TL;DR
At this point, we all heard the great things Bitcoin provides us. Except you can’t really use it for daily economic activities, like buying coffee or paying off your taxes. So what to do? While Bitcoin serves as digital money, it is not so useful as a day-to-day currency. Luckily for us, there is another type of digital asset whose purpose is for daily economic use: central bank digital currency (CBDC).
Many economies and countries across the world are exploring the idea of a fully digital currency, while other countries are testing and implementing the idea. However, the golden question is, how does it work?
Introduction
Technology as a whole has made leaps and bounds in almost every industry. Traditional finance in a sense still hasn’t experienced much change and innovation until recently. While it is more than just sending bits of information from one place to another, sending money over the current traditional financial way can be costly and time-consuming.
Many governments across the world are currently researching and actively developing the technology in place to have a new digital currency. The main difference between this digital currency and the current fiat system in place will be the increased efficiency and lower costs for everyone involved. The new digital currency will be built on blockchain technology.
The likelihood of this technology being adopted within the next decade is high. So how does this digital currency work?
What is Central Bank Digital Currency (CBDC)?
CDBC is simply a digital form of fiat currency issued by a central bank of a country. Think of the Federal Reserve (USA’s Central Bank) issuing a digital dollar coin.
There could be vastly different implementations that are issued by different countries and are based on varying forms of blockchain technology. Some countries could use a distributed ledger, much like Bitcoin, while others could use some form of a centralized database. Just like how blockchain-based projects have a native token, CDDCs could be the native token for blockchain-based ones.
It is also important to note that CBDCs are issued by a state and can be declared legal tender. In other words, a government would accept the CBDCs as the national currency which is a stark difference from cryptocurrencies since they are independent and out of government control.
Many countries are still in the concept phase while others are rolling out experiments with this digital currency. China is a great example when it comes to experimenting with a new digital currency. It has worked on various experiments since 2014 and has rolled out an active trial of the digital yuan across various Chinese cities. Other places that are assessing the potential benefits of digital currency are Europe. The European Central Bank (ECB) has rolled out experiments that assess the merits of rolling out a digital currency.
Central Bank Digital Currencies (CBDC)
From a technological standpoint, CBDCs don’t differ too much from current cryptocurrencies. They are essentially a database controlled by the government or private sectors (who have been approved by the government). This will be a permission database as only approved actors can transact on the network.
One outcome of this is that the central authority controlling the database has the ability to prevent transactions from being completed. They could also revert transactions, “freeze” accounts, and even blacklist addresses.
Many CBDCs could run on top of their own blockchains. Nonetheless, some may be issued on a public blockchain which could allow for permission assets to be settled on top of a permissionless layer. In this scenario, the blockchain could guarantee the control and security of the network.
Nevertheless, having a public blockchain would be difficult to implement. It would be difficult for it to have the capacity to handle such a task. Though generally, blockchain would be the method of choice, it is difficult to outline how it might work since every country could tailor their CBDCs in a way that is conducive to their specific needs.
Perks of Central Bank Digital Currencies (CBDCs)
Cryptocurrencies have allowed many people who would normally not be able to have a bank account due to access or costs, to have one. The phrase “banking the unbanked” comes from that. CBDCs could play a major role in allowing citizens to have a bank account that is easily accessible at low costs.
Another benefit of CBDCs is the improvement of the outdated system. An example is the transfer period. Sending money over blockchain takes a matter of seconds while sending that over the current financial system can take days.
Further, another reason to subscribe to such a system is due to efficiency. One notable example is Covid-19. The government could respond to covid relief funds a lot sooner rather than weeks or months.
Another thing is that it helps the government track illicit money activity. In the current system, it is much more difficult to track dollars than it is to track digital currency. CBDCs would allow the government to track every economic activity.
CBDCs vs Cryptocurrencies
One of the main differences is centralization. CBDCs are centralized while cryptocurrencies are not. One popular example is Bitcoin. You could send money over the blockchain to someone else without concerning yourself with national borders or central authority.
Cryptocurrencies like Bitcoin don’t concern themselves with borders and are truly decentralized. However, there are downsides. One of them is that if you were to send your money to the wrong address it would be impossible to reverse that transaction. Whereas a central currency like a CBDC could aid in that issue.
It depends on which perspective you look at it. Often it is good if a central authority aids in reverting transactions or blacklisting addresses, other times it may seem like a breach of privacy and lack of control for your own money.
CBDCs vc Stablecoins
Another common comparison for CBDCs is stablecoins. Stablecoins are cryptocurrencies whose goal is to mimic an underlying currency. For example, Tether USDT tracks the price of a dollar where 1 U.S Dollar is equal to 1 US Tether.
Although they may seem like the same thing, under the hood they represent vastly different goals. For one, a stablecoin is issued by a private entity and could be redeemable for the value it represents. On the other hand, a CBDC is just a digital asset that takes over for a fiat currency. They are issued by the government as fiat currency.
Final Thoughts
CBDCs are a form of fiat currency displayed digitally. It seeks to improve and use the blockchain technology that has created many of the popular cryptocurrencies today. Many CBDCs that will be issued across the world will have some form of blockchain technology. Their goal is to make economic transactions frictionless and
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