Many central banks have expressed interest in using a digital form of fiat currency known as a CBDC — central bank digital currency.
After reading this, you'll understand:
CBDCs can be interoperable with those from other countries, enabling fast, cheap cross-border payments.
Central bank digital currencies don't necessarily rely on blockchain technology, as cryptocurrency does.
Many CBDC critics worry that digital currencies will enable the government to track all their financial dealings.
Central bank digital currencies (CBDCs) are essentially digital fiat currencies. These are digital currencies issued by a country's central bank and generally aren't backed by another asset. The Federal Reserve, the central bank of the United States, acknowledges that it's considering its own CBDC.
Digital payments have existed since the late 1940s when the first credit card was released, and most American money already exists in a digital format. So, why is the Federal Reserve considering a central bank digital currency?
In this article, we'll discuss CBDCs, how they work, and their pros and cons.
America is becoming less reliant on physical currency, with only 59% of Americans using cash on a weekly basis. Some reports suggest that as few as 18% of global point-of-sale transactions are in cash. Many central banks, such as the Federal Reserve, have expressed interest in using a digital form of fiat currency known as a central bank digital currency. Countries like China, Australia, and India are already using CBDCs.
These digital currencies aren't meant to replace physical money. Unlike cryptocurrencies, they don't have to be backed by fiat currencies to have value since a country's central bank issues them. Still, suppose you divide the United States' M0 money supply (the total of all physical currency in circulation) by its M2 money supply (cash, checking & savings accounts, and short-term savings vehicles). In that case, you'll see that roughly 25% or less of America's money exists as cash. This may lead you to wonder why a CBDC is necessary since most of our money is digital already.
According to a report issued by the White House, CBDCs can be interoperable with those from other countries, enabling fast, cheap cross-border payments. They can also eliminate the risks posed by bank runs, increase financial access for unbanked individuals, and lower costs for financial infrastructure.
Central bank digital currencies don't necessarily rely on blockchain technology, as cryptocurrency does. Some use centralized ledgers or non-blockchain distributed ledgers. Still, blockchain and other distributed ledger technologies, such as directed acyclic graphs, could benefit CBDCs in many ways. For one, these technologies are well-established, so central banks could save time, money, and effort when developing CBDCs. Additionally, cryptocurrency-based ledger technologies are well-known for lightning-fast international settlements. Hedera's distributed ledger technology, hashgraph, is also carbon negative, so a central bank wouldn't expand its carbon footprint when building a CBDC.
CBDCs exist in two forms: wholesale CBDCs and retail CBDCs. Financial institutions generally use wholesale CBDCs to settle large-sum financial transactions and interbank transfers. Retail CBDCs are those that individuals and businesses use.
Most, if not all, CBDCs rely on centralized intermediaries to operate. Remember, they are issued by a country's central bank. Although this has numerous drawbacks, there are also several benefits. A centralized CBDC can be closely monitored and controlled by the nation's central bank, meaning it can counteract fraud.
CBDCs generally rely on a permissioned (private) ledger rather than the permissionless ledgers we are familiar with in the cryptocurrency ecosystem. CBDCs can use public-key cryptography (PKC) or zero-knowledge proofs for added security.
Central bank digital currencies seem like a logical progression for the global financial system, and they have many benefits. Still, this system isn't without its faults.
Reduced transaction costs. CBDCs eliminate the need for complex distribution and conversion systems when making cross-border transactions. There would be fewer, if any, intermediaries involved in transactions, meaning general transaction fees would be lower.
Improved financial inclusion. Many cite security concerns as a primary reason for not opening a bank account. CBDCs secured with advanced cryptography may be a more attractive payment option for those with security concerns. According to a report by the International Monetary Fund, bank accounts aren't necessarily required for CBDCs, meaning those without bank accounts can build credit and access lower-interest-rate loans.
Enhanced monitoring and regulation. CBDCs using robust distributed ledger technologies are easily traceable. They can further reduce the use of cash, which is notoriously hard to track. CBDCs can also be regulated more easily than cryptocurrencies since they are issued and controlled by central banks.
Risk of cyber-attacks. Over the years, numerous cyber-attacks have targeted cryptocurrencies, leading to wide-scale losses. However, because cryptocurrency wallets don't store personal information, such as Social Security and bank account numbers, these attacks haven't resulted in identity theft. CBDCs will likely require users to input personal details into their wallets, which could be compromised in a cybersecurity attack.
Privacy concerns. Many CBDC critics worry that these digital currencies will give the government the ability to track all their financial dealings.
Potential to increase inequality. These digital assets will require digital devices and internet access, meaning they won't be accessible to those who lack access to these technologies. They are also a new technology, meaning they could worsen financial illiteracy. Although CBDCs can technically enhance financial inclusion, those who are already financially vulnerable will be at the highest risk of being left behind.
Central bank digital currencies are an exciting concept. However, if not designed and implemented carefully, they could exacerbate existing inequalities and create new ones.
Although distributed ledger technologies aren't required to operate and issue a digital currency, they can eliminate many of the hurdles central banks face when implementing one. The Hedera network is an ideal solution for CBDC issuance since it already has a robust token creation system. Additionally, Hedera is known for low fees, fast finality, and carbon-negative operations.
Hedera provides grants and resources to developers and organizations that seek to launch decentralized applications and has partnered with projects like EMTECH to enhance financial inclusion. EMTECH uses the Hedera API to provide central banking and financial services to populations without adequate access to global financial networks. This exciting project has already brought robust banking services to institutions such as the Bank of Ghana and will continue to enhance financial access for underserved populations.