Will The Concept Of A Central Bank Digital Currency Work?

Over the past few months, there have been numerous debates regarding the advent of central bank digital currency or CBDCs. The concept is simple: digitizing the current domestic currency on a blockchain to rival networks like Bitcoin. An intriguing idea, but will it prove feasible in the real world? 

The Central Bank Digital Currency Idea

It is not hard to see why banks and governments mull the idea of creating a digital currency. Bitcoin and other crypto assets’ success can be perceived as a “threat” to the legacy system. Although cryptocurrencies will not gain global traction for payments and other services right away, they tend to become more appealing over time. Even publicly traded companies have begun setting up a Bitcoin Treasury as of late. It is a clear sign of how traditional investments start to lose appeal and traction. 

Despite this current situation, it is not easy to create a central bank digital currency. Venturing into this industry requires ample knowledge, preparation, and the necessary infrastructure. Digitizing a domestic currency is straightforward on paper but poses many challenges in reality. Several proposals have been put forward in recent years, but there are no tangible CBDCs as of yet.

Contrary to cryptocurrencies, it remains unclear if a central bank digital currency will require a blockchain or distributed ledger. Based on previous proposals, that may not necessarily be the case, raising a fair few questions about how these CBDCs will function. Currently, this is merely a theoretical concept and nothing more, but the situation can change quickly. 

The History of Banks And E-Money

Contrary to what most people may assume, banks have experimented with e-money and ideas akin to digital currency in the past. Central banks tend to explore this concept every decade or so, although the success rate is not spectacular. It is challenging to create some digital and try to get people to use it, especially when other viable alternatives are available. For e-currency, that uphill battle may be even steeper now that cryptocurrencies like Bitcoin exist.

Avant Card In Finland

One example of e-money attempts by central banks is the Avant Card, a concept launched in 1993. Although it existed for 13 years, the Avant Card failed to gain any major traction. Using this vehicle was both annoying and too expensive, rendering the concept moot. One cannot offer an alternative solution to traditional finance if it is too costly and clunky to use regularly. Additionally, the Avant Card had to compete with regular debit cards, which gained a lot of traction during this period.

At its core, the Avant Card is a phone card – when phone boots were still a thing – with a chip on it. The card could hold electric money in the chip and was designed to be disposable. Starting in 1994, Avant Card appeared in a refillable format, letting users top them up with bank ATMs. With a maximum limit of 2,000 markkas, the option became slightly more appealing on paper. Unfortunately, it has a relatively high loading and unloading fee of 2-5 mk, and a purchase fee of 1%-5%, usually paid by the merchant.

Despite the fees and clunkiness, it became possible to use the Avant card on the internet in 1997. Customers could buy things and top up the card online, yet they had to own a native card reader, which cost 390mk, or roughly 65 Euro. It was a very complex and expensive way of transacting online, despite the initial excitement surrounding it. Becoming the single national electronic purse system was an ambitious and unattainable goal, however. 

One of the main drawbacks was the lack of merchant adoption. Despite signing on thirteen McDonald’s restaurants initially, no one else seemed interested in the option. Debit and credit cards were superior to use in every way, quickly pushing the Avant Card into obscurity. Ultimately, it was discontinued in March of 2006. Around this time, similar efforts in other countries started disappearing as well, as there was no way to compete with debit cards. 

Other Failed Attempts To Date

The concept of a central bank digital currency was rekindled in 2014 by the Ecuadorian central bank. A retail CBDC was created, which could be accessed via a mobile phone. Despite not using blockchain technology, the bank assumed this approach would prove viable. Unfortunately, the project did not last long, as it was canceled in 2018 by the central bank due to a lack of citizen adoption.

Since that time, there have been numerous trials and experiments by various central banks. One can find efforts in the UK, Sweden, Uruguay, Eastern Caribbean, Spain, and others. The majority of these efforts are proofs of concept and not actual currencies as of yet. It is unclear if they will ever leave the “concept” stage, although China’s recently launched effort appears to be ahead of the pack. It is the only CBDC project to be issued to a limited audience, yet no one knows how the project evolves today. 

Implementing a CBDC

One of the pressing questions is how central banks want to create and implement their digital currencies. There are many ways to go about this aspect, yet it remains questionable if they use a blockchain or distributed ledger. As we covered earlier, blockchains can be permissionless- like Bitcoin – or permissioned, where a central authority retains some degree of control. 

A more plausible outcome is how a central bank digital currency is tied to a bank or government database. This database can keep records of the amount of money in circulation and who owns which amounts. Opting for this route will require the use of privacy and cryptographic protections, however. Unfortunately, neither banks nor governments have a good track record regarding these aspects. 

The big difference with traditional cryptocurrencies is how a central bank digital currency will never be decentralized. There always needs to be some degree of central control to keep tabs on the network and adjust where necessary. This also means users will never control their money, similar to how the financial system works today. With a blockchain or other distributed ledger, exerting this top-down control would be challenging, if not nearly impossible. 

Even if the technology is developed to implement a central bank digital currency, it will remain challenging to incorporate it into the real world. Merchants and consumers have dozens of payment options to choose from. Adding a CBDC to the list – unless it is made a mandatory currency – may not be as easy as some governments may think. Moreover, there are no details on the overall costs of using a central bank digital currency or anything along those lines, leaving many questions unanswered. 

What Are The Characteristics?

As a digital financial instrument, every central bank digital currency needs to adhere to high-security standards. What those standards will be, remains undetermined at this time. There can never be a way to create more currency out of thin air like counterfeiting does to paper notes. Moreover, the system needs to let users retain a degree of privacy, which is rather complex when storing everything in a centralized database. 

One aspect to consider is introducing a way for each unit of account to have a unique identifier. The Bitcoin network has this approach nailed down, yet a central bank digital currency is unlikely to use a blockchain. Developing a different system capable of providing the same security, privacy, and accountability may require significant time and effort. 

Additionally, there is the topic of whether a central bank digital currency will be part of the base money supply. In theory, this is the only viable approach, yet banks and governments can create unlimited amounts of money if they want to. It is not entirely unlikely banks or governments will use a CBDC to create more inflation if they don’t understand the consequences of their actions. Industry standards will need to be drafted to prevent any abuse, misuse, or misappropriation. 

Assuming the CBDC becomes part of the base money supply, it will need to balance other currency forms. It will create more liability for the central bank or government, as they will need to manage the balances alongside overseeing the physical currency. As a digital currency can be stored, transferred, and transmitted relatively freely, keeping a close watch on these proceedings will prove essential. 

A significant part of the characteristics will hinge on how consumers and merchants adopt this central bank digital currency. Creating a digital asset is only the first step, as it needs a broad infrastructure to be helpful in daily life. That means creating wallets, payment processing solutions, and so much more. It is a very daunting task for any bank or government, explaining why such a currency isn’t widely used as of yet. 

The Benefits And Drawbacks Of A CBDC

As is often the case, creating a new [form of] currency will have advantages and potential drawbacks. Striking a balance between both aspects is crucial yet also tremendously challenging. 

Central Bank Digital Currency Benefits

The primary benefits of a CBDC can be classified as follows:

  • Efficiency: the potential of achieving real-time payments
  • Financial inclusion: low-cost access to essential financial services
  • Illicit activity monitoring: a CBDC makes it easier to keep track of payments and recipients, curbing money laundering and tax evasion
  • Modern currency: a CBDC can replace physical cash, preserving the public utility of bank-issued money
  • Broader competition among public and private payment networks
  • Seigniorage preservation: a CBDC cannot disappear from circulation, unlike cash bills and coins, which often need to be replaced
  • New monetary policies: more direct control of the money supply

You Can’t Ignore The Drawbacks

Although all of the above may sound positive, it doesn’t necessarily have to be. Giving a central bank or government even more control over the monetary supply is not always ideal for consumers, merchants, and corporations. 

  • Bank run potential: introducing a CBDC can make many people nervous, tempting to trigger a bank run and withdraw all funds from the system altogether
  • Centralized control: nothing prevents the central bank’s digital currency controllers from adding or removing money from anyone’s balance. 
  • The potential for even broader financial inequality is genuine. 
  • Oversight: who will oversee the behavior by banks or governments regarding a CBDC? They are already the top-level administrators.

Closing Thoughts

The advent of a central bank digital currency is almost upon society. It remains to be seen which country will take the plunge first, although China seems to be ahead of the pack at this time. There is also the question of whether being first to market will offer any significant advantage. Most countries may hold off on experimenting with a CBDC until other currencies have rolled out. Additionally, this entire concept may never gain any traction, like other banks and governments’ attempts to “modernize” money in the past. 

The popularity of Bitcoin and other digital assets confirms there is a space for virtual forms of money to succeed on a global scale. Unlike Bitcoin, however, a CBDC will always have limited appeal, as no currency is accepted globally due to laws, regulations, and governments. Bitcoin and other cryptocurrencies have no one to curb their potential, making them better-suited candidates for global currency solutions. Unfortunately, the adoption of these currencies has proven a bit slow; thus anything can happen in the years and decades to come. 

One viable example of a bank-like digital currency is The Standard’s S-EUR. users benefit from bank-grade security, but with more transparency and control. The support for both precious metals and crypto assets as collateral to generate S-EUR is a big step forward for the DeFi industry.

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