CBDCs — The fight for fiat currencies to remain relevant in the age of digital cryptocurrencies

• Many countries are looking at launching a central bank digital currency (CBDC) to take advantage of blockchain technology without losing control over the supply of money in their respective economies.
• Such digital currencies are intended to be stable in value, unlike the inherently volatile Bitcoin.
• 83 countries are currently in the process of testing CBDCs even though the end goal may vary from geography to geography.

By the year 2027, many will transact using truly ‘digital rupees’, trade online using Tether and pay for Chinese imports with ‘digital yuan’, at least according to enthusiasts lobbying for cryptocurrencies to become mainstream.

Cryptocurrencies aren’t only private virtual assets like Bitcoin, Ether or Solana — any form of digitally transferrable currency secured using cryptography, usually using a blockchain or encrypted ledger that records all transactions made comes under the umbrella of cryptocurrencies. This includes central bank digital currencies (CBDCs).

Major countries like Sweden, Uruguay, South Korea, China, the US and India are already on the bandwagon — each at different stages of launching their own CBDC using blockchain technology.

CBDC projects around the world
Source: The Atlantic Council

However, not everyone is excited to use a new type of currency. Sceptics prefer the current status quo of ‘normal’ rupees and dollars, seeing no need to change what works. Many believe co-opting cryptocurrency would damage the economy and invite trouble.

Regardless, CBDCs seem inevitable. As of mid-2021, 83 countries that represent most of the world economy, had shown interest in launching their own CBDC. The countries have different goals, ranging from simply complementing existing national currency to stay relevant, all the way to displacing and eliminating the appeal of decentralised cryptocurrencies such as Bitcoin.

The most significant has been China’s Digital Yuan (e-CNY) – in trials since a year with selected participants. As of July 2021, the trials included 19 companies, over 20 million wallets/users, and over $5 billion worth of transactions.

Nations need to keep up with private cryptocurrencies — or risk missing the bus

Some, like the Bank of International Settlements (BIS) — also called the ‘central bank of central banks’ — believe that countries may be losing the race against private cryptocurrencies. The old guard came out firmly in support of CBDCs last weekend. The head of the BIS, Benoît Coeuré, warned that central banks need to keep up with developments in the private sector such as cryptocurrencies.

Speaking at the Eurofi Financial Forum, he highlighted that central banks have the responsibility to develop their CBDCs for more than just international settlements, since digital assets are reorienting the economy.

Nations need to address attendant regulatory challenges, stabilise the economy, and bring in control by accountable institutions instead of for-profit entities. Welcoming competition and innovation, he expressed that countries should enable an open and safe platform around which the new payment system can organise.

Stablecoins — The origin story of CBDCs

Governments and global financial institutions, like the World Bank and the International Monetary Fund (IMF), argue that Bitcoin and its fellow altcoins are too volatile in value to be used as a currency. Its supply is limited and it’s traded more like an asset rather than a ‘currency’ — not that it has stopped countries like El Salvador and Panama to look at it as legal tender.

Like paper money and stock markets in preceding centuries, it was clear to central banks that blockchain and crypto were innovations that made people richer. But the big question they faced was how to reconcile a controlled national currency with the disruptive potential of legitimised cryptocurrency.

Those aspects of concern were exactly what economists would study with the rise of stablecoin — a type of cryptocurrency, designed for minimum volatility. It does so by pegging its value to existing instruments like the US dollar. Its control is more centralised, and new coins are issued by the company backing it with its own reserve of the fiat currency.

Conveniently for them, major stablecoins such as Tether (USDT) and USDCoin (USDC) have ridden out allegations of not being fully backed by claimed reserves thus far. For reference, national currencies today are ‘fiat money’ whose value ‘floats’ simply based on confidence in the country, and have not been linked to gold reserves since decades.

The stablecoin experiment seemed to have answers, and central bankers were watching and taking notes. If the current financial system wanted to hold its own against decentralised cryptocurrencies, a CBDC would be their best chance yet.

CBDCs versus stablecoins — it’s a competition of intensity

On the surface, the differences between a generic stablecoin and a generic CBDC could be a matter of degree.

Stablecoins vs CBDCs — Five major features compared

Benefits of CBDCs — making the case for a government-owned cryptocurrency

While some laud the transparency CBDCs could provide, others see it as state surveillance. However, there are other benefits to a country launching its own digital currency. A centrally controlled national currency, which increases liquidity in the financial system could seem attractive, especially since it could fuel faster GDP growth.

To an everyday person, a hypothetical digital rupee — perhaps e-INR — would not be very different from the normal rupee they use for transactions online. The difference could be lower fixed costs for digital-only bank accounts, an inclusive financial system, lower transaction cost, and fewer merchants who accept the e-INR initially — any ecosystem takes time to build.

Keep in mind, an e-INR has no physical form, so it would be entirely accounted-for at tax time, and always present in people’s accounts for banks to further lend to others.

The pitfalls of CBDCs

Unplanned spending over the past two years due to the COVID-19 pandemic and global conflicts have amounted to trillions of extra dollars globally, financed by budget deficits. Government budgets and sovereign currencies are already on shaky footing, even before considering the impact of digital currencies.

You may not be looking for a shortcut to earn some quick money but rest assured that many others are. In the case of CBDCs, a currency that is entirely digital, circulating between users through a central server would concentrate the risk of hacker attacks on a single point.

Vulnerabilities in such a currency, its policies and its trade patterns may cause a vicious circle of hyper-inflation. For example, sceptics believe there is a chance that the normal and digital currency variants may eventually be valued differently due to limitations and trade volumes. That could make one e-INR worth less than one standard INR, leading to confusion and price mark-ups that spiral prices upwards continuously.

As with anything digital, further risks that can’t be imagined today may arise at any time, related to the underlying software. To an average user though, a CBDC is risky only to the extent of privacy concerns.

On the whole, a well-implemented CBDC could be an improvement over our current conventional banking system – perhaps even the logical next step for centralised banking as it exists today, but only time will tell.

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