Central Bank Digital Currency(CBDC) and its impact on the ecosystem
By : Susmith Karan
Central Bank Digital Currency (CBDC) has been a hot topic these days. The 2021 BIS survey of central banks found that 86% of the countries were actively researching the potential for CBDCs, 60% were experimenting with the technology, and 14% were deploying pilot projects. Is this interest is to counter the popularity of cryptocurrency, or is it a natural progression or both? How does it will impact the overall ecosystem?
What is CBDC?
CBDC is the digital currency issued by the Central Bank of a country with legal tender status. This digital currency will make real-time payments more accessible, cheaper and reduces the burden of handling cash. There are two types of CBDCs: Retail CBDC and Wholesale CBDC. A Retail CBDC would be used as a digital extension of cash by all people and companies. In contrast, a Wholesale CBDC could be used only by permitted institutions as a settlement asset in the interbank market[i].
CBDC is like an electronic version of currency like the dollar and rupee, which coexist with physical cash. Like a paper-based currency note with a unique serial number, each CBDC unit will also be distinguishable to prevent imitation[ii].
Currently, 83 countries are now exploring CBDC. Out of which, five countries have fully launched CBDC. The Bahamian Sand Dollar was the first CBDC to become widely available. Fourteen other countries, including major economies like China, Sweden, and South Korea, are now piloting their CBDCs and preparing a full launch[iii].
Why CBDC?
Different countries are adopting different versions of CBDC, and their benefits differ according to its adopted version. More broadly, the advantages of a country for adopting the CBDC are improving the efficiency in the payment systems, minimizing settlement risk and reducing the liquidity needs.
CBDC can be used as a financial inclusion tool to bring the unbanked into the mainstream and minimize the bank’s liquidity needs by reducing the banking system’s leakages. More importantly, this will improve the monetary policy transmission, a process by which a central bank’s monetary policy signals (like interest rate) are passed on to influence the businesses and households to meet its ultimate objectives of inflation and growth.
CBDC has a traceability feature to help deal with money laundering and black money issues that contribute to revenue leakage and threaten national security. The inherent benefits of CBDC are prompting the countries to adopt the CBDC. The utility and success of CBDC will depend upon the socio-economic structure of that country.
Can Cryptocurrency and CBDC coexist?
It is also true that the phenomenal rise of blockchain-based cryptocurrencies like Bitcoin, Ethereum etc., can disrupt the traditional payment system and threaten the country’s financial stability.
Given the evidence in the news, It is not very clear if all the countries will be using blockchain technology and distributed ledger in their CBDC. Even if it uses blockchain technology, CBDC works on permissioned blockchains, i.e., only authorized institutions like Banks and Financial intermediaries can validate and provide access to the users. This permissioned blockchain is a cost-effective and practical system exercising centralized control on the network.
Some economists argue that blockchain use is unnecessary for a retail CBDC as the central bank already establishes trust[iv]. The country’s interest in the blockchain-based CBDC is also could be to counter the private cryptocurrencies. For example, According to Finance watch, Facebook-based private digital currency — Diem, a permissioned blockchain-based payment system, is considered a massive risk to public monetary sovereignty. Many countries have even opposed this development.
Nevertheless, cryptocurrency market capitalization has touched more than $2 trillion, up from $260 billion a year ago. To hedge against this rising inflation, many have retreated from the dollar and have taken shelter in safe-haven assets that historically have held value and appreciated. These ‘safe-haven assets’ include precious metals, stocks in generally less volatile sectors, and Bitcoin more recently[v]. Further, certain Central Banks like European Central Bank propose a penalty for hoarding the digital currency, i.e., restricting the use of CBDC only to payment transactions.
In these circumstances, if the CBDC comes live and uses blockchain technology, we can expect some crowding-out effect in the cryptocurrency space. But this will not stop the cryptocurrency investment. Many investors will see cryptocurrency as an alternative investment opportunity, including speculative traders and DeFi enthusiasts.
Impact of CBDC on the existing infrastructure
I believe that it is improbable that CBDC could eventually replace the existing financial intermediaries. CBDC should make room for the Financial institutions to coexist; otherwise, any drastic changes in the economic infrastructure will derail the country’s economy and decay the Central Bank’s credibility. The adoption of CBDC will force the traditional banks to focus, upgrade, and adopt the technology-driven innovative system to embrace digital currency. It also makes the Banks collaborate or compete with different Defi applications for their growth and development.
Impact of CBDC on DeFi and other Crypto projects
Decentralized Finance(DeFi) is a blockchain-based form of finance that does not rely on traditional financial instruments and instead utilizes Smart Contracts on blockchains[vi]. Every year the amount of investment going into DeFi and cryptocurrency-related projects are increasing on a record-base. KPMG study indicated that the investments in blockchain and cryptocurrency projects during the first half of 2021 were more than twice as much as that of all of 2020[vii].
Suppose once CBDC becomes a reality and countries impose regulations on the growth and use of DeFi. Then, in that case, the existing DeFi and blockchain projects would fly away to the regulatory haven countries. The main issue for the country is the money laundering that is happening through cryptocurrency. Banning it will not solve the problem. Instead, creating a bridge through CBDC to invest in cryptocurrency could be a relevant solution. Therefore, it is implausible for the Government to restrict other cryptocurrency and DeFi projects in the long run, given the Venture Capitalists’ raining investments in Crypto and Blockchain projects.
Further, CBDC will broaden the customer base for the digital currency by promoting financial inclusion and technology penetration within the country. This awareness and adoption of technology will motivate the crypto and DeFi projects to develop more feasible and relevant services fostering technological innovations.
Future of CBDC
The privacy of the individual transactions using CBDC will remain dependent on the intent and credibility of the Government. To what extent Government would scrutinize the financial transactions is not very clear, and it may change according to the country. Cybersecurity is another concern that many users would try to assess by looking closely at the design of CBDC.
Also, establishing gross international settlements in real-time through CBDC would not be without any hiccups, as inter-country or international consensus on the CBDC is needed. We have seen many countries that are not very open to sharing their data with other countries in the past. Without this sharing and agreement among the nations, developing a universal CBDC or basket of CBDCs would be difficult. This lack of consensus will create room for private and other cryptocurrencies to grow and evolve.
The CBDC’s success will depend upon the intent, design, and implementation of the CBDC and how it will fit in the country’s specific social and economic structure. It is interesting to see how the final version of the CBDC will evolve and influence the ecosystem.
[i] https://www.omfif.org/wp-content/uploads/2019/11/Retail-CBDCs-The-next-payments-frontier.pdf
[ii] https://www.investopedia.com/terms/c/central-bank-digital-currency-cbdc.asp
[iii] https://www.atlanticcouncil.org/cbdctracker/
[iv] https://cointelegraph.com/news/blockchain-not-suitable-for-cbdc-says-swiss-national-bank-economist
[v] https://www.investopedia.com/tech/cryptocurrency-this-week/
[vi] https://en.wikipedia.org/wiki/Decentralized_finance
[vii] https://coinmarketcap.com/alexandria/article/crypto-investment-doubled-in-first-half-of-2021
