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Market Update - What are CBDCs?

Central banks and digital currencies

Bitcoin and other cryptocurrencies have entered the public consciousness in a big way, and not only because of the incredible volatility and the fortunes that have been made and lost on them. It’s also the revolutionary aspect of this new form of money which excites many people, as it brushes aside governments and central banks. Bitcoin is of finite supply, and for many people a truer and more honest medium of exchange than anything governments have created. But twelve years isn’t long enough to establish trust in Bitcoin or the thousands of other cryptos out there. There have been too many scams, hacks, and thefts from exchanges, along with stories of missing wallets and lost codes that continue to undermine investor confidence. For most people, let alone investors used to dealing in equities and other financial assets, there’s no straightforward way of buying and storing cryptos. Even if you do take the time and effort to research the best exchange and storage methods, there’s a strong likelihood that your bank will block any transfer request you make when it concerns cryptocurrencies.

Bitcoin not money?

It's often said that Bitcoin will never be widely accepted as money as it doesn’t fulfil the basic definitions. To be money it should be widely accepted as a medium of exchange and a reliable store of value. While Bitcoin may fail these tests now, it may not in the future. Also, different cryptocurrencies are designed to do different things. For instance, whereas Bitcoin is a digital form of money, Ethereum is a ledger technology and a network for smart contracts, using a token called ether.

Types of crypto

Broadly speaking cryptocurrencies break down into three types – decentralised cryptocurrencies, stablecoins and central bank digital currencies (CBDC). Decentralized cryptocurrencies are unregulated tokens like Bitcoin, Ether, Ripple and Dogecoin. They can be exchanged for goods or services like traditional currencies. Most use distributed ledger technology, such as blockchain, that can confirm tokens as valid and log transactions. They are issued by a network, and not any central authority or government. Stablecoins also use distributed ledger technology, but they are pegged to an existing entity, like the US dollar or a commodity like gold. This, in theory, should reduce their volatility. Examples include Tether and Facebook's Libra project, now known as Diem. CBDCs are the newest cryptos on the block. They are issued by governments and are basically digital versions of an existing national currency. Central banks have been rattled by the growth in digital currencies and are worried that Bitcoin and others, particularly stablecoins, could eventually undermine traditional fiat currencies, including the world’s reserve currency, the US dollar. CBDCs use the same underlying distributed ledger technology of cryptocurrencies. But governments recognize CBDCs as legal tender in the issuing central bank's jurisdiction, meaning anyone can use them for payments and every merchant must accept them. They are currently under development and several central banks are running feasibility studies. These include the People’s Bank of China, the European Central Bank, Sweden, the Bahamas, the US, and the Bank of England.

What are CBDCs for?

But why should a government issue a CBDC when fiat currency exists? How would a CBDC differ from the electronic money we already use such as credit cards and online banking? With a CBDC it is the government that is the counterparty and accepts liability for the money. That contrasts with a commercial bank cash deposit where the bank takes responsibility, and your deposit sits in the bank’s own ledger. With the government as counterparty this raises the possibility of more efficient clearing which would lead to faster processing and transfers. CBDCs could also improve the efficiency of cross-border payments if countries work together. But it also means that the government could control how your money is spent. For instance, there may be governments that allow you to buy food, clothing, and medical supplies, but not cigarettes or alcohol.

Leading the charge

Perhaps it’s unsurprising that China is leading the way with its digital yuan. It has already been used in $5 billion-worth of transactions in a trial version. A digital yuan would be the ultimate way for China to control citizens in terms of how much they get paid, and for what, and what they spend this money on. It is this controlling aspect along with the privacy angle which are the greatest concerns. Some have said that the US has been slow off the mark when it comes to CBDCs. Perhaps not for long, especially if a digital yuan were to threaten the dollar’s reserve status. To avoid a backlash about privacy and control, the US could develop a CDBC with limits about its use. It would also be more acceptable if the CBDC lived alongside existing forms of money, including physical cash, bank deposits and other cryptos. The trouble is that there have been far too many calls for cryptocurrency regulation in the US and elsewhere. While some oversight may boost confidence in cryptos, too much would kill what is an exciting, and beneficial technology. Why not build on that and encourage development in this area? There is plenty of room for unregulated and volatile cryptos, some light-touch regulation on stablecoins, together with fully regulated CBDCs. Let the developers and entrepreneurs do their thing and all could flourish together.

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