentralized as the governing entity desires. Indeed, these co-chains can run independently of the Algorand blockchain and only need to access it when transacting with other co-chains on the network.
One glaring problem with some blockchains, including Bitcoin, is the power needed to engage in transactions. Energy consumption can be excessive with proof-of-work models, and this leads to a large and unsustainable carbon footprint. Algorand has a much lower level of energy consumption and aims to be consistently carbon negative.
CBDCs are growing ever more popular and are rumored to become the future of finance. Learn more about CBDCs and digital currency by reading this article.
