CBDC vs. Cryptocurrencies: Which Technology Will Dominate the Future?

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The development of digital technology was an innovative breakthrough at the intersection of finance, which was the foundation for the creation of blockchain technology and cryptocurrencies. Recently, many crypto-industry experts talk and argue about cryptocurrencies, but often overlook the fact that the phenomenon of cryptocurrencies and blockchain technology has demonstrated many new possibilities in finance, one of which is the Central Bank Digital Currency (CBDC).

This article will shed some light on what CBDCs are and what role they play today. In addition, we will look at the essential advantages and significant disadvantages of this technology and find out which countries are developing CBDCs today and their practical implementation chances. Ultimately, you will learn what the future holds for CBDC technology.

KEY TAKEAWAYS

• CBDC is a third form of state money, a digital form of the national currency denominated in the national monetary unit and serving as a means of payment and account measures to regulate the exchange of value and preserve value.

• On the one hand, CBDCs can reduce the issue of national currency and the level of dollarization in the world, but on the other hand, carries the risk of cybercrime.

• It is assumed that the introduction of CBDC will help improve the financial stability of financial institutions and payment systems, which will completely transform the existing economic structure.

What is CBDC and What Role Does it Play Today?

CBDC, or Central Bank Digital Currency, is a financial instrument that continues the development of cryptocurrency and blockchain technology with some limitations and is intended for implementation in the state economic system. This digital currency is an alternative version of the paper and non-cash money in the territory of a state. Among other things, it serves as a measure of value, accumulation, and payment system.

There are many applications for central banks (CBs) to use blockchain technology in their operations, from optimizing the settlement of securities markets to issuing bonds and managing cash flow. However, one of the key applications of distributed LEDGER technology for central banks is the issuance of central bank digital currencies, which can be used in both national retail and cross border payments. The issuance of CBDCs involves the modernization of existing technologies of providing central bank settlement and payment services, as the introduction of a new form of money into international monetary system circulation, leading to increased efficiency in the functioning of modern financial systems.

The widespread introduction of central bank digital currency may lead not only to global changes in payment, clearing, and settlement mechanisms but also affect the composition of the monetary base and the structure of the money supply, change the functions of commercial banks, and the competencies of central banks in the financial and payment systems, and have to influence the conduct of monetary and macroprudential policies.

Important Advantages and Significant Disadvantages of CBDC Technology

CBDC, like any other technology, has its advantages and disadvantages, as well as many distinctive features that allow it to gain confidence from different states already engaged in creating the digital analogs of their national currencies. Being a digital form of the national currency of a single state, CBDC technology is designed to improve the financial system due to the following advantages.

Advantages of CBCD Technology

Let's start by looking at the merits of the technology, which is intended to change the idea of what digital money is.

• Reducing the Number of Banknotes in Circulation

Today, every country in the world has its own currency, which is used for mutual settlements between states, companies, and even ordinary citizens. The state of each country independently calculates the amount of currency to be issued and, in accordance with certain criteria, regulates this volume. Introducing CBDCs into the economy will help to significantly reduce the amount of paper money in circulation and eventually completely replace cash with digital money.

• Decreasing Dollarization of the World Economy

The U.S. dollar today is the strongest and most widespread currency in the world, used to pay for all kinds of services and goods and for cross-border transfers. Such massive use and stability of the dollar are due to the historical crisis of many countries that could not pay their obligations in local currency. CBDCs will help to reduce the involvement of the dollar for mutual settlements, as other countries in the world will have the opportunity to strengthen their currency, which will be more reliable and stable in digital form .

• Financial Stability

CBCDs, by their nature, are a digital alternative to existing fiat currencies, many of which are so resistant to various financial crises that they almost always object to investing and saving capital, indicating that they are financially stable regardless of the political or economic situations in the world. Moreover, unlike Bitcoin, the issue of central bank money has no restrictions, which creates the preconditions for their use as a reliable tool for insurance, investment, and risk hedging.

Disadvantages of CBCD Technology

Now let's look at a few significant weaknesses of CBDCs.

• Capital Outflow from the Banking Sector

Being a highly liquid and risk-free asset, the new currency may begin to compete with deposits in large, systemically important commercial banks. These banks are positioned as the most stable and, therefore, can offer relatively low deposit rates. With near-zero nominal interest rates, even if no interest is paid on the central bank’s digital currency, hypothetical CBDCs could become an alternative to many fixed-income investments and thus make the central banks a competitor to commercial banks in terms of attracting liabilities.

• Cybersecurity Risks

Cybercrime has become a massive problem with the advent of distributed ledger technology. Today, many areas of development of this concept are going through difficult times because attackers have come up with new ways to hack and deceive investors to get tokens, crypto assets, or other financial instruments. Unfortunately, CBDCs are no exception and cannot guarantee 100% safety of funds in either the public or private sector, at least at the moment.

• Novelty Technology

Even though the economic progress of many countries is moving rapidly towards a complete transformation of the financial system, particularly in the public and banking sectors, the economic situation of many countries leaves much to be desired. It does not allow the creation of the infrastructure for implementing the launch and maintenance of CBDC technology. This can become a stumbling block on the way to digitalizing the economy and mutual settlements between financial institutions.

CBDC vs. Cryptocurrencies: Which Technology Will Dominate the Future?

Conducting a comparative analysis between cryptocurrency assets and CBDCs, we can conclude that these two technologies are very similar, but they are designed to perform completely different tasks.

The main difference between CBDC and cryptocurrencies is centralization. CBDC operates under the supervision of a single supervisory authority. That is, the central bank controls its issuance and circulation. Meanwhile, cryptocurrency does not fall under the direct influence of financial regulators. If cryptocurrency uses consensus algorithms to validate transactions, CBDC does not need a blockchain to work effectively because the central bank will validate transactions.

CBDC is a new payment instrument characterized by absolute centralization, closed (we cannot see all transactions in the blockchain, only the Central Bank), and a lack of anonymity. Cryptocurrencies are the opposite of CBDC because it is characterized by decentralization, transparency, and anonymity. Moreover, CBDCs still need to solve the main problem of fiat money – inflation. The issuance of new units of CBDC, just as with traditional fiat, is fully controlled by the central bank. That means no halving and burning of tokens, no impartial smart contracts.

Thus, CBDC is not a competitor for cryptocurrencies, and it cannot be unequivocally stated that central bank money will be able to displace cryptocurrencies anytime soon. The reason for this is straightforward – cryptocurrency exists in a different plane – a parallel financial, non-state system and is completely decentralized. It can be assumed that the CBDC technology will not only not be able to force crypto assets out of the financial system but also will increase financial inclusion, becoming a catalyst for even stronger development of the crypto market and the influx of even more new users who are not ready to accept the total control of the central bank of the country.

FAST FACT

• According to the research as of 2023, 20 countries in the world are actively developing CBDC and are going to introduce the technology into their financial system soon.

Which Countries are Developing CBDCs and What are the Chances of Practical Implementation?

CBDC today is a new, immature concept, the mere expediency of which is still debated among experts in both the crypto industry and other financial fields. Many rightly believe that the elaboration and implementation of CBDC are extremely premature. Others argue that this technology will become a life jacket for the global economy, especially in times of crisis.

However, there are already countries today that are actively developing their own CBDC infrastructure in order to keep pace with progress. Below is a list of some of the most ambitious of them.

• Bahamas

In October 2020, The Sand Dollar was issued by the Central Bank of the Bahamas. It was the first nationwide CBDC in the world. In the Bahamas, part of the population cannot access financial services because it is unprofitable for commercial entities to operate in all areas, partly due to the country's geography, which is divided into many islands. Consequently, an estimated 20 percent of the population still needs a bank account.

The Sand Dollar is supposed to help improve financial inclusion and strengthen protection against money laundering and illicit economic activity. CBDC users must go through the Know Your Customer (KYC) and Anti-Money Laundering (AML) compliance processes.

• Nigeria

Nigeria became the first African country to launch a CBDC last October. eNaira is stored in a digital wallet and can be used for contactless payments in stores, as well as for transferring money. By the end of January 2021, almost 700,000 users had downloaded the eNaira wallet.

• China

China became the first major economy in the world to try out digital currency in April 2020. The People's Bank of China aims for widespread domestic use of the e-CNY, or digital yuan, and aims to completely transform the economy through digital assets. According to the IMF, China now has more than a hundred million individual active users transacting in the billion-dollar range.

• Jamaica

On August 9, 2021, the Central Bank of Jamaica began issuing its CBDC, the Jamaica Digital Exchange, or Jam-Dex. The Jamaican government considers the accelerated transition to a digital society and economy vital to the development of the economy. Also, the state government has stated that the expected benefits of the CBDC include increased financial inclusion, as it will provide another, more easily accessible means of making payments and moving away from financial intermediaries.

• Uruguay

The Central Bank of Uruguay has launched a pilot project to introduce a national digital currency called e-Peso. An official statement from the country's central bank stresses that the digital peso will be regulated similarly to the ordinary Uruguayan peso, but will have technological support.

CBDC Prospects in the Near Future

From a theoretical point of view, the emergence of central bank digital currencies can be justified by the key provisions of credit monetary theory and the state theory of money. The need for the evolution of fiat money in general and central bank money, in particular, is determined not only by socio-economic processes associated with the adaptation of modern monetary forms to the changing needs of economic agents but also by the need for the state to maintain control over the issuance of money.

Although the introduction of central bank digital currencies does not lead to the transformation of the modern fiduciary monetary system, it symbolizes a new stage in the development of fiat money. For the first time in economic history, universal central bank money, one of modern money's basic components, is digitized. In this regard, the emergence of a new form of money is no less significant than the evolution of their types.

The main motives that drive central banks to implement digital currencies for settlements are to increase the efficiency of cross-border payments and improve trade finance tools and capital market settlements. The security and efficiency of retail payments, as well as financial inclusion, are critical reasons for central banks to introduce digital currencies into the future economic system. On the other hand, factors such as maintaining financial stability, maintaining monetary sovereignty, and de-dollarization of the economy also play an essential role in determining the future of CBDC.

Conclusion

Undoubtedly, the implementation and practical application of CBDC will contribute to the elaboration of mobility and transparency of the settlement system of each country in the world, facilitate mutual settlement processes, as well as allow for investment cooperation. On the other hand, the introduction of CBDC technology will undoubtedly stimulate the development of fintech and increase competition between technologically advanced banks and other financial institutions.