All You Need To Know About Central Bank Digital Currencies (CBDCs)

Introduction

Blockchain is often considered to be one of the most innovative inventions of the 21st Century. However, it is still under development, and blockchain is under consideration for finding new use cases and implementation. Blockchain technology is valued for its decentralized nature.

However, in the post-internet world, the majority of financial transactions have been shifted to digital platforms. Therefore, even the staunchest critics of blockchains are convinced about their utility. Keeping the innovative advantage of blockchains, the central governments of many countries have come up with the concept of CBDCs.

What are Cryptocurrencies?

Cryptocurrencies are the financial instruments or alternative for paper money that is issued by Blockchains. Blockchains are computer programs that are decentralized as they are based on DLT technology and operate like digital banks.

Blockchains do not need the backup of centralized governments to keep operating. They are like a store of digital transactions that are stored on nodes rather than servers under the control of a singular financial enterprise or a central bank.

In this manner, the users on the blockchains can make financial transactions on the internet without needing any approval for a supervising agent. The transactions on the blockchain are verified by the use of different Consensus Mechanisms.

Therefore, blockchains are known as trustless networks where the transactions are verified based on historical transaction records.

There are various types of verification methods available on a wide array of different blockchains, such as PoW, PoS, and PoH, among others.

How do Cryptocurrencies Work?

Cryptocurrencies are considered to be digital alternatives to paper money issued by a central government. Today, the world is divided into several countries and each sovereign nation issues a legal tender or fiat currency.

This fiat currency or legal tender is accepted by all the merchants and citizens of the country to conduct trade and perform everyday tasks. However, the legal tender of one country is usually not accepted in a foreign jurisdiction.

Bitcoin is the first ever blockchain, and its white paper defines Bitcoin cryptocurrency as the digital alternative to fiat currencies. It is important to note that fiat currencies are no longer backed by the gold reserves in central banks.

Instead, the fiat currencies are directly tied to the GDP growth and the stability of its issuing government. On the other hand, anyone hailing from any place can use and trade cryptocurrencies since they have international recognition.

At the same time, cryptocurrencies are decentralized by design therefore they can keep operating without any need for regulations or control of centralized governments.

Types of Cryptocurrencies

There are many types of cryptocurrencies that are currently present in the market. At the same time, many new classifications of cryptocurrencies are emerging on account of their utility and other factors such as a source of issuance. Here are some of the most basic types of cryptocurrencies:

Coins and Tokens

There is a common misconception that one blockchain can issue only one cryptocurrency. However, the fact of the matter is that many blockchains can support more than one cryptocurrency.

For example, Ethereum is a type of blockchain that can host other decentralized applications such as DEXs, Swaps, DAOs, and NFT marketplaces, etc. Therefore, the Ethereum blockchain also can host more than one cryptocurrency. The coin is a cryptocurrency that is the main issue of a blockchain.

In contrast, the tokens are all secondary cryptocurrencies that are issued by one blockchain. It means that ETH is the main coin issuance of the Ethereum blockchain, while all the other tokens associated with the network, such as MATIC, are tokens.

Altcoins

Bitcoin is often regarded as the first ever or flagship cryptocurrency. Before Bitcoin, many companies and individuals had been working on coming up with the perfect formula for digital money.

However, Bitcoin was able to introduce the idea of DLT-inspired decentralized blockchains. Therefore, Bitcoin has managed to become the foundational coin of the entire cryptocurrency market.

However, Bitcoin founder Satoshi Nakamoto has chosen to make the project open-sourced. So many other developers were able to take the Bitcoin blockchain design and come up with personalized versions of other decentralized blockchains.

All these secondary blockchains also issued their native coins and tokens. In this manner, all the other cryptocurrencies that came after Bitcoin are referred to as Altcoins.

Payment Tokens

Bitcoin and any other cryptocurrency are not issued by any government. Therefore, these cryptocurrencies are not recognized as legal tender in most countries. For this reason, most companies do not accept these cryptocurrencies as payments for their products.

However, as time has passed and cryptocurrencies have gained more traction in the market, many companies have listed them as acceptable payment options.

For example, companies like AMC Theater, Tesla, and Spacelink have allowed their consumers to pay for products or services with crypto options like Bitcoin and Dogecoin. Fur

Utility Tokens

The applications of cryptocurrencies are bigger than just fiat currencies, stocks, commodities, or stores of value. There are many cases, where certain cryptocurrencies are assigned a special task that is tied to their ownership.

For example, there are many cryptocurrency exchanges, such as Binance, that issue their native tokens, such as BNB. In the same manner, there are DEX networks or liquidity pools where the users are issued yield tokens that they can redeem to earn yield income or transfer their staked position ownership.

Governance Tokens

Governance tokens are cryptocurrencies that represent the voting rights of the participants of the said blockchain. In most cases, blockchains are decentralized, which means that they do not have any centralized authorities that can rule on important decisions to run the network.

To run the blockchain and make important decisions, this blockchain network issues governance tokens for its users. The users who have governance tokens can vote on different proposals that are presented by validators, miners, witnesses, or delegates.

Security or Equity Tokens

As visible from its name, a security token or equity token is closer to a digital stock rather than a normal cryptocurrency. It is important to note that a virtual asset must fulfill all the conditions of a Howey Test to qualify as a security equivalent.

Therefore, the companies that wish to issue their stocks on a public or private blockchain must get registered with their relevant financial regulator, such as SEC. In most cases, equity tokens are regulated to avoid the violation of the securities law in their jurisdiction.

Stablecoins

Stablecoins are the type of cryptocurrencies that are free from the massive price volatility that most crypto coins and tokens have. It is because stablecoins mimic legal tenders, and they are pegged to a reserve currency such as fiat or other cryptocurrencies.

In some cases, stablecoins maintain their stable value with the help of an algorithm that burns new cryptocurrencies to maintain the total reserve market cap of the stablecoin that is pegged.

NFTs

NFTs do not typical cryptocurrencies that only represent the underlying financial value. NFTs stand for non-fungible tokens, which means that one NFT cannot be replaced by any other NFT. NFTs can maintain the original ownership record of a said cryptocurrency.

Therefore, NFTs are used by artists and musicians to sell their creative projects such as music, videos, artwork, and other creative media. When these artists mint and sell their artwork as NFTs, they can maintain the legal right over its legal ownership, just like real artwork.

In contrast, normal cryptocurrencies are interchangeable. For example, one Bitcoin can be exchanged with another Bitcoin, and it would not make a difference in its market value for the owner.

CBDCs

CBDCs are also a type of cryptocurrency because they are based on blockchains. The governments of many countries have come to acknowledge the uses of blockchains and they intend to adopt this technology to issue digital versions of their legal tenders.

For example, the government of China has been working on the e-CNY project that was introduced during the Beijing Olympics of 2022.

What are CBDCs?

The full form of CBDCs is Central Bank Digital Currency. CBDCs are centralized legal tenders that are issued by a Central Bank and regulated by the financial agencies in the sovereign nation.  Many countries have acknowledged the innovative advantages of blockchain technology.

Therefore, these governments have decided to adopt it to digitize their local legal tender. The world today has become mostly dependent on the financial versions of money. Most people do not use paper money anymore, and they use digital payment platforms or debit/credit cards to perform financial transactions.

Therefore, there is an increasing need for digital money. The same reason was also one of the inspirations behind the invention of the Bitcoin blockchain.

How do CBDCs Work?

CBDCs are issued by a Central Bank, and they are also written as legal tender of the country, just like their paper equivalents. Unlike cryptocurrencies, CBDCs are regulated and have all the legal protection and precedents attached to them as fiat currency in the same region.

The people and the merchants of the said country are required by law to accept and issue these CBDCs as payment. Furthermore, these currencies can be used to conduct international transactions with simplified forex exchange processing.

CBDCs can reduce the cost of remittance, increase transaction speed, ensure accuracy, and make the international trading process more hassle-free. The governments are likely to issue specialized state-sanctioned wallets or applications to hold CBDCs.

The banks under the jurisdiction of the Central Bank would be required to provide custodial services for the CBDCs and make room for their operations within their digital banking applications.

Types of CBDCs

CBDCs offer certain advantages for a government that is bigger than just its local jurisdiction. Therefore, CBDCs can be divided into two different types based on their functions and utility:

Retail CBDCs

Retail CBDCs are used among local businesses and retail consumers. In this manner, the banks and the masses are no longer exposed to the dangers of dealing with privately issued tokens and coins.

These privately issued cryptocurrencies can run out of favor among their limited users at any time and result in bank runs or rug pulls. There are also two sub-types of Retail CBDCs:

Digital Identification Retail CBDCs

This type of CBDC is used for account generation, where users can store their CBDCs. For getting this account, the users are required to create a digital identity that is issued by the concerned financial regulator in the region.

Privacy Retail CBDCs

The second type of CBDC Is used for privacy purposes, and it grants the users freedom to refrain from sharing their transaction history with the government. This type of CBDC usually comes with a private and public key attached to it.

Wholesale CBDCs

Using the Wholesale account, the Central banks can remove the intermediaries between citizens and Central Banks. Today, retail banks play the role of middlemen to offer services to the citizens, such as lending and loans of every type.

However, with Wholesale CBDCs, the consumers are going to be able to deal directly with Central Banks, which could lower their transaction costs and decrease interest rates significantly.

Origin of CBDCs

It is also important to understand the origin of CBDCs. The earliest example of CBDC can be traced back to the 1990 Bank of Finland. The bank issued a digital transaction card called Avant Smart Card that had a chip on it to store all the financial information of its users.

The Avant card was experimental and allowed the fintech researchers to lay the foundation for something as useful as CBDCs more than 30 years later. In the 90s, the internet had a foot barely in common households. Some financial experts also consider the DigiCash project from 1980 as the first CBDC.

The eCommerce economy was yet to become popular. At the same time, there were considered security risks connected to digital money payments. Furthermore, most people were not comfortable with the concept of using digital money.

At the same time, banks, businesses, and even governments lack the financial infrastructure to record and analyze CBDCs. However, after the popularity of e-commerce platforms and digital money applications and the introduction of blockchains, the world has become more ideal for the implementation of CBDCs.

There are more use cases applicable for CBDCS in both retail and international markets, given the technological transformation of the world.

Goals of CBDCs

Many people can ask that people have been using Credit and Debit cards for decades, so why is there a need for CBDC? The answer is not that simple. The current banking system has come along a long way, but it has some issues that can be solved by blockchain implementation.

Therefore, there are some goals that governments would be able to achieve with the implementation of CBDCs. Some of these goals or use cases for CBDCs are given as under:

• Governments can issue CBDCs as a sovereign currency under designated financial regulators such as Central Bank.
• The Central Bank can put CBDC reserves as liabilities on their balance sheets.
• The government can issue a public blockchain that can allow the citizens to trace the utility of their income taxes and other government expenditures utilization.
• The citizens of the country present anywhere in the world can receive and send the CBDC using their state-issued wallets.
• The government can automatically deduct taxes from its citizens and make the process of tax filing easier or even fully automated for its citizens.
• CBDCs are convertible against commercial bank loans and cash.
• The citizens of the country can transact and store CBDCs without needing a bank account, just like fiat currencies.
• The cost of transactions, remittances, and other transactional services charges would be reduced to a very low amount on account of the automation of CBDCs.
• CBDCs can eliminate the need for a third-party fiat currency such as USD for conducting international transactions.

CBDCs vs. Cryptocurrencies

With the help of conducting a comparative analysis between CBDCs and cryptocurrencies, the reader would be to grasp the concept better. Here are some of the most important parallel parameters:

Blockchain Type

In the case of CBDCs, governments are most likely to adopt permissioned networks or private blockchains. Private Blockchains allow government regulators to control the amount of information that the users on the networks can access.

On the other hand, most decentralized cryptocurrencies aim to be public networks and permissionless networks to ensure transparency.

Structure

The structure of CBDCs is centralized while cryptocurrencies are usually and preferably decentralized networks.

Privacy

The financial history of the citizens of CBDCs is going to be hidden from other retail users, but permissioned parties such as banks, intelligence agencies, financial regulators, and law enforcement agencies could gain access to them.

On the other hand, the goal of blockchains is to keep digital transactions private in terms of their user identification. However, the records of all transactions are available on the blockchain under their digital identification.

Utility

CBDCs could be used for daily transactions, remittances, trading, lending, borrowing, or any other function, just like their fiat currency counterparts. On the other hand, the cryptocurrencies on DeFi blockchains are used for their innovative uses, such as international anonymous payments, incentivizing users, utility, governance, etc.

Conclusion

CBDCs are an important innovation that can elevate the current financial infrastructure. However, there are also certain reservations attached to CBDCs, such as operating as the stronghold of the government over the masses.

There is security and personal freedom issues related to the issuance of CBDCs that can result in limiting free speech and hinder freedom of expression for many. The citizens of a country should keep all aspects in mind before voting in affirmative or negative for the CBDC adoption in their countries.