Home Beginner Understanding Central Bank Digital Currencies – CBDC

Understanding Central Bank Digital Currencies – CBDC

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Are Central Banks going to Adopt Own Cryptocurrencies
Are Central Banks going to Adopt Own Digital Currencies/ CBDC?

How did we get here?

In 2008, the world experienced a financial meltdown, now known as “once in a century credit tsunami”. Before the 2008 crisis, the US was experiencing a housing boom, which was fuelled by an unregulated shadow banking system. The lack of effective regulation and oversight by the Federal Reserve fuelled the crisis further, many large financial institutions were struggling to manage own risks. Consequently, creditors and investors lost trust and confidence in these institutions. More specifically, concerns if these institutions would be able to meet short-term liabilities and concerns over their liquidity. Notably, the US investment bank “the iconic” Lehman Brothers filed for bankruptcy in the year 2008. Finally bursting the financial bubble, and creating a disaster, which led people to lose trust and confidence towards banks more so, central banks.

The financial crisis shook people faith in banks and the emergence of new alternatives was bound to gain enormous momentum. Researchers and computer scientists were working tirelessly to solve various issues with money and financial systems. For instance, in 1983, David Chaum introduced the first concept surrounding the idea of digital currencies and formed digital cash. His idea was to have a digital currency system that improved on three things namely personal privacy, control and auditability. In his paper, David discusses this core concept through blind signatures a cryptography technology aimed innovating further the automated payment systems of the world.

Then came Satoshi Nakamoto in November 2008 when he announced his success realized in a project dubbed “a new electronic cash system that’s fully peer-to-peer with no trusted third party”. Satoshi further argued in his Bitcoin whitepaper that banks and central banks often breach people’s trust by actions of banks lending people’s money in credit bubbles and maintaining very little as a reserve. Thus, as was experienced during the 2008 financial crisis central banks and other financial institutions due to maintaining such minimal reserve become vulnerable to liquidity problems. Therefore, inconveniencing the people who deposit with banks when they need their money back. All this shows Satoshi’s dissatisfaction with working of the current financial system thus the birth of Bitcoin. Fast forward to the year 2011, the concept of cryptocurrencies gained popularity. Litecoin and Ether came into existence in 2011 and 2015 respectively. Ever since new cryptocurrencies are announced each year with the highest number recorded in 2017 at the height of Bitcoin all-time high price to date reaching $20K mark.

So what is a Central Bank Digital Currency (CBDC)?

In the simplest terms, a CBDC is fiat money in the digital form also known as digital fiat money. In practicality, it is a digital extension on the medium of exchange by a central bank to aid settling of a transaction between involved parties. Any party within the central bank network thus can instantaneously transfer value to any other party as long as they are party to the network. Therefore, central banks issuing CBDC will be able to remove credit risk as well as ensure the digital fiat money stability through guaranteeing of its value just as it happens with paper money.

Central Bank’s Stance on CBDC’s

A study conducted by the Bank for International Settlements (BIS) reveals a spiking interest in introducing CBDC is high in emerging economies compared to advanced economies. Out of the 63 central banks participants to the BIS survey, 41 were from emerging market economies and among these 70 per cent were keen on implementing a CBDC. Some had either adopted own CBDC or in the process as illustrated below.

Central Bank Digital Currencies Defined
Countries so far interested in CBDC (Source BIS, 2019)

Benefits of a CBDC

Central banks introducing own digital currencies aim to improve on cost, speed and efficiency. Besides, CBDC’s are developed to overcome limitations experienced in present financial systems including resilience and systems security. For example, an effective CBDC should aim at reducing operational costs and risks. This is possible through the central bank’s ability to tokenize financial assets and have them recorded on distributed ledgers thus taking advantage of such productivity gains.

Risks Associated with Central Bank Digital Currency

Central banks issuance of CBDC poses threats to existing financial systems. For instance, during political or financial crisis access to CBDC will have financial product users run from commercial banks to the state. Hindering ability of commercial banks to make loans or meet other financial obligations, as creditors no longer deposit funds into the banks. Worse still unstable countries either politically or financially will experience a high level of capital flight to those countries perceived as stable.

Conclusion

It is likely in the next 3 to 5 years as the knowledge and cryptocurrencies continue to spread, more central banks will look into issuing own CBDC. This may be largely inspired by the need to regulate the emergence and use of some cryptocurrencies. Also, geopolitics and a certain sense of state’s exclusionism as well will influence certain government’s stance on the need to issue own central bank digital currency. Irrespective of the benefits aforementioned, striking of balance is necessary to avoid crowding out commercial banks at least not for now.

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