The cryptocurrency markets are poised for the upcoming bull run. The bitcoin ETF and halving have achieved significant milestones, and the currency has surged to an all-time high of $73,798. Many expect it to surpass the $100,000 mark. The Ethereum ETF is also rumoured to be close.
There is also a lot of anticipation for the altcoin season when scores of other coins are expected to peak in value. Many revolutionary technologies in the decentralised currency, apps, and finance protocol ecosystems that are in development could radically alter the way we interact with each other.
Blockchain and subsequent technologies have been at their core working towards decentralisation and moving power away from behemoth financial institutions like central banks and toward common folks such as ourselves worldwide. The promise has always been an escape from a government-controlled environment to more democratic, peer-to-peer-regulated systems.
This hope of freedom remains strong in the cryptocurrency movement. However, there is pushback from governments around the world that aim to use blockchain technology to consolidate even more power by developing digital currencies (Central Bank Digital Currencies, or CBDC) issued by their respective central banks.
Blockchain is a double-edged sword that you can use to either decentralise and democratise or centralise and wield unlimited power, just as you can harness atomic energy to power megacities and annihilate human civilisations.
What is CBDC?
CBDCs are central bank-issued digital currencies that complement cash rather than replace it. In a CBDC world, the wallet holder can easily transfer each virtual currency unit’s digital code to other people’s digital wallets.
These digital currencies, unlike “traditional cryptocurrencies,” are not decentralised; central banks issue them instead of independent entities like Bitcoin. Theoretically, the value of CBDCs would be as stable as the fiat currency of the country issuing them, unlike other crypto assets that can experience significant fluctuations.
Furthermore, different countries are testing a variety of CBDC strategies. The Eastern Caribbean is implementing DCash, an account-based concept that is one kind of CBDC. Customers maintain direct deposit accounts with the central bank through DCash.
China’s e-CNY, a CBDC pilot programme, is at the other extreme of the spectrum. It is up to private-sector banks to provide and manage digital currency accounts for their clients. In 2022, China will present e-CNY at the Beijing Olympic Games. The money was usable for purchases made within the Olympic Village by athletes and visitors.
The European Central Bank is also considering a different model, in which authorised financial institutions run individual permissions nodes on the blockchain network to facilitate the issuance of virtual euros. To preserve user privacy, the last model, well-liked by “cryptophiles” but not thoroughly tested by central banks, distributes fiat currency, government-issued money unbacked by a commodity, as anonymous fungible tokens.
Some 87 countries, or more than 90% of the world’s GDP, are exploring the possibility of CBDCs. Let’s take a deeper look:
Launched in June 2022, the JAM-DEX from Jamaica is the first officially recognised CBDC as a legal tender. There are no sophisticated use cases (such as cross-border payment for smart contracts) and the offering is somewhat basic. Unlike the Bahamas’ Sand Dollar and the Eastern Caribbean Central Bank’s DCash, Jam-Dex is not based on blockchain technology.
Nigeria introduced eNaira in October 2021, becoming the first nation in Africa to implement a CBDC.
Africa’s Sub-Saharan region is about to embrace CBDCs. The extensive adoption of the mobile money transfer service M-PESA has created a robust financial and social framework for the possible future application of CBDCs.
The central banks of Saudi Arabia and the United Arab Emirates collaborated to create Project Aber. This project explored the use of a jointly issued digital currency as a tool for domestic and international payments between the two nations.
Why are governments pursuing CBDCs?
Some proponents of blockchain technology believe that new digital instruments, like CBDCs, may solve problems with efficiency, security, and accessibility that plague the current physical infrastructure and alternate cryptocurrency assets. Money is expensive to print and some cryptocurrencies, such as Ethereum, have exorbitant gas fees (transaction fees) that aren’t viable for day-to-day transactions. CBDC enthusiasts (mostly big tech and banks) believe centralised digital currencies are the answer.
Among the frequently cited benefits are:
Lower Operational Costs: Financial service providers can potentially reduce their yearly direct costs by $400 billion by allocating funds toward digital banking instead of physical infrastructure. However, we must weigh the lower costs against the substantial new technology investments that CBDCs would require.
Faster Transactions: The electronic payment systems in many nations could operate more quickly and effectively thanks to CBDCs. As we’ll see below, this argument is becoming less persuasive.
Improved Accessibility: The percentage of US adults without bank accounts is less than 5%, whereas the global unbanked population was 1.6 billion in 2016. Mobile-accessible CBDCs have the potential to improve financial inclusion. Additionally, mobile money gives digital financial service companies access to untapped areas. But adoption isn’t a given; a lot of underbanked individuals could prefer the complete secrecy that cash provides.
Increased Safety: Implementing a regulated digital currency accessible through mobile devices may improve payment security and lower the likelihood of fraud by guaranteeing a complete and irreversible transaction, even in the absence of a formal bank account. Users may be able to “sign” transactions digitally through the controlled use of private-key cryptography. This would boost the confidence of all stakeholders and expedite the transaction’s completion.
Interoperability: For those who are unaware, some argue that blockchain interoperability holds the key to resolving the disjointed and compartmentalised characteristics of blockchains. Without external intervention, blockchains cannot communicate with one another because they are trustless systems. Cross-chain solutions can be helpful. Cross-chain solutions facilitate the smooth transfer of data between blockchains. Users of defi protocols and dApps practically need to interact with cross-chain solutions, as many of the most significant and fascinating projects currently exist outside of platforms like the Ethereum L1 blockchain.
Currently, blockchain interoperability is fragmented and incompatible. Many rival interoperability efforts compete with one another to become the most successful, resulting in customised cross-chain products with differing levels of security and reputation that ultimately serve only to manipulate the blockchain environment. One of the biggest ironies of blockchain technology is that various cross-chain solutions are still incompatible with one another. Even worse, this incompatibility makes it more difficult for consumers, businesses, and authorities to evaluate the security of each choice, endangering the general acceptance of blockchain technology.
According to some, a common interoperability framework is the answer.
One project cannot be responsible for ensuring blockchain compatibility. There must be an industry-wide initiative. We need to come together and establish once and for all how we want to send, receive, and verify data from another blockchain rather than taking an “everyone for himself” approach.
Adopting a common framework for interoperability might jeopardise the viability of the economic models behind ongoing interoperability projects. Instead, it would merely serve as the framework for an extremely secure layer of basic infrastructure, atop which individual projects might construct products that incorporate various trade-offs specifically designed for certain use cases. This distinction is what matters.
CBDC utilisation and development
Many nations’ central banks have started research projects and pilot programmes to ascertain if a CBDC would be useful and viable in their respective economies.
The first nation to enact a CBDC was the Bahamas. It intended to improve financial inclusion for its 700 island-dwelling citizens, some of whom have restricted access to ATMs and banking services, so it introduced the Sand Dollar in 2020.
As of March 2024, the Bahamas, Jamaica, and Nigeria were the three nations with operational CBDCs. For technical reasons, the Eastern Caribbean Currency Union suspended its CBDC and launched a new trial programme.
Nineteen of the G20 have programmes under development, while 36 CBDC pilots are now in operation. A CBDC is being considered by the BRICS nations: Brazil, Russia, India, China, and South Africa.
The United Kingdom’s Britcoin, which was in existence from 2011 to 2019, is one instance of a CBDC endeavour that was unsuccessful.
The United States is one of the nations investigating whether a CBDC “might improve on an existing safe and efficient U.S. domestic payments system,” according to the Federal Reserve.
When it comes to the authoritarian use of technology, China is always ahead. It has outlawed private cryptocurrencies, but the nation has experimented with virtual money. The Central Bank of China (PBOC) has developed the most sophisticated market application of CBDC to date. Private-sector banks are required to distribute and manage these accounts for their clients under China’s CBDC e-CNY pilot programme.
In late 2019, PBOC began testing e-CNY for use in consumer lifestyle applications such as shopping, transit, government services, and wallet-based payments. After starting in four cities, the pilot programme swiftly spread to five more. By May 2022, the e-CNY pilot had processed 260 million transactions totalling over 83 billion yuan through 4.5 million merchant wallets.
Proponents claim China’s CBDC experiment revealed the following possible advantages. To use e-CNY, you do not need to have a bank account. Six approved state-owned banks offer digital wallets that customers without an account can download and use. CBDC, like blockchain-based cryptocurrencies, allows users to authenticate themselves with banks using personal digital fingerprints. By doing this, banks avoid doing business with unreliable parties, which may prevent them from becoming involved in fraud and other illegal actions like money laundering.
Banks may save money using CBDC to reduce transaction reporting and monitoring costs. At the same point of time, it could be feasible for e-CNY to simplify the allocation of subsidies, like employee transportation.
However, it is important to see how China’s social credit system and CBDC go hand in hand to have absolute control over the populace. With CBDC, the government can monitor each individual’s transactions in real-time, and it can even control spending limits and what one can buy with their money. Because of this, CBDCs are a source of fear for many in the tech and economic circles.
Battle for the soul
We are witnessing an epic struggle for the very spirit of the financial system, even though the fighting is mainly silent and hidden from the public eye. Central banks are considering replacing the bank-issued digital currency that consumers use daily with publicly issued digital currency. This could significantly alter and weaken the financial system’s stability.
Fear of losing in a growing arms race often drives government decisions. If another central bank introduces a more appealing form of exchange, no one wants to deal with falling demand for their currency or soaring withdrawals from their financial institutions. However, the rush to get ready for the economic equivalent of military mobilisation could create a highly unstable international order that undermines monetary authority.
The digital currency of central banks (CBDC) might be in several formats. Some versions might be harmless, but the most extreme, one that is widely accessible, elastically supplied, and interest-bearing, can cause unsettling changes in the financial system, erode the availability of credit, and jeopardise privacy.
The financial system that exists now is the result of several factors that came together over the last century. First, authorities obstruct the issuance of private paper money by combining harsh taxes with outright prohibitions. Governments grant licences to private intermediaries, typically commercial banks, so long as the liabilities issued by the latter are convertible into liabilities of the central bank on an equal footing. Last but not least, the private sector manages the retail payments system for the rest of us, while the central bank oversees the wholesale payments system for banks.
All of this indicates that almost everything that people consider to be money in our day and age is a commercial bank’s digital liability. For instance, demand and time deposits, which are digital entries on bank ledgers, make up 97% of the overall amount of M3, or 144% of GDP, in the United Kingdom, where the total quantity of M3 is 148% of GDP. In the euro region, 91% of M3 is digital. Furthermore, in China, 96% of broad money, which accounts for over 200% of GDP, is digital.
Most people are unaware of this, as Bank of England Deputy Governor Jon Cunliffe pointed out in a recent lecture. When they buy groceries, buy a new phone, or renew a software subscription, they are unaware that their bank is creating digital money for them. Crucially, we can depend on this system because the central bank provides the necessary framework.
Authorities genuinely pledge to turn specific bank liabilities into the means of exchange, the liquid, safe asset known as reserves, under as many different global conditions as they can to accomplish this. Experience tells us that under most global conditions, central banks dedicated to price stability are better able to accomplish this than private entities. We depend on this framework, in Cunliffe’s words, to “tether private money to the public money issued by the state.”
Central banks are moving forward, frequently citing goals like monetary policy execution, financial inclusion, and payment efficiency. Two more significant drivers are visible. First, there is a desire to stop the issuance of private monetary instruments like Libra (now Diem) and replace cryptocurrencies like Bitcoin. Governments, on the other hand, have extensive experience with these private currencies and can either apply harsh taxes or outright bans when they come to light. The second is FOMO or fear of missing out. Central bankers want to ensure that they can issue CBDC as soon as others do. This, in our opinion, leads to instability, since, theoretically, a sudden and unexpected incident can prompt several central banks to quickly mobilise their digital currencies to avoid falling behind.
This brings up some important information concerning CBDC. Before releasing retail digital currency, a central bank must decide on several design elements. Is this an instrument for anonymous bearers? Will a person’s holdings be subject to quantity restrictions? Is it only available to citizens of the issuing jurisdiction to hold? Will it also have 0% interest, like paper money?
We are aware of the solutions to these queries regarding paper money. It is an anonymous-bearer instrument. The supply is elastic enough to permit, in most cases, the limitless conversion of certain bank obligations at par into the medium of exchange. Everyone has the option of using paper money. It also has no interest.
The CBDC’s likely characteristics are also readily apparent. CBDC must maintain its anonymity to avoid promoting illicit activities. For CBDC to truly serve as a substitute for paper money, its distribution must be flexible. People may store an infinite amount; lacking such an opportunity, bank obligations may not convert into CBDC on an equal basis. Limiting citizens’ possessions is an example of capital controls that are foolish and unworkable. Lastly, we observe two justifications for CBDC’s need for interest. First, we believe that a central bank paying interest on commercial banks’ reserve deposits but not on individual deposits is politically untenable. Second, in its absence, authorities would be unable to reduce nominal interest rates below the effective lower bound.
Four major issues arise from inventing such a “universal” CBDC: disintermediation, currency replacement, lack of privacy, and the impossibility of guaranteeing compliance. On the first hand, financial strains would eventually force uninsured deposits to leave private banks for the central bank, even though inertia (along with interest rate rises and service enhancements) would keep money in the banking system for a while. Furthermore, these inflows will come from highly reputable central banks, based in rather stable political and financial environments. Imagine what would happen if the Fed gave universal, unlimited accounts, given the current high overseas demand for US paper money. The implications might be disastrous for emerging markets and developing economies.
Privacy and compliance are the last two linked difficulties that arise from CBDC’s non-anonymity. Everything we do on the first day becomes traceable. Although we do not support free banking or libertarianism, we do agree that there are significant risks associated with giving governments access to this kind of in-depth data on our daily activities. It is therefore difficult to understand why democratic nations would consent to such a concentration of power.
Moving on to compliance, someone will need to put in the effort to make sure CBDC users follow the law. These KYC and anti-money laundering initiatives are expensive. Nowadays, we outsource these responsibilities to commercial banks. In addition, banks offer a wide range of other services. Who will pay the price, and who will carry out this task?
The establishment of an intermediated CBDC is one method of addressing privacy and compliance concerns. Under this arrangement, banks or brokers manage individual accounts, protect customer privacy, oversee compliance, and aggregate balances into central bank accounts (which are likely to generate interest). Despite this strategy, the dangers of currency substitution or domestic disintermediation remain. Even so, money would continue to enter the central bank indirectly, through what are essentially narrow banks.
In light of this, it is easy to understand why the People’s Bank of China is developing a digital renminbi before other central banks. Even during a financial crisis, there is little chance of disintermediation because most of the big banks are state-owned. Strict capital controls currently impose significant restrictions on currency inflows. Expectations of personal privacy are already low. Last but not least, state-owned banks can readily finance access if the government so chooses.
Returning to the original query: In what areas is the current monetary system deficient? We respond that, independent of new digital currencies from central banks or private issuers, there is a great deal of room to enhance the payment system and increase financial accessibility.
Both the public and private sectors are already making efforts to offer retail payment systems that are more affordable, quicker, more dependable, and easier to use both domestically and internationally. The TIPS system, for instance, costs €0.002 per transaction and has a processing time of 10 seconds in the euro region. Furthermore, the US Federal Reserve plans to introduce FedNow in 2023; the UK has faster payments; and Canada is trying real-time rail (RTR). None of these initiatives advocate for CBDC.
In terms of financial accessibility, India’s example is useful. Launched in 2014, the Pradhan Mantri Jan Dhan Yojana (PMJDY) uses the nation’s universal biometric personal identity to save expenses and offer free basic bank accounts. Account balances average almost $50 for the approximately 420 million users brought into the system. Once more, subsidies were necessary for India’s success—not the issuance of CBDC.
All of this makes us worried. To be clear, we are ardent supporters of technologies that raise welfare and save costs. However, the most significant innovations, those that enhance credit availability and payment infrastructure, do not necessitate ubiquitous CBDC and its associated dangers. Why, then, are central banks working so hard to get ready? Why would someone make such a plan for contingencies?
We don’t see any simple ways to stop this unfavourable result. The cooperative equilibrium in which no one introduces CBDC is difficult to enforce, much like in a traditional prisoner’s dilemma. First, central banks cannot promise that they will never issue CBDC. Second, others now believe it is too late to oppose China’s move toward the CBDC; even though they are fully aware of the dangers, they feel obliged to prepare.
The best chance may be in the central banks, all moving extremely cautiously and working to “get the design right.” That, in our opinion, entails going considerably beyond universally available, elastically supplied, interest-bearing CBDC.
Taking everything into consideration, we conclude that issuing universally accessible, elastically supplied, interest-bearing CBDC is a foolish move on the part of central banks. On a domestic level, it might displace private middlemen by enticing authorities to direct credit through direct deposit inflows into the central bank. An elaborate collateral and haircut system would be required, which would significantly increase officials’ power over credit distribution even if the central bank were to re-circulate the funds to potential lenders through an auction process.
Worldwide, there might be a tidal wave of money moving from areas seen as less stable to those seen as safe, which would increase inequality and the power of the wealthy receivers. And lastly, privacy. Although this issue might be solvable, the fact that CBDC grants access to all of our activities would undoubtedly entice totalitarian regimes.
For now, Federal Reserve Chair Jerome Powell’s words are of some reassurance: “We would not want a world in which the government sees, in real-time, every money transfer that anyone makes with a CBDC.”